The available resources of our Latin American countries, which are always limited and insufficient to carry out the works that development requires, must be used efficiently, always seeking the well-being of the national community, therefore, objective studies and analyzes are required to guarantee this purpose, taking into account the balance between the criteria of equity and efficiency. This determines the need for governments to promote permanent actions and strategies aimed at attracting national and international private capital to share responsibilities, risks and, of course, benefits in the execution and operation of development projects. The golden rule is that private participation should only occur if the “social benefit” derived from the project exceeds its “social cost”.
Benefits arising from the participation of the private sector:
It should be noted some desirable results that would arise from the participation of private investors in the financing, construction and / or operation of the service infrastructure (health, education, housing, roads, ports, airports, generation, transport and distribution of energy, telecommunications, recreational parks, etc.).
- The possibility of having a basic infrastructure for development with the participation of financial, technical, and organizational resources from the private sector that would alleviate the burdens of the public sector, whose released resources would be directed more effectively to the security, justice, defense and defense services. other meritorious needs that cannot be delegated to other private agents or that do not arouse their interest as they do not contain financial returns The opportunity to generate employment through these projects and improve the qualification of workers Construction of additional public service works such as centers health, schools, sewers, aqueducts, housing, fire stations and others that may be triggered by the construction and operation of a project of any magnitude.The establishment or expansion of an industrial base that provides materials and inputs to the needs of the project in its execution stage and during operation The increase in tax resources generated by income, valuation, new land use, industry and commerce The multiplier effect in industry, commerce and employment, which is always manifested as a dynamizer of the economy due to the effect of carrying out large infrastructure works The ability of private companies to generate and show high management rates efficiency and competitiveness, which is rare in the public sector.The increase in tax resources generated by rent, valuation, new land use, industry and commerce, etc. The multiplier effect in industry, commerce and employment that is always manifested as a dynamizer of the economy due to the effect of realization of large infrastructure works The ability of private companies to generate and display highly efficient and competitive management indexes, which is not frequently found in the public sector.The increase in tax resources generated by rent, valuation, new land use, industry and commerce, etc. The multiplier effect in industry, commerce and employment that is always manifested as a dynamizer of the economy due to the effect of realization of large infrastructure works The ability of private companies to generate and display highly efficient and competitive management indexes, which is not frequently found in the public sector.that does not occur frequently in the public sector.that does not occur frequently in the public sector.
Self-financing of projects (project finance)
Self-financing (project finance) is conceived when an organization is established as a business to build, own and operate a project profitably as an independent economic unit. The company created finances its construction based on the project notion, which implies the issuance of shares and / or debt securities designed as self-liquidating exclusively with the income derived from the operation of the project. In effect, project self-financing is a mechanism for obtaining funds to attend an investment project in which the cash flow of funds is considered as the origin of the resources for debt service and the return on the capital invested in the project. With this modality you can finance oil pipelines, refineries, electricity generating plants, hydroelectric projects,port construction, mining exploration and exploitation, and in general all kinds of infrastructure works that require a large amount of financial resources.
Some authors point out that the first project financed with this modality dates from the 13th century, when the British crown obtained a loan from Florentine bankers to develop a mining project in Devon. The condition established then was that said debt would be amortized only with the proceeds from the sale of the mine's production during a specified period. This financing mechanism for large works has been evolving at the same time that new financial engineering techniques are discovered and put into practice, applied mainly to projects with the following characteristics: long-term (long execution period, sufficient operating time to generate the resources necessary to service the debt and other debts);significant resource requirements and incidence of commercial, technical and political risks.
The magnitude of these projects implies the presence of a fairly heterogeneous financing package: risk capital, funds generated by the project and debt provided by multilateral agencies and organizations, commercial banks, insurance companies and pension funds, and in general, the capital market. Given the magnitude of these projects, it implies the availability of huge long-term resources that conventional commercial banks do not handle and governments are not able to attend because they must commit a large part of their budgets to social development works.
The structure of this modality supposes:
- The preparation of rigorous pre-investment studies that allow with a high degree of reliability to project the flows of funds for the entire horizon of the project. The preparation of complex contracts that establish the commitments and rights of a financial, technical and legal order between the different agents involved.
