Financing and start-up
Damian Von Stauffenberg
Damian Von Stauffenberg is Investment Officer for the International Finance Corporation, Washington. D C.. USA. This article has been adapted from two different papers presented by Mr Von Stauffenberg at the June 1982 and June 1983 meetings of the FAO Advisory Committee on Pulp and Paper
Once the decision is made to build a new pulp and paper plant, 6 to 10 years are needed to bring it into actual operation. A key element in the plant's eventual success or failure is the way the financing is arranged. Moreover, the mere construction of a plant is not enough. Such problems as training and raw materials and spare parts supply must be resolved if the plant is to continue to be viable. In developing countries with no previous experience in the pulp and paper industry, the solutions to these problems are difficult.
PULP MILL IN SWAZILAND: large, efficient and close to resources
· For a developing country, a paper mill signifies a large step, a veritable leap, on the way to industrialization. Whereas other industries tend to grow bit by bit, expanding slowly until they eventually reach a significant size, a pulp or paper plant, because of economies of scale, tends to be very large from the outset. Industries that grow slowly experiment as they go along, discovering what is possible through experience and adapting to the environment in which they operate. Conversely, their environment also adapts to them.
An electric power-supply system built with a small power grid, for example, will foster enterprises that have limited electricity requirements. As more electric power becomes available, industry will respond with production techniques that consume more electricity. Eventually, vast supply systems will be able to attract such energy-intensive industries as the aluminium industry.
The development of industrial plants, on the other hand, can be compared to the growth of a tree. A tree will grow to the extent allowed by its environment. Planting a small tree is not difficult and its chances of success are fairly high, particularly if one knows that the type of tree being planted can grow in the particular area involved. The problem of pulp and paper mills is that building them in a developing country tends to be like transplanting a fully grown tree - a giant - into an environment that has not known trees before. Although one can analyse such obvious things as soil and climate, there is never any certainty that the tree will take root and grow. More likely, there are unforeseen factors to which the tree must adapt before growing.
Much of the work involved in financing a pulp and paper project consists of tailoring a financial structure to suit a project's special needs. The word "tailoring" can be used quite literally in this particular context. Just like a tailor, one must pay close attention to shape, size and other characteristics of a project to which one "fits" a financial suit. Since pulp and paper projects happen to have quite distinct characteristics, financial packages that are, so to speak, just taken off the rack will usually not fit. A considerable amount of tailoring is needed before such a suit, or plant, will be ready to wear.
Capital intensity. The first and most outstanding characteristic of pulp and paper projects is their capital intensity. As a rule of thumb, it seems to be accepted that under most conditions the minimum size for a plant producing, say, writing paper is at least 30000 tonnes per year. By the same token, a tonne of annual capacity requires an investment of US$ 2000-3000. This means that the cost of even a minimum-sized plant will certainly not be less than $60 million, and it is more likely to run close to $100 million.
Small, relatively simple mills are now being proposed which look as if they would be economical if the conditions were right. But these are exceptions which prove the rule that pulp and paper projects tend to be highly capital-intensive.
"Capital intensity", apart from indicating the sheer size of an investment, also refers to the fact that annual sales are usually much smaller than the investment. In other words, every dollar invested in a paper mill will, as a rule of thumb, generate only about 40 cents in annual revenue. In that sense, even an ice-cream vendor whose plant consists of a $200 pushcart is in a capital-intensive business if sales are no more than $100 worth of ice-cream cones per year. A capital-intensive plant does not necessarily have to be big. Rather, what characterizes a capital-intensive business is a situation in which the fixed charges - interest expenses and depreciation - constitute an important part of operating costs.
What does that mean in practice? It means that high-capacity utilization becomes extraordinarily important. The reason is obvious. The fixed charges on a $100 million plant can easily reach $15 million per year. That works out to $500 per tonne if the plant runs at a full capacity of 000 tonnes. If it operates at only 50 percent of capacity, then the fixed charges double to $1000 per tonne. The highly cyclical nature of the pulp and paper industry, the tendency to keep a plant operating even if it is running at a loss, can be traced back to this basic aspect of capital intensity.
Things have to get very bad indeed before it is worth shutting down a pulp and paper mill. Stopping production can reduce variable costs, but fixed charges keep on accumulating whether the plant runs or not. As a result, when demand drops, producers will cut prices in an attempt to maintain sales rather than stopping production.
