Subject: Management of Project Financial Services

Assignment on Risk in Project Finance Submitted to Dr. P.K. Gupta

Caselet: Risk in Project Finance

Vinayak Saini N-82, FMS (PT), Delhi University 2nd Year (2009-2012 Batch)

Caselet on Risk in Project Finance

Project finance is about appraising and financing a project. A project is a proposal for capital investment to develop facilities that provide goods/services in the expectation of a stream of benefits spread over a long-term period. The source of a project involves capital investment in the form of expansion, diversification, replacement and modernization. Even for the new unit sufficient funds are available to promote it. Obviously a project is undertaken with a very clear objective i.e., it must provide a reasonable return on the capital invested therein. To meet this end, when a project is undertaken it is subjected to the process of a rigorous appraisal and assessment of promoter's resourcefulness, track record and commitment to the project. The whole idea about this detailed exercise, known as feasibility study, is to explore whether the proposed project will meet the objective of providing a reasonable return on the capital invested therein or not. Banks and financial institutions have in place, an elaborate mechanism to appraise, assess and analyze the entire report. All wellknown project consultants are also supposed to be in possession of such mechanism for carrying out feasibility studies, and be aware of the criteria applied by the lending institutions in carrying out the appraisals which more or less match with the broad financial requirements. Despite that there is always an uncertainty about the realization of estimated returns. lt is this uncertainty, which is termed here as the risk in project finance. The estimated returns may also not be realized due to non-anticipation of future events or future events not turning as anticipated. The feasibility study formulation and appraisal process takes into account three basic factors general economic conditions, industry factors and company factors. Any adverse unforeseen or unexpected change or a change that is at a variation from expectation in future in any of these factors will lead to enhanced risk and, thus, influence the estimated results negatively. The range of factors influencing the returns is so large and complex that it is not possible to eliminate the risk inherent in any project. Yet, what can be done is minimize it or in other words manage it. Factors like capacity utilization, pricing, availability of raw materials, etc manage such risk and measure the profitability. On the other hand sensitivity analysis, seeks to assess the project viability in adverse scenarios. The project should withstand and justify its financing based on the adverse scenarios so identified and assessed. The crucial importance of risk management in project finance cannot be over emphasized. The tact remains that despite best efforts to mitigate risks, projects fails. Hence, one needs to be extremely cautious and meticulous in project appraisal and institutions need to continuously develop better and more effective techniques of risk management in project finance so as to take care of their own interest, entrepreneurs interest and the nations interest.

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Que.1 List the events that influence the estimated returns leading to risk in project finance. Risks in Project Financing The term Project Financing refers to a wide range of financing structures where the provision of funds is not primarily dependent upon the credit support of the sponsors or the value of the projects physical assets but on projects capacity to serve the debt and provide an equity return to the sponsors through its cash flows. Risk management is important to any operation of project financing as it ensures the completion of the system on time, to budgeted cost and the delivery of service in line with expected standards. As cash flow generation depends on all these variables, financiers are concerned with the feasibility of the project on its whole and with the way to manage the impact of potentially adverse factors. A successful financing structure for satellite projects entails a balanced allocation of project risks among the various interested parties. These risks must be fully understood by all involved parties and must be properly mitigated. Risks associated with Project finance can be broadly classified in following three categories: 1. Regulatory Risks Regulatory is the risk of not obtaining all approvals required to build (e.g. export licenses) and operate (e.g. orbital slots assignment and frequency coordination, landing rights) the system. Inability to understand and interpret the regulatory requirements associated with the project can often lead to smooth and successful completion of the project. The hurdles associated with regulatory issues may lead to long term delays and complex unavoidable situations. One classical example of the regulatory risk is foreseeing the environmental clearance requirements. 2. Completion Risks Completion risk is the risk that the project will not be completed within the established performance, schedule and cost objectives. There are basically three ways of approaching completion risks in project financing: Adopting proven technologies Involving experienced systems manufacturers Defining an adequate contractual structure.

