🧗 Project Finance 101: The Ultimate Guide to Funding Your Next Big Idea!
OIJ (#9) Sharing my experience modeling funding schemes of large-scale projects, such as infrastructure, energy, or industrial project. BONUS case study at the end.
My dear fellow Hermits 👋
Welcome back to 🧙♂️ The Hermit 🧙♂️
ICYMI:
🎧 The Hermit Podcast: Limes Schloss Clinics Interview w/ CEO
💼 Hermit Portfolio: June Update
📈 Investment Thesis: Cardlytics
If you haven’t yet, subscribe to get access to this post, and every new post
What is Project Finance?
Even though Project Finance might sound like the twin brother of Project X, it’s only a fancy way of saying advanced Excel modeling.
By definition, Project Finance involves modeling the funding of large-scale projects, such as infrastructure, energy, or industrial projects.
Source: Acuity Knowledge Partners
Future cash flows and assets serve as the primary collateral for the loan of these mega projects. This type of financing is typically used for endeavors that require substantial capital investment and have a long development timeline.
Consider large hydroelectric power stations that supply electricity to millions of households. These projects come with a hefty price tag, often in the billions, require years of meticulous planning and construction, and typically grant operators a 35-year concession to manage and profit from the facility.
Source: Mercato Finance on Medium
Hydroelectric dams (pun intended) are massive projects typically undertaken through Public-Private Partnerships (PPPs). These partnerships align public interest with private financing. Successful PPPs require a project manager who can harmonize the interests of all stakeholders, including the government, users, financiers, construction teams, asset managers, operators, and environmental groups. That’s where I came in.
I used to work for one of the project managers who worked for multilateral development banks (World Bank, African Dev Bank, CAF, EU Investment Bank, etc.). This allowed me to travel the world and work on large projects as a Stronghold Taskmaster minion. Here’s how I added to a few projects (CV BS-style):
Contributed to seamless project operations while coordinating the conduction of a 600MW hydroelectric plant in Ecuador.
Collect information, perform research, and analyze assets while serving as an analyst for the Quality Infrastructure Investment World Bank Fund.
Modeled the restructuring of the complex capital structure of a 700MW hydroelectric power station in Zambia.
Eliminated procedural inconsistencies as well as ensured on-time attainment of set objectives by providing expert-level advice to USAID-financed logistics airport facility expansion in El Salvador.
And here’s my not-so-beautiful face in a magazine published by my former employer CPCS (Canadian Pacific Consulting Services). You’ll find two Cambridge-educated hard-working gentlemen (left and middle) and then there’s me (on the right) at a transportation networking event. P.S. We almost won the bid for the expansion of the metro in Tel Aviv during this conference.
Applying Modeling
For me, involvement in all of these projects was less about dealing with stakeholders and more geared toward elaborating backbone reports and models. This paperwork trail would serve as proof of certain recommendations that would later be voted in and out of the project’s different stages.
My core competence resided in understanding and evaluating different elements (inputs), putting them through a black box (model), and extracting conclusions from them (output). The model looked something like this:
Source: Adobe Experience Cloud
Models for these types of projects are usually very complex, overly complex if you ask me. However, when all is said and done, in most cases they are a necessary evil.
On the one hand, you have to convince people to put in large sums of money (in the billions), which potentially translates to losing these same amounts if the project fails.
On the other hand, I’ve seen some crazy “necessary” expenses and uses of funds pass by unencumbered. The craziest example is by far the pay-in-kind structure of an African railway company C-suite. These managers would get indirect compensation by hiring members of their families for random positions.
Source: milanuncios
🚗 It got to a point where the CEO of this railway company had - exclusively for himself - 30 chauffeurs under direct employment.
As ridiculous as this may sound, it is 100% true.
How can YOU use Project Finance
Okay. Perfect. Got it.
“But, what’s in it for me?”, you may ask
Naturally, Dr. Watson.
You see… if pros use this to evaluate massive projects, and they do so - for the most part - successfully… why don’t we use a simplified version to replicate their accuracy on a smaller scale?
Sure… that might work.
Let’s start by examining the key information required, then understand the different valuation methodologies, and finally close out with a practical example.
