The International Finance Corporation (IFC) is a member of the World Bank Group that promotes development in its member countries by supporting the private sector. The IFC is the world’s largest source of direct investment for private project finance in developing countries. Since it began operations in 1956, the IFC has financed over twelve hundred business ventures in more than one hundred countries.1
In recent years, the trend throughout the world has been to move away from government control of the economy and toward greater encouragement of private initiative and the development of a viable private sector. The sweeping reforms in Central and Eastern Europe, the Baltic countries, Russia, and the other countries of the former Soviet Union are the most obvious example. These changes in the political and economic climate have confronted the IFC with a special challenge and a special burden.
IFC’s Role as Investor in the Private Sector
The IFC’s principal traditional activity is as a project lender or investor. Using its own funds, the IFC lends money to, and invests equity in, private sector projects whose prospective earnings, the IFC believes, are likely to be sufficient to meet debt service and to earn an acceptable return on equity. Projects must also benefit the local economy and be environmentally sound. Unlike the World Bank itself and many other multilaterals, the IFC does not accept government guarantees of its loans or equity investments. Although, as a rule, the enterprises financed by the IFC are wholly or majority privately owned, the IFC may provide finance for a company with minority government ownership, provided that the private sector is participating and the venture is operated on a commercial basis.
IFC’s Role as Mobilizer of Resources: The “B” Loan Program and the Capital Markets
Another important IFC function is as a mobilizer of resources. The IFC raises additional funds for projects from other lenders or investors that derive comfort from the IFC’s involvement. In the IFC’s “B” Loan Program, the IFC is the lender of record but is itself funded by commercial banks through participation agreements that the IFC signs with such banks. In fiscal year 1994, for every dollar that the IFC approved for its own account, it mobilized about six dollars from other investors.2
The IFC also mobilizes finance through the capital markets. For example, the IFC may sponsor and underwrite portfolio funds for investing in local markets or arrange and underwrite international securities issues by companies from emerging markets.
Current Developments
Privatization
The dramatic political and economic changes in Central and Eastern Europe, the Baltic countries, Russia, and the other countries of the former Soviet Union have necessitated equally dramatic changes in the legal and institutional framework, thus increasing the demand for investment and advisory services in these countries, particularly in the area of privatization. The IFC’s aim in these former command economies is to maximize its impact in accelerating the transition to productive market economies.
Frequently, the IFC starts by providing technical assistance in areas such as securities market development and privatization. When warranted, the IFC makes investments directly in medium- and large-sized private enterprises. It also fosters the development of smaller enterprises through investments in the country’s capital markets, for example, by providing credit lines through financial intermediaries and financing venture capital and leasing companies.
Noteworthy advisory assignments have involved preparing and implementing, with financing from the U.S. Agency for International Development and the U.K. Know-How Fund, the privatization of thousands of small enterprises in Russia, as well as scores of small firms in Ukraine.3 The IFC designed an auction method for privatization that is being used as a model in both countries. An estimated 70,000 small businesses have now been privatized in Russia using this method.4 In Russia, the IFC also participated in the privatization of trucking firms and collective farms in one region, and both of these projects are now being used as models for other regions.
Power Sector B.O.T. Projects
Significant changes are under way in the financing of basic infrastructure. Many governments are now looking for private capital for infrastructure investments, as well as for investments in telecommunications, power, ports, roads, and the like, which were formerly financed exclusively by the public sector. For example, power projects frequently involve high capital costs and long payback periods, thus requiring long-term financing. However, private power projects may find it difficult to attract foreign direct investment. Typically, a private power project might have only one purchaser for its power, often a public utility that, owing to a subsidized tariff structure, is not creditworthy. In many cases, privatized companies have no track record, so there is no basis for judging their performance. In addition, few lenders worldwide have experience in financing private power projects because the power sector has not historically been open to private companies in the developing world. Foreign investors are particularly cautious because power projects are not export oriented and thus do not generate hard currency. Furthermore, revenues are often subject to the rate-setting policies of government agencies. Most export credit agencies are used to the comfort of government guarantees and are just beginning to accept the concept of nonrecourse or limited-recourse project finance. The IFC therefore has played an important catalytic role in power projects by attracting other investors.
