Project finance is the financing of long-term infrastructure and industrial projects based upon a complex financial structure. Project financing plays a pivotal role in development of any economy/ sector. It is a technique of employing a carefully engineered financing mix. A judicious combination of debt and equity needs to be used to finance the project, and debt is repaid using the cash-flow generated by operation of the project, rather than the resources of the project sponsors. The financing is typically secured by all of the project assets. Project lenders are given a lien on these assets, and are able to assume control of a project if the borrowers have difficulties complying with the loan terms.
Project financing discipline includes understanding the rationale for project financing, preparation of the financial plan, assessment of the risks, designing the financing mix, and raising the funds. In addition, one must understand the cogent analyses of why some project financing plans have succeeded while others have failed. A knowledge-base is required regarding the design of contractual arrangements to support project financing; issues like the host of legislative provisions, government and administrative constrains, public and private infrastructure partnerships, public and private financing structures; credit requirements of lenders, how to determine the project's borrowing capacity; how to prepare cash flow projections and use them to measure expected rates of return; tax and accounting considerations; and analytical techniques to validate the project's feasibility.
Project finance is finance for a particular project, such as a mine, toll road, railway, pipeline, power station, hospital, which is repaid from the cash-flow of that project. Project finance is different from traditional forms of finance because the financier principally looks to the assets and revenue of the project in order to secure and service the loan. In contrast to an ordinary borrowing situation, in a project financing the financier usually has little or no recourse to the non-project assets of the borrower or the sponsors of the project. In this situation, the credit risk associated with the borrower is not as important as in an ordinary loan transaction; what is most important is the identification, analysis, allocation and management of every risk associated with the project.

Types of risks
Financiers are concerned with minimising the dangers of any events which could have a negative impact on the financial performance of the project, in particular, events which could result in the project not being completed on time, on budget, or at all; the project not operating at its full capacity; the project failing to generate sufficient revenue to service the debt; or the project prematurely coming to an end.
Every project is unique and it is not possible to compile an exhaustive list of risks or to rank them in order of priority. What is a major risk for one project may be quite minor for another. In a vacuum, one can just discuss the risks that are common to most projects and possible avenues for minimising them. However, it is helpful to categorise the risks according to the phases of the project within which they may arise (1) The design and construction phase; and (2) The operation phase. It is useful to divide the project in this way when looking at risks because the nature and the allocation of risks usually change between the construction phase and the operation phase.

Construction phase risks
Completion risk allocation is a vital part of the risk allocation of any project. This phase carries the greatest risk for the financier. Construction carries the danger that the project will not be completed on time, on budget or at all because of technical, labour, and other construction difficulties. Such delays or cost increases may hold up loan repayments and cause interest and debt to accumulate. They may also jeopardise contracts for the sale of the project's output and supply contacts for raw materials.
Commonly employed mechanisms for minimising completion risk before lending takes place include: (a) obtaining completion guarantees requiring the sponsors to pay all debts and liquidated damages if completion does not occur by the required date; (b) ensuring that sponsors have a significant financial interest in the success of the project (c) requiring the project to be developed under fixed-price, fixed-time turnkey contracts by reputed and financially sound contractors whose performance is secured by performance bonds or guaranteed by third parties; and (d) obtaining independent experts' reports on the design and construction of the project.

