Introduction
The purpose of this paper is to examine the requirements for special purpose vehicle (SPV) project financing for a large infrastructure project. The project to be financed is a 200-mile underground railroad that will be used by electric trains in the UK. The project will cost approximately 12 billion pounds.
Thus, a special purpose vehicle will be necessary to generate adequate funds to complete the project. In this respect, the paper will discuss the project financing process, advantages of using SPVs, and the requirements for a robust business case for using SPVs.
Project financing refers to “the raising of funds on a limited recourse basis for the purposes of developing a large-scale capital intensive project through a special purpose vehicle”. Generally, the borrowed funds are often repaid using the revenue from the project.
A special purpose vehicle refers to a firm whose “operations are limited to the acquisition and financing of specific assets or projects”. SPVs are usually established as subsidiaries whose assets and liabilities are structured in a manner that makes their obligations secure irrespective of the financial difficulties of their parent companies.
The Requirements for a Robust Business Case
Using SPVs is likely to have a robust business case if the following requirements are met. First, the sponsors must demonstrate the financial sustainability of the project to be financed. In particular, the goods or services that are to be provided by the project must have a clear demand in order to justify funding.
For instance, the railroad must have adequate demand as a transport system in the UK. This will enable the sponsor to collect adequate revenue to repay the loans that will be used to construct it. Thus, the financial sustainability of the project must be examined by modeling the vulnerability of the projected cash flows to macroeconomic changes such as an increase in oil prices.
Second, the lenders and sponsors should be able to identify all the major risks that are likely to affect the implementation of the project. The rationale of this requirement is that an unidentified risk cannot be mitigated. Thus, it will inevitably jeopardise the stability of the project, thereby exposing the lenders and sponsors to the risk of losing their investments.
Some of the major risks that often affect the stability of large infrastructure projects adversely include completion delays, cost overruns, sponsor’s poor credit worthiness, and limited access to feedstock. The Channel Tunnel in the UK is an example of a major project whose stability was negatively affected due to poor identification of risks before implementation.
Specifically, the stakeholders did not agree on the key details of the project and contingency measures were not put in place to cater for improvements such as adding the ventilation system. As a result, the project delayed by nearly 19 months, which in turn caused a cost overrun of approximately $3 billion.
Third, accessible financing must be available to ensure a robust business case. The financing arrangements must guarantee high leverage and long tenor to improve the economic viability of the project. High leverage is important because it reduces the amount of capital that the sponsor has to invest in the project at the initial stage.
Long tenor, on the other hand, ensures that the SPV has adequate time to repay the loan in a sustainable manner. In this respect, sponsors of large infrastructure projects use an elaborate mix of financing instruments to access the desired funds.
Some of the major sources of financing that ensures high leverage and long tenor include commercial banks, export credit agencies (ECAs), and the bond market. The City Link in Melbourne, Australia is an example of a large-scale transport infrastructure project that was financed through several sources. The project’s total cost of $2.2 billion was obtained by raising equity capital, bonds, and bank loans.
Finally, political stability is necessary to ensure the success of a large-scale infrastructure project. Political risks such as wars often interfere with the implementation of large-scale projects. For example, the construction process is likely to be suspended during a war, thereby causing delays and cost overruns. Therefore, the government must establish long-term political stability to ensure completion of the project and the repayment of the borrowed funds.
Reasons and Advantages of Using SPVs
Reasons
One of the main reasons for using SPVs is to share the risks associated with implementing large-scale infrastructure projects with the financiers. SPVs are often formed as independent legal entities with several shareholders. The common shareholders of SPVs include lenders such as banks, the sponsoring company, institutional investors, and constructors.
This means that the sponsoring company usually owns just a small percentage of the SPV. As a result, it is able to share the risks associated with the project with other shareholders of the SPV. For instance, in the event that the railroad project fails during implementation, the losses associated with the failure will be shared by the members of the consortium that will implement it.
Thus, the overall negative financial impact on the sponsor will be reduced. SPVs are also used because they ensure limited recourse. In particular, the funds borrowed through SPVs can be viewed as limited recourse debts since the creditors have “only limited claims on the loan in the event of default”.
