In the project finance business, deal origination happens through the direct relationship that relationship managers across different sectors enjoy in the industry. Proposals are presented in the form of appraisal notes put up to either the credit committee or a committee of senior management, whichever is the appropriate sanctioning authority. Due diligence in project finance involves thoroughly reviewing all proposals involved in a deal.
An appraisal note ideally contains a write up on the company background, its management and shareholding pattern, its physical and financial performance, purpose of the project being funded, details of costs involved and means of financing, the market for company’s products, future prospects and profitability projections, risk analysis, and the terms and conditions of sanction.
How is Due Diligence in Project Finance carried out?
Due diligence in project finance is a process that consists of multiple steps to ensure the most comprehensive analysis:
Assessment of promoter history and background
Evaluation of the company and project business model
While there are multiple steps when conducting due diligence in project finance, there are four key processes that require significant evaluation.
Assessment of Promoter History and Background
An assessment of the promoters’ history is conducted to ensure the commitment of promoters to the project. The main motive is to identify the background and track record of the promoters sponsoring the project. The following terms are assessed:
Assessment of group companies – Involves in-depth study of various companies promoted by the sponsor. Assessment of group companies is necessary even in cases where no direct support from companies to the project company exist. In case the group is facing a severe financial crunch, the possibility of diversion of funds from the project company cannot be ruled out. In such circumstances, the lenders need to take adequate steps to ring-fence the project revenues.
Track record of sponsors – In case of any subsisting relationship with the sponsor, the track record of the sponsors should be studied in light of its relationship. The lender should identify any incidences of default and analyze the causes for the same.
Management profile of sponsor companies – Helps in assessing the quality of management. Lenders are typically more comfortable taking exposure with professionally managed companies.
Study of shareholders agreement – Study of the shareholders agreement should be done in order to get clarity on issues such as voting rights of shareholders, representation on the board of directors, veto rights (if any) of shareholders, clauses for protection of minority interest, procedure for issuing shares of the company to the public and the method of resolution of shareholders disputes.
Management structure of project company – Study of shareholders agreement helps in determining the management structure of a project.
Evaluation of the Company and Project Business Model
An extensive evaluation of the business model assists the lenders in assessing the financial viability of the project. Typically, a business model is developed in consultation with financial and technical consultants. The lenders need to undertake the following steps while accessing a business model:
Understanding the assumptions – Major assumptions are involved regarding revenues, operating expenses, capital expenditures, and other general assumptions like working capital and foreign exchange
Assessment of assumptions – Involves evaluating the various assumptions and benchmarking the same with respect to industry estimates and various studies. Sometimes the lenders appoint an independent business advisor to validate the assumptions made in the business model.
Analysis of project cost – One of the most important stages in due diligence, as a substantial amount of capital expenditure is to be incurred. The project cost is benchmarked to other similar projects implemented in the industry. Also, there needs to be the assurance that appropriate contingency measures and foreign exchange fluctuation measures have been incorporated into the estimated project cost.
Sensitivity analysis – A business model involves many estimates and assumptions. Some of these assumptions do not materialize in view of changing business scenarios. Hence, it is important to sensitize the business model to certain key parameters. The lenders need to assess the financial viability of the project in light of sensitivity analysis coupled with ratio analysis.
Benchmarking with the industry – An analysis of the key ratios in light of available industry benchmarks is useful in an overall assessment of the business plan.
Legal Due Diligence
Legal due diligence is usually conducted using an independent legal counsel appointed by the lenders. Legal due diligence consists of a few steps:
Determining the rights and liabilities of the different participants within the project scope
Analyzing the schedule and implementation plan of the project
Evaluating the appropriateness of liquidated damages if the project fails to deliver as promised
Analysis of Financial Statements and Structure
The following aspects need to be considered when assessing the financial structure and statements:
Debt to equity ratio – A good project would ideally have a low debt-equity ratio which helps in reducing the cost of the debt, thereby increasing the net cash accruals. Higher net cash accruals enable the company to build up sufficient cash reserves for principal repayment and provide a cushion to the lenders.
Principal repayment schedule – The lender endeavors to match the principal repayment schedule with the cash flow projections while leaving sufficient cushion in the cash flow projections. One way of safeguarding lenders’ interests is to negotiate the creation of a sinking fund for this purpose
Sinking fund build-up – Build-up of a sinking fund or Debt Service Reserve Account is usually established in order to safeguard the lenders’ interests. Such a fund entails deposit of a certain amount in a designated reserve account which is used towards debt servicing in the event of a shortfall in any year/quarter of the debt repayment period.
Trust and retention mechanism – In projects, a trust and retention mechanism is often incorporated in order to safeguard the lenders’ interest. The mechanism entails all revenues from the company to be routed to a designated account. The proceeds thus credited to the account are utilized towards payment of various dues in a predefined order of priority. Generally, the following waterfall of payments is established: statutory payments including tax payments, operating expenditure payments, capital expenditure payments, debt servicing, dividends, and other restricted payments.
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