The complexity of this financing modality involves a heterogeneous number of independent agents, these are:
- Project-company: it is the company that is constituted and is responsible for the execution and operation of the project, therefore it stands as a debtor of the financing and recipient of the resources derived from the operation and sale of the products. The promoters' financial risk is reduced to their capital contributions, which means that the sole liability for the debt will be backed by the assets of the "project company" and its cash flows. The most appropriate legal form for the project company is usually a public limited company (which limits the responsibility of the partners to the amount of their shares or contributions). Promoters or managers: they assume the task of designing and establishing a new company or organizational vehicle through of some suitable mechanism (consortium, association, joint venture, trust, etc.) formed with the assets of the project. Debt agents: commercial banks, export promotion agencies, multilateral development organizations, pension funds, insurance companies and in general the capital market are the providers of resources. Generally, commercial banks subscribe short- and medium-term debt for construction and then syndicate other institutions so that once the construction is finished, they transform them into long-term loans. International agencies such as the IDB, World Bank, CAF provide financing protected from political risks and which also tend to provide confidence to other investors.Executor or builder: another strategic agent is the specialized firm that can guarantee the construction and start-up of the project.A fixed price turnkey contract is generally signed with the expert firm that rewards efficiency and punishes non-compliance. This contractor in turn carries out various types of subcontracts with specialized companies. Suppliers: to guarantee the operation of certain types of projects, long-term purchase contracts are signed with suppliers for some necessary input. Buyers: to ensure the security of the flows of Income, long-term contracts are also signed with potential buyers of the product or users of the services, respectively. Operator: for proper operation and maintenance, specialized national or foreign firms are hired. Advisors: given the financial, technical and legal complexities of each the agents involved link all kinds of advisers (bankers,financiers, lawyers, technicians, financial engineers, insurers, stock brokers, etc.) to guide them in making decisions State: given the need to free up resources for projects with a social content, the State has a special interest in promoting this modality to execute infrastructure projects necessary for development. In the case of infrastructure construction, the State transfers risks to the private sector and at the same time ensures that the project operates properly for the benefit of the general interest, in addition, it allows the entry of fresh capital that invigorates the economy, promotes the transfer of technology, the qualification of the workforce improving the competitiveness of the country.) to guide them in decision-making. State: given the need to free up resources for projects of social content, the State has a special interest in promoting this modality to carry out infrastructure projects necessary for development. In the case of infrastructure construction, the State transfers risks to the private sector and at the same time ensures that the project operates properly for the benefit of the general interest, in addition, it allows the entry of fresh capital that invigorates the economy, promotes the transfer of technology, the qualification of the workforce improving the competitiveness of the country.) to guide them in decision-making. State: given the need to free up resources for projects of social content, the State has a special interest in promoting this modality to carry out infrastructure projects necessary for development. In the case of infrastructure construction, the State transfers risks to the private sector and at the same time ensures that the project operates properly for the benefit of the general interest, in addition, it allows the entry of fresh capital that invigorates the economy, promotes the transfer of technology, the qualification of the workforce improving the competitiveness of the country.Given the need to free up resources for projects with a social content, the State has a special interest in promoting this modality to carry out infrastructure projects necessary for development. In the case of infrastructure construction, the State transfers risks to the private sector and at the same time ensures that the project operates properly for the benefit of the general interest, in addition, it allows the entry of fresh capital that invigorates the economy, promotes the transfer of technology, the qualification of the workforce improving the competitiveness of the country.Given the need to free up resources for projects with a social content, the State has a special interest in promoting this modality to carry out infrastructure projects necessary for development. In the case of infrastructure construction, the State transfers risks to the private sector and at the same time ensures that the project operates properly for the benefit of the general interest, in addition, it allows the entry of fresh capital that invigorates the economy, promotes the transfer of technology, the qualification of the workforce improving the competitiveness of the country.It allows the entry of fresh capital that invigorates the economy, promotes the transfer of technology, the qualification of the workforce, improving the country's competitiveness.It allows the entry of fresh capital that invigorates the economy, promotes the transfer of technology, the qualification of the workforce, improving the country's competitiveness.