Gathering Data
Before we jump into a quick exercise, we must first look at the source of this information. In the US, we can either go to SEC Edgar or type in Google the name of the company (or ticker) followed by “investor relations” (e.g. HGV invest relations). We will be using Hilton Grand Vacation (HGV) as an example.
You’ll land on either one of these:
Source: HGV on Edgar SEC
Source: HGV Investor Relations
We are looking for the SEC filings either 10Q (quarterly report) or 10K (annual report) that look like this:
Source: HGV May 2024 10Q
You can use Edmund SEC, a comprehensive AI-powered search tool for financial data, to locate key information within filings efficiently.
EdmundSEC provides access to earnings transcripts, company documents, and allows data downloads to Excel.
Try out the full version for free with the 7-day trial, and get 15% off your subscription by using this link
The 3 Statements
Within these filings, we will look for data and key figures in the three financial statements: the Income Statement, the Balance Sheet, and the Cashflow Statement.
Source: HGV May 2024 10Q, Income Statement
This would be the typical income statement.
I prefer using TIKR Terminal to perform a rough preliminary analysis of the financials (this is not sponsored content). Tikr provides accurate aggregated data that can be broken down into more comprehensive bits, giving us a much better overview of the company.
Source: TIKR Terminal, Income Statement of HGV 03/2021-03/2024
Source: TIKR Terminal, Balance Sheet of HGV 03/2021-03/2024
Source: TIKR Terminal, Cashflow Statement of HGV 03/2021-03/2024
This post will not dive deep into analyzing each item on these statements. However, I went ahead and highlighted the key elements that we will use in this exercise. Here’s a brief explanation of each one:
Income Statement
Revenue: Sales or turnover. Quantity of product/service sold * $price$
Gross Margin: Revenue minus Cost of Goods Sold (raw materials)
Operating Income or Earnings Before Interest & Tax (EBIT): Money generated by the business after all ordinary expenses
Balance Sheet
Net Financial Debt (NFD): Total financial debt (excluding shareholder debt, non-bank debt, etc.) minus the company's immediately available cash. Capital leases are typically included as debt. When calculating NFD, be cautious about including cash equivalents, as only highly liquid assets should be considered
NFD = Short-term Debt + Long-term Debt - Cash (and some cash equivalents)
Market Capitalization + NFD = Enterprise Value (EV)
Cashflow Statement
Cash from Operations: Cash inflows and outflows resulting from the normal operating activities of the business
Capital Expenditure (CAPEX): Cash used for maintaining and expanding the company's productive assets
Free Cashflow = Cash from Operations - CAPEX
Valuation: The 3 Methods Overview
There are three popular ways of arriving at an approximate valuation:
DCF Analysis: Based on intrinsic value and future cash flows, detailed but assumption-sensitive.
Precedent Transactions Analysis: Based on historical M&A activity, reflects acquisition premiums but dependent on comparable transaction availability.
Comparable Company Analysis: Based on current market multiples of peer companies, quick and easy but influenced by market conditions
Each one has its pros and cons. There is no one rule of thumb here. You should look at all three before making a purchase.
However, I’d strongly recommend you use DCF as the base measurement. I know some people will disagree, but a business that has perpetual negative or zero cash flows is worth $0.
Therefore, cash flow analysis is a necessary but not sufficient condition. Otherwise, you are just playing a game of hot potatoes (more like a hot turd).
You REALLY don’t want to be the one holding the turd when the music stops.
Source: iStock
Valuation: The 3 Methods Explained
A) Discounted Cash Flow (DCF) Analysis
The DCF analysis is a method of valuing a company based on the present value of its expected future cash flows. This approach involves projecting the company's free cash flows over a specific period and then discounting them back to their present value using the company's weighted average cost of capital (WACC).
