Formulating Infrastructure Projects for Financing

Russell Duke Chairman of National Standard Finance, LLC Global Sovereign & Infrastructure Investors

Russell Duke
Chairman of National Standard Finance, LLC
Global Sovereign & Infrastructure Investors

Over our many years of experience, and our research on infrastructure financing, we have witnessed that poor project preparation is one of the main reasons for slow infrastructure rollout in many countries, particularly in emerging markets where experience often lacks, as the projects are then difficult to fund. Project sponsors need to assemble a competent and experienced team to prepare a bankable project. This is called project development, which involves developing a capital intensive project from concept until it commences operations. First, a project must be originated, which often starts with an idea or concept generation, followed by project engineering and architectural design, then contracts negotiations, financing, construction and commissioning. It can easily take several years to prepare a project, and it can cost up to 5% of total project cost to prepare the project properly.

Feasibility Studies
A bankable project must have a solid technical and financial feasibility study prepared by a multi-disciplinary team of engineers, finance experts, quantity surveyors, project managers, legal advisors, environmental specialists and many other relevant professionals depending on the nature and complexity of the project. A project feasibility study will consider the appropriateness of the project design relative to the needs to be serviced, including social, environmental and legal issues. Issues such as site selection, capacity to implement, phasing of the project; availability of major inputs, project cost, price of the final products to users and market existence must be analyzed to assess commercial viability. Both current and projected market conditions must be factored into the feasibility. Additional factors that must be analyzed include the potential for unanticipated delays and the project’s operating characteristics that includes its useful life, reliability, efficiency, required maintenance, and vulnerability of its technology to innovation. A preliminary technical feasibility study would generally incorporate a margin of error of plus or minus 30 percent while a very complex project could have a larger margin of error.

We believe that a good feasibility study should focus on both the “hard” construction costs, and an initial estimate of the project financing and development costs. Including financing and development costs is a difficult call in the early stages of project development. This is because project agreements will not have been negotiated yet and the interaction between costs and revenues will not have been fully tested. However, with experience, a good estimate can be made. Ultimately, it is the interaction between revenue and costs during the life of a project that determines the success and sustainability of a project, so these should be tested from day one and refined continuously as the project development process unfolds. Ultimately, you must select an experienced and financially strong contractor that has the proper construction performance bonding capacity to insure delivery of your project. The contractor should also provide a Gross Maximum Price contract meaning they guarantee the costs of the project at a set building cost and if the cost exceeds this amount the contractor is responsible for the over-run of costs.

Infrastructure market, revenue and costs analysis
Analysis of supply and demand, hence the revenue and costs, under various market conditions is an important step in project preparation. Assuming that a project is completed on schedule and within budget, its economic and financial viability will depend primarily on the marketability of the project’s output. Off-take agreements with strong counterparties are important to guarantee revenue. In the absence of an off-take agreement, the products would be sold directly to the market on an on-going basis at unknown future prices. The sponsor would, therefore, need to commission a market study of projected demand over the expected life of the project. Such a market study must confirm that, under a reasonable set of economic assumptions, demand will be sufficient to absorb the planned output of the project at a price sufficient to recover the full cost of production, enable the project to service debt, and provide an acceptable rate of return to equity investors.

A market study should generally include a review of competing products and their relative cost of production; an analysis of the expected life cycle for the project output; and an assessment of the potential impact of technological obsolescence. Most projects would operate within regulated industries. It is, therefore, extremely important to assess the impact of potential regulatory decisions on production levels and prices, and ultimately the profitability of the project. For very large projects, it may be important to obtain certain guarantees from the host country government for a minimum period to ensure that the impact of any regulatory decisions during the life of a project is not adverse. Such guarantees assist in managing regulatory and political risks.

Projects that have a single product whose price may vary widely, such as most commodity based projects, are particularly vulnerable to changes in demand, and may need to hedge against product price risk. Off-take agreements from strong counterparties and certain guarantees become very important for the hedging. There are also risks on the raw material supply side. Projects whose success or failure relies heavily on the price of one raw material would also require an input supply agreement on guaranteed prices.

Financial modelling
Financial modeling is another very important aspect of project preparation, especially when engaging investors. A financial model reflects, in dollars and cents, the provisions made and reached in the project agreements. This must include reasonably accurate assumptions with regard to revenue and costs. Metrics such as the internal rate of return (IRR), the net present value (NPV), pay-back period, debt coverage ratios and their acceptability must be analyzed. The financial model often considers, through sensitivity analyses, the impact of construction delays, cost overruns, adverse regulation, inefficiency of the project relative to existing and projected competition, interest rate fluctuations, unavailability of major project inputs, and major unanticipated inflation and volatility in foreign exchange rates. Project sponsors should also have their own equity capital to invest into a project showing they are committed and willing to take financial risk. The normal equity percentage should be approximately 30% in most cases and project types.

As investors, the benchmark that we look at is that the project must generate enough cash flow so as to give lenders a margin of safety with respect to its debt service obligations. This is normally a minimum of 1.50 times the debt service amount, but preferably 2.00 times debt service coverage. We are interested to know that the projected net cashflows i.e. the revenues less operating expenses, debt service and payments to investors are consistent with project agreements and that realistic estimates of future project revenues are sufficient to cover operating expenses and repay project debt with an acceptable margin of safety. All these issues should be reflected in the financial model. We see many projects that are presented for funding without these issues clearly articulated, hence 95% of projects presented for funding are not ready for financing and do not actually know the exact project costs nor do they have proven financial models to support financing underwriting standards and would generally not qualify. Project sponsors also should consider currency issues and political risk mitigation via political risk insurance.

Russell Duke is Chairman & Managing Principal at National Standard Finance, LLC. Mr. Duke can be reached at
Michael Tichareva is Principal & Managing Director of Africa operations at National Standard Finance, LLC. Mr. Tichareva can be reached at

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