A popular option today for power projects is based on the B.O.T. Model, by which a private company builds, operates, and, after several years, transfers to the government a privately financed power plant. The IFC has financed B.O.T. projects for new power stations in Asia and Latin America and is currently considering a number of such power projects in other regions. Most recently, the IFC completed, as lead financial adviser and lender, the structuring and arranging of the financing for a 700-megawatt coal-fired plant to be constructed on a B.O.T. basis in the Philippines, with a project cost in the range of $900 million.5
Typical Power Project Arrangement
In order to mitigate the risks and attract the necessary capital to the private power sector, one of the IFC’s main objectives in B.O.T. projects is to ensure an adequate revenue stream for debt repayments. Therefore, the contractual arrangements, particularly a strong power purchase agreement and provision for any potential conditionality affecting the revenue stream, are important.
Regulatory Agencies
Equally important to the strength of the project agreements are stable relationships with the regulatory agencies. Because of the IFC’s long and close relationships with its member governments, the IFC’s participation in a project is often viewed as a sign to investors that a company’s relationship with the government will be stable.
Foreign Exchange Risk
Because most power projects generate local currency revenues, potential foreign investors are concerned about the foreign exchange risk. To address this risk, lenders typically require local currency payments to be adjusted for changes in the foreign exchange rates on the date of payment. Depending on the circ*mstances, lenders may also require some assurances regarding convertibility or that some level of reserves of foreign exchange be maintained in offshore accounts.
Commercial Risks: Construction and Completion
Lenders typically will not assume much completion risk in power projects. The project company is expected to hedge this risk through use of a fixed-price, date-certain, turnkey contract that contains warranties and provisions for performance bonds and liquidated damages if the contractor fails to perform (and bonuses for better-than-expected performance). Lenders may also require at least a limited completion guarantee that commits the sponsors jointly and severally to complete the project through additional equity injections or subordinated loans up to an agreed capped amount based on a worst-case scenario.
Political and Governmental Risks
The IFC has found that lenders typically require the purchasing utilities and governments to assume the risk of uninsurable or political and governmental force majeure both during construction and operation. To achieve this, the power purchase agreement with the local utility provides that the utility is not excused from making that portion of payments necessary to service debt if any of the enumerated events occurs. Alternatively, or in addition, the utility sometimes agrees to purchase the project at fair market value if certain force majeure events occur.
Government’s Performance Undertaking
If the state-owned utility is perceived to be insufficiently creditworthy or the tariffs that the utility charges to its customers are not set by an independent regulatory agency, sponsors and lenders also typically require the government to provide some level of backup support of the utility’s payment and other obligations under the power purchase agreement.
New Products
As more countries are encouraging private entry into the power sector, the IFC is working to respond to the increased demand, focusing particularly focus on capital market development. The IFC is investing in specialized infrastructure funds, underwriting bond issues, and, in Hungary, borrowing for itself local currency for on-lending locally, a product that would be particularly suitable for power projects, which generally do not earn foreign exchange.
COMMENT
WILLIAM M. BERENSON
Global Environment Facility
The Global Environment Facility (GEF) was recently restructured. It was not restructured as an international treaty organization, but rather to use existing administrative facilities and structures within the participating agencies. This is an experiment. The Secretariat for the administration of the Global Environment Trust Fund (GET) is now within the World Bank and will be operating under the legal personality of the World Bank, as the agency itself will not have a legal personality.1 Although the agency, in its restructuring, is not an independent legal personality, it has taken on some of the trappings of treaty organizations. The Secretariat has a Chief Executive Officer appointed every three years. It has an Assembly (or what is called a Board of Governors in some international financial institutions), which is made up of the member states and which will meet every three years to establish general policy directives and make general decisions about the direction of the institution.2 The GEF has a Governing Council, which meets twice a year and which is composed of 16 members from the so-called industrialized countries, 14 members from the so-called developing countries, and 2 from countries in economic transition.3 Finally, there is a panel of distinguished scientists, the Scientific and Technical Advisory Panel, which will be established within the United Nations Environment Program (UNEP) and offer technical advice to the GEF. The United Nations Development Program (UNDP), in its role, will provide direct technical assistance to the member states. Thus, these three executive agencies, UNEP, the UNDP, and the World Bank, are under umbrella direction from the Council and from the Assembly within their special competences.
