4.3 - How to Finance Construction

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From the course by Università Bocconi

Financing and Investing in Infrastructure

478 ratings

Università Bocconi

Financing and Investing in Infrastructure

478 ratings

Learn how debt and equity can be used to finance infrastructure investments and how investors approach infrastructure investments! According to the OECD, the global infrastructure investment requirement by 2030 for transport, electricity generation, transmission & distribution, and water & telecommunications totals to 71 trillion dollars. This figure represents about 3.5% of the annual World GDP from 2007 to 2030. The European Commission estimated, that by 2020, Europe will need between 1.5 - 2 trillion Euros in infrastructure investments. Between 2011 and 2020, about 500 billion Euros will be required for the implementation of the Trans-European Transport Network (TEN-T) program, 400 billion Euros for Energy distribution networks and smart grids, 200 billion Euros on Energy transmission networks and storage, and 500 billion Euros for the upgrade and construction of new power plants. An additional 38 - 58 billion Euros and 181 - 268 billion Euros in capital investment will be needed to achieve the targets set by the European Commission for broadband diffusion. Traditionally investments in infrastructure were financed using public sources. However, severe budget constraints and inefficient management of infrastructure by public entities have led to an increased involvement of private investors in the business. The course focuses on how private investors approach infrastructure projects from the standpoint of equity, debt, and hybrid instruments. The course concentrates on the practical aspects of project finance: the most frequently used financial techniques for infrastructure investments. The repeated use of real life examples and case studies will allow students to link the theoretical background to actual business practices. In the end of the course, students will be capable of analyzing a complex transaction, identifying the key elements of a deal, and suggesting proper solutions for deal structuring from a financial advisor's perspective. Course Format The course will consist of lecture videos, readings, and talks given by guest speakers. Although we do hope you will attend the entire course, it is possible to just focus on single topics. Suggested Readings The course is designed to be self-contained, there are no obligatory readings that must be acquired outside of the course. For students interested in additional study material, you may refer to: • Gatti Stefano, "Project Finance in theory and practice", Academic Press, 2nd edition, 2012.

From the lesson

Capital Budgeting

Module 4 introduces capital budgeting of infrastructure deals. Firstly, we will present the key elements making up the budget of the construction phase and the sources of finance used for the construction of said infrastructure. We will then move on with the analysis of the budgeting of the operational phase pointing our attention to the sources and uses of funds. Special care will be given to the analysis of the system of reserve accounts of the SPV.

4.1 - Project Finance and the Set up of Capital Budgeting2:34

4.2 - Setting Up The Construction Phase Budget9:14

4.3 - How to Finance Construction6:59

4.4 - Exercise #1: Construction Phase Budgeting10:20

4.5 - Setting up the Operational Phase Budget8:19

4.6 - Exercise #2: Operational Phase Budgeting12:53

4.7 - Takeaways2:22

Meet the Instructors

Stefano Gatti
Director
Full Time MBA, SDA Bocconi School of Management

In this session we start analyzing what happens on the

liability side of the special purpose vehicle during the construction phase.

We have seen all the items on the asset side.

It is now time to understand how these items are financed.

On the right hand side of the balance sheet of the SPV.

In order to understand exactly what happens, let's simplify a lot, and

let's assume that even if this exemplification is not far from reality.

The project is financed with two basic sources of financing.

Debt on one side and equity on the other side.

Let's start from the equity.

Equity is provided by the shareholders.

And typically equity contribution follows the so-called âmilestone timeline,â

which basically implies that every time the contractor completes a milestone.

Equity shareholders provide a portion of the funds in

order to finance the other advancement of the construction phase.

On the debt side the situation is a little bit

more complex, in the sense that, either banks or other financiers.

Typically provide debt, but debt is articulated into different brackets.

Or as it is said in technical terms in tranches.

Every tranche of the debt is earmarked for

financing, a specific portion of the asset side.

Let's start from the most important part of the debt side.

Which is represented by the base loan, also known as base facility.

The base facility is the most important bulk of financing, that typically is

earmarked to fill in, to cover the cost of construction, the cost of land,

a portion of the interest that has accrued during

construction and the fees that accrued during the construction phase.

This loan is a typical long term loan

and the loan, is a typically amortizing structure.

Which basically means that the loan will

be reimbursed, on a given timeline of payments.

A schedule of repayments.

As long as the operational phase, goes on.

The second important bulk of financing

is in countries where the VAT tax is in action,

the value added tax, facility or VAT loan.

The VAT loan is the amount of funding that is required to lenders.

In order to finance the VAT that has accrued during the construction phase.

And this is an important point to be remarked.

There is a perfect correspondence between the VAT accrued on

the asset side and the VAT loan on the liability side.

So lenders finance 100% of the VAT need, that

has been determined by the construction, during the construction phase.

You can also understand that VAT will

be reimbursed, not on a given amortizing schedule.

But simply using the cash flow that

the SPV will gain during the operational phase,

on the VAT that will be charged to

customers, once the project is up and running.

It is said that the VAT loan will be reimbursed using the compensation scheme.

Using then, the VAT that has been cashed with

the VAT that has been paid during the construction phase.

The third tranche that is typically set up by

lenders, in the construction phase, is called standby facility.

The name standby is indicative, in the sense that this bulk of funds.

Is earmarked to finance a portion of the contingencies

that could arise during the construction for whatever unexpected event.

So you can understand, if the contingency does

not happen, the standby facility will never be used.

If on the other side contingency arises, the standby facility will be used.

And you can also understand that if creditors and shareholders have

agreed on a given Debt to Equity Ratio, if a contingency arises

the contingency will be financed with a given portion of debt.

And a given portion of additional equity that the shareholder

will inject in the SPV, in case the contingency arises.

The fourth and final tranche is typically the so called, working capital facility.

Working capital facility will be activated only

when the SPV enters into the operational phase and you can understand why.

When the project is up and running, it is

pretty obvious that on a daily basis, working capital needs.

Where working capital basically means

inventories, accounts receivables, and accounts payables,

would be generated by the day by day activity of the SPV.

And that's why, banks typically provide additional funds up to

a certain maximum amount, in order to finance the fluctuations.

Of the working capital, throughout the operational life of the project.

You can also understand that the working capital facility

compared with the previous tranche is typically a revolving credit.

Revolving means that you have a certain amount

of money that you can reuse many different times.

Whenever you need to finance the fluctuations,

of the values, of the working capital needs.

Overall then, we have all this financial package, the

base facility, the VAT, the standby, and the working capital.

One final element that is particularly important to

understand is that all this financing on the

debt side, is fully collateralized by all the

assets that the vehicle has on the asset side.

So in project and infrastructure finance, we don't

have the typical difference between secured and unsecured creditors.

Every senior creditor is always fully collateralized, by all the assets

of the SPV of the left hand side, of the balance sheet.

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