An eBook by Operis

An eBook by Operis

What do you really need to know about financial models in project finance?

Financial models are at the heart of every project finance deal. This is agreed by bankers, financiers, lawyers and commercial bid managers. But they use them in different ways.

Currently there is little in the way of training to provide these different audiences with the skills they need to do this. Until now.

Table of Contents

Introduction 4 – 5

Section 1: The model literacy challenge 6 – 8

Bankers and financiers 7

Lawyers 8

Section 2: What do I need to know about models? 9 – 13

Building financial models 10

Assessing and interrogating financial models 11

Aligning contracts and financial models 12

Section 3: Operis training offerings 14 – 18

Assessing and interrogating financial models 16

Aligning contracts and financial models 17

Building project finance models 18

Project finance modelling 18

PPP/P3 finance modelling 18

Conclusion 19

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Introduction

Credit agreements, contracts and sub-contracts combine to make a raft of paperwork that covers each element of a project in fine detail. Quite often these documents are created and negotiated by separate people, in separate rooms, at separate times. The only place in which the combined economic effect of their contributions is visible is the financial model that details the long-term financial prospects of the project in question.

The success of Public Private Partnerships (PPPs), major infrastructure initiatives and energy and natural resource projects rests on well-built and well-understood financial models. It is for this reason that financial models are so vital and why it is equally vital that all those who have contact with them are highly skilled in interacting with them. The solution is not as simple as training everyone who works with a financial model on how to build or read one. There is no one size fits all approach.

A typical project finance deal involves a commercial bid

team aided by a wide range of professionals from the banking,

finance and legal sectors. Between them these individuals could easily fill a metre or so of

shelf space with files and folders relating to just one deal

To be effective different professions require different skills and their own training programmes.

Banks insist on understanding how a project will behave economically under a range of circumstances before they will agree to lend to it. They get this assurance by performing and interpreting a sensitivity analysis of the financial model. It’s a task that one particular group of project finance specialists frequently gets lumbered with. They are ones who served their apprenticeship in the industry as financial model developers. Those of their colleagues who don’t share this background are at a considerable disadvantage when called upon to assess an unfamiliar spreadsheet, and even those who do have these skills can benefit from being taught time-saving techniques directed specifically at the interpretation of existing, rather than the development of new, financial models.


“Anyone who is running a reasonably complex organisation needs to have a keen grasp on the financial performance of the organisation not only historically but even more so prospectively. This is where models are critical. People, whether internal or external, providing financial advice to the leaders of organisations should know how to build models. All industries across private and public sectors can find uses for models.”Raymond Campbell – Financial Modelling & Valuation Advisory Partner – KPMG

For legal practitioners, a distinct set of skills is relevant. They do not need to know how to assemble or manipulate a financial model themselves. Their concern is that the parts of contracts and agreements that look to financial models to calculate deal-defining quantities do so in widely-accepted ways. Their interest is in the trade-offs and pitfalls that lurk in the topics whose treatments are not yet considered settled. These subjects have the capacity to make commercially meaningful differences to deals, for which reason they are of concern as well to the lawyers’ clients, the bid managers and transaction leaders.

It is in these two areas that opportunities exist to move project finance practitioners from arduous effort to calm mastery. The authors have heard this message increasingly in recent times from their training clients, a murmur of discontent growing to a more insistent expression of

dissatisfaction with current training offerings among many project finance protagonists. Operis has responded by extending its portfolio of courses in financial modelling to meet these emerging demands of the contemporary project finance environment.

In this eBook, we take a look at the present state of modelling

David Colver

David Colver is Chairman and co-founder of Operis. He has over 30 years’ experience in the project finance industry, working for the likes of Strategic Planning Associates and N M Rothschild. David is also an active committee member of and regular presenter at EuSpRIG.

Jonathan Swan

Jonathan is Director of Training at Operis. He has been involved in developing and delivering financial modelling training since 1993, when Operis’s training was first incorporated into the graduate induction training programmes of a number of the City’s investment banks. Since then he has been involved in training financial analysts and financial managers around the world. Jonathan is also the author of the book Practical Financial Modelling, now in its third edition.

About the authors

in project finance, the distinct challenges faced by bankers, financiers, lawyers, and commercial bid managers, and the impact modelling training can have on each. Our interviews with sector experts in accountancy, banking and law reveal a generally held belief that gaining the relevant skills is harder work than it needs to be.

