Management of risk in project finance viola-funding September 24, 2023

Management of risk in project finance

Management of risk in project finance
Management of risk in project finance

This issue of management of risk in project finance is especially relevant for large projects based on innovative technologies, which carry the greatest risk for potential investors and lenders. Risk management is an important element of the project finance method based on the distribution of risks among the participants.

Risk management is one of the most important elements of project management. However, such a general definition has the disadvantage that it is difficult to draw conclusions about the nature of the risk and the type of risk based on it.

Viola Funding Limited offers long-term financing for projects around the world, including loan guarantees.

Viola funding Limited offer her customer supports at all stages of investment, including planning and risk management in project finance.

 Risk in project finance: the concepts

Describing the various types of risk in the project finance literature, the definition of risk itself has been largely ignored. In its most simplified form, risk can mean a threat to the implementation of plans.

In the case of investments in the securities market, the measure of risk is the dispersion of predicted or empirically observed results in relation to the expected level.

Due to the significant differences between individual investment projects, the only way out in this situation is the expert method and modeling of various scenarios and their chances, as well as sensitivity analysis.

At the same time, the complexity of the projects does not allow for a deep study of all the factors that affect the final result of the investment projects. There are threats here that cannot be quantified. This happens, for example, when the implementation of the project is under threat due to the lack of appropriate qualifications of management personnel. It is impossible to estimate in advance either the potential losses that may arise as a result of inefficient management, or the likelihood of such a situation occurring.

When this chance is unknown, we are dealing with a decision-making situation under conditions of uncertainty. However, the goal of risk management in project finance is not so much to quantify all risks, but to accurately identify areas of threat and develop effective methods to protect against them.

There are several implications of this definition of risk.

This approach not only allows the inclusion of non-quantifiable hazards in the analysis, but also has a significant impact on the risk testing methodology.

Another important feature of the aforementioned concept of risk is that only those events that have a negative impact on the finances of the project are taken into account.

 Project finance VS corporate finance

Due to the scale of projects and their isolation from sponsors, the assets of a special purpose vehicle (SPV) are usually not enough to repay the debt. For this reason, lenders have to look for alternative ways to secure their financial interests.

Some experts mention full recourse financing, but this method differs little from traditional debt financing.

In the case of a traditional investment loan, the borrower is liable to the bank with its assets and thus assumes all the risk associated with the project. Both banks and other lenders, in order to minimize the risk associated with issued loans, often require collateral that significantly exceeds the value of loans issued. Thus, lenders increase their chances of getting their money back in case of failure of the investment project or financial difficulties of the debtor.

The introduction of project finance schemes is excellent for risk management, which is of great importance in the case of large investment projects, the failure of which means huge losses for both their initiators/sponsors and lenders.

For example, burdening a construction contractor with the consequences of delaying the commissioning of a building will force him to do everything to prevent this from happening. The capital provider, for example, has no such influence on the construction schedule, and therefore cannot influence the risk sufficiently.

There are two basic forms of project finance:

• Non-recourse financing.
• Limited recourse financing.

Although one of the main benefits of project finance is to reduce the risk of sponsors, non-recourse financing in its purest form is extremely rare.

There are three levels of risk sharing that can be distinguished here:

Risk associated with the failure of the project, the delay in debt repayment.

Risk associated with this project among themselves.

Different types risk at stages of projects

Depending on the purpose of the risk analysis, they can be classified according to different criteria. In PF, insured risks, bank risks, and sponsor risks are often distinguished.

While insurance risk is easy to separate, the division between bank risk and sponsor risk is highly variable. While banks try to minimize exposure to other types of risk besides credit risk, in the case of project finance they tend to take on most of the risks traditionally borne by business owners.

Another proposed risk classification is the separation of internal and external threats. This classification is difficult in practice for two reasons.

It causes significant difficulties in classifying certain risks.

He does not clearly separate the causes and characteristics of these two groups of risks, as well as the tools for managing them.

For example, the risk of cost overruns is classified as an internal risk, but one possible reason for cost overruns is changes in regulations requiring the purchase of equipment that meets more stringent standards (external).

A large number of risks associated with projects and their diversification cause problems with classification.

Due to the complexity of risk classification in project finance, a single universal scheme has not yet been developed.

It is worth mentioning the classification of risks by phases of the investment project.

Modern approach to risk management in project finance

The higher the risk, the higher the probability of business failure and loss of invested funds. At the same time, there is increasing pressure from lenders to pay higher risk compensation. This increases the cost of the project, and high risk is often the reason for abandoning it.

The risk management process can be represented as follows:

1. Identification of risk areas.
2. Determining the threat posed by the different types of risk.
3. Choice of strategies and tools of risk management.
4. Implementation of the chosen strategy.
5. Monitoring and control of project results.

The template use of one tool helps to protect against any risk only in rare cases. For this reason, several options are usually used, and the risks are shared among the participants. For example, a special purpose vehicle can reduce risk by using non-combustible materials in the construction of the facility. This will reduce the threats associated with fire.

In a complex investment project, it is not easy to renegotiate contracts between participants, but there are a number of tools that can be used to manage risks in the investment process.

Project finance is characterized by a broad understanding of risk management.

This includes proper project design, hiring experienced engineers and operators, or the aforementioned use of non-combustible materials in construction.

Environmental risks and force majeure

These are threats that are beyond the control of the project participants and affect the success of the project, including natural disasters, fires, floods, earthquakes, hail, and lightning strikes.

Risks that threaten any investment project is the risk of unforeseen impact of external forces, including environmental risks.

General recommendations include the following:

Project insurance.
Partial transfer of risk to creditors.
Risk taking by other participants.

Since the impact of force majeure on the project cannot be prevented, the management of this risk is focused on providing ex post coverage of losses and is very limited.

If you are interested in project finance, VIOLA FUNDING will make it happen.

Our experienced financial team is ready to offer you customized solutions for any project, including professional risk management and consulting support from planning to the operation stage.

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