Most utility executives are probably familiar with the financial and legal structures used in project finance transactions in the United States. These contractual constructs are widely accepted in the U.S., can be negotiated expeditiously and are readily enforced by courts. This creates a level of certainty that comforts those investing in the project.
Completing the same project with the same comfort level across the border may be more difficult. Certain elements of international project finance transactions require additional attention to avoid complications down the road.
In international transactions, it is vital to identify unique risks early in the process-especially risks concerning the process itself. Working across the border means dealing with time zone differences, logistical problems, language problems, cultural differences, and foreign legal, tax and regulatory systems. Early business and legal due diligence can help you identify and manage the financial, legal, regulatory, and political hurdles you must overcome.
ferret out financial risks
Valuing an international project finance transaction poses several complications. There may be few comparable companies for a unique project. Depending on the reliability of the supply chain and the off-take purchaser or ultimate distribution customers, it may be difficult to predict future cash flows or establish an accurate discount rate. These uncertainties can make valuing the project difficult. Investment bankers will normally use short payback periods and high discount rates to compensate for these risks. As you eliminate uncertainties in the due diligence process, you should work closely with your financial advisors to continuously update the financial model.
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Getting the information needed to determine financial feasibility can be a challenge. Historical financial statements may be unavailable or unreliable. They may not adhere to generally accepted accounting principles or anything close, necessitating large adjustments, something important to SEC-reporting companies. It may be best to approach these situations like a first-round venture capitalist, with a complete financial review of every element of the business.
Another key piece of information-the creditworthiness of your equity partners, suppliers, and customers-may be difficult to determine. Even if you are dealing with major industry players, the project companies they set up as investment vehicles may have limited recourse or be subject to unknown or contingent liabilities. Similarly, when dealing with small or relatively new governments, the risk of fraud can be high. Seek comfort through due diligence that the government (or its financing arm) is applying at least basic internal controls.
If the transaction is generating revenue in a foreign currency, but expenses are in U.S. dollars or another currency, you will want to hedge the risk of exchange rate fluctuation. Knowing your cash flow timing can be critical to identifying exposure to currency risk. Some governments also control exchange of currency that can prevent the repatriation of invested capital. Additionally, high inflation in the local currency can undermine the project. It is helpful to obtain specific economic forecasts when dealing with financially unstable countries.
To manage these risks, establish a relationship with a reputable, local bank early in the process. A local joint venture partner can be even more helpful. Either may have access to helpful information about local conditions and reliable (and unreliable) parties. Achieving a genuine, helpful relationship can take an extended period of time, so be prepared to invest in the relationship for the long haul.
know the local legal and regulatory regimes
On the legal front, engage local counsel early to understand the legal lay of the land. First, you must know your ability to obtain and enforce judgments and understand the rights of creditors and debtors in bankruptcy-if the concept exists in the project country.
Project finance is contract intensive, but it is difficult to rely on negotiated contracts if they cannot be effectively enforced.
Many parties to international transactions agree in advance to arbitrate disputes if they are from countries that signed on to the United Nations Convention on the Recognition and Enforcement of Arbitral Awards, commonly known as the New York Convention. Arbitration can resolve disputes faster than litigation, but the parties should negotiate a written, abbreviated process to follow if a dispute arises.
Second, understand the regime of regulatory oversight to which you will be subject, both nationally and locally. Many countries have a body that must approve transactions that result in a foreign investor owning land or infrastructure deemed “in the national interest”-which typically includes electric and gas utility assets. Some countries have far more stringent environmental regulation than the U.S. Further, some countries require that a certain percentage of officers or directors be from the host country, which can have a dramatic impact on the structure and control of the project.
Finally, be aware of U.S. laws and regulations that pertain to doing business overseas. In addition to income tax concerns, the Foreign Corrupt Practices Act precludes U.S. companies and citizens from engaging in activity that may be commonplace abroad, including bribery or payments to “grease the tracks” of commercial transactions.
To manage these legal risks, be sure to engage local counsel shortly after you have completed your initial financial analysis. Undertake extensive and well-planned legal due diligence to accurately weigh the risks. Discuss potential issues with the appropriate governmental agencies, whether local or national. Finally, be prepared to design your project structure around legal constraints. For example, if it is not possible to purchase or own the land or assets needed to undertake a project, perhaps you can enter into a long-term lease of 100 or 200 years.
assess and allocate the political risks
Many project finance opportunities arise in small or developing countries, where a critical assessment of political risk is necessary. While rare, confiscation or nationalization of assets has occurred; more likely is political instability or changes in laws and regulations that can undermine a project financially. Whether through political risk insurance or contractual clauses, at the end of the day, you want to address which parties bear any political risk inherent in the project.
Ultimately, project finance transactions are complex-doing one across the border can be even more so. Understanding the political and legal challenges will save valuable time and resources. Allowing yourself enough lead time to find appropriate financial partners and obtaining reliable advice from financial and other advisors will ensure your success.
Deady is an investment banker with Christenberry Collet & Co., a Kansas City-based investment bank that specializes in mergers, acquisitions and finance transactions. Deady previously was a partner with a large Midwest law firm, where his practice focused on mergers and acquisitions, international transactions and corporate reorganizations. He can be reached at 816-421-0050 or [email protected].