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http://www.amazon.co.uk/Practical-Financial-Modelling-Current-Practice/dp/0750686472


Section 1The model literacy

challenge

Many financiers develop and test financial models. They need a thorough and up-to-date understanding of the building process, supplemented by refresher training. While the practice of modelling may not change significantly over the years, emergence of new accounting standards and changes in market conditions may change what is modelled.

Other financiers have no involvement in the model development process, but still rely on the models to make decisions. They do not require such an in-depth technical knowledge of model building. Instead they need a strong understanding of how to correctly inspect, assess and understand models, in order to ensure that risk is kept to a minimum and the decisions they are making are correct.

Lawyers working on a project finance deal do not require any

Different disciplines interact with models in different ways which

require different skills

working knowledge of model construction. What they need is the ability to understand the relationship between models and loan agreements to the extent necessary to define terms that will form part of those agreements.

To gain expert insight on the work, challenges and priorities of those involved in project finance, we interviewed three experienced project finance practitioners:

• Brett Forbes, Head of Infrastructure Finance, London, at the Dutch banking and financial services corporation ING

• Mark Richards, Partner and Head of Projects and Infrastructure at the international law firm Berwin Leighton Paisner LLP

• Raymond Campbell, CBV, FCCA, FCA, BSc, Financial Modelling and Valuation Advisory Partner at the global accountancy firm KPMG


All three have carved out long, successful careers in project finance, and are acutely aware of the risks posed by modelling errors. When asked if they believe that it is as easy as it could be for people in their respective industry sectors to gain fluency with models, they all gave a one word answer: “No.”

This section of the eBook explores how the challenges differ from one project finance specialism to the next.

Bankers and financiers

The challenge for financiers is defining the right level of expertise for them and ensuring that they maintain these skills throughout their careers. Finance is unlike law and accountancy in that there is no continuing professional development obligation. And while many organisations offer some level of training to their employees, it is not always the right training. Having an office full of colleagues who can operate at ‘Excel Level 4’ is not the same as having an office full of trained financial modellers, any more than having an academic qualification in French guarantees the ability to write prize-winning French literature.

According to Raymond Campbell, Partner at KPMG in Jamaica, not enough people in finance are trained to an acceptable level in financial modelling. He explains: “Lower than desirable levels of knowledge means poorer decisions taken at both the micro and macro levels. Poor decision-making means less than optimal results by an organisation or nation, which in turn lowers the personal income level of stakeholders.”

The answer, according to Campbell, is to start training early for every employee who will work with financial models.

Then continue it throughout their working lives to ensure that gaps do not appear in their knowledge base. “There is a need for refresher training on a regular basis,” he says. “Everyone involved in corporate or project finance should have a base level of skills and a knowledge of new technologies and techniques as they come through.”

Certain banks will insist on full model build training for all staff. ING’s Head of Infrastructure Finance in London Brett Forbes cites this as one of his organisation’s priorities “We like our people to be trained in how to build models,” Forbes says. “Even if they aren’t going to do that in practice. The people best placed to interrogate models are those who know all the details of the model. They know not just what is being achieved but how it is being achieved.”

Forbes is equally clear when discussing what his industry’s relationship with financial model training should be in ten years’ time. “Everyone should be trained. It should be part of basic training in the financial sector. Not just in certain banks.”

But this kind of commitment to training is by no means standard. Contact with models of numerous financiers at all levels is characterised less by quiet confidence than by nervous necessity.

Lawyers

Lawyers have a significant part to play in project finance transactions, but they require a very different knowledge base from bankers and financiers. Instead of being able to build and assess models, they need to understand them well enough commercially and conceptually to write the legal definitions that will form the basis of loan agreements.

Berwin Leighton Paisner LLP Partner Mark Richards says that financial models “are the backbone of a transaction. As lawyers we have a strong working knowledge of the financing documents we prepare. From my perspective lawyers need to know enough about the financial model to be clear that our draft finance documents work as intended.”

Core to being able to work in project finance as a lawyer is a solid understanding of what a model does, what it looks like and the language it speaks.

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Section 2What do I need to

know about models?

The three core model skills this eBook is focussing on are:

• Developing new financial models

• Assessing and interrogating existing financial models

• Aligning contracts with financial models

But who needs to know what?

The answer depends on whether a worker spends all day actively involved with financial models, uses them in decision-making, or specifies the covenants that the model calculates in contractual language. Each role is different.

Building financial models

Building is the process of designing and developing a new financial model to the point that it can transform a given set of inputs into trustworthy projections that describe and illustrate a deal.