The limited claim is achieved by transferring the assets and liabilities acquired using the loan to the SPV’s balance sheet. This means that the creditors’ claims will be limited to only the assets of the SPV if the sponsor fails to meet its debt obligations. Thus, the parent company or the sponsor will avoid the risk of losing its assets to the creditors if it fails to repay the loan.
Advantages
Using SPVs to access funding for a large-scale infrastructure project has the following advantages. First, it reduces the overall cost of accessing credit and ensures flexibility in financing. SPVs do not depend on the credit lines of their parent companies since they are treated as external entities.
As an independent firm, the SPV is expected to establish its own credit lines. In this context, the SPV has to be presented to “the creditors as a stand-alone entity with its own risk-reward characteristics”. Therefore, the sponsoring firm can improve the credit worthiness of the SPV through adequate capital allocation.
As a result, the SPV achieves favorable credit rating, which in turn reduces its cost of borrowing. In addition, the after tax cost of capital will reduce significantly if the interest paid on the debt is deductible from the pretax profit. Conversely, the sponsoring company can transfer its debts to the SPV to reduce its debt-to-equity ratio.
As a result, the sponsor will be able to access credit easily and at a low interest rate. Apart from borrowing from banks, the SPV can access funding by selling equity to investors. This reduces the cost of capital since the investors will be compensated using the profits generated by the SPV rather than interest.
Second, using SPVs facilitates high leverage financing. For instance, the SPV can enable the sponsor to finance up to 90% of the project through debt. The main benefit of high leverage to the sponsor is that it makes the project affordable and less risky.
For instance, if the SPV that will implement the proposed railroad achieves a 90-to-10 debt-to-equity ratio, the sponsor will require only 1.2 billion pounds to invest in the project. This will not only make the project affordable, but will also reduce the financial risks that the sponsor will take by implementing the project.
Third, special purpose vehicle project financing enables the government to achieve fiscal optimisation. In this case, the government uses a public-private partnership (PPP) arrangement to implement a large-scale transport infrastructure project. Specifically, the government uses the PPP to select a private company that finances the project through a special purpose vehicle.
As a result, the government shifts the financing responsibility to the private sector, thereby enabling it to avoid tying huge financial resources in a single project. This perspective is based on the fact that the government amortises the cost of the project over its concession period.
Fourth, SPVs allow financiers to earn a level of return on investment that is proportional to the risks associated with the project. This perspective is based on the fact that the financiers directly obtain revenue from the services provided by the project. For instance, the investors in the SPV will be compensated by charging users of the railroad a predetermined fee.
This ensures cost recovery and a high return on investment, especially, if efficiency is enhanced during the implementation and operation of the project. In addition, charging a user fee improves the success of the project since the users will only pay the fee if the services are excellent. In this regard, the SPV will focus on improving the quality of the project to avoid losing money during the operation phase.
The investors in the SPV are also likely to make excess profits if the internal rate of return (IRR) is higher than the cost of capital. Another benefit is that the assets of the SPV act as collateral for borrowed funds. This allows lenders to recover the borrowed funds if the SPV fails to repay. The sponsor, on the other hand, is likely to benefit from low interest rates if the assets of the SPV can provide adequate collateral.
Fifth, using SPVs enables the sponsor to collaborate with a variety of investors. This not only ensures access to adequate financing, but also access to the technical expertise that is required to deliver the project. For example, technical risks such as poor workmanship can be eliminated if the contractor is one of the investors in the SPV.
The Project Financing Process
The project financing process has three main phases namely, the pre-financing stage, the financing stage, and the post financing stage. Each of these stages has specific processes that have to be completed effectively.
Pre-financing Stage
The first process in this stage is to identify the project to be financed. Since the proposed railroad is a public good, the project will be identified and announced by the government. This will include identification of the services that will be provided by the project, their demand, and users. The second process is identification of risks and developing strategies for mitigating them.
In this process, the sponsor should collaborate with consultants or technical advisors to identify and quantify a variety of risks that are likely to derail the implementation of the project. The risk assessment should cover areas such as project completion, pricing, operation, technology, environment, interest rate, and insolvency risks among others.
Once the risks are known, effective strategies must be adopted to prevent or minimise their effects on the project to ensure success. The last process involves “conducting technical and financial feasibility studies”. Technical feasibility studies should focus on assessing the suitability of the proposed project location, design, operation, and the equipment to be used.
