01 Apr 2001
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Big Deals: Project Finance Helps Mitigate Risk in Large-Scale Investments

by Julia Hanna

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Forget millions; think billions. That’s what HBS associate professor Benjamin C. Esty does in Large-Scale Investment, a new MBA elective course he has developed that examines how companies structure, value, and finance large, first-of-a-kind projects. “Most of these projects are start-ups, yet they cost something on the order of $5 billion, not the $5 million one might expect for a typical start-up,” Esty explains. And all too often, he adds, they can turn out to be losing propositions. The managerial challenge is to make sure that $150 billion or so of annual investment produces good projects and good returns.

Project finance — Esty’s specialty and the focus of his course — involves highly leveraged deals and risk-taking, something that has interested Esty since he wrote his doctoral thesis on risk-taking in the savings-and-loan industry during the 1980s. “I’ve long been intrigued with high leverage and its effects on managerial incentives and firm performance,” says Esty. “The projects I currently study are financed with 65 to 90 percent debt, compared with 25 to 35 percent for the typical industrial firm.”

Both the size and the uniqueness of the projects Esty examines make them difficult to manage and prone to conflicts between actual and optimal investment behavior. An inherent lack of flexibility compounds these challenges, because most projects involve binary “go/no-go” decisions. Esty uses the forthcoming 550-passenger Airbus A380 jet as an example: “You can’t build a wing and learn anything about underlying demand for the plane. Instead, you have to sink the full $12 billion into the project before learning if there is, or is not, sufficient demand.”

Given the level of uncertainty involved with these projects, they require years of negotiation, including careful allocation of risks and returns among the various parties so that they have incentives to manage efficiently. Also important is the possibility for adjustments in risk allocation and responsibilities should the project’s definition or underlying conditions change. Overall, a key element in risk mitigation is the use of off-balance sheet project finance instead of traditional, on-balance sheet corporate finance. Consider, for instance, Iridium LLC, a $5.5 billion global satellite communications firm backed by Motorola that filed for bankruptcy in August 1999.

“At the time it set up Iridium, Motorola was a $9 billion company with a AA-rating,” says Esty. “If Motorola had financed Iridium on its balance sheet, the project’s bankruptcy might have dragged down an otherwise healthy corporation. By using project finance, Motorola shielded itself from much of the damage, while retaining some ability to benefit had Iridium been successful. This ability to facilitate large, risky investments without jeopardizing sponsoring companies is one of the main benefits of project finance.”

More and more firms are turning to project finance to support large capital investments, and the trend is likely to continue due to privatization, deregulation, and globalization. “In an increasingly global business environment, achieving minimum efficient scale in production requires massive capital investment,” Esty explains. In one case coauthored by Esty and HBS research associate Fuaad A. Qureshi, the subject is a $1.4 billion aluminum smelter in Mozambique known as the Mozal project. Ravaged by a seventeen-year civil war that claimed 700,000 lives and destroyed much of the country’s infrastructure, Mozambique presented formidable risks as a project site. The cost of the plant, which was approximately equal to the country’s gross domestic product, made the investment decision even more of a gamble. Despite these challenges, the sponsors believe the country has turned a corner. They appear to be winning their bet, since the project was completed ahead of schedule and under budget.

“The social, environmental, and developmental influence of these large-scale projects can be enormous,” Esty notes. “The Mozal project employed seven thousand people during the construction phase. Along with the enduring benefits of technology transfer, it offers opportunities for local people to learn from skilled outside workers and managers while providing good wages in a country where the average person makes under $100 per year. Equally important is the project’s catalytic impact on future investment. The sponsors have decided to spend another $1 billion to double the plant’s capacity, while other companies have announced plans for additional billion-dollar investments in Mozambique.”

After a brief slowdown in 1997 and 1998 because of the Asian and Russian financial crises, the project finance market has come roaring back in the last two years. According to Esty, the use of project finance in new geographic markets and for new types of undertakings, combined with an increasing need to finance development in countries with limited resources, suggest that project finance should continue to loom large in the years ahead.

This article was adapted from material that originally appeared in Working Knowledge, Vol. IV, No. II. For related links and research information on project finance, visit Professor Esty’s portal at www.hbs.edu/projfinportal.

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