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Risks in Project Finance

Understand the Risks in Project Finance

Last Updated May 16, 2023

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Risks in Project Finance

Risks in Project Finance: Four Categories of Risk

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
  • Planning/consents
  • Design
  • Technology
  • Ground conditions/Utilities
  • Protestor action
  • Construction cost overruns
  • Construction program management
  • Interface with existing infrastructure
  • Operating cost overruns
  • Operating performance
  • Maintenance cost/timing
  • Raw material cost
  • Insurance premium fluctuations
  • Interest rate
  • Inflation
  • FX exposure
  • Tax exposure
  • Output volume
  • Usage
  • Output price
  • Competition
  • Accidents
  • Force majeure

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 here.

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 Risks 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:

  1. Conservative Case – assumes the worst case
  2. Base Case – assumes an “as planned” case
  3. Aggressive Case – assumes the most optimistic case
  4. 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)
  • High infrastructure, engineering, and construction costs
  • Few active engineering and construction firms
  • Long project durations
  • Lack of standardized risk allocation
  • Long government approval processes
  • Legislative constraints
  • Medium to high-risk ratings
  • Political and sovereign risks
  • Weak balance sheets
  • Investments not economically viable
  • Poor tax and tariff regulations
  • Socio-political pressures for competing needs for funding
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