5.7. Pension Funds role in project financing

The development of a fertilizer production plant in Peru brings value to the Pension Funds portfolio and is in principle an attractive investment. Risk and Chances shall now be analyzed and a possible role for Pension Funds is then derived from the results.

Chances for Pension Funds participating in the fertilizer project

A growing market, an economic structure that is focused on cash flow for debt service and the opportunity to develop the domestic economy are strong arguments for participation.

Table 19: Chances for Pension Funds involvement in project financing

A project financing scheme is an independent small economic world with its own rules. The stability of the project and the credit rating is solely depending on the risk sharing agreement of the project sponsors and their ability to fulfil these.

A project financing scheme with potent and experienced sponsors that also bring the required expertise, seals off to a great deal the negative impact of external forces like economic or financial crises. Providing such strong sponsors the world of the special purpose entity will be save even in stormy weather.

Risk for Pension Funds participating in the fertilizer project

Many of the factors that weight against a participation of a Pension Fund in the project can be broadly described as different species of risk.

Industrial projects are complex, even more a project financing scheme that involves several parties, requires expertise in many fields and a high number of contractual agreements, that all have to be aligned with each other. In addition there is no fertilizer production in Peru yet.

Therefore information asymmetries between the project developers, sponsors and the Pension Funds play an important role. Peru’s Pension Funds therefore require from the project, the sponsors and other participants third party opinion about creditworthiness and investment rating issued by a rating agency. Also for other aspects impacting creditworthiness the Pension Funds would need to rely on in this case third party opinions for market development, technology selection, feedstock availability.

All risk impacting the creditworthiness of the project would have to be resolved until the project achieves an acceptable level of investment rating

• This could be realized through
  • Risk during project completion; completion guarantee with guaranteed capped investment cost by general contractor;
  • Supply risk: the risk of non availability of natural gas: the sponsors need to agree on the required level of security and compensation;
  • Technology risk; Sponsors/ Partners would need to supply extensive guarantees for the performance of the plant
  • Operational risk; Sponsors/ Partners would need to supply extensive guarantees for the availability of the plant and days of production
  • Off-take risk; Sponsors/ Partners would need to supply extensive guarantees for a minimum product price and off-take

Predictability and capacity of cash flow are the most important elements not only for the viability of the project itself, but also for the Pension Funds considering participation and the fund has to review the potential risk associated with it.

If the off-taker guarantees to pay a floor price than the volatility is reduced and a minimum cash flow can be assumed and the creditworthiness is depending on the off-takers ability to fulfil the guarantee, either through pure financial strength or through a diversified portfolio for the matter. The same conclusion can be drawn for the feedstock supplier who must be able to guarantee the supply at the agreed price. In case of natural gas is this guarantee solely depending on the quality of the resources reserve.

Regulatory issues

In addition to knowledge and information asymmetries, there are regulatory barriers preventing pension funds from investing in such assets. Every investment in infrastructure has to be approved by SOB and though the portfolio of the Peruvian Pension Funds show already some participation in industrial projects it is required to review the regulation and consult with the supervisor (SOB).

A specific regulatory issue might be the size of the Pension Funds and the loan volume required by the project. The Peruvian Pension Funds manage today about 30bn US$ roughly 25% each. The current investments in infrastructure, which would fall in the same sector class of the portfolio, already sum up to 11% or 3.5bnUS$. Given a typical world scale ammonia urea plant to be built in Peru that would require approximately total investment of 1.2bnUS$ the participation of a Pension Fund alone would be small.

Potential role of Pension Funds in project financing

Pension Funds involvement during the project phases may be different as the risk profile changes significantly also.

The investment phase is characterized through the project realization and erection and the risk of completion and performance whereas during the operational phase the project is confronted with market risk, operational risk, supply and off-take risk. The difference is that until project completion no cash flow is generated.

Lack of cash flow during the investment phase might be a problem for a mature Pension Fund that is cash negative. In the case of Peruvian Pension Funds, which are all immature and very cash positive, participation during the investment phase might be an option and has already be seen in other projects¹⁴¹.

As for the question of the type of capital that Pension Funds could provide, and the vehicle some consideration shall be discussed. In principle equity and debt could be considered as direct or indirect investment.

Direct investment

Direct investment mandates that the investor’s portfolio could balance the chance / risk profile. The balance can be achieved by adjusting the volume of the participation and by the type of capital.

As equity capital is risk capital, the volume of a direct participation would be small compared to other possibilities. Debt capital would allow for a larger volume given its higher protection against default.

Debt capital also allows buffering the information asymmetries between project finance and the Peruvian Pension Funds expertise. A bank as intermediate could supply debt until project completion at a higher interest rate (as compensation) and refinance itself through bonds which are bought by the Pension Fund. After completion the bonds may be converted into direct debt with a smaller interest or even shares. See also chapter side note 1 chapter 5.1

financial risk" class="wp-image-11419 size-full" height="182" src="https://sgbs.ch/wp-content/uploads/Illustration-22-Bonds-as-bridge-between-long-term-and-financial-risk.png" width="299"> Illustration 22: Bonds as bridge between long term and financial risk¹⁴²

Indirect investment

Indirect investment could be through funds or a trust as they already have been set up in the Peruvian capital market. Private Pension Funds can pool their investments and diversify risk as these funds can built up a portfolio of investment projects.

Illustration 23: Possible project financing with bonds and banks as intermediate

¹⁴¹ E.g. the financing used for the IIRSA Sur highway. As work progresses, the Ministry of Transport issues annual works payment certificates (CRPAO), which are used by the concessionaire to gather funds on the capital markets; Peru LNG
¹⁴² Following Brodehser p 221