Due Diligence in Project Finance

What is Due Diligence in Project Finance?

In project finance, due diligence occurs when proposals are presented as appraisal notes to the relevant authority, such as a senior management committee or a credit committee.

This diligence involves a thorough review of all necessary proposals related to the deal. The appraisal notes contain crucial information about the company, including its history, management, shareholding structure, and physical and financial performance. Other essential components cover the project's purpose, associated costs, financing options, market analysis for the company's products, projected profitability, risk assessment, and the terms and conditions of the sanction.

In essence, due diligence in project finance ensures a comprehensive examination of all aspects relevant to a proposed project, providing a solid foundation for decision-makers.

Project Finance

Project finance simply means the funding of long-term projects, typically in areas like infrastructure, industries, and public services. It involves financing independent capital investments, where the project is financially distinct, and its cash flows and assets are contained together.

Notably, project finance is non-recourse, meaning that the risk and debt are dependent on the project's generated cash flow. The project needs to sustain itself, covering operating expenses and funding financing repayment, as it operates as a standalone entity.

The financing in project finance includes a mix of debt and equity, tailored to the asset's lifespan. Examples of project finance projects range from mining and oil to real estate development.

A common question arises: how does project finance differ from corporate finance?

In corporate finance, cash flows from various operating activities fund projects, and the corporation can leverage its credit rating for debt. Unlike project finance, corporate finance doesn't require isolating the project for funding purposes.

Due Diligence

Due diligence is essentially an investigation or audit conducted by a buyer before entering into an agreement or transaction with another party. The primary goal is to ensure the accuracy of the information provided by the seller and assess its value. This process helps mitigate the risk associated with investment decisions.

Due diligence is a standard practice in various financial areas, including stocks, mergers and acquisitions (M&A), and project finance. However, due diligence in project finance differs in its approach.

Risks in due diligence 

Due diligence in project finance is usually conducted by lenders and other relevant entities, whose main objective is to determine and assess the risk of the project's operation. The project's risk appraisal involves assessing the project's:

• Technical
• Legal
• Finance
• Environmental aspects. 

This will help detect any possible events that may negatively impact the project and lead to any risk of partial or total failure. In this context, "failure" means not generating sufficient cash flow to reimburse the financing within the specified deadline.

There are other risks that the project finance operations can be exposed to, and these include

1. Completion risk
2. Operation risk
3. Supply risk
4. Currency risk
5. Political risk

Despite all the efforts to organize project finance operations, it is important to remember that each project has its unique characteristics, specificities, and risks that, although comparable to dangers found in other projects, may affect the various projects differently.

As a result, the due diligence conducted on a project must be done through a "tailor-made" solution.

It cannot adhere to the "one size fits all" concept because it could result in a situation where certain project risks are not discovered. In addition, other risks may be discounted or exaggerated, altering how lenders perceive risk.

How is Due Diligence in Project Finance carried out?

Approximately ten steps are carried out when conducting due diligence in project finance. However, the four main ones require significant and careful consideration. 

Ten steps carried out in due diligence project finance

1. Study of the Project Sponsor
2. Evaluation of the project's business study
3. Legal, due diligence
4. Evaluation of financial structure 
5. Identifying risks
6. Analysis of financial statements
7. Evaluation of the tax consequences
8. Regulations of the Central Bank
9. Credit ratings, security evaluations, and industry experts
10. Examination of the key loan terms
11. Study of the Project Sponsor

1. Study of the project sponsor

A study of the project sponsor ensures the promoter's dedication and commitment to the project while obtaining relevant information about the company's background and the reputation of the promoters that fund the project.

Several steps must be accessed, and the first step requires assessing the group companies. This involves a thorough investigation of the businesses the sponsor is promoting. 

• The second step requires tracking the record of sponsors. If there is an ongoing relationship with the sponsor, that relationship should be considered when analyzing the sponsor's past performance. Finally, the lender must track down default instances and examine their causes.
• The third step is managing the profile of sponsor companies which will aid in evaluating the management's quality.

• The fourth step is accessing the management structure of the project company. The management structure of a project can be determined by studying the shareholder's agreement.
• The fifth step involves studying the shareholder's agreement. The impact will result in obtaining clarity on shareholders' voting rights, representation on the board of directors, issuing shares to the public, and the procedure for resolving shareholders' disputes. 

2. Evaluation of the project's business study

The lenders' capacity to determine the project's financial feasibility is made possible by a thorough analysis of the business model where it is created with the help of financial and technical advisors. When accessing the business model, lenders must conduct the following actions:

• Understanding major assumptions which involve revenues, operating expenses, capital expenditures, and many more.
• Assessing the various assumptions and comparing them to various industry estimates and studies.
• Analyzing the project's cost is one of the most important phases in due diligence. As a result, sizable capital expenditure must be made. The project cost is then compared to similar projects in the sector.
• Undertaking sensitive analysis is a crucial element. Some numerous estimates and presumptions go into a business model. However, some of these assumptions are, in fact, not true. 

As a result, making the business sensitive to a few key parameters is crucial. 

Therefore, the lenders must evaluate the project's financial feasibility in light of sensitivity and ratio analyses.

• Comparing or benchmarking with the industry is significant. When evaluating the business strategy overall, comparing the main ratios to the relevant industry benchmarks is helpful.

3. Legal, due diligence

In most cases, legal, due diligence is conducted by an independent legal advisor who the lenders choose. Several processes include:

• Determining each project participant's rights and responsibilities 
• Examination of the project's implementation timeline
• Adequacy of liquidated damages and any penalties due for failure to comply

4. Evaluation of financial structure

Several important elements need to be considered to evaluate the financial structure. The following elements are:

The debt-equity ratio: 

A successful project would ideally produce a low debt-to-equity ratio as the lower the cost of debt would consequently lower the cost of debt and raise net cash accruals.

The higher net accruals would allow the business to accumulate enough cash reserves for principal repayment and give lenders a safety net.

Principal repayment schedule:

The lender makes an effort to align the principal repayment schedule with the cash flow forecasts while providing enough room in the cash flow projection. 

For this reason, negotiating the establishment of a sinking fund is one strategy to protect lenders' interests.

Sinking fund build-up:

This is a debt service reserve account whose purpose is to protect the lender's interest. 

A specified amount must be deposited in a designated reserve account to employ such a fund. The reserve account's funds are then used to service debt in the event that any year or a quarter of the debt payback period is short.

Researched and Authorized by Viriyan Dharma | Linkedin

Reviewed and Edited by Justin Prager-Shulga | LinkedIn

• Buyout
• Express Warranty
• Memorandum of Understanding (MOU)
• Restrictive Covenant
• Transaction Risk