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Pick up most business magazines these days and you'll probably find an article on some venture capital transaction involving millions of dollars. From HBS Associate Professor Benjamin Esty's perspective, however, these deals are small change. His research focuses on projects much bigger than the latest e-commerce enterprise. And in a new MBA elective course he has developed, Large-Scale Investment, Esty examines how private firms structure, value, and finance large, first-of-a-kind (or greenfield) projects.
"Although the course is really about project finance, I jokingly refer to it as venture capital for people with real guts," quips Esty. "Most of the projects are start-ups, yet they cost something on the order of $5 billion, not $5 million." And all too often, he adds, they turn out to be losing propositions. Private-sector ventures such as the Euro Tunnel, Euro Disney, and Iridium, and Boston's Central Artery Project (the "Big Dig") in the public sector, are examples of some recent efforts that went bankrupt or had to be restructured. The managerial challenge is to figure out how to make sure that $150 billion or so of annual investment produces good projects and good returns.
Esty's interest in project finance evolved out of his doctoral thesis on risk-taking in the savings and loan (S&L) industry during the 1980s. "I have been intrigued with high leverage and its effects on managerial incentives and firm performance for quite some time," he remarks. "In my thesis, I analyzed why certain S&Ls adopted high-risk strategies while others did not and found that high leverage was an important consideration." As the S&L crisis passed and interest in other highly leveraged entities such as LBOs waned, Esty shifted his research to project finance, one of the hottest applications of leveraged finance today. "The projects I study are financed with 65 to 90 percent debt, compared with 25 to 35 percent for the typical industrial firm," he notes.
Both the size and the uniqueness of the projects Esty has chosen to examine make them difficult to manage and generate conflicts between actual and optimal investment behavior. Indeed, he points out that managers often forgo large, risky projects—even those that are expected to add shareholder value. An inherent lack of flexibility compounds these challenges, because most projects involve binary "go/no-go" decisions. Esty uses the Euro Tunnel as an example: "You can't build the first 100 yards and learn anything about underlying demand for the tunnel. Instead, you have to sink the full $10 to $15 billion into the project before realizing that the demand isn't there. And if things go well, you can't expand capacity, which means there is limited upside potential," he continues. "As a result, companies can't take a portfolio perspective and rely on a few big winners to cover a majority of failures. They have to succeed regularly."
More and more companies are turning to project finance to support large capital investments, and the trend is likely to continue due to privatization, deregulation, and globalization. "In an increasingly global business environment, achieving minimum efficient scale in production requires massive capital investment," Esty says. And as natural resources are tapped out in developed countries, it becomes necessary to explore geographic areas that may not have an established track record in a particular industry. For this reason, his course has an emerging markets focus, with case studies on projects in Venezuela, Kuwait, China, and Thailand, among others.
For example, Esty and research associate Fuaad A. Qureshi coauthored a case on a $1.4- billion aluminum smelter in Mozambique known as the Mozal project. Ravaged by a 17-year civil war that claimed 700,000 lives and destroyed much of the country's infrastructure, Mozambique presented formidable risks as a project site. The cost of the plant, which was approximately equal to the country's gross domestic product, made the investment decision even more of a gamble. Despite these challenges, the sponsors believed the country had turned a corner. They appear to be winning their bet, since the project is ahead of schedule and under budget.
"The social, environmental, and developmental aspects of these projects are also of great interest to me," Esty remarks. "The Mozal project employs 7,000 people, and it provides skills and good wages in a country where the average person makes from $90 to $100 per year. Equally important is the project's catalytic impact on future investment. The sponsors are considering adding a second smelter of equal size, while other companies have announced plans for additional billion-dollar investments in Mozambique."
Given the level of uncertainty involved with these projects, however, they require years of negotiation and careful allocation of risk among the various parties. "Identifying key risks, deciding who should bear them, and ensuring that there is an incentive to manage these risks efficiently is the key to success," he notes. With billions of dollars on the line and five to ten parties involved—ranging from sponsors and contractors to suppliers and host governments—it is no wonder these deals take years to negotiate.
As project definition or underlying conditions change, risk allocation and responsibilities must change, too. "If someone agrees to bear a certain risk, they expect to be compensated for it," Esty comments. "If that risk grows, they expect more compensation, which means someone else has to get less. Negotiating these deals is like squeezing a balloon—if you squeeze it in one place, it pops out somewhere else. Finding an equilibrium in the midst of this kind of multiparty negotiation is a difficult task."
One way to mitigate the risks is to use off-balance sheet project finance instead of traditional, on-balance sheet corporate finance. Consider, for instance, Iridium LLC, a $5.5-billion global satellite communications firm backed by Motorola that filed for bankruptcy in August, 1999, and appears to be worth less than $50 million today. "At the time it set up Iridium, Motorola was a $9-billion company with a AA rating," says Esty, who has recently completed a case on Iridium. "If Motorola had financed Iridium on its balance sheet, the project's bankruptcy might have dragged down an otherwise healthy corporation. By using project finance, Motorola shielded itself from much of the damage, while retaining some ability to benefit had Iridium been successful. This ability to facilitate large, risky investments without jeopardizing sponsoring companies is one of the main benefits of project finance."
After a brief slowdown in 1997 and 1998 because of the Asian and Russian financial crises, the project finance market came roaring back in 1999 and continues strong into 2000. According to Esty, the use of project finance in new geographic markets and for new types of undertakings, combined with an increasing need to finance development in countries with limited resources, implies that project finance should continue to loom large in the years ahead.
Despite the magnitude of annual investment and recent growth, however, there has been relatively little academic work in this area. Esty's research and course development activities are an attempt to fill this void and improve the way firms manage their capital investment.
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