Introduction
“Ahsaan, it’s John on line 2.”
“I really don’t think I’m going to want to hear what he has to say,” Ahsaan muttered to himself.
Ahsaan is a 27-year-old associate at a large project finance bank. He went to undergraduate on the East Coast and had only come to Chicago for his first job in banking after graduation. Ahsaan is currently negotiating a term sheet for a large debt deal with John, who is calling to respond to his latest volley on terms.
The Negotiation
Ahsaan had suggested that John might need to add a debt service reserve account (DSRA) to the financing package for the 500 MW wind project on which they were both working. Ahsaan started off the negotiations on this topic with a recommendation for a reserve account sized for 12 months of forward debt service. And now John was calling, ostensibly to respond to Ahsaan’s recommendation.
Ahsaan braced for a tongue-lashing. He’d run the numbers and a DSRA sized as he’d recommended would increase the bank’s risk adjusted return on capital (RAROC) substantially. But that also meant a commensurate downward adjustment to John’s project’s IRR. As a partner at the firm sponsoring the project and a respected deal maker, Ahsaan knows John won’t gleefully accept the reduction in his firm’s carried interest that the DSRA represented.
Back to class
I like to tell some version of this story to the students who take my classes on best practices financial modeling. It’s a great way to personalize some of the more obtuse financial concepts at play when describing the economics of construction finance, namely DSRAs and the priority of draws (i.e., equity first, pro-rata, debt first).
I usually start by ascribing some lofty credentials to John, our antagonist. He may have graduated from the University of Michigan with a degree in mechanical engineering and then from Michigan State with a masters in the same field. Then, after working with EIG Partners or LS Power on gas-fired energy projects, John might have gone back to law school at Notre Dame and then return as a principal at a large wind developer like Invenergy or NextEra.
Clearly, John isn’t a real person with a last name; he’s an amalgam of the educational and professional backgrounds of people I’ve encountered across the project finance industry. And his interest in the project is quite simple: to make the project’s equity IRRs as high as possible. Which presents a clear and present issue for the protagonist of our story, Ahsaan, whose own age, profession, and educational background are intended to mirror that of the class at large.
I try to give a fictional face to these ideas because the concepts alone can get quite weighty and boring.
Here’s the boring stuff
A DSRA requires an upfront investment of capital, which is doubly expensive because it comes early in the cash stream of the project and acts solely as a dead weight for John. For Ahsaan and his team, the DSRA appears to be a necessary cost of doing business, though it adds little to the actual economics of the deal for the bank.
By teasing out this misalignment of incentives, we identify how the model that the class and I are engaged in building together can help Ahsaan think through what John is going to recommend next (hint: it’s usually some modification to the three main levers of project finance debt valuation.)
Out templates make all this easy to manage
Orbis’ project finance template was created to support our training classes by allowing all participants to manipulate what they care about quickly and efficiently. The file is available for download on our website. While the file will be useful for those already conversant with the financial and commercial concepts at play in this fictional example, our training classes build up these ideas from first principles and give participants a chance to negotiate their own best deal.
Send us a note if you or your team could benefit from John’s story. info@orbisllc.net