The attached figure presents a self-financing scheme based on the project that is located as the center of all activity. Raw material and supply contracts are directed to the center, while production proceeds from there and sales contracts are consolidated, generally long-term, which will guarantee the income flows necessary to service the debt.. On the other hand, from bottom to top appear the credits and reciprocally the amortization of the debt with interests that are covered with the income derived from the operation of the project. From the bottom to the center, funds flow from equity investors and receive returns in compensation, also served by sales of production.Some passive shareholders (who are not involved in either management or risk) contribute additional resources in search, of course, of satisfactory returns.
STRUCTURE OF THE PROJECT FINANCE
As has been noted, the project-company corresponds to a set of assets (mining or oil reserves, equipment and machinery, buildings, land extension, knowledge and information, etc.) capable of functioning as an independent economic unit. The operations supported by various contractual agreements are organized in such a way that the project has the capacity to generate a sufficient cash flow to pay off the debts and produce satisfactory returns for the different committed agents.
The "self-financing of projects" differs from conventional financing in:
- In conventional financing, creditors consider the total equity of the promoter firm as sufficient collateral to support the debt service. On the other hand, since the project is a different legal entity from the company that sponsors or promotes it, the cash flow of the project is segregated and is completely independent of the sponsoring entity, it is off its balance sheet. In the conventional way, it is clear that control allows owners to allocate project benefits to other activities selected at their discretion. While the income of the project is tied to the credits and the remuneration of the contributions of the different agents.Project finance is designed to distribute returns and risks more efficiently than the traditional structure.
Project-based financing is highly recommended:
- When the expected production experiences such strong demand that buyers express the desire to negotiate long-term contracts. When the contracts have sufficiently firm, reliable and attractive clauses for the banks and financing agencies to be interested in financing the execution of the project.
Many projects with proven reserves of mining or oil exploitation, large infrastructure works, industrial plants, tourist developments, telecommunications projects, etc. In some emerging countries, they are striking for different agents who would be willing to participate in their financial structuring: foreign investors who would contribute capital and operating and administrative technology; buyers who would benefit from long-term contracts advantageous in quantity, quality and price; some eventual manufacturers or lessors of equipment; And of course, the government, stimulated by the growth of infrastructure and by the generation of employment, could grant certain temporary tax exemptions with the incentive to collect significant taxes in the medium and long term.On the other hand, "passive investors" also tend to appear, that is, those who place their capital in search of safe returns but who do not take risks.
It is important to observe the variety of agents involved in the process, who assume greater or lesser risks depending on their level of participation and the expected returns. The challenge is to design a sufficiently structured, clear and explicit “financial engineering” model, backed by contracts that determine the level of resources required, the contributions and incentives from each source and, of course, the diversification of risk among the different protagonists. The aim is to find in the model a balance between performance and shared risk by the different agents involved.
Since the project is constituted as an independent company, it does not have antecedents to support them, therefore the only valid arguments before potential investors are the serious and reliable pre-investment studies, which guarantee a satisfactory level of profitability that is striking for credit support or participation provided by third parties through clear and explicit contractual arrangements.
Obtaining the necessary resources to finance the construction or execution of a project requires convincing eventual long-term lenders of the technical viability, economic feasibility and convenience, and the intrinsic solvency of their finances. Investors are concerned about all the risks that a project implies, they are interested in knowing who and in what way they will face them, and if the returns will be enough to offset the risks they will run. It is clear that the sponsors, as well as the investors and their advisers, must know in depth the technical and legal aspects of the project and the risks it carries,and they must have the ability to independently evaluate financial aspects and their ability to generate a sufficient cash flow to service debt and cover operating costs.
