What are Risk Management Techniques in Project Financing?
Large-scale infrastructure projects running across the world play a major role for the development of global economy. The execution of these projects comes along with risks that need to be addressed efficiently. This is where project financing, also known as limited resource financing, comes into the picture.
Project financing coupled with risk management is the key to the successful completion of a project. Read this blog to learn more about risk management techniques and their application in project financing.
What is project finance?
Project finance refers to the arrangement of financial support for a specific project, with the purpose of gaining cash flow in the future. Mostly, large and complex operations such as oil and gas explorations, dams, power plants and roads utilise project financing. The types of projects considered for funding include:
Public services with a non-recourse or limited recourse financial structure.
Note: with a non-recourse loan, a debtor will not be able to pursue any payment beyond the seizure of the asset.
The loan structure of project finance is made up of three elements: build, operate and transfer (BOT). The major components of project financing are:
Financing of long term infrastructure projects – these projects not only have a low technological risk but also possess a predictable market. They are the most appropriate sectors for developing innovative financial techniques.
Non-recourse and limited recourse financial structure – special purpose vehicle (SPV) is the sole economic entity on which project financing is based and is considered a source of loan reimbursement by the lenders. In a situation when the borrower is in debt, structured financing gives the lender the right to capture the assets of the SPV.
Payment from the generated cash flow – the majority of the amount received from cash flow is utilised to fund the operating costs and repay debts. Any remaining funds can be used to pay dividends to the sponsors handling project finance.
Risk in project finance
The direct financing of infrastructure and industrial projects typically includes the following risks:
In case the sponsor disagrees with the terms of the transaction, the financial institution providing the funds can gain control of the project assets;
The project generally encounters challenging social and environmental issues because of its large and complex operations;
Halting of project operations can lead to legal complications, posing a direct financial risk, thereby threatening the success of the project;
Furthermore, larger projects lead to exceeding budgets failing to set issues like:
o Delays in project delivery due to technical problems;
o Pre-exaggerated benefits not matching the larger strategy;
o Unavailability of financial resources;
o Multiple design reconstructions.
What is risk management?
A large portion of the above-mentioned risks can be avoided with a contemporary, end-to-end integrated risk management system. A risk manager should be placed at the level of an executive committee of a relevant organisation. Each company should include risk management as a part of its operations to get an insight into the relevant risks with the help of the following aspects:
Identifying risks – major risks should be reviewed regularly to avoid unexpected disasters. New risks spotted should be immediately added to the list and mitigations put in place to prevent the risks from causing irreversible loss.
Accessing impact and probability – as probability and impact vary throughout the project duration, it is necessary to observe both these dimensions when assessing a risk. An original scale must always be used to quantify the impact and probability measures accurately.
Mitigating risks – risks should be mitigated wherever possible as it will ensure that an efficient risk management team is in place and the workforce is managed well.
Calculating residual impact and probability – If a temporary or damage control solution is provided, the risk will not be critical anymore. Thus, calculation of residual impact and probability makes sure that risk management is functioning well, further reducing the effects of the risk.
Re-classifying risks – risks are often reassessed to gauge the level of its potency. Once proven to be less critical, risks managers can permanently shift their focus to the next important risk and try to mitigate it as well.
Prioritising risks – based on the previous two criteria, we can prioritise all risks in a one-dimensional manner, in the form of a risk matrix. Risk matrix is a tabulated form of classification, which is based on Multi-Criteria Decision Analysis (MCDA).
Risk management methods in project financing
It is essential that risk management is the foundation of all project engagement. Generally, the risk manager on site is responsible for ensuring that risk management remains the focus. These are the steps:
Risk identification– risk identification refers to the refining and re-organisation of risk administration to transform the project, both realistically and profitably. The generic risk factors include:
o Technological risk;
o Natural disasters;
o Cost overrun;
o Delay in project execution;
o Credit risk;
o Cash-flow risk;
o Financial market risk;
o Political risks.
Risk assessment – risk assessment involves re-allocation of risks to parties in the form of a risk matrix. This enables the management to better understand the major risk elements of a large infrastructure.
Risk quantification – this signifies the mathematical calculation of risk measures. Risk quantification enables us to calculate the expected loss of a loan.
Risk is a part of every project, but understanding, analysing and addressing those risks help an organisation achieve its objectives. The learning platform of the London School of Business and Finance (LSBF) consists of a wide range of programmes concentrated on finance. These undergraduate and postgraduate courses will provide you with an in-depth understanding of financial risk management.
This article was written by Deblina Dam and edited by Anisa C.