What are the Risks in Project Finance?
In the field of project finance, risk management is all about identifying the risks associated with a project and the proper allocation of those risks among the different parties engaged.
The risks in project finance can be segmented into four categories: construction, operations, financing, and volume risk.
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What are the Four Categories of Risk in Project Finance?
Project finance is about structuring a deal to manage risk among all the project participants, including lowering costs by negotiating interest rates.
Generally speaking, there are four main categories of risk:
- Construction Risk
- Operations Risk
- Financing Risk
- Volume Risk
The table below shows some examples of each:
| Construction Risk | Operations Risk | Financing Risk | Volume Risk |
|---|---|---|---|
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The management of these individual risk categories must be divided up between the different participants in any given project. The departments negotiate who is responsible for this risk management, and it usually breaks down depending on how the risk impacts each department’s profitability.
For a deeper dive into the different departments that are involved in structuring a project finance project, we’ve broken down and explained the career paths you can take within the project finance field.
As the project progresses, the amount and type of risk can change. The image below is an example of how and why this happens over the lifetime of a project:
How to Measure Risk in Project Finance
In project finance, analysts use scenario analysis to determine and measure project risk and determine the various impacts from changes to key ratios and covenants. Because project finance deals often last for decades, a thorough assessment of risks is essential.
There are four primary types of scenarios that most projects fall into:
- Conservative Case – assumes the worst case
- Base Case – assumes an “as planned” case
- Aggressive Case – assumes the most optimistic case
- Break Even Case – assumes all SPV participants break even
In order to assess the risk profile, analysts will model these various cases to understand how the numbers look under each scenario.
How Scenario Impacts are Measured
Each scenario will result in a different impact on key project ratios and covenants:
- Debt Service Cover Ratio (DSCR)
- Loan Life Cover Ratio (LLCR)
- Financing Covenant (debt/equity ratio)
The table below shows the typical average minimum ratios and covenants for each risk case:
| Conservative Case | Base Case | Aggressive Case | Break Even Case | |
|---|---|---|---|---|
| DSCR | 1.16x | 1.2x | 1.3x | 1.18x |
| LLCR | 1.18x | 1.3x | 1.4x | 1.2x |
| Covenants | 60/40 | 70/30 | 80/20 | 65/35 |
Once the risks are identified, methods for protecting against these risks are then reflected in various interrelated contractual agreements:
Support Packages
- Bonds that lenders can draw on in the case of construction and operational delays or non-performance
- Additional standby financing in case of cost overruns
Contractual Structures
- Remedy and cure for unforeseen events
- Allow lenders or public authority to “step in” or take over a project if underperforming
- Requirements for insurance agreements
Reserving Mechanisms
- Reserve accounts that get funded with excess cash for future debt service and major maintenance costs
- Requirements for minimum ratios
- Cash lock-up if there is not enough money for the project
Hedging
- Interest rates swaps and hedges for fluctuations in market rates
- Foreign exchange hedges for fluctuations in currency
Legal Agreements for Projects
During the deal structuring stage, all of the parties involved in the project will construct a variety of agreements to structure cross-party relationships and to aid in managing risk.
The image below shows some examples of legal agreements that serve to mitigate risk:
Common Reasons Why Projects Fail
Even with the best of intentions and diligent planning, some project finance projects will fail. There are some common reasons why this may happen, as summarized below:
| Investment Costs | Regulation and Legal Framework | Availability and Cost of Finance | Project Funding (Direct Subsidy from Public Authority) |
|---|---|---|---|
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The key to structuring a project finance deal is the identifying of all key risks associated with the project and the allocation of those risks among the various parties participating in the project.
Without a detailed analysis of these project risks at the beginning of the deal, project participants will not have a clear understanding of what obligations and liabilities they may be assuming in connection with the project and, therefore, will not be in a position to use appropriate risk mitigation strategies at the appropriate time. Considerable delays and expense can be incurred if problems arise when the project is under way and there will be arguments around who is responsible for such problems.
From the lenders’ perspective, any issues that arise from the project will have a direct impact to their financial returns. In general, the more risk that lenders are expected to assume in connection with a project, the greater the reward in terms of interest and fees they will expect to receive from the project. For example, if lenders feel the project will have an increased chance of construction delays, they will charge a higher interest rate for their loans.
Common Types of Project Risk
All project risks have a direct cost of financing impact. The following are typical project risks at various phases of the project:
| Construction | Operations | Financing | Revenue |
|---|---|---|---|
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The task of identifying and analyzing risks in any project is conducted by all parties (financial, technical, and legal) and their advisers. Accountants, lawyers, engineers and other experts will all need to give their input and advice on the risks involved and how they might be managed. Only once the risks have been identified can lenders decide who should bear which risks and on what terms and at what price.
