Financing is a core part of any project. The availability of funding makes it possible to purchase the required material, pay the people involved, among other aspects of project life cycle. However, even with sufficient funding, the success of a project is never a guarantee. There are always risks involved. This relates to the fact that no aspect of project management is independent of the influence of other factors, both within the project management cycle (such as delays) and without (i.e. in the external environment). Factors of the external environment include weather and political uncertainties, among others. When it comes to financing, risks may include cost overruns. This is true for all countries and projects (Esty 2004; Faulkender & Petersen 2006; Daube et al. 2008). However, Esty (2004) observes that projects in less developed countries (LDCs) tend to face greater country, political, business and currencies risks. On this note, project finance is the best strategy for mitigating sovereign risks, and it is not possible to replicate the same function(s) of it in conventional corporate schemes.
This qualitative study will investigate the relationship between the different public funding strategies and project financing risk management in the LDCs. This will include an examination of the ways that the adoption of project finance varies across different corporate schemes.
Research Questions and Objectives
- What are the potential risks associated with project financing in LDCs?
- What are the risk management strategies and principles can organizations in LDCs use to mitigate and manage risks associated with project financing?
Toward in investigating the focus topic, the main aims and objectives will be:
- To examine how the challenges of the globalized business environment have impacted on organizations and project financing in LDCs;
- To examine the limitations/shortfalls of project financing in LDCs, including low resource capabilities;
- To suggest frameworks or models that organizations in the LDCs may adopt toward the mitigation of risks relating to project financing, i.e. develop guidelines designed to provide detailed risk management frameworks for identification, assessment and mitigation of all forms of risks related to project financing;
- To establish contingency strategies for project sustainability and continuity in the face of project financing risks.
Types of Project Financing
When carrying out a project, there is need for some financial resources, which may be funded by one or a combination of various sources. These often include both internal capital and external sources, including bank and syndicated loans, venture capital, project finance as well as arm’s-length capital markets (such as securitization or even bond issuance). Internal capital is one of the most typical sources. In this case, projects must compete for corporate resources against other projects, and the firm is tasked with the responsibility of efficiently allocating the various resources appropriately to create value (Daube et al. 2008).
According to Faulkender and Petersen (2006), internal capital market is often the most effective financial strategy especially in the case of underdeveloped external markets where the sense of agency and information problem exists, “and the accounting and auditing technology and legal protection for investors are weak” (p.55). It is the responsibilities of the firm’s headquarter to perform the selection of the winner on projects that have strong control rights (Faulkender& Petersen, 2006).
Some public sector projects, or projects that relate to the public sector, may access government subsidies and loans. For instance, projects of partnership between the public and private sectors can be long-term contractual agreements with the aim of cost-effective and efficient realization of public infrastructure and services than they would under traditional procurement. These projects tend to be characterized by optimized risk allocation as well as a holistic life cycle approach. Often, these projects are funded by non-recourse forfeiting of installments model and project finance (Daube et al. 2008).
Projects with positive NPV (i.e. net present value) can be funded when project returns exceed the capital costs. This happens if capital market is without friction in relation to information regarding the quality of borrowing firms, and where project quality is symmetric between the borrowers and the lenders alike. These are dependent upon financial intermediaries (such as banks) that specialize in gathering information about projects and borrowers. These intermediaries may be able to alleviate- albeit partially- the asymmetry of information by such interaction (information gathering process) with borrowers (Faulkender& Petersen 2006). These intermediaries enjoy some advantage over some lenders by closely monitoring the projects as well as enforcing efficient choice of projects. Regardless, this process of monitoring by financial intermediaries tends to incur substantial costs, which in turn have to be transferred back to the borrowers in various forms (including higher interest rates). This implies that the capital costs in such imperfect markets depend on both the project risks and the resources needed to verify the said project’s viability (Manove et al. 2001; Faulkender & Petersen 2006).