One temptation for project sponsors in developing countries is to choose the most sophisticated technology available. The less experienced the sponsors, the more susceptible they appear to be to that temptation. If they resist at all, it is usually because they cannot afford to pay the price. But the cost of such an advanced plant is actually less of a problem than the difficulty of operating it. If service and spare parts are continents away, project sponsors are better off with simple technology that is within their capacity to operate and maintain. The price of a sophisticated plant under those circumstances is prohibitive not so much in terms of capital cost as in terms of down time.
Another characteristic, closely related to the size of paper projects, is the long time it takes to build them. If everything goes well - and it rarely does - you can assume that it will take about three years to build a new paper mill. In addition, it requires at least another three years to work the bugs out of a new plant, to get the staff fully familiar with it and to bring it up to capacity. In other words, it is fortunate indeed if no more than six years pass from the moment an investment decision is taken until a new plant operates at full capacity. Eight years would still not be bad, and even 10 years is not unheard of. In terms of project financing, this means two things. First, pulp and paper projects require a large equity base, and second, debt has to be as long-term as possible.
Equity. Raising equity is a difficult problem. Obviously, it is not easy to attract investors to a project that will not show profits for another six years or more. The problem is compounded in developing countries because capital markets are usually far too small to absorb investments of the required size. If the smallest economically feasible paper project requires investments of somewhere between $60 million and $100 million, its equity needs are about $2440 million, or roughly 40 percent of project costs. There is nothing magic about that figure - it does vary somewhat in practice, but experience shows that it does not vary very much.
The importance of a sufficiently large equity base to the success of a project cannot be over-emphasized. Projects quite commonly do not allow for enough equity in their initial financial plan. Sponsors often engage in wishful thinking in this area. Project cost estimates tend to be optimistic and, even more frequently, the time it takes to construct a plant and run it up to full capacity is underestimated. If, for example, it were possible to reach full-capacity production after only a year or so, internal cash generation would therefore be much larger and equity could then be smaller. The project could afford to repay its loans in a shorter period. However, this is usually not possible, and project sponsors who have based their investment on such assumptions frequently find themselves in the unenviable position of running out of funds. To return to the metaphor of the tailored suit, their financing plan does not fit the plant.
The penalty for running out of funds can be severe. One immediate consequence is work stoppages or slowdowns, which increase costs further. A vicious circle can develop. By the time the sponsors have finally raised additional money, the project cost can have gone up and a new financing gap will have appeared. Then the sponsors will need to look for more money, work will stop again, and so on. There are several examples of projects that have gone through repeated cycles of this type.
Funds tend to be most difficult to obtain when they are needed most. Everyone is familiar with the adage that banks will be happy to lend to you if you have no need of their money. Well, they will be considerably less eager to lend to an 80-percent-completed project that has just run out of money. If funds can be obtained at all under these conditions, it will be at a high price. The borrower is in no position to do much about it.
The kind of cost figure that emerges from a feasibility study is, in most cases, something quite different from the cost estimate on which the financing plan is built. The former is an engineering estimate, used to control project implementation. It therefore tends to be low. The financial plan, on the other hand, includes all contingencies and reserves, precisely because the consequences of running out of funds are so serious. In some cases, projects are deliberately over-financed to make sure there will be enough funds.
It is therefore extremely important for anyone undertaking a project of this kind to be realistic and to recognize that realism begins with an adequate level of equity. What constitutes an adequate level depends on the terms at which you manage to borrow. If your loans are very long-term - say 15 years or so and if they carry a grace period which lasts not only until the project is completed but until it has reached capacity production, then you might be able to afford to cover less than 40 percent of the project cost with equity. But in this writer's experience such cases are rare indeed. More frequently, loans carry too short a term, with the result that more than 40 percent is needed as equity.
... AND IN GUATEMALA: pulp and paper generates employment
Quasi-equity. The difficulties associated with raising enough equity have led to a number of hybrid forms of financing which combine features of equity with those of loans. The closest form to straight equity is preferred shares, but these are uncommon in developing countries.
More frequent is some form of quasi-equity. A subordinated loan, for example, which is convertible into equity, can be attractive both for the sponsors of a project and for the lenders. For the sponsors, a subordinated loan is very close to an outright equity contribution, since it increases the borrowing capacity of their company much as an equity investment does. The higher risk for the lenders, on the other hand, is compensated by the conversion feature. If the project is a success, they convert their loan into equity and earn a much higher return than they would have if they had held only a loan
There are too many forms of quasi-equity to discuss here, but it should be said that this is an important alternative tool for financing a new pulp and paper project. Hybrids between loan and equity have in many cases made it possible to finance projects that would not otherwise have gone ahead.
