Financing the Mozal Project
Li Hongru, Ji Bian & Frantz Moudoute
Analysis of an Project Finance case in Mozambique
The University of Hong Kong, MBA Class of 2016
Summary
Summary ........................................................................................................................................ 2
The Mozal project – Presentation ........................................................................................... 3
Project Financing – Definition ................................................................................................. 3
Project finance -‐ Advantages and disadvantages ............................................................. 4
Advantages ................................................................................................................................ 4
Disadvantages .......................................................................................................................... 4
Project Financing -‐ A solution for Mozal ............................................................................. 5
“Hujambo Mozambique!” .......................................................................................................... 5
Risk assessment ........................................................................................................................... 6
Sovereign risk........................................................................................................................... 6
Political Risk ............................................................................................................................. 6
Currency Risk ........................................................................................................................... 7
Economic structure risk ........................................................................................................ 7
Why investing in Mozambique? ......................................................................................... 7
Internal Rate of Return Calculation – Solving CF Equation ............................................ 8
Internal Rate of Return Calculation – Solving CAPM Equation with a 7.5% Market
Risk Premium ............................................................................................................................... 8
Internal Rate of Return Calculation – Solving CAPM Equation with a Brady Bond
Yield spread ................................................................................................................................... 9
Required Rate of Return Simulations ..................................................................................10
Mozal project finance structure and risk management ...........................................................11
Political Risk Insurance................................................................................................................13
The Mozal project – Presentation
Mozal is an aluminum smelter project in Maputo, Mozambique, involving 4 main parties including the local government, striving to rebuild the country after 30 years of civil war ended in 1990. With an initial design in
1998 scheduled to handle 250,000 ton
per annum Mozal will later more than double its size through 2 major construction phases. Ultimately the project will have a cost of $2bln including am internationally syndicated
$1.1billion non-‐recourse 1 project funding. Seating in the Beluluane
Industrial Park of Maputo, Mozal will not only contribute to the economic growth with an estimated 53% increase in exports & 28% in imports, but also create a large number of jobs (direct and indirects) and last but not least improve the quality of life of the Mozambicans among others.
Project Financing – Definition
Project financing is a multi-‐party long-‐term funding solution mostly used for large projects, using a special purpose vehicle to carry solely the assets related to the project and protect the sponsors in case of failure from a liability stand point.
The financial engineering behind project financing involves a combination of equity owned by a group of sponsors, and a loan from a pool of financial
1
Liability-free secured loan
institutions. Unlike classic types of funding, project finance will strictly rely on the initial investments from the owners, and the distribution and levels of projected cash flows (earnings and asset management generated) for the valuation of the project and the reimbursement of the associated loans. Last but not least the Special Purpose Entity ultimately allows a smooth transfer of assets from the sponsors hands unto the actual manager of the project.
Project finance -‐ Advantages and disadvantages
The advantages of project finance will stand around valuation matters, while disadvantages will tend to be at an administrative or contractual level.
Advantages
•
The segregation of the SPE2’s assets from those of the sponsors will allow a leaner valuation of the project and increases transparency in ALM3.
•
Project Finance improves the borrowing conditions as the future income-‐ based cash flows are expected to remain within the SEP accounts.
•
At a higher level, project finance limits the usage of the credit line of the sponsors simultaneously allowing the SEP to borrow with significant leverage. Disadvantages
•
The number of sponsors, lenders, advisors and agency involved can increase the complexity of the deal
2
3
SPE: Special Purpose Entity
ALM: Asset and Liabilities Management
•
Significant legal and administrative costs can occur -‐ according to a World
Bank study legal cost could be between 5 and 10% of the project total cost4. •
Project finance require specialist at a legal and financial advisory level to reduce contractual and responsibilities risk
Project Financing -‐ A solution for Mozal
Due to the number of parties, the presence of sovereign and political risk and for optimization of the usage of balance sheet, project finance appears as an ideal solution for foreign investors considering allocating funds to the Mozal project.
“Hujambo Mozambique!” 5 A former Portuguese colony independent since 1974, Mozambique went through
18 years of continuous civil war ended in 1992 through a peace accord signed between the Frelimo and the rename parties. Since then the 10.6 million inhabitants southeast African country has committed to a consistent post-‐war reconstruction program, preparing a brighter future for its young population –
45.9% of which is between 0 and 14 year old. Among the reforms undertaken by the Mozambique government since the end of the war are ports roadways and railways upgrades, the Maputo Development, the Nacala and the Beira Corridors
4
5
Transaction Costs in Private Infrastructure Projects—Are They Too High? (link)
Hello Mozambique !