There are important differences between collateral in lending for projects and collateral in lending for project screening. On one hand, by getting collateral from the borrowers, creditors can protect themselves. This enables bigger and cheaper credit. Conversely, as a result of extensive experiences with the same projects in some industries, the expertise in general economic features and trends, financial intermediaries (often banks) tend to possess more knowledge about some elements of project quality and, therefore, more capable of appraising the projects’ potential performance. In the end, bank-financed firms and projects have higher rates of survival than those funded by other sources like family investors and entrepreneurs, who often tend to overestimate the profitability of these projects (Manove et al. 2001; Daube et al. 2008).
Other than financial intermediaries and internal capital, other sources of project financing are the arm’s length capital markets. These include structured loans and bonds markets. Structured finance include project finance and securitization, and are a means to separate an activity from the sponsoring and/or originating organization (Leland 2007). Typically, project generating cash flows or assets are “placed in a bankruptcy-remote special purpose entity (SPE) (Leland 2007, p.769). SPE raises funds that compensate the sponsor by selling securities collateralized by the generated cash flows.
Project Financing and Potential Risks
Several factors could pose risk to project financing, for both the borrower and the lender, and which require effective and efficient risk management. For instance, macroeconomic factors can have negative impacts on project financing (Stefano 2008; Wang 2012). Moller (2008) looks at the significant risks that political factors could pose against project financing. Moller (2008) argues that political factors go beyond just democracy and/or variables of politics-related violence. Rather, Moller (2008) considers the properties of the prevailing political system relevant to growth driven by the private sector, particularly the political variables that could have potential impact on investment decisions as well as the success of projects that are under the influence of banks. In relation to this premise, Hainz and Kleimeier (2006) use the World Governance Indicators as guideline to the analysis of variables of political risk.
On the part, Blanc-Brude and Makovsek (2013) focus exclusively on project financing risks associated with the construction of infrastructure. They touch on various issues, including construction cost overruns, which have to do with poor accuracy in cost estimation in traditional infrastructure procurement: on-budget and on-time delivery of construction- of infrastructure- projects, among others.
The size and profitability of the company can also have adverse effects on project financing. Generally, companies with bigger profits are often more susceptible to financing-related risks (Stefano 2008).
Risk Management and Project Financing
Although internal financing does not guarantee success of the project, they tend to bear fewer risks. This is because internal financing are often low-cost and are generally flexible and characterized by independent use of money (Stefano 2008; Ying & Wei 2009; Wang 2012). Most project financing risks are associated with external financing, regardless of the type and/or source. The debt ratio, for instance, increases the risk of bankruptcy. Equity enterprise financing also tends to lead to reduced efficiency of fund usage (Stefano 2008). Particularly, the most common financing methods of bank loans and stock issuance have the inherent risks of sponsors using these to make money rather than for the sake of the project per se. The general mitigation strategies against external financing include selecting the debt financing types that typically pose low risk, as well as issuance of new stock (Ying & Wei 2009).
Risks and risk management in relation to project financing are a major concern for all organizations in all countries. However, according to Alquire & Lagasse (2006), LDCs are more vulnerable in this regard, particularly their sensitivity to economic risks.
Generally, risk management entails establishing risk strategy; identification and assessment of risk; prioritizing and managing risks (Watt, 2007). However, even following this standard protocol may not lead to success without the right system or framework in place. One framework-related factor is the how many departments and/or personnel in the organization are involved. In this regard, organizations in LDCs may be limited in some way. Watt (2007) observes that in LDCs risk management is sole responsibility of the organizations’ administrate arms. The result is that risks and risk management do not receive sufficient attention. This is a major disadvantage in the LDCs. In agreement with this observation, Ntlhane (1995) calls upon the entrepreneurs and management in the LDCs pay more attention to the identification of future uncertainties and risk anticipation, risk deliberation, as well as the formulation of risk identification, reduction and elimination.