The indicators given most attention in such models in project finance are:

• the rate of return of the project, which indicates whether it is worth doing at all

• the rate of return for the shareholders, which measures whether it would be attractive to participate as an investor

• various debt cover ratios, which quantify how safe it would be to participate as a lender

The widespread expectation is that these metrics are derived by a complicated-looking spreadsheet. The best modellers accomplish the calculations in a way that, far from looking complicated, appears effortless and expressive to the reader. Besides long experience and practice, this feat requires a specific skillset unique to a financial modeller, one that goes beyond a general understanding of the role and workings of financial models.

What makes a good model builder is a robust knowledge of not only what financial models say, but how they work.

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That knowledge is commonly acquired though dedicated training at the beginning of a career followed up by a period working intensively with models. This kind of apprenticeship has served as the entry point into the industry for many in project finance. It should be backed by a commitment to the modeller’s continuing professional development from his or her employer – an area already identified by Raymond Campbell as one in which the finance sector needs to improve.

Assessing and interrogating financial models

Assessing and interrogating financial models are the skills that are called on when the information that underpins a decision has to be extricated from spreadsheets that were developed by other people.

The central elements of assessing models include applying checks, verifying results, and tracing logic, as well as understanding measurements such as the debt coverage ratios and their subtleties. The interrogation component is mainly about working out how to cajole a spreadsheet you didn’t construct into cooperating in a sensitivity analysis. Each of these is a tool a financier will need in order to ensure that the project they are considering is able to perform according to plan.

Most models are developed by a single person, or perhaps a small team. Many more than that have a stake in what the model says. It follows that the number of people who have to absorb information from models developed by others must be several times greater than the number who originate their own examples.

For example:

• Bankers preparing papers championing loans they are submitting for credit committee approval

• Analysts supporting funds’ and equity houses’ investment committees in their decision to participate in greenfield or acquire interests in operational projects

• Public sector advisors evaluating competing bids for PPP concessions

They don’t write models; they read models sent to them from prospective borrowers or partners.

ING’s Brett Forbes and KPMG’s Raymond Campbell agree that being able to understand models

is part of the job. As Forbes says, “It really is impossible to assess a project without knowing what the model represents.”

Unlike development, the need to be able to assess and interrogate financial models affects entire institutions, rather than select departments and roles within them. According to Brett Forbes, whose company prioritises modelling training for all project finance employees, the need to know how to assess financial models includes “everyone from the board, to analysts to senior CFOs. Anyone who is working on a major transaction and any corporate assessing its own cash flow and future financial requirements. If you are working for a bank in project finance it is one of the core skills you need to do your job.”

Individuals who have served their time in the model-development apprenticeship already described often graduate to roles in which model assessment and interrogation are prominent. One would expect them to be well equipped for these new responsibilities. But not everyone filling these roles has the same background.

Many institutions seek to prepare those whose job will be to assess financial models by retrofitting

“It is possible to understand outputs and to query the ‘correctness’ of an output without knowing the design logic or principles. We know whether the functionality of the building we are in works without being engineers. We can use knowledge of the industry or sector and past experience to determine whether the results of the model are directionally right without having the knowledge to build the model.”Raymond Campbell – Financial Modelling & Valuation Advisory Partner – KPMG

In doing so they need to ask two questions:

• Is this model to be trusted as a representation of the proposed deal?

• And is the deal an attractive one?

It is these questions that we seek to capture in calling this kind of activity Assessing and Interrogating financial models.

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training on how to build financial models. Until now, there has been little alternative. It is, though, akin to insisting that drivers take lessons in engineering and assembling a car from sheet metal, when their interest in a vehicle is confined to driving around the neighbourhood. Anyone who builds cars on a less than industrial scale will never do it as well as the manufacturers who have specialised in it for decades, and devoting time to car construction won’t bring much improvement to their driving.

Those with limited modelling backgrounds, and others who once had it but now find it rather rusty, can be shown a simple way to subject a model to a regime of black-box testing. They drive the financial model slowly, methodically and with added stabilisers giving them a high margin of safety. In many cases the job can be done with almost no contact with the external model’s formulas and independently of its style of construction.

Even those who do have years of model development experience are likely to produce more dependable analysis, at greater speed, as a result of becoming familiar with this purposeful approach, which they won’t have been taught on any model development course. Crucially, because the models they deal with originate in other organisations, professionals in this category are likely to be confronted with models written in a variety of styles. A career in finance will bring individuals into contact with modelling styles that vary by sector, by territory and by the background of the model builder. Those whose initial training to build models centred on a highly prescriptive methodology may be at a disadvantage when required to interpret a model that was built in a style that is different from the one they are most familiar with.