This will help in identifying and correcting technical problems that might lead to failure. Financial feasibility studies, on the other hand, should include a “business model that highlights the projected financial statements with assumptions, the financing structure, internal rate of return, and the net present value”.
The pitfalls at this stage include identification of a project whose services have no adequate demand. The Betuweroute in Rotterdam is an example of a major transport infrastructure project whose implementation was highly resisted by the public, thereby causing delays in its completion.
The public resisted the project because the technical feasibility study did not consider alternative transport solutions that could have reduced costs, while improving efficiency at the port of Rotterdam. Poor risk assessment is another major pitfall in the pre-financing stage. For example, the lenders and investors in the SPVs that were established by Enron made losses because they could not determine the financial stability of the company.
Financing Stage
Equity arrangement or allocation is the first process in the financing stage. This process involves identifying the lead sponsor and the co-sponsors. Additionally, the proportion of equity that will be allocated to angle investors, financial institutions, and non-financial institutions has to be specified.
Once the equity arrangement is complete, the SPV must embark on negotiations and syndication to access the credit needed to complete the project. The negotiations are often followed by equity and loan disbursements. The main pitfall in this stage is failure to negotiate a favorable price and repayment schedule for the loans.
For instance, a high interest rate might lead to financial difficulties in the SPV. Moreover, failure to establish a contractual agreement to guide the relationships among the stakeholders can lead to disagreements that might jeopardise access to funding.
Post Financing Stage
This stage focuses on monitoring and evaluation to ensure that the project implementation is on schedule and within the planned costs. Therefore, the managers of the SPV must evaluate project status reports and financial reports to identify and correct emerging problems in time to avoid default and project failure.
Financial closure is also done at the post financing stage. This involves completing all financial transactions that are associated with the project to ensure that all outstanding invoices are paid before the completion of the project.
Repayment of the borrowed funds is also a major process in the post financing stage. Repayment typically begins after the end of the grace period. Based on the contractual agreements between the SPV and the lenders, the loans must be paid in time through quarterly, monthly, or annual installments to avoid penalties.
In addition, the investors in the SPV can be compensated through dividends. After the project closure, monitoring efforts should shift to the operation process. Monitoring the operation of the project will facilitate collection of adequate revenue to repay the borrowed funds and compensate the investors.
Thus, the main pitfall in the post financing stage is failure to monitor the progress of the project effectively to avoid completion delays. For instance, cost overruns and losses are likely to arise if completion takes longer than planned.
Sustainability Aspects
First, economic sustainability is necessary to ensure the success of large-scale infrastructure projects that are financed through SPVs. In particular, the project should be able to generate adequate income during the concession period to compensate the financiers effectively. Thus, the services provided by the project should be of high quality.
In addition, equity and affordability must be enhanced to ensure adequate use of the project, which in turn leads to revenue maximisation. Second, environmental sustainability is a pre-requisite for the success of large-scale transport infrastructure projects.
Large-scale projects often cause environmental degradation through emission of greenhouse gases, destruction of vegetation, pollution of water bodies, and destruction of animal habitats. Therefore, a project can only be successful if its ecological footprint is minimal. For instance, constructing a railroad through a wildlife conservancy or forest can be resisted by the public, thereby causing failure during the implementation stage.
Finally, social sustainability has to be ensured to enhance the success of large-scale transport projects. Enhancing social sustainability involves reducing the undesirable effects of the project on the health, leisure, culture, and economic activities of the community in which it is implemented.
Generally, a project that improves the welfare of the community is likely to avoid resistance and attract capital from lenders and investors. Therefore, social sustainability has to be addressed to enhance the success of the project.
Conclusion
A special purpose vehicle should be used to access funding for a large-scale project if there is a clearly defined business case. The main advantage of using SPVs is that they enable the sponsor to access off-balance sheet financing by transferring the assets and liabilities of a credit facility to an independent entity.
As a result, the sponsor benefits from low cost of capital. In addition, SPVs enable the sponsor to protect its core business from the risks associated with the credit and the project to be implemented. However, these benefits can only be realised if due diligence is done to identify and mitigate the pitfalls associated with the various stages of the project financing process.
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