In relation to project financing alternatives and risk management, many studies assert that structured finance offers projects important cushion against risk, including low-risk cash flow projects by the securitization of asset and high-risk cash flow projects by separate financing. Leland (2007) suggests that it is best to use separate financing – more than internal financing- for large and risky investment projects, such as through project finance or as a spinoff. Leland (2007) argues that this may lead to greater ability for total financing, cheaper financing for the assets that remain in the firm as well as the preservation of core firm assets for risks associated with bankruptcy. Esty (2004) argues in favor of project finance in particular, arguing that it may benefit both the sponsor and the project through the reduction of costs of information, incentive conflicts, corporate tax and costs of financial distress.
Particularly, ample amount of literature drum up support for project finance as the best mitigation strategy against risks related to project financing. Project finance is arguably the best answer to risk allocation and mitigation. Vaaler et al. (2008) believe that this effectiveness of project finance explains its rise in popularity across the world, and especially in the less developed countries (LDCs). Further, Vaaler et al. (2008) argue that project finance, unlike other conventional loans and funding sources, encompasses not just the project sponsor’s credit worthiness, but also the commercial viability of the entire project. Many researchers emphasize that the main benefits of project finance is that it allocates to specific project risks (including revenue and price risks, completion and operating risks, as well as risks of expropriation) to the parties that are best-placed to manage them (Leland, 2007; Vaaler et al. 2008).
Epistemology refers to that which constitutes acceptable knowledge in a particular field of study. These range from principles of realism, positivism, and interpretivism. According to Saunders et al. (2009), only the observable phenomena can lead to credible data upon which a researcher can then develop a hypothesis based on a theory that already exists. The positivist approach places emphasis on the independence of the researcher. This means that is free from the subject of the study. This approach starts with a theory, moves on to a testable hypothesis that can be tested empirically and concludes with whether the theory should be modified or not in light of the empirical findings (Saunders et al.2009).
This study considers these approaches. However, mostly, this study will mostly adopt the interpretivism approach. Saunders et al. (2009) describe this approach as one that advocates that it is important and necessary that the researcher understands the differences between humans as social actors, who interpret things differently in accordance with their ‘world’. Accordingly, as already noted, this study will be based on the premise that, LDCs adopt the elements of project finance differently from the developed nations. For instance, political unrest may be a more realistic risk in the LDCs than it is in Europe. Therefore, among other things, the study aims to show how and why replicating the application of project finance as a risk management tool may be a bad idea. Ultimately, the study will attempt to justify the recommendation of a different application of project finance in these countries.
Ontology is about the nature of reality that inspires the assumptions of researchers regarding how the world operates and commitment assigned to certain views. Generally, there are two ontological aspects. Objectivism rests on the premise that social entities exist in reality that is isolated from the social actors (humans) concerned with their existence (Saunders et al. 2009). In accordance of the epistemological approach above, this study will utilize the subjectivism aspect of ontology. Subjectivism promotes the premise that social phenomena are a product of the perceptions and congruent actions of the humans concerned. In other words, this study will seek to understand the application of project finance in the LDCs as a product of the unique factors in these environments.
First, this will be an exploratory study, with the aim of finding what happens, seeking new insight, asking questions and assessing the contextual application of project finance as a project financing risk management strategy.
For sample selection, convenience sampling will be used. This decision is attributable to the fact that there is limited information on project finance and risk management in LDCs.
To gather the appropriate qualitative data, this study will use mainly interviews to gather primary data from practitioners who have been involved in project management in LDCs particularly those that employed project finance. The interviews will use structured interviews with pre-determined questions.
The selected interviewees will be contacted and scheduled one at a time either by telephone or face to face. All the interviewees will be asked the same set of pre-determined open questions. Each interview will be expected to last an average of 30 minutes. The interviews will cover general questions regarding the general project finance practices and how certain factors influence these practices. The interview will also cover specific ice-breaking (i.e. insight) questions that will also seek examples, as well as wrap up questions. The participants’ responses will be noted down by writing and will be edited later.