The use of unproven technologies or innovative technical solutions is never welcomed by financiers. Adoption of unproved technologies does not preclude financing innovative systems but decreases the likelihood such systems will be financed on a pure project finance basis. In addition to this, the involvement of established industry players with excellent track record will be a prerequisite to be met by the project in order to raise the necessary funds. Furthermore the contract will be structured around an incentive payment scheme which involves the contractor placing a portion of the contract price at risk. Clearly, the greater is the portion at risk and the level of performance required, the greater is contractors commitment to the new system and, consequently, financiers confidence in the venture. 3. Market risk Market risk is the risk that the target market will not get materialized. In project finance this risk must be carefully assessed and mitigated; the most usual way of doing so is represented by the signing of off-take agreements. An off-take agreement is a contractual obligation by a customer to affect a series of payments over a certain period of time, in exchange for certain products/services. As it is indicated above not only the nature but also the level of project risks varies over the life cycle of a project. The investment phase comprises all the activities associated with the construction of project assets, i.e. the

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capital expenditures relating to the space segment, ground infrastructure and launch campaign. The investment phase starts with financial closing and ends when projects assets are completed. The financial exposure increases throughout the investment phase and reaches its peak when all debt and equity funds have been drawn down. Another classification of the risks associated with Project finance is as per below components: 1. Availability of Raw Material 2. Supply of other sources like labour, capital goods, specialized personnel etc. 3. Change in the statutes or legal formalities 4. Change in the market conditions 5. Interest rate fluctuations 6. General economic conditions like GDP and Inflation 7. Natural calamities

Que. 2 The range of factors influencing the returns is so large and complex that it is not possible to eliminate the risk inherent in any project. Discuss the various measures to minimize risk. The various measures that can be incorporated in order to minimize risk depend on the attitude towards risk of the organization. Based on the risk perception of the risk management team the various ways of managing the risk can be summarized as follows:

Risk Avoidance: Although, every risk can be wholly avoided and that an action that avoids one risk can simply transfer that risk to another area. Risk Reduction: This can be done by reducing the probabilities of the undesired event or reducing the consequence of the undesired event. Risk Transfer: It is a means of deflection by which all or part of the risk is transferred to another party by some form of contract (e.g. insurance, sub-contractors). Risk Retention: A risk can be considered acceptable when its magnitude is less than the prescribed limit. It is an acknowledgement of the fact that risk.

Risk management process can be divided amongst following steps:

1. Risk Identification: This step is of paramount importance in the frame of Risk Management. It does not
matter how good the Risk Assessment or Risk Response Development are, if you have not identified the key risks that are going to affect the project then Risk Management is worthless. Several techniques are available to assist in risk and opportunity identification: expert interviews, analogy comparison, independent technical assessment, etc. Risk Identification may be explored by means of brainstorming techniques in search of potential risks (and opportunities) in several areas (technology, requirements, manufacturing, verification/integration & test, development status, team experience and availability, planning, supplier, customer, contractual and legal, financial). Check lists as well may be used to improve the brainstorming results.

2. Risk Quantification/Assessment: The purpose of this step is to determine the magnitude of the
individual risks and to rank them with respect to Cost, Schedule and Performance. To this aim it is

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necessary to determine the probability of occurrence and the consequence severity of the events identified in the previous step as Risk Items. In order to standardize this evaluation and to reduce possible subjectivity during the assessment, a set of reference tables (both for probability and for consequence) shall be prepared and shall be used throughout the project. The Risk Items identified as possible source of risk for the program will be presented to one or more experts. A considerable help in performing this activity is to use the historical data from previous programs. Experts shall provide, for each one of the identified Risk Items, sufficient information to perform a statistical analysis. The Risk Items are then classified by their magnitude. A proper threshold of acceptance shall be defined and all the risks whose magnitudes are above this threshold shall be reduced and controlled.

3. Risk Response Development: Proper actions for risk response development shall be defined and
implemented in order to maintain risks within the acceptable level. Risk reduction effectiveness shall be continuously monitored and verified.

4. Risk Monitoring, Communication and Acceptance: Risk information shall be properly documented
and communicated to all the stakeholders of the project. The use by the performing organization of a risk data base, to take memory of the past experience, is a key element to assure improvement of technical performances and savings of resources in terms of time and cost. The mysterious nature of lots rules of thumb concerning good design and proper processes is usually the result of improvements obtained by past generation of designers and technicians not documented properly. We must be careful not to repeat this mistake and make sure we document the reasons along with the lesson learned. Eventually all residual risks shall be subjected to formal risk acceptance by the project manager.