Technological feasibility: pre-investment studies (feasibility) must contain a rigorous detailed engineering analysis that allows validating the technological processes, the size of the plant and its expansion capacity, its location, the chronology of the activities and the costs of the construction. Potential creditors must be sufficiently convinced of the relevance and availability of the technological processes to be used at the stipulated commercial scale. This means that they will demand guarantees that the project will be able to operate at its design capacity, and will seek the assistance of independent consultants and experts who endorse these technical assumptions and confirm that there is a reliable construction program in which it is stipulated:
- Time considered necessary to obtain regulatory approvals and permits and environmental licenses for construction Delivery time of purchased equipment or availability of leased equipment Time required for pre-execution activities: designs, order placement of construction equipment and materials, site preparation and hiring of labor. It is necessary to know the critical path of the construction program and the analysis of the causes that potentially affect the timely delivery of the project and therefore the income flows. That the assigned budgets are sufficient to complete the execution taking into account eventual contingencies.The detailed design and engineering work gives the guidelines for estimating the construction costs of all the facilities necessary for the operation of the project as an independent economic and administrative entity. Construction cost estimates should include an appropriate contingency factor to absorb potential design errors or unforeseen factors. The magnitude of this factor depends on the level of uncertainty in which the construction takes place, but it can be generally estimated at a level of 8% to 10% of the construction budget. It is obvious that the estimates of financial resources for the execution period must include the needs of working capital as well as the amount of interest accrued during the installation of the project.If at the end of the execution the facilities will be able to operate at the planned capacity.
It is obvious that the financial advisor must be aware of possible technological uncertainties and their potential impact on the financing needs, the operational and management characteristics and, of course, the profitability of the project. This does not usually involve major problems when it comes to known and appropriate technologies, but when these are not sufficiently proven, the risks assumed are greater as well as the difficulties in negotiating the participation with investors, who will demand greater guarantees and returns to the extent that technological risks increase.
Financially and economically convenient: that the expected net present value of future cash flows (income) exceeds the expected present value of expenses (investments and operating costs). In any case, the viability of the project depends on the commercial demand for the production or provision of the service in terms of price, volume and quality. To weigh the product market, analysts study the projected demand and supply conditions during the project's useful life. The marketing study is designed to confirm that according to a series of reasonable economic assumptions, the demand will be sufficient to absorb the planned production at adequate prices to cover the cost of production,that allows the project to service the debt and that generates an acceptable rate of return for investors.
Qualified operator: on the other hand, participating agents must be guaranteed that they will have a qualified administration through a highly experienced operator. The project financing system lends itself very well to the incentive system towards the operator, in which the remuneration towards the operator is directly linked to project performance. When managers have a direct participation in the project, they are encouraged to take measures aimed at improving profitability.
Sophistication of financial engineering: creditors may pay special attention to the "credit strength" that the project demonstrates through:
- Inherent value of the assets involved in the project (proven reserves, land, equipment, knowledge and information, etc.). The expected profitability. The amount of capital that the sponsors are risking in the project. The commitment that third parties acquire with the project. project Appropriate technology and safe market for the product.
One of the advantages of self-financing projects is that it allows the distribution of operational and financial risks among the different parties involved. It is usually not practical and a little inappropriate for a single agent to assume the different financial, economic, technical, environmental or political risks. The structure that facilitates multiple ownership and distributes risks is the most suitable for project financing. The leverage capacity that a project can achieve depends on its profitability, the nature and magnitude of the risks, the seriousness of the contracts for the purchase of inputs and the sale of products, and the firmness of the debt and credit arrangements.
From the foregoing, it can be inferred that project financing arrangements always imply contractual relationships between several interested parties, which determines that a genuine concurrence of interests must be established among the participants, which is manifested through an agreement to obtain benefits and risk taking under an agreed financing structure. This is why financial engineering must design a structure that fulfills the aspirations of the participating agents, which will necessarily and unequivocally appear in the corresponding contracts.