Operation phase risks
These are business risks that may affect the cash-flow of the project by increasing the operating costs or affecting the project's capacity to continue to generate the quantity and quality of the planned output over the life of the project. Operating risks are impacted by the level of experience and resources of the operator, inefficiencies in operations or shortages in the supply of skilled labour. The usual way for minimising operating risks before lending takes place is to require the project to be operated by a reputable and financially sound operator whose performance is secured by performance bonds. Operating risks are managed during the loan period by requiring the provision of detailed reports on operations of the project and by controlling cash-flows by requiring the proceeds of the sale of product to be paid into a tightly regulated proceeds account to ensure that funds are used for approved operating costs only.
Resource/reserve risk: This is the risk that is peculiar for mining projects, whether there are adequate inputs that can be processed or serviced to produce sufficient return. Such resource risks are usually minimised by: (a) experts' reports as to the existence of the inputs (e.g. detailed reservoir and engineering reports which classify and quantify the reserves for a mining project) or estimates of public users of the project based on surveys and other empirical evidence (e.g. the number of passengers who will use a railway); (b) requiring long-term supply contracts for inputs to be entered into as protection against shortages or price fluctuations (e.g. fuel supply agreements for a power station); (c) obtaining guarantees that there will be a minimum level of inputs (e.g. from a government that a certain number of vehicles will use a toll road); and (d) "take or pay" off-take contacts which require the purchaser to make minimum payments even if the product cannot be delivered.
Political risks: This is the danger of political or financial instability in the host country caused by events such as insurrections, strikes, and suspension of foreign exchange, creeping expropriation and outright nationalisation. It also includes the risk that a government may be able to avoid its contractual obligations through sovereign immunity doctrines. Common mechanisms for minimising political risk include: (a) requiring host country agreements and assurances that project will not be interfered with; (b) obtaining legal opinions as to the applicable laws and the enforceability of contracts with government entities; (c) requiring political risk insurance to be obtained from bodies which provide such insurance (traditionally government agencies); (d) involving financiers from a number of different countries, national export credit agencies and multilateral lending institutions such as a development bank; and (e) establishing accounts in stable countries for the receipt of sale proceeds from purchasers.
Force Majeur risks: This is the risk of events, which render the construction, or operation of the project impossible, either temporarily (e.g. minor floods) or permanently (e.g. complete destruction by fire). Mechanisms for minimizing such risks include: (a) conducting due diligence as to the possibility of the relevant risks; (b) allocating such risks to other parties as far as possible (e.g. to the builder under the construction contract); and (c) requiring adequate insurances which note the financiers' interests to be put in place.

Risk mitigation process
The minimisation of project risks involves three steps. The first step requires the identification and analysis of all the risks that may bear upon the project. The second step is the allocation of those risks among the parties. The last step is creation of mechanisms to manage the risks. If a risk to the financiers cannot be minimised, the financiers will need to build it into the interest rate margin for the loan.
Step 1 - Risk identification and analysis: The project sponsors will usually prepare a feasibility study, e.g. as to the construction and operation of a mine or pipeline. The financiers will carefully review the study and may engage independent expert consultants to supplement it. The matters of particular focus will be whether the costs of the project have been properly assessed and whether the cash-flow streams from the project are properly calculated. Some risks are analysed using financial models to determine the project's cash flow and hence the ability of the project to meet repayment schedules. Different scenarios will be examined by adjusting economic variables such as inflation, interest rates, exchange rates and prices for the inputs and output of the project. Various classes of risk that may be identified in a project financing will be discussed below.
Step 2 - Risk allocation: Once the risks are identified and analysed, the parties through negotiation of the contractual framework allocate them. Ideally a risk should be allocated to the party who is the most appropriate to bear it (i.e. who is in the best position to manage, control and insure against it) and who has the financial capacity to bear it. It has been observed that financiers attempt to allocate uncontrollable risks widely and to ensure that each party has an interest in fixing such risks. Generally, commercial risks are sought to be allocated to the private sector and political risks to the state sector.
Step 3 - Risk management: Risks must be also managed in order to minimise the possibility of the risk event occurring and to minimise its consequences if it does occur. Financiers need to ensure that the greater the risks that they bear, the more informed they are and the greater their control over the project. Since they take security over the entire project and must be prepared to step in and take it over if the borrower defaults. This requires the financiers to be involved in and monitor the project closely. Imposing reporting obligations on the borrower and controls over project accounts facilitates such risk management. Such measures may lead to tension between the flexibility desired by borrower and risk management mechanisms required by the financier.

Conclusion
Project financing discipline includes understanding the rationale for project financing, preparation of the financial plan, assessment of the risks, designing the financing mix, and raising the funds. Proper identification, analysis and allocation of risks at the construction and the operation phases are very important. Effective management of risks proves to a key for successful project financing.}

(Dr. CA Varadraj Bapat is Assistant Professor, Finance Area, and Neha Parekh is a Second Year MBA student, National Institute of Industrial Engineering.)