Risk Shifting Through Nonfinancial Contracts: Effects on Loan Spreads and Capital Structure of Project Finance Deals
45 Pages Posted: 16 Jun 2008 Last revised: 26 Jul 2008
Date Written: May 5, 2008
In project finance, sponsors and lenders set up a special purpose vehicle (SPV) that receives limited or no-recourse lending for the design, construction and management of a specific project with limited economic life. A network of nonfinancial contracts (NFCs) is set up in order to limit the managerial discretion of project sponsors, to make cash flows better verifiable for lenders, and to reduce the negative impact of unexpected events on project cash flows. Using a sample of more than 1,000 project finance loans worth about US$195 billion closed between 1998 and 2003, we study negotiation of financial packages between sponsors and lenders and their cost. We use a two-stage least squares methodology to model the joint determination of spread and leverage. Our results confirm the widespread adoption of a business practice in which sponsors tend first to set up the contractual network of the project finance transaction, and only later seek financing and negotiate the level of spread and the debt-to-equity ratio with a bank syndicate. In this negotiation process, we find that lenders: (1) rely on the network of contracts as a mechanism to control agency costs and project risks, (2) are reluctant to price the credit more cheaply if sponsors are involved as project counterparties in the relevant contracts, and finally (3) do not consider sponsor involvement as a contractual counterparty of the SPV when determining the level of leverage. Overall, the lack of NFCs increases loan cost some 19 bps, and the use of NFCs signed by counterparties other than project sponsors reduces loan cost by some 110 bps. Furthermore, the absence of NFCs is responsible for a drop of 1.1 bps in the debt-to-equity ratio used for deals. Further, results indicate that - in contrast to the level of the D/E ratio - country and industry risk do not influence the level of spread, which is instead driven by the negotiated leverage and by the existence of NFCs. Finally, our findings indicate that sponsors face a trade-off between higher financial leverage and lower interest rate levels during negotiation of loan terms with lenders.
Keywords: project finance, contractual arrangements, long-term contracts, loan pricing, capital
JEL Classification: G21, G32, F34, K12
Suggested Citation: Suggested Citation