Rationale for the Choice of Research Method
Indeed, no single method of study is intrinsically better than all other methods. In fact, many researchers have increasingly called for the combination of different methods. The premise here is that all methodologies have strengths as well as weaknesses, but different methods used together, it is argued, would complement each other, largely canceling out each other’s weaknesses. However, the choice of methodology is primarily dependent upon the objectives of the research (Kaplan & Duchon 2003). In this case, as already noted, the use of convenience sampling and interview has to do with the fact there is limited research on project financing risk management in LDCs, which means there is hardly sufficient secondary data to base a whole study on. Therefore, this study utilizes primary data gathered through interviews. Convenience (non-random) sampling would help avoid wastage of time looking for participants. The study also uses open questions. This would give the interviewees the freedom to express themselves. Since there is limited research on this topic, the researchers are likely to ‘not anticipate’ certain themes. In answering open-ended questions, the interviewees may offer unanticipated insights. In other words, the use of open-ended questions will mitigate the limitations associated with the fact the questions are also pre-determined, which may be restrictive to an extent. Open-ended questions will allow for more in-depth exploration of the topic (Kaplan & Duchon 2003; Kothari 2007). This being an exploratory study,
The data gathered will be analyzed by regression. Regression analysis seeks to establish the relationship between two or more variables, with the aim of understanding of the mechanics. In this case, the analysis will try to establish the relationship between project finance and risk management. This analyses is to help predict the general nature of this relationship in not just the case investigated here (i.e.Nigeria), but also other LDCs.
Reliability, Validity, Generalizability and Ethical Issues
This study will take into serious consideration reliability and validity to avoid getting the wrong answers to the questions asked. Reliability has to do with the consistency of the findings of the study. Consistency is associated with the repetitiveness of same data collection and analysis techniques and procedures. Although the researchers will make serious effort to ensure reliability, there may still be problems of participant or subject bias as well as observer bias and/or error. To mitigate these problems, the study will employ structured interviews accompanied by pre-determined questions as well as the use of interview notes.
Validity entails the question of whether or not the findings are really about the issue investigated, in this case whether the findings show that the application of project finance in LDCs should be different from the application in the developed countries, and as a matter of context. There are three types of construct validity considered: construct validity; internal validity; and external validity. To achieve construct validity, the interview(s) will cover general questions about the effects of the differentiating attributes of project finance as well as specific questions seeking solid reasons and concrete example. External validity will be achieved by including interviewees with various experiences in different LDCs.
This may be the main limitation of the paper. Due to the scope and financial limitations of this paper, the sample size may not be representative enough.
This study will consider four main ethical principles: whether there is harm to participants, whether or not the participants give their informed consent; whether the study involves the invasion of the participants’ privacy; and whether the researchers deceive the participants to get information.
First, this study will not necessarily involve activities that could cause physical harm to the participants, such as studies involving tests to the human body. However, the researchers will make sure the interview environments do not place the participants in danger. The interviews will be conducted in safe and quite rooms. Second, the research team will make sure the participants know what the study seeks from them and how the data will be used afterward and seek their consent. The participants will consent forms, declaring that they understand what the study entails and accept it. Third, the researchers will promise to protect the privacy of the participants. In this respect, the researchers will promise to keep their participation in e study confidential and that the information they give will be kept safely and will not be accessed by anyone else except the members of the research team.
Limitations include the use of secondary data as well as assumptions in the analyses. These may significantly affect the study’s credibility to some extent. However, this does not diminish the significance of the paper.
The main thesis of this study implies the general premise that the elements of project finance do not apply the same in every case. Now that the study is yet to be conducted, it is not possible to confirm this premise. However, based on the general notion of situational/contextual leadership (Watson 2004), this premise sounds justified. Nevertheless, the implication of these assumptions may have to do with the fact that there is little study on project financing in the LDCs, including the associated risks. Yet, the LDCs also conduct many projects, such infrastructure construction, among others. Most importantly, there are many projects by many foreign investors, and which are increasingly on the rise as the LDCs constitute most of the emerging markets. In other words, there is an informational gap in this field of research. This study will add to the work of others that have already focused on project financing and risk management in LDCs, particularly the use and application of project finance as a risk management tool.
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