(export ways to neighboring countries) and the creation of Linhas Aereas
Mocambique (LAM).
The Government Investment Promotion Centre (CPI) has taken the main role into bringing foreign investors to Mozambique, offering co-‐investments program with the government of Mozambique.
A part from the post-‐colonial nationalization events of 1975, expropriation risk remains pretty low. For dispute settlements Mozambique joined several international compensation and bilateral investment treaties to reduce foreigners risk exposure. Last but not least, strikes and social manifestation continues to occurs but have rarely tuned violent.
Risk assessment
Sovereign risk With a Total debt to GDP standing at 355% Mozambique appears to have one of
Africa’s higher sovereign risk. However one can claim that the ratio is trending lower from it’s 1992 high at 413.7% and might have room for further downside.
Further improvement on the total debt management can help the country exit a vicious circle: “Relying on Foreign Direct Investment to attract Foreign Direct
Investment”
Political Risk
Thanks to continuous peace dialogue the country manage to work on political stability and raise its ICRG risk rating from 42 in 1985 to 56.0 in 1997, the year prior to the launch of the Mozal project.
Currency Risk
Economic structure risk
Mozambique has very strong exposure to agriculture, which should be offset by a strong dependence on mineral exports as Mozal production kicks off. Further efforts in agriculture and tourist industries will be a positive step towards diversification. Why investing in Mozambique?
On top of having a very good fit in the Mozambican industrial scene, Mozal would allow its investors to benefit from a macroeconomic stability with very positive
GDP outlook. Investors would be part of a booming natural era, while benefiting from the government efforts in attracting foreign investors via co-‐investment
Foreign reserves of the government of
Mozambique
Foreign Reserves in $Bln
Mozambique have remained at a fairly high level compares to peers, and investors can
greet
a
strong
6
4
2
0
improvement since the low of $1.69bln in 1994. (Source World Bank Data) solutions. Last but not least they will be at the doors of the very powerful South
African market of 250million consumers.
Internal Rate of Return Calculation – Solving CF
Equation
We calculate the respective total equity cash flow for each year using the following formula: = − − − ! −
Where for year x:
CFx = Cash flow
EIx = Equity Investment
SD = Subordinated debt i = interest paid.
The above calculation provide an IRR
500
of 10.14% using a 2012 project time limit, or 14.09% assuming a full 25
0
1997 2001 2005 2009 2013 2017 2021
years of service and a stable income
-500
from the 17th year.
Mozal Project - Cash flow
Projection
Internal Rate of Return Calculation – Solving CAPM
Equation with a 7.5% Market Risk Premium
An alternative calculation method would be to use the CAPM equation, by first deducing the inflation index using the Fisher Equation:
1 + ! =
Where:
1 + ! 1+
Ri is the Real interest Rates
Ni is the Nominal Interest Rates
F is the inflation index With the assumption of a market risk premium of 7.5%, it follows: = 3.5% + 1.5936× 7.5% = 15.45%
Where:
=
(! , 0)
1328
=
= 1.5936 100 + 312 + 216 + 22
Base on the sole calculation of the IRR at 14.09% and the RRR at 15.45% the
Mozal project cannot be approved by Alusaf or Gencor at the look of our results.
But further assumptions can be made, which will have significant impact on the result of our calculation.
Internal Rate of Return Calculation – Solving CAPM
Equation with a Brady Bond Yield spread
With the assumption of a market risk premium of 7.5% and a BBY at 6.8%, it follows: = 3.5% + 1.5936× 6.5% + 6.8% = 26.3%%
Where:
=
(! , 0)
1328
=
= 1.5936 100 + 312 + 216 + 22
Base on the sole calculation of the IRR at 14.09% and the RRR at 26.3%% the
Mozal project cannot be approved by Alusaf or Gencor at the look of our results.
But further assumptions can be made, which will have significant impact on the result of our calculation.
Required Rate of Return Simulations The following table is a result of a simulation taking with and without the
“Equitisation” of the Beta, on an RRR calculation with and without the Nigerian
Brady Bond Yield.
