Due Diligence in Project Finance
It involves managing and reviewing the aspects related to a deal.
Before diving directlyin project finance is, it is essential to understand several terms in the topic to understand the content better. The following terms are project finance and due diligence.
In simple words, project finance refers to the financing of long-term projects. The project mostly covers areas in infrastructure, industries, and public services.
It can be deemed as long-term financing of independent capital investment. "Independent" can refer to the project being distinctly isolated as the cash flows and assets can be seen to be contained together where the financing is based around them.
One of the main features of project finance is that it is non-recourse, which means that the amount of risk and debt relies on the the project can generate.
One of the requirements requires the cash flows to be sufficient toand to fund the financing repayment requirements because it is a stand-alone entity with no other cash flows to help fund the project.
The financing in project finance consists of debt and equity, which are matched to the asset's life. Examples of project finance are mining, oil, gas, real estate development, and many more.
The most common question frequently asked is: what is the main difference between corporate and project finance?
uses cash flows from other operating activities to fund the project. It can also take advantage of the credit of the corporation to utilize debt in its . Unlike project finance, it doesn't need to isolate the project and get funding solely from it.
In a financial setting, due diligence refers to an investigation or audit of a buyer before entering into an agreement or transaction with another party.
Due diligence aims to ensure the accuracy of the information provided by the seller and appraise its value. This verification process can also help mitigate the risk of an investment decision.
Due diligence can be conducted in many areas, such as stock, mergers, and acquisitions (M&A), as project finance. However, due diligence in project finance is conducted differently than in any other area.
With the terms already covered above, we can now answer the question of what due diligence is in project finance.
When a project finance business takes place, proposals are handed out in the form of appraisal notes that are provided to the authority in charge, either the committee of senior management or the credit committee.
Due diligence takes place by thoroughly reviewing all the proposals required in the deal. In addition, the appraisal notes include several relevant pieces of information, such as the company's history, management, shareholding structure, and physical and.
Other important ones include the project's purpose, the costs involved, the financing options, the market for the company's products, the company's prospects and projected profitability, risk analysis, and the terms and conditions of the sanction.
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, and 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 completion risk, operation risk, supply risk,, and 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 it conducted in project finance?
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
- Study of the Project Sponsor
- Evaluation of the project's business study
- Legal, due diligence
- Evaluation of financial structure
- Identifying risks
- Evaluation of the tax consequences
- Regulations of the
- Credit ratings, security evaluations, and industry experts
- Examination of the key loan terms
- 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 '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 ofanalyses.
- 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- : A successful project would ideally produce a low debt-to-equity ratio as the lower the 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 astrategy 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 debtis short.