Capital Project Advisory in Modern China
Thomas Minnich, Prime Capital Services Ltd., Hong Kong
John Lee, American General Business Association, Beijing
Introduction
Planning and executing capital projects in modern China, where risks are very present and international investment standards are becoming more important, requires a comprehensive approach to securing project funding based on project credit risk, lenders capital requirements, and the assets cash flow expectations. Overseas sources of funding, particularly from banking institutions, are adhering to more and more stringent rules that govern their lending activities with a much more critical analysis of a project finance deals risk exposure. Beginning at the end of 2006, overseas financial regulators will begin to mandate capital requirements of the Bank for International Settlements Basel II Accord, which for project finance loans require a bank to allocate capital according to a detailed analysis of the projects exposure to risk in five categories:
- Financial Strength Cability of the project to service the debt
- Transaction Characteristics Cproduct offtakes and technical and contractual aspects of the project
- Project Sponsor Strength Csponsors experience in the industry
- Political and Legal Cappropriate government concessions in place
- Security Package Clenders control over cash flow
The strength of the project determines minimum capital requirement under Basel II, which directly affects the lending cost to the borrower. Overseas banks, in additional to multilateral sources of capital, are also adopting new minimum standards for their projects?? impact on the environment and the local community known as the Equator Principles, which further complicate the project financing process. The key to investing in a capital project in China is to partner with appropriate advisors who can facilitate the planning of the project with local Chinese business and government officials as well as advise on the most current standards in international finance and capital project planning.
Site Selection
The location of the proposed project can have a lasting impact on the success of the project well beyond the funding and construction of the asset. Many factors that influence a project sponsors decision on locating a site for the project are covered by the Basel II criteria and the Equator Principles environmental and social impact guidelines; however, there are certain basic site selection factors that should be highlighted on their own. A comprehensive capital advisory solution should include a quantitative analysis of potential project sites location, human resource, cost, and industry factors.
Each potential project site must be evaluated for their locations?? impact on the short and long term strategic performance of the asset. In the short term, sites must be evaluated on their constructability do they have reasonable proximity to key construction materials such as steel and concrete, and what issues exist about the ability to transport purchased equipment and materials into the area? For the long term strategic impact, does the site have optimum proximity to logistics channels where finished products can reach their customers destinations in the shortest amount of time. Long term strategic location impact also includes proximity to raw material sources and the availability of skilled labor, professional, and academic resources. Of particular interest in attracting Foreign Direct Investment into China where expatriate professional and managerial staffs are required are quality of life issues ranging from typical weather to cost of living to availability of international schools.
[John is there something you can insert here to talk about local building code issues that may affect where a project would be located, and perhaps government incentives available from local provincial governments to locate a project at a particular site]
A final remark on site selection is that according to the International Site Selection Association, many companies place too much emphasis on the initial costs of locating a project and not the long term strategic costs of projects?? permanent location after it is built and operating.
Project Finance
A suitable advisor for investing in capital projects in China can address both project holders?? and lenders?? needs, ranging in scope from advisory consulting services to development of full-scale integrated technical and financial solutions. When working with project holders and developers, a skilled advisor can evaluate the impact of financial instruments on the project during the initial project planning stage and structure the terms of the project to attract favorable lending terms and strategic investment partners. When working with lenders, the advisor can facilitate the screening of project finance opportunities and develop strategies for minimizing the capital requirements mandated by central bank regulators and the Basel II capital accords. The ideal capital project advisor for investing in China should have established relationships with multilateral development banks, lenders, and equity investors experienced in China projects who can arrange up to a majority or all of a project??s funding requirements.
International standards governing the deployment of capital throughout Asia-Pacific and China have begun to adopt the capital requirements defined by the Basel II capital accords. These accords, being adopted by most of the central bank regulators in Asia over the next few years, define standards on how a lender allocates capital according to credit risk of the borrower. Capital allocation is the amount of cash a bank must hold in reserve to cover the probability of losses from loan defaults. The accords have identified specific criteria for specialized lending activities including Project Finance, and the ability of a bank to demonstrate a project??s ranking against these criteria can dramatically reduce their capital allocation and the associated pass-through cost to the borrower or project holder. The specific criteria, grouped in the five categories below, essentially form the credit rating of the capital project, which can vary greatly from the borrower??s corporate credit rating.
Financial Strength:
Economic feasibility metrics such as Net Present Value and Internal Rate of Return must be extended to appropriate debt service coverage metrics to propose to lenders how the project loan will be repaid.
Transaction Characteristics:
This is the category traditionally associated with a ??bankable feasibility study?? required by most lenders in the past prior to full adoption of Basel II. Contractual issues such as those between the developer and construction contractor are considered as well as how well industrial process technologies being installed have been demonstrated in other commercial applications. One of the most critical aspects of this category is the strength of the product offtake agreements. The strongest and most attractive capital projects include product offtake contracts to export destinations and not commodity market products intended for more regional destinations.
Project Sponsor Strength:
The project sponsor or holder should have demonstrated commercial experience in the industry they are investing. All aspects, from the sponsor??s experience with constructing similar projects through their agility in marketing products in the specific industry are considered.
Political and Legal:
Government concessions, from both local and central governments in China, are absolutely critical to the credit worthiness of a capital project. The project should have long lasting concessions in place with appropriate government decision makers. Additionally, project sponsors and their related business partners should not have exposure to corrupt practices. The ideal project advisor can help sponsors and lenders identify business interests in the project that have been susceptible to governance exposures.
Security Package:
The project holder must have the capability of managing the operations of the asset after construction is complete and must also be willing to provide covenants to the lenders to guarantee first rights to cash flows generated by the project.
Choosing the right advisor with presence in China and experience with international business governance standards can improve the bankability of capital projects in China with greater control over risks and the ability to monitor and advise on the project during its development.
Environmental and Social Impacts
One of the most significant developments in the behavior of project finance investors and lenders is their increasing interest in promoting responsible environmental and social impacts of the projects they finance. The best capital project advisors for new China projects must possess the experience and expertise to assess a project??s cumulative geopolitical, environmental, social, and cultural impact. Even in cases where financing is not being provided or guaranteed by multilaterals or export credit agencies, bankers are requiring strict adherence to standards set forth by World Bank on a project??s environmental and social impact in a set of international standards known as the Equator Principles. A summary of an Equator Principles evaluation can be summarized in the following three categories
