Neutralizing Project Finance Risks: A Global Perspective

Last week I met Paul Allen, CEO/Project Director, Project Executive Group. Being fairly immersed in the software development world for a while, it was fascinating meeting someone equally immersed in the complexities of the oil and gas industry. I thought I understood complexity.....

He's been doing some work with Hossein Razavi, Ph.D., Sector Director, Infrastructure and Energy at the World Bank. This post describes some of the research they've done together.

So if you work for a gas or power company, and you want to do business in a developing country, you have to figure out how to protect the assets of the global corporation. But if Chevron wants to build a plant in, say, Bolivia, you don't want the country, and people you're doing business with in the country, to have access to the huge reserves of the corporation, should things all go pear-shaped.

So there's this concept of non-recourse financing, where no assets secure debt. How does this work? Is this like one of those no-money-down real estate deals I keep hearing about on late-night TV?

A project company must be formed specifically for the construction of the new power plant or whatnot, so there is no recourse back to the corporation. The assets and the cash flow of the project itself secure the debt, not the parent organization. There is no parent organization. This company has nothing to do with Chevron, okay?

Project financing allows you to deliver the keys back to the lenders if the project goes south, and all you lose is your equity. Your credit rating for the project is based entirely on who you have a contract with -- it's like you're a tiny startup that happened to get a multibillion dollar contract from a top tier firm, and everyone plays along.

So what are the big risks we're so afraid of? Well, bad organizational structures, bad regulatory systems and political instability for starters. These can lead to higher costs, loss of revenue or margin, and safety issues.

What happens if the government stops the project halfway through? What happens if the project isn't completed with acceptable quality, schedule or cost? What happens if it all works, but it's not maintainable?

There's an entire field of "financial engineering," which implies layers upon layers of guarantees and contracts, put together to protect the assets. Lenders aren't going to fund the project without adequate security documentation -- you have to prove you've neutralized project financing risks. Lenders want to be sure that costs, revenues, safety and getting the money back home are all protected. This leads to a formidable pile of documents, including agreements with the host country, operating agreements, fuel supply agreements, utility agreements, transportation agreements, and endless pro forma financials. Getting government guarantees and agreements with all the related contracts and suppliers takes a lot of time at the outset, but companies who try to short-circuit this process can pay a hefty price in a project that can't be optimized. And that only covers commercial risks!

The real nightmare is political risks. Nationalization, war and unrest, currency inconvertibility, labor permits, police harassment, government regulations.....

The answer to these is to make sure everyone has some skin in the game. Getting local investors involved will diffuse political situations. Some organizations may be tempted to screw over the host country, because you can, not realizing the amount of influence that screwed over party has to completely destroy your project. Don't even think about it.

Negotiate with the host country to ensure support before you ever get the project started. For political risks especially, you need a combination of guarantees -- offshore escrow accounts, insurance, risk guarantees by the World Bank are all good risk mitigation and guarantee instruments. It's also critical that you define force majeure very carefully -- it's amazing what can be an Act of God these days if you aren't specific enough. You should even get concession agreements with the host government. And what the heck -- force your vendors to take on the currency risk by only doing your contracts in dollars...

Normally in projects, we like to nail down organizational structure early. It's not going to change much, and it's good to know who's accountable for what. But in project financing, it's critical that the organizational structure remains flexible for as long as possible, so that you can include more local participation -- more skin in the game means less chance that your project will be disrupted.

Ultimately you may even need to fragment into multiple project vehicles, due to conflicting tax laws and accounting rules. The organization may need a holding company in a low tax country for the purpose of holding ownership interests in the project country.

Funny, in software projects I'm used to engineers chomping at the bit to start coding before the requirements are worked out. This is an entirely different, and much more painful, kind of planning. I can't imagine being this patient.

Developing minds want to know...

Ziff Davis approached me a few weeks ago about doing an interview as part of their "Great Minds in Development" series. It was posted this week -- thought you might get a kick out of it.

Yeah, I know, I can't make eye contact to save my life.

One Risk Per Child

Negroponte's One Laptop Per Child project is skewered by few, lauded
by many. It's certainly impressive.

The project is to develop a laptop costing approximately $100, and distribute it to chidren in developing nations. The proposed machine will be a Linux-based, with a dual-mode display—both a full-color, transmissive DVD mode, and a second display option that is black and white reflective and sunlight-readable at 3× the resolution. The laptop will have a 500MHz processor and 128MB of DRAM, with 500MB of Flash memory; it will not have a hard disk, but it will have four USB ports. The laptops will have wireless broadband that, among other things, allows them to work as a mesh network; each laptop will be able to talk to its nearest neighbors, creating an ad hoc, local area network. The laptops will use innovative power (including wind-up) and will be able to do most everything except store huge amounts of data.

Negroponte is requesting 100 million laptops, at $115 or $130 or $150 each from six developing nations to participate in the program. Developing nations have a lot more critical things to do with $100 million than to participate in a program which might work, but might not.

Yes, the brilliance of this vision is breathtaking. If Negroponte's project would succeed, what a fantastic gift to mankind.

From the project wiki:

The choice is not currently between this system and a more capable one. It is between this and nothing. This is better.

Why does this remind me of Google's justification for censorship in China -- it's between allowing the Chinese to have our product or to have nothing. The above statement was made in reference to a question about limiting what software the laptop can support, but I find it's just as applicable to the "my way or the highway" approach of Negroponte. Why insist that countries make a profoundly reckless $100+ million investment in an experiment, when the country's leadership needs to be focused on health care and helping their people get out of poverty? Why insist on one laptop per child when the model of shared technology (such as one mobile phone per village) has worked much better in microfinance experiments?

The issue I have is not the vision -- it's the execution. Imagine if we were talking about a company, instead of a government. What corporation, in dire financial straits, would invest that much money they don't have, betting the farm on an unproven concept, payment due in advance? It starts to look as reckless as your perpetually broke brother, "investing" his entire unemployment check in lotto tickets. Even the few corporate partners, such as Google and Red Hat, have only invested $2 million each in the initiative, which is paltry compared to the investment he's expecting unstable, corrupt governments to make. In a corporate environment, an initiative using unproven hardware, unproven software, unclear distribution and international involvement would require comprehensive risk planning.

Requirements need to be validated, prototypes need to be driven. At the bare minimum, cultural assumptions need to be verified every bit as much as hardware and software assumptions. How will illiterate families use the computer? How will this new object be treated by the family? What is the problem we're trying to solve? These questions are much harder than the technical problems, such as power management, software efficiency and who is going to provide technical support. Prototypes should be deployed in different sizes of villages in each country which wants to participate, and observations can be made about the appropriate number of laptops per child, the applications which need to be developed in order for this tool to be useful, etc. Due diligence needs to be performed to demonstrate that this proposal actually solves a problem, and is a sound investment. The risks of such a bold experiment should lie with the side that has the money, until it can be proven that this is a good use of extremely limited funds on the part of poor governments.

Yet, by his own admission, he has gotten no negative press on the project.

Many thanks to Eric Brewer, UC Berkeley prof and Inktomi founder, whose discussion at the last 106 Miles provoked many of these thoughts. Professor Brewer has been leading up the TIER project, Technology and Infrastructure for Emerging Nations. TIER impressed me because it starts with the problems first -- microfinance needs and health care -- and looks to see how technology can help solve some of those issues.

However, it's just not as sexy to be methodically working through real problems....