As the COVID-19 pandemic accelerates across the World, sponsors and lenders to infrastructure projects are grappling with the impact that government policy responses are having on the demand for infrastructure assets, along with the potential consequences of the move to a ‘new-normal’ with regard to working practices and travel.
Project financial models are therefore now, more than ever, critical in helping investors understand the impact of the current crisis on cash flows, enabling appropriate action to be taken to protect investments. Whilst it is not uncommon for project finance models to be capable of reflecting an extensive array of scenarios, many existing models are however unlikely to contain the flexibility required to assess the extremes of the current situation, or are perhaps unreliable in such circumstances. Projects may now be faced with additional costs, restrictions and implications thereof which project or financing documentation may demand.
As an example, the now increasingly common scenario of prolonged periods of severely reduced revenues is one that models may struggle with – usually because such a scenario was inconceivable when the model was built. Equally, whilst it is common for the impact of construction delays to be assessed when financing a project, such events are often considered discretely to other potential downsides. The lack of flexibility in some models may manifest itself as either the model simply ‘breaking’ (i.e. not accurately reflecting a project’s true financial position), or via the inability to reflect the contingency measures that project sponsors may look to implement in their efforts to ride the storm.
In this article London-based DWPF, a leading financial modelling and advisory firm focused on the infrastructure sector, provide insight into some of the challenges that may be faced in respect of the financial modelling of projects.
Issues with models for existing projects
As a firm DWPF sees hundreds of third-party models over the course of each year, either through our work as a provider of model audit and assurance services, or where engaged to work with or redevelop existing client models. DWPF therefore has considerable insight into the issues commonly affecting models, and highlight below those of particular relevance in the current climate:
- Construction delay
COVID-19 has caused major disruption to infrastructure construction activity, with delays and/or revisions of construction programmes commonplace. Given the complexity of modelling construction delay, it is common for models to either fail when implementing a delay (with issues relating to ratio calculations, lock-ups and funding shortfalls arising), or indeed to have no or limited functionality included to adequately reflect such delays. The unique nature of current circumstances may mean bespoke modelling solutions are therefore required;
- Incorrect operation of reserve accounts and facilities
Many models contain the basic calculations required to reflect the cost of debt service reserve accounts and facilities. They may not however include the functionality that allows these to be utilised in distress scenarios. Loan agreements may also permit lifecycle and other reserve balances to be used to pay debt service where shortfalls exist, but again, financial models do not commonly reflect the full complexity of the permitted flows of the accounts agreement;
- Macroeconomic assumptions
Whilst perhaps more relevant for projects operating in Europe, negative inflation and/or interest rates are a realistic prospect which could have unintended consequences in financial models. Models may not correctly pick up ‘floors’ on payments (e.g. where contracted payments increase by the higher of 0% and prevailing inflation rate), and the potential also exists for index-linked debt to react incorrectly to such changes in assumptions (again, floors are often in place to protect in the event inflation turns negative);
- Lock-up/default ratios
Senior lenders frequently impose ratio covenants (‘lockup’ ratios) that must be met before equity distributions can be paid. One common such ratio is the Loan Life Cover Ratio (“LLCR”). Given the forward-looking nature of the LLCR this can cause issues when linked to distribution tests and we frequently see this ratio ignored for such purposes. This can therefore lead to issues in periods of ratio distress; and
- Logical errors
Models may exhibit erratic behaviour caused by revenue that is close to zero or non-existent for prolonged periods. Further, error checking functionality may not cope with severe downsides, with model errors ‘hidden’ by other checks which fail for genuine reasons (e.g. lockup ratios being breached). Models may therefore need a thorough review and testing of functionality in such downside scenarios.
In addition to the above, existing financial models are unlikely to contain the functionality required to appraise the range of options investors may be considering in times of distress, for example equity injections, debt restructurings or the introduction of government support (perhaps in the form of loans). Similarly, existing models may not be capable of running the ‘what-if’ analysis required prior to implementing the above options.
Importance of an experienced modeller
The types of issues highlighted above may arise either as the result of:
- Deliberate action (e.g. keeping a model simple by restricting functionality to that considered necessary at the time);
- A lack of experience (either the modeller does not possess a wider appreciation of the project documentation which the financial model should reflect, or does not have the capability to develop sometimes complex functionality); or
- A lack of adequate testing of the model in its development phase to identify issues.
Whatever the cause however, it is times like these where the value of an experienced financial modeller becomes apparent, particularly when financial modelling issues become a drain on valuable time and resource – or even hinder the ability take quick and decisive action when most needed.
Author: Jack Lowe
Jack is Head of Head of Business Development at DWPF.
DWPF – an internationally recognised financial modelling firm
DWPF’s leading financial modelling team is vastly experienced in all aspects of modelling, including the development of new project transaction and operational models, through to corporate restructuring and M&A modelling. The modelling team also supports our advisory business, who are proud to have provided innovative and independent advice to clients across the infrastructure sector for over 20 years, arranging in excess of £7bn of financing for over 150 transactions. We also boast a highly experienced model audit team which provides model assurance services to a range of clients globally, ranked in the top tier of Inframation’s model audit league table.
Alongside our extensive track-record, a unique aspect of our offering is the overlap of the modelling, advisory and audit teams, helping ensure our experience from each of these areas translates into robust, user-friendly and commercially informed financial models. We therefore believe we are best placed to assist with your modelling needs during this time of crisis.
To discuss any challenges your company may be facing with one of experienced modellers, and to learn how we may be able to provide support please contact us at info@dwpf.com