Leaving them knowledgeable of only a favourite subset of modelling techniques leaves them exposed when confronted by spreadsheets built to other standards. It is worth looking into ‘methodology-agnostic’ training which instead of teaching methods specific to a particular modelling brand, emphasises approaches applicable to them all.

The essential point is that those who need to assess and interrogate financial models should be equipped with the skills and techniques to do that job effectively and quickly, and not left to fathom out how to apply training in the relevant but different job of model development.

Aligning contracts and financial models

Aligning involves ensuring that the provisions of term sheets and loan agreements are consistent with a transaction’s financial model.

Extensive due diligence precedes the drawing of any funds in a project financing. As part of that process it is now routine in most, if not all, markets for the financial model to be subject to audit. The purpose of an audit is not to say

whether a deal is a good or bad one. It is simply to confirm that the model accurately reflects the provisions of the contracts that have been agreed between the parties to the deal.

There are opportunities for the numbers in the spreadsheet to diverge from the words in the contracts on nearly every page. In practice, the area where most audit issues are raised is in the handling of loan covenants: debt cover ratios, and the actions demanded when the ratio requirements are breached.

At least so far as concerns models developed by competent advisers, the response to inconsistencies between a model’s handling of a ratio and the contractual specification is to adjust the specification more often than it is to alter the model. The shortcoming is more likely to be in the words because the individuals who are responsible for drafting them are generally less familiar with the nuances surrounding the subject than are the modellers who code ratio calculations every day. Those nuances can have commercial significance, and give opportunities for winning a negotiation to the benefit of those who understand the topic over those who don’t.

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The individuals for whom this is relevant are, initially, the bankers who put forward term sheets, setting out in non-binding terms the basis on which they are willing to lend. Later, legal advisers formalise the offer in a credit agreement or equivalent document. In the long run, both kinds of institution are likely to seek to standardise their terms, saving the effort of reinvention on every new deal. Most have designated individuals or small groups as the custodians of the firm’s template agreements.

The unappetising alternative is for drafting to be pursued by individuals who have never had training specifically in the subject and are open that they don’t feel perfectly on top of the concepts. They adjust ratio definitions by taking dictation from the financial adviser, without being quite sure what it means. People in this position do not need to know how to put models together or take them apart – just what they say.

Lawyers working on project finance deals should be equipped with enough knowledge about financial models to understand the debt cover ratios, what financial models produce and how to assess ratios in long- and short-term deals. From that point they will be able to draw up contracts that are conceptually solid and handle confidently the prickly edge conditions that can otherwise go unanticipated.

These topics are not technical matters of concern only to the lawyers and bankers in the back room of a deal. They can be the points of friction which determine the lowest price that can be bid in a project that has a competitive element, such as renewable power or a PPP. In this way they can make the difference between a share-price lifting and career-enhancing victory or a bid budget spent with nothing to show for it.


Section 3Operis training

offerings

Following consultation with industry experts and colleagues, Operis has extended its portfolio of courses to capture more closely what project finance practitioners actually do.

Assessing & Interrogating

Financial Models

Aligning Contracts &

Financial Models

Building Project Finance Models

Learn a time-saving, dependable and repeatable method for understanding

and checking unfamiliar financial models and running

sensitivities through them.

Gain a first-principles understanding of how

financial covenants should be defined in credit agreements.

Learn how to construct a robust project finance

model from scratch and use it to assess the feasibility

of a project and develop a financing plan.

“At last. Training that addresses what we actually do.”ING Delegate

For more information about Operis’s training courses Click here


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“It is one of the core skills you need to do your job in project finance. If it’s not something an employee can do, they are probably in the wrong role.”Brett Forbes – Head of Infrastructure Finance, London – ING

We offer a two day course which teaches delegates a rapid, dependable and repeatable method for making sense of unfamiliar project finance models. The course is based on real-world practice as used by our own staff, and is aimed at those who do not need to build financial models but do need to understand them.

Delegates spend the first day assessing a case study model, working out whether it meets a basic level of quality. They are taught where to start in examining a new model. They practice getting it to deliver its projections in a standardised layout specifically designed to get it to tell the story of its transaction simply and clearly. They rehearse exposing and testing the workings of key debt cover and equity return ratios by a method that largely avoids the need to tangle with the subject model’s own, possibly impenetrable, calculation of these quantities.