Some characteristics of this financing modality:
- This form of financing does not always represent the lowest cost. Since the only resource management tool is the "business plan" supported by rigorous pre-investment studies (feasibility), seriousness and high qualification of the consultants in charge is required, and allocate the time and resources necessary to offer a document that is sufficiently robust and reliable to inform and persuade potential participating agents. They are often costly to negotiate. Financing is structured based on a series of contracts that must be negotiated by all the parties involved in the project, they are usually complex and require more time in the negotiation and agreement process. These higher transaction costs are reflected in the design tasks of the legal, financial and tax structure,in the negotiation of property and credit contracts Credit support for the financing of a project is established through contractual commitments and not through a direct promise to pay Risk Assessment and Weighting: Lenders do not commit to invest in a project until they are sufficiently sure of its technical viability and financial and economic convenience, and therefore require protection against certain basic risks through sufficient guarantees to partially offset and mitigate such contingencies. In effect, investors will demand "security arrangements" designed to transfer to financially sound third parties. The risks that are usually covered through these security mechanisms are:those related to the completion of the construction and execution of the project, the technological risks of incapacity or premature obsolescence, risks that involve the supply of raw materials, risks of an economic, financial, monetary, inflationary, exchange, political, environmental or force nature. A critical aspect of financial engineering for a project involves identifying all relevant risks and then devising contractual arrangements to share them among stakeholders. New financial products such as futures, swaps, interest rate ceilings, have made new schemes available to project managers to manage certain types of risks.Legal structuring: Legal structuring is one of the challenges that experts must face on behalf of of the sponsors,as this depends on various accounting, tax and regulatory factors, and must adhere to the corresponding standards of the countries of origin of the different participating agents. Such is the complexity of the process, both from the legal and technical-financial point of view, which determines that the advisory team must objectively weigh the advantages and disadvantages of each legal organization model, for each of the interested agents.which determines that the advisory team must objectively weigh the advantages and disadvantages of each legal organization model, for each of the interested agents.which determines that the advisory team must objectively weigh the advantages and disadvantages of each legal organization model, for each of the interested agents.
The legal definition of the new entity must take into account:
- The number of participants and the business objective of each one The estimated cost of capital for the project and its profitability index The requirements imposed by the regulatory authorities The debt instruments available The tax situation of the participants The political jurisdiction in which the project will operate.
Formulation of the financial plan: as we noted earlier, the challenge for project managers is to harmoniously serve the benefit of the different participating agents. Lenders will demand greater security, less risk, and timely payment of debts and under the best interest rate and guarantee conditions. The promoters will pursue the cheapest loans, with more flexible conditions and the greater assumption of risks by creditors. It is therefore a question of finding a point of equilibrium in which the parties are satisfied. Given the magnitude of the projects, the necessary concurrence of a series of agents is required to contribute money, take risks and benefit from the results, therefore the legal structuring and financial formulation of the project,It should be of such transparency that potential participants can adequately weigh the costs and benefits that are derived from them, and especially corroborate the autonomous capacity of the project during operation, to generate the resources that allow meeting the tax commitments, those of the service of the debt and, of course, those securities that as profits satisfy the expectations of the agents involved. The design of the plan for the financing of the project includes the obtaining of resources both for the execution and to guarantee sustainability; therefore, it requires the identification and analysis of potential sources of funds and their availability period by period and, obviously,the production and sales scheduling for estimating income in each period of project operation. Therefore, the financial plan must respond precisely to each of the following approaches:
- Level of external indebtedness required (leverage): the feasibility study offers all the pertinent information to measure the capital needs for financing the project both in the execution period and during the operation. The appropriate level of external indebtedness is determined from the debt / equity ratio, and to a greater or lesser degree depends on: the cost of the facilities necessary for execution; financial costs that must be assumed for the financing of the construction and the rest of the administration of the credit; the amount of the needs of the working capital that proscribes any attempt of paralysis due to lack of resources; the expected profitability and operating risks of the project; the ability of sponsors or promoters to contribute capital;the participation as investors of the potential buyers of the product or service, or the intention of participation by input suppliers; solvency of the interested parties in the purchase of the product or service manifested in the signing of solid medium and long-term purchase contracts; and finally a margin of safety that allows