Another interesting structural aspect of the GEF is the method of voting. Previously, the GEF lacked formal rules for voting. Now, while there is the aspiration that it can do everything by consensus, if consensus fails, a provision has been made for the use of a double-weighted method of voting: a vote representing 60 percent of the contributions and 60 percent of the total membership will carry a proposal (if consensus cannot be made in either the Council or the Assembly).4
This interesting structure could be a model in the future for other institutions within the international organizations community. The idea of preventing a proliferation of new secretariats requiring additional contributions for administrative exercises is a positive one in the world of international organizations.
Developments at the International Finance Corporation
There are four criteria that the International Finance Corporation (IFC) primarily looks for when making its loans to support private sector development:
the economic (or earning) stream of the project;
the sufficiency of the revenues generated by the project, that is, will they sufficiently pay back the capital and support debt service?
the benefits to the local economy that the project will provide; and
the environmental soundness of the project.
The fourth criterion, environmental soundness, has been increasing in importance in international projects over the past 10–15 years, and particularly since the UN conference on the environment held in Rio de Janeiro and the establishment of the GEF.
Power projects fall within a range of infrastructure projects, including telecommunications, highways, and waterworks, that used to be largely government owned and operated. Now, however, there is a tendency for power-generating facilities to be placed in private hands or to be developed by private businesses. A new spirit of privatization seems to have enveloped most of the world over the past ten years. In funding a power project, the IFC often uses the B.O.T. Model, in which a private company builds the facility, operates it for a couple of years, and then transfers it to the government.
The major concern for the IFC in this kind of a development project is whether the resulting revenue stream will be sufficient to pay off the capital cost and the debt service. Other concerns, as well, are of particular interest. For example, will there be a stable relationship with the regulatory entities? Often these facilities are not owned by governments, but by private parties. Some may be eventually transferred back to governments. The power utilities buying the power, however, may be private companies; they may have tariffs that are subject to governmental regulations; and there may be licensing requirements and safety and environmental standards. The necessity of compliance with those standards is important because compliance has a cost, and, as costs increase, profits may go down. Therefore, information is needed regarding the stability of the relationship with the regulatory entities. Also, there is the question of how likely it is that additional regulatory requirements will be imposed that will make the investment less attractive and result in insufficient revenue to fund the debt service and a return of the capital.
Another important question, which is critical to foreign investors and to financial institutions investing in a country, relates to exchange risks. Foreign investors want to make sure that they can get their money out. Are there provisions in the local law that prohibit or obstruct repatriation of capital and profit? Corporations, private banks, and central banks will ask, “What kind of assurances can we get from the government? What kind of procedures are going to be in place? Are these going to be complicated or simplified?”
Still another factor that foreign investors look at is completion risk. There is an element of completion risk in every project, whether privately or publicly financed. An investor who is financing a project wants to see the performance bond, the completion bond, and provisions for liquidated damages if the project is not completed in a timely fashion.
Other considerations include, How creditworthy is the entity that is going to be buying the power? Is it going to pay its bills? If it is a private entity, what happens if it becomes insolvent? Is it subject to government guarantees? There must be revenue streams. If the buyer of the power goes out of business or cannot pay its bills because it has other demands, the project is a bad investment. Therefore, the buyer’s creditworthiness must be investigated, and the investor should obtain and secure the necessary guarantees, in order to be sure that the investment is going to be secure.
Investment in Legal Infrastructure
Many countries will need to make investments in their legal infrastructure, including arbitration facilities, and take other measures for the resolution of disputes between investors and public entities. Investors must be confident that the justice system is fair. These countries will have to train people, invest in equipment, and build new courthouses. The investment cannot be a onetime affair; it has to be a continual process.
The greatest legal structure in the world can be designed, but if the administration of that system is not funded, it does not do anybody any good. The system must attract and keep good talent. Salaries that are competitive with the private sector must be paid in order to get the best talents into the system. Otherwise, it will fail. There should not be a revolving door, through which people come and go. This leads to conflict-of-interest problems. Also, the staff must be paid enough money so that it does not become dependent upon the people whom it regulates.
This problem of regulators being captured by the regulated must be avoided. The only way that it can be done is by making sure that the administrative law structure has adequate resources.