Forecast Free Cash Flows: Estimate the company's free cash flows for a forecast period (usually 5-10 years)
Calculate Terminal Value: Estimate the company's value beyond the forecast period using methods like the perpetuity growth model or exit multiple
Discount Cash Flows: Discount the forecasted cash flows and terminal value back to their present value using WACC
Sum the Values: Add the present values of the forecasted cash flows and terminal value to determine the total enterprise value (EV)
Pros and cons
➕ Based on intrinsic value and fundamental analysis
➕ Comprehensive as it considers detailed future projections
➖ Highly sensitive to assumptions and estimates (e.g., growth rates, discount rates)
➖ Can be complex and time-consuming
B) Precedent Transactions Analysis
Precedent transactions analysis, also known as transaction comps, involves analyzing the prices paid for similar companies in past M&A transactions. The idea is to derive a valuation multiple based on how much acquirers have paid for similar businesses under similar circumstances
Identify Comparable Transactions: Find recent transactions involving companies similar to the one being valued
Calculate Transaction Multiples: Determine relevant multiples from these transactions, such as EV/EBITDA, EV/Revenue, P/E, etc.
Apply Multiples: Apply the median or average multiple from the precedent transactions to the corresponding financial metric of the target company
Pros and cons
➕ Reflects current market conditions and acquisition premiums
➕ Easy to understand and apply
➖ Historical transactions may not always reflect current market conditions
➖ Finding truly comparable transactions can be challenging
C) Comparable Company Analysis (Comps)
Comparable company analysis, often referred to as comps, involves valuing a company by comparing it to similar publicly traded companies. This method uses valuation multiples derived from these peer companies to estimate the value of the target company.
Select Peer Group: Identify publicly traded companies that are similar in size, industry, and financial metrics
Calculate Trading Multiples: Determine relevant valuation multiples for these companies, such as P/E, EV/EBITDA, EV/Revenue, etc.
Apply Multiples: Apply the median or average multiple from the peer group to the corresponding financial metric of the target company
Pros and cons
➕ Reflects current market sentiment and trading conditions
➕ Generally quicker and easier to perform than a DCF analysis
➖ Subject to market fluctuations and sentiment
➖ Difficult to find perfect comparables, leading to potential inaccuracies
Valuation: Practical Example
With all this in mind, I want to share a practical case with you. During summer break, I had to solve this case in under 12 hours as part of a final-stage interview process with Ricoh, a listed Japanese company.
The task involved creating a comprehensive M&A model and screening six potential acquisition targets.
The case was based on transactions the 5-person team had completed over the past three years, meaning they were very familiar with the outcomes.
Once I completed and submitted the task, I had two hours to defend my case and answer questions in a meeting with a senior analyst and the head of M&A EU. Both were very competent and well-prepared, and their questions were fantastic, making for an incredibly engaging meeting.
Needless to say, I was not hired. To be frank, I think I did a pretty good job, especially given the time constraints.
Feel free to judge my work harshly, but before you do, know that I got the price right within a margin of ±5%! 😊 hehehe
Context over. Now, I’ll provide a step-by-step explanation of how I solved it. I dislike publications that tease readers with “Here is the demo, for the full case you need to pay $XXX.” So here are the case’s instructions and base data. You will find my solution behind a $15,000 paywall.
Just kidding 🤣
Scroll down, and you’ll find it at the very end.
Feel free to try it out yourself or follow along with the step-by-step solutions outlined below. This solution is not a model-perfect template; it’s simply the way I solved it.
Exercise 1: Target Evaluation (Step-by-step Solution)
The first problem was fairly straightforward. You were presented with 6 targets that should be ordered from most attractive to least attractive. The testers provided comparable information on each target with some added explanation of what they were looking for. Additionally, the testers suppressed one or more characteristics of each company to make the task slightly more challenging.