Having established the function of the spreadsheet, delegates devote the second day to the interrogation of the model, running sensitivities. They are shown

Assessing and Interrogating Financial Models

how to establish precautionary checks that monitor whether the analysis is being performed correctly. They discuss when it is necessary to freeze model elements such as debt profiles, and when that is inappropriate; and have the opportunity to try this themselves. They are taught to log the steps so that they can give an account of what they have done at a later date and can repeat it when necessary. They are shown how to reuse their analysis when a new version of the model arrives that has been revised and updated.

The methods taught are effective at making sense of models developed in widely ranging styles and do not demand a deep background in financial model development to apply them.

Model assessment and interrogation is a core skill for anyone working in project finance who has to make sense of other people’s modelling efforts. The overwhelming reaction of attendees of this new course is “At last. Training that addresses what we actually do.”

Learn a time-saving, dependable and repeatable method for understanding and checking unfamiliar financial models and running sensitivities through them.

For more information about Operis’s training courses

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Aligning Contracts & Financial Models

This is a one day course covering the definition of loan covenants in term sheets and credit agreements. Delegates rehearse the fundamentals of what loan covenants are seeking to accomplish. They examine how a term sheet or credit agreement and a financial model interact to achieve those objectives. They consider details that compete for attention and discuss how those trade off against each other. These ideas prepare them to understand what if any are the commercial implications of alternative covenant draftings.

Gain a first-principles understanding of how financial covenants should be defined in credit agreements.

“The best kind of training is to do the basics, main principles and concepts until you understand them. Trying to learn on the job is a very haphazard way of learning.”Mark Richards – Partner & Head of Projects & Infrastructure – Berwin Leighton Paisner LLP


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We offer an intensive, four day course on developing project finance models. Comprising two sections (Methodology & Techniques and Extended Techniques), the course gives delegates a thorough understanding of model building techniques and processes.

The first section of the course shows how to take an investment decision: does a project proposal make economic sense? Delegates construct, from a blank screen, a model capable of making projections of the venture’s future statements of cash flow, income and financial position. They use the model to perform a discounted cash flow analysis, and examine the sensitivity of the key results to variations in the

Building Project Finance Models

assumptions. The case study serves as a vehicle for teaching a number of techniques and concepts which will prove invaluable to future modelling assignments.

Having reached a positive investment decision, in the second section of the course delegates develop a plan for financing their project. They learn more sophisticated modelling techniques to handle subordinated debt, a debt service reserve account, the cash cascade and debt sculpting. They explore techniques for handling and managing circularities. They cover the concepts and applications of the various debt cover ratios, and use the model to devise a financing structure that satisfies the specified financial covenants.

Learn how to construct a robust project finance model from scratch and use it to assess the feasibility of a project and develop a financing plan.

PROJECT FINANCE MODELLING

We also run a four day course focussed specifically on constructing a model to bid for public-private partnership (PPP or P3) concessions. The course covers similar ground to the project finance modelling course, with the addition of material devoted to using the model to establish the price that should be included in a bid.

“Models are critical. People, whether internal or external, providing financial advice to the leaders of organisations should know how to build models.”Raymond Campbell – Financial Modelling & Valuation Advisory Partner – KPMG

PPP/P3 FINANCE MODELLING

Learn how to construct a robust PPP/P3 model from scratch and use it to price a bid.


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Conclusion

Lawyers, financiers and modellers all have different roles to play in

project finance deals. It is not only young new recruits who need the

knowledge and skills to do their jobs to the best of their ability.

More experienced colleagues have the same need, and that need

changes as their career progresses and their responsibilities evolve

Operis has combined its years of project finance modelling and training experience with interviews of specialists currently in the front line of their industries. We have identified an urgent need for high quality training in the handling of financial models. This goes beyond training in the construction of models, which has long been offered by Operis and by others. That discipline is essential for a particular audience, which remains under-served. It is not the right starting point for others, whose need is not

to build models from scratch but to deal with ones that have already been prepared by others.

Operis offers the only financial modelling training specifically designed by experts and practitioners to cater to the distinct needs of modellers, other bankers and financiers, commercial bid managers and lawyers. The courses are the best way of ensuring a basic level of expertise for everyone involved in project finance, across the team, whatever their role.


Operis Europe

110 Cannon Street London United Kingdom EC4N 6EU

T: +44 207 562 0400

E: [email protected]

Operis North America

36 King Street East Toronto Canada M5C 3B2

T: +1 647 846 7382

E: [email protected]

Training Enquiries

Saleem Ahmed

T: +44 207 562 0418 E: [email protected]

W: operis.com/services/financial-modelling-training

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