CAPM &
CAPM &
CAPM & BRADY &
CAPM
INFLATION
BRADY
INFLATION
With Beta Asset(0.78)
9,35%
7,09%
14,65%
12,39%
Decision
Accept
Accept
Reject
Accept
CAPM &
CAPM &
CAPM & BRADY &
INFLATION
BRADY
INFLATION
With Beta Equity(1.59)
15,45%
10,83%
26,29%
21,67%
Decision
CAPM
Reject
Accept
Reject
Reject
The following table summarizes the decision process using the NPV and the various Cost of Equity obtained from the previous simulation. Required
Beta Asset
RoR
NPV
Decision
CAPM
9,35%
176
Accept
CAPM & INFLATION
7,09%
397
Accept
CAPM & BRADY
14,65%
(111)
Reject
CAPM & BRADY & INFLATION
12,39%
(17)
Reject
Beta Equity 15,45%
CAPM
(138)
Reject
CAPM & INFLATION
10,83%
71
Accept
CAPM & BRADY
26,29%
(311)
Reject
CAPM & BRADY & INFLATION
21,67%
(266)
Reject
An amendment of the dividend and interest payment under the equity and subordinated debt investors would result in an increase of the IRR there for creating more political risk and increasing the risk of expropriation.
Mozal project finance structure and risk management Origin
Amount (millions)
% of Total Funding
Cash
35
2.56%
Subordinate debt
150
10.98%
Equity
500
36.6%
Senior debt
680
49.81%
Total
1365
100%
Figure 1: Financing Structure for Mozal Project
The Mozal project presents several risks that are mitigated as follow:
Risk
Mitigation
Expropriation
Verbal guarantees except for case of national interest on adding to Investment protection and Promotion treaty.
Dispute
Modification of the commercial code in action since 1998
Settlement
providing basis for modern commercial arbitration and creation of CACM6
Performance
Introduction of World Trade Organization Trade-‐related
Requirements
Investment Measures
Transparency
Project to introduce new financial reporting standard
Financial
Eligibility since 1998 to benefit from HIPC Initiative assuring
Strength
$1.4 billion in nominal debt relief.
In addition to the government effort to mitigate overall risk, the the use of leverage contribute to reduce the notional at stake for the parties involved in the transaction. 6
CACM: Commercial Arbitration, conciliation and Mediation – under the USAID umbrella Currency risk remains a key point to focus on as it could result from the government actions to devaluate its currency or from external flow from other operators in the region. It can be hedged partially using the World Bank facilitation services, or by entering a currency swap with a regional counterparty of respectable credit name.
At a broader level operational risk in the Mozal project will mitigate by the involvement of several international actors such as Eskom and EdM for the electricity delivery. Bauxite would be coming from Australia, Crude Oil from the
USA, Coal from South Africa and Japan providing a diversify source of raw materials. The role or LME for the pricing, the usage of subordinated debt for interest rates risk management and the involvement of the World Bank to limit sovereign risk.
Political Risk Insurance
Political risk Insurance is defined as a protection contract that business can subscribe against political risk such as political violence, expropriation, business interruption and inconvertibility of foreign currency. The political risk insurance business has been growing with globalization but remains a just above 1.3 billion dollar market counting AIG, Atradius, Catlin and Coface as the biggest players. 250
200
150
1997
1998
100
50
0
Total
Developpping Countries
Figure 2: Project Finance Notional in 1997, Source Capital Data
For the Mozal project, multilateral investment guarantee agency CGIC of the
Mozambique government provided cover for 15 to 20 years, pricing 1 to 1.5% sector dependent and additional credit risk cover with the Mozambique government as a counterparty. Among CGIC solution for hedging the risk underwritten for Mozal project is the shorting of a basket of regional funds. One could think of funds listed on the near-‐by South African exchanges. IFC – The World Bank Group
Incorporated in 1956 as a division of the World Bank Group, IFC offers investments, advisory and Asset Management to stimulate private sector investments in Emerging Countries. Well known for its due diligence approach, its commitment to social impact investments, it’s properness and fairness in dealing, IFC was a key player to trigger the discussion between parties on the
Mozal project. The group would partly share the same objective as investors, but it will have a complementary function of providing loans with ultra-‐long
maturities and unlike a lot of banks, it would provide funding at a subordinated level. With the capacity to work on the contractual terms of the project it occupies a very central position in the negotiations. From a risk management perspective, being able to diversify a single investment between equity and debt can be seen as a competitive advantage for such institution. Last but not least, due to the commitment of the firm for social impact investments, and the low participation in Sub-‐Saharan Africa, one of the most dynamic region to come
(7.4% of portfolio) we would approve the deal at a conceptual level, but would apply greater care in the economics of the trade.
Conclusion
The world had navigated through several crisis which taught us a lesson about exercising unparalleled care on analyzing projects as a whole. While project finance as a field is significantly less used than traditional funding solutions – partly due to the size and scarcity of large projects -‐ it remains once the preferred channel for multi-‐party large size investments. As of 1997, the World
Bank estimates about $250 billion of funding needs per annum which could benefit from Project Finance. The Mozal project in Mozambique shows us how project finance responds to the needs of risky investment in emerging country among other, with a good integration of functions and a relatively smooth execution. 