Due Diligence in Project Finance

What is Due Diligence in Project Finance?

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 engaged 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, the purpose of the project being funded, details of costs involved and means of financing, the market for the 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
• Legal due diligence
• Analysis of financial statements and capital structure
• Determine significant risks associated with the project
• Analysis of tax effects
• Credit analysis and evaluation of loan terms
• Project valuation

Due Diligence in Project Finance – Key Processes

While there are multiple steps when conducting due diligence in project finance, four key processes require significant evaluation.

Assessment of Promoter History and Background

An assessment of the promoters’ history is conducted to ensure promoters’ commitment to the project. The main motive is to identify the background and track record of the supporters sponsoring the project. The following terms are assessed:

• Assessment of group companies – Involves the in-depth study of various companies promoted by the sponsor. Evaluation of group companies is necessary even in cases where no direct support from companies to the project company exists. If the group is facing a severe financial crunch, the possibility of diversion of funds from the project company cannot be ruled out. The lenders need to take adequate steps to ring-fence the project revenues in such circumstances.
• 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 association. The lender should identify any incidences of default and analyse the causes.
• 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 shareholder’s agreement – Study of the shareholder’s contract should be done 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 the protection of minority interest, the procedure for issuing shares of the company to the public and the method of resolution of shareholders disputes.
• The management structure of project company – A study of shareholder’s agreement helps determine 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 multiple 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 critical stages in due diligence, as a substantial capital expenditure is to be incurred. The project cost is benchmarked to other similar projects implemented in the industry. Also, there needs to be an assurance that appropriate contingency 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 materialise in view of changing business scenarios. Hence, it is essential to sensitise the business model to vital parameters. The lenders need to assess the project’s financial viability in light of sensitivity analysis coupled with ratio analysis.
• Benchmarking with the industry – Analysing the critical ratios in light of available industry benchmarks helps assess 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
• Analysing 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 reduce the debt cost, 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 endeavours to match the principal repayment schedule with the cash flow projections while leaving a 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 – The build-up of a sinking fund or Debt Service Reserve Account is usually established to safeguard the lenders’ interests. Such a fund entails a deposit of a certain amount in a designated reserve account 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 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 utilised to pay 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.