Here is a brief explanation of what each variable means and how we can use it to better understand the company:
Provided info:
Country: Marketplaces where the company offers its products/services. The team expressed a preference for the EU but is open to EMEA
Current Capabilities: A measurement of redundancy and potential synergies within the company
Offering: Products and services provided by the target. We aim to match these to existing offerings or client demand to create synergies
FTEs (Full-Time Employees): In a software company, we expect this number to be low. Generally, the lower the FTE count, the easier it is for a larger company to integrate culturally
Revenue & CAGR: Sales and 1-year Compounded Annual Growth Rate (CAGR). We prefer a fast-growing CAGR. For startups, this can be 50%+ per year; for mature companies, 5%+ per year; and for microcaps, 15%+ CAGR
Gross Margin (GM): The difference between sales and the cost of raw goods. In software companies, we expect a high GM due to personnel costs. For product-manufacturing companies, a healthy GM is around 60%+
EBITDA: Earnings from normal operations, excluding Depreciation and Amortization (D&A). D&A represents the decay in value of both tangible and intangible assets
EBIT: In software companies, EBITDA and EBIT should not differ significantly. A large difference may indicate substantial fixed assets and higher expected capital expenditures (CAPEX)
Annuity (Return): The expected return on the investment in the company at the current market rate or price. An annuity is often used as a substitute for the coupon or expected annual payment received by bondholders
Ownership: The counterparty we are negotiating with. Private Equity (PE) firms generally demand higher payments, while owners or founders may care more about business legacy and their role post-merger
Type of Process: Indicates whether other firms are also trying to purchase the target. Most serious negotiations include an exclusivity clause, preventing the company from bargaining with competing firms until negotiations conclude
Sell-side Advisor: Advisors, usually experts or investment bankers, who counsel the party in the divestment process. In my opinion, these advisors are either a waste of money (if you know what you're doing), or a warning sign (suggesting you might not be ready for the process). The best deals are often made directly between buyer and seller over a meal
I've been eager to share the following image for quite some time. In the graph, the Fundsmith team illustrates how much value various industries add to or subtract from society, based on the principle that ROCE (Return on Capital Employed) greater than WACC (Weighted Average Cost of Capital) signifies added value. Take a look at the top spot on the subtraction list - what a surprise!
Source: Fundsmith 2024 Annual Gathering
Ratios:
Currency: To compare processes effectively, we need a common currency, which in this case is euros
WACC (Size Premium): Weighted Average Cost of Capital (WACC) serves as an indicator of a project's investment worthiness. It considers various factors, including the size of the enterprise. WACC demands a higher return from smaller projects due to their inherent risk.
Revenue per FTE: A metric for measuring profitability, especially useful in Software as a Service (SaaS) business models.
Depreciation: Expressed as a percentage of revenue, this metric provides a rough estimate of expected CAPEX levels.
Each company possessed unique characteristics that could make for a compelling case. To determine what constituted an attractive target, I first drafted a list of objective criteria, starting with company fit and ending with location.
This approach provided a clear framework for identifying desirable targets and facilitated decision-making, particularly in close-call situations.
Check the solved doc for more information
Exercise 2: Company Valuation (Step-by-step Solution)
The model has a few different tabs:
Each tab serves a specific purpose. Some of it is redundant on purpose to avoid making silly mistakes. The Data and Input tab should be very similar. Data is where you post the information you received, while Input is where you order it to your needs. Many models also have an assumptions tab.
The Output tab serves as a way to project the numbers from the input tab into the future, in this case, 5 years. Lastly, Valuation is where you perform your DCF and multiple calculations.
The P&L, or Income Statement, is a straightforward way of understanding what this business has done. Additionally, with clear assumptions, we can project this into the future. The two most common assumptions are i) % growth, based on past growth averages, and ii) % of revenue, based on past averages as well.
The balance sheet is usually the most complex item. Unlike the Income Statement, the following cannot be calculated with easy assumptions. Instead, we need dedicated estimates for the evolution of working capital, debt, and fixed assets.
Once we get all these online we can move on to, IMO, the most important statement: the Cashflow Statement.
With cashflows out of the way, we can finally move on to the actual valuation of the business by using a DCF.
Check the solved doc for more information. Do not hesitate to reach out if you need help.
Valuation: Practical Example (Solution)
If you found the second part a bit brief, you're absolutely right. A comprehensive DCF breakdown should be much longer and more detailed. However, such an extensive post might put readers to sleep. Don't worry, part two will provide a step-by-step guide on how to arrive at a figure using a DCF case study. Stay tuned!
🙏 Feel free to ❤️ and comment so that more people can discover and enjoy this Substack 😇
Really good information, Alejandro! Thanks for sharing.
The bit about the railway CEO with 30 chauffeurs - classic case of "creative accounting." Reminds me why I prefer the straightforward world of stocks. At least there, when someone's taking you for a ride, it's usually metaphorical ;)