to cover eventual unforeseen situations. On the other hand, if technical circumstances allow it in some projects, the start of operations can be scheduled before the total completion of the project (in a modular way), which originates the early availability of certain income that alleviates the amount of the credits Previous commitments to guarantee financial resources:It is obvious that the commitments of lenders and equity investors must be coordinated with the manifest needs of responsible construction contractors and equipment suppliers. Construction does not begin until the sponsors have secured the commitments to cover the expenses necessary to attend the entire installation and start-up of the project (financial closure). In the event that a public offer is chosen to finance construction, it must be supported by solid commitments from reliable financial companies through contingent or stand-by loans that oblige such financial entities to solve the problem of resources in case that the public offer does not have sufficient answers.Adequate synchronization of the execution's own disbursements with the flows originating from the resource providers: the execution program is conditioned to the arrival of resources from the different committed sources. Estimate of the cash flow period by period: of course, that A technically conceived financial plan must harmoniously balance the service of the commitments with the income generated by the project. In principle, the financial information derived from the feasibility studies is usually presented in annual periods, however, the advisers of the parties will have to corroborate the behavior of the cash flows on a monthly scale. The best way is to consolidate long-term purchase contracts that ensure income on certain future dates to meet scheduled expenditures.Selection of currencies to finance the project: when it is agreed to receive money as a contribution or credit or derived from sales, and the payment of receivables in different currencies is also agreed, an exchange rate risk may be incurred that must be mitigated, through negotiation in several currencies that reduces the exchange risk, by weighing their needs according to the origin or destination of the financial resources Estimation of the project horizon or its useful life: it is clear that the maturity of the debt of a Project must not exceed its useful life. Some mineral or oil extraction projects, depending on the rate of production and depletion, can accurately determine their useful life.and the payment of debts in different currencies is also agreed, an exchange rate risk may be incurred that must be mitigated, through negotiation in several currencies that reduces the exchange risk, by weighing your needs according to the origin or destination of financial resources Estimation of the project horizon or its useful life: it is clear that the maturity of a project's debt should not exceed its useful life. Some mineral or oil extraction projects, depending on the rate of production and depletion, can accurately determine their useful life.and the payment of debts in different currencies is also agreed, an exchange rate risk may be incurred that must be mitigated, through negotiation in several currencies that reduces the exchange risk, by weighing your needs according to the origin or destination of financial resources Estimation of the project horizon or its useful life: it is clear that the maturity of a project's debt should not exceed its useful life. Some mineral or oil extraction projects, depending on the rate of production and depletion, can accurately determine their useful life.when weighing their needs according to the origin or destination of the financial resources. Estimation of the project horizon or its useful life: it is clear that the maturity of a project's debt should not exceed its useful life. Some mineral or oil extraction projects, depending on the rate of production and depletion, can accurately determine their useful life.when weighing their needs according to the origin or destination of the financial resources. Estimation of the project horizon or its useful life: it is clear that the maturity of a project's debt should not exceed its useful life. Some mineral or oil extraction projects, depending on the rate of production and depletion, can accurately determine their useful life.
Financing for construction or execution:
- Bank loan: Construction financing can originate from a company or a special finance company that issues promissory notes or raises short-term funds from commercial banks. By using a special finance company, the project company will borrow the money raised by the finance company on similar terms as it was borrowed. While financing for construction is used, research for long-term credit begins to be carried out, for which lenders will be more inclined to replace it, that is, seek financial entities to change short-term credits for Long-term loans Direct loans from sponsors to the project company:a second way is for each of the sponsors to borrow a short-term amount according to their participation from commercial banks and then lend them to the project. Upon completion of execution, the project company negotiates long-term financing backed by income streams derived from production or service provision. At the same time, the project company repays the monies it borrowed from the sponsors with the resources received from long-term financing. Long-term financing: it is not easy to convince investors to accept permanent financing commitments with more than two years of anticipation,especially when the project corresponds to a large engineering work whose execution can last for several years and whose technology has not been sufficiently proven, therefore, they usually require guarantees that all the necessary financing commitments have been consolidated. Securing such funding commitments requires, as a minimum, that the project sponsors sign a termination agreement.
1 Taken contextually from the book “Gestión de Proyectos” (fifth edition) by Juan José Miranda Miranda.
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