WHEN IT IS BETTER TO HOLD UP PROJECT?

SHAMSUL GHANI (feedback@pgeconomist.com)
Feb
15 - 21, 2010

Project financing is the trickiest yet the most fascinating aspect of corporate banking. It brings closer the two most important sectors of the economy-banking and corporate-with the possibility of their getting locked into a long-lasting relationship.

As mentioned earlier, project financing was basically the domain of development financial institutions (DFIs). National Development Finance Corporation (NDFC), Pakistan Industrial Credit & Investment Corporation (PICIC), Investment Corporation of Pakistan (ICP), Banker's Equity Limited (BEL) etc. were the institutions that practically monopolized project financing till early eighties.

When the then Nationalized Commercial Banks (NCBs), HBL, NBP, UBL, MCB, and ABL were raised to the status of development bankers, entitled to use World Bank's and Asian Development Bank's foreign currency credit lines, the corporate banking assumed new dimensions.

The banks, unlike development bankers, expedited the project evaluation job in comparatively less time and, therefore, attracted the corporate sector for tying up into a new kind of relationship that revolved around their project financing needs. NCBs' project evaluation reports that were essentially scrutinized by the international loan giving agencies drew a word of appreciation from them. The traditional DFIs also responded to the situation and scaled their performance a few notches up. Almost all the foreign currency credit lines were used up. The middle and late eighties and early nineties saw the launching of a number of industrial projects throughout the country.

Those were the days-mid eighties-when the US dollar and British pound were sold at about Rs16, and a single Pakistani rupee fetched more than two Japanese Yens. Since most of the textile machinery was imported from Japan, the era saw a textile sector boom. The subsequent devaluation of Pak rupee increased manifolds the financial viability of the projects for which machinery import L/Cs were opened during those days. But how a number of those projects defaulted on loan payback, is altogether a different story.

Project financing could either be for the expansion of an ongoing project or for new establishment. Submission of feasibility report in either case is the standard norm. The feasibility report is either an in-house preparation at the borrowing company's end or the job is outsourced to some consultants. Irrespective of the fact that who prepares them, the borrowing company's viewpoint and assumptions form the basis of such feasibilities. Bank's job is to critically examine those assumptions and where necessary, amend them and retest the viability of the project. The change in assumptions may either straightaway render the project unviable or significantly alter the total project cost to the borrowing company's chagrin.

This is the most critical phase when both sides roll up sleeves and a war to defend respective assumptions breaks out. The bankers need to be pragmatic and positive and desist from entering into the battle of upmanship. They should take the corporate sector representatives into confidence and emphasize the need to make alterations at this stage rather than ignore the issue that may entail high cost and time waste.

Further, the required change in assumptions could be highly material and the bankers may not be in a position to compromise on it. For example, the product demand forecast could be highly erroneous and in total disregard of the existing market glut conditions. The borrowing company should realize that taking the realistic market view at this stage is better than the setting up of a failed project. If it is a capacity expansion project, the company management should go into a huddle to decide on the postponement of expansion till such time the market conditions improve and demand supply gap becomes favorable.

The SBP prudential regulations' role in ascertaining the financial viability of a project, though limited, is of some importance particularly in the case of an expansion project. The existing financials of the company and the group's management performance record provide certain guidelines to the bankers. The past sales trend, inventory turnover, and receivables management give an insight into the group's ability to make profitable use of capacity enhancement. It can be safely assumed that the financing of an expansion project is easier than the financing of a new or a green seed project; the obvious reason being the availability of a host of information about the management capability, product market share, technical competence, financial standing of the group, and loan payback track record.

For an expansion project too, the calculation of the project cost estimated to go into the planned expansion is elementary. The mode of financing of this project cost is clearly spelled out in feasibility. The company share of financing may include internal cash generation, additional equity injection, directors' subordinated loan infusion etc. The bank's portion of financing should be assessed in such a manner that the overall debt/equity ratio condition is not violated with reference to SBP prudential regulations. The incremental benefits to be accrued after the planned expansion should be critically examined by the lending bankers. The additional sales revenue must result in a cash flow that guarantees enhanced loan repayments. The capacity expansion process that may include import and installation of additional plant and machinery should be completed within the allotted time. Any time overruns might turn the things topsy-turvy. The internal cash generation sucked in by the expansion activity might create a default situation if the on-time completion of process is not materialized. The bank's job is to closely monitor the implementation phase and develop an early warning system for corrective action. The time overruns might require the borrowing company and the lending bank to jointly work on a loan restructuring plan to forestall the default situation. This certainly is not the most ideal scenario from bank's viewpoint.

Consolidated projected financials for at least next five years are drawn and included in the company feasibility. These financials are critically examined by the lending bankers to ensure that the incremental benefits accruing from expansion are realistic and stand to enhance company profitability and liquidity. Although the SBP prudential regulations apply to actual financials, and not the projected ones, the projections should give a fair view of company's future.