Export credits. Unlikely as this may sound, raising loans tends to be the simplest part of assembling a financing package. The main reason is that the countries producing capital equipment are engaged in strong competition for export markets. They are therefore prepared to extend export credits which, by today's standards, are extraordinarily favourable. There have been efforts during recent economic summit meetings to curb this competition: the mere fact that export credits have repeatedly been on such agendas demonstrates just how important they are.
Thousands of millions of tax dollars are spent every year by the governments of capital-goods-producing countries to subsidize export credits. What is a problem for these governments is an opportunity for the pulp and paper industry. With export credits now available at well below commercial rates and on a long-term basis, any project sponsors today would be well advised to make export financing the heart of their financial plan.
Apart from their long repayment terms, export credits have one other characteristic that makes them especially attractive for pulp and paper projects: fixed interest rates. Floating interest rates would introduce an element of risk for projects in an industry where financial charges are already high and which is particularly ill-equipped to bear such a risk. In today's environment, it is practically impossible to avoid floating interest rates entirely - banks simply will not lend at fixed rates - but floating rate loans can at least be held to a minimum.
Having advocated the use of export credits, I must now point out their drawbacks. While export credits have a strong cost advantage, they also tend to narrow down competition among equipment suppliers. The result can be higher equipment costs, which would offset at least part of the initial cost advantage.
There are various ways of encouraging competition even if export credits are used. One is to rely as much as possible on buyers' credits (credits extended by the export-financing agency directly to the project) rather than on suppliers' credits. Another consists of obtaining commitments for export credits from as many equipment-producing countries as possible and then using only those from countries to which equipment contracts have been awarded. But there are practical limits on how far a project sponsor can go in this direction. No matter what measures are taken, export credits will tend to weaken competition.
There are in existence various export credit agencies whose objective is to promote export sales and which will therefore not provide the kind of advice and assistance a project can obtain from institutions specializing in development finance. Export credit agencies would, for instance, not become deeply involved in determining the viability of a project; nor would they take it upon themselves to devise a financial plan. For these reasons, it is quite common for one of the smaller lenders to act as lead bank for a project while export credit agencies, which have provided the bulk of the other financing, take a more passive role.
Other loans. Export credit will never cover all of a project's borrowing needs. Additional loans will have to be obtained from commercial banks and from institutions specializing in project finance. Given that loans for pulp and paper projects must necessarily carry long payment terms, the choice of sources is not excessively wide. Basically there are two other types of lenders for such projects in developing countries: international development banks and private commercial banks.
International financing agencies or development banks such as the World Bank - which is by far the largest of them - along with regional development banks or the International Finance Corporation, have the advantage that they specialize in project financing. They are therefore used to dealing with development projects with little to offer by way of collateral or operating experience. Moreover and this is a particularly important point - their loans usually carry fixed interest rates.
Such institutions assure themselves through careful analysis that a project is viable. This can mean considerable free technical advice for the sponsor. They also tend to play an active role in designing a financial package for the project and in putting the various parts of that package into place. In effect, they become the financial adviser to the project. At the same time, these institutions need time to perform their role. Analysis of a large, complex project is not an easy process, and therefore development banks do not move with the agility and rapidity of commercial banks.
The services of international financing agencies are best used if they are involved in a project as early as possible. This allows them to carry out their analysis as the project evolves. They are thus able to give their advice while it can still be incorporated into the project. By the same token, to present a financing request to these agencies after the project is already under way is the least effective way of using them. At this stage their project experience will no longer do the sponsor much good. All basic decisions will presumably already have been made, and the time required for project analysis may lead to delays.
Traditionally, project financing has not been one of the targets of commercial bank activity, but in the last decade commercial banks have become increasingly willing to support projects in developing countries. By now, it is no longer uncommon to see them extending 8 or 10 year loans. Thus, commercial banks must now also be considered seriously as financing sources for pulp and paper projects.
The International Finance Corporation (IFC) occupies a position somewhere between the other international development agencies and commercial banks. It is clearly a project-financing institution, with all this entails in terms of project analysis, advice, and involvement in designing a financing package. In fact, it belongs to the World Bank group. However, IFC is also committed to mobilizing funds from commercial banks and to acting as a kind of channel through which commercial funds reach projects in developing countries.
People. The first and probably most important point of contact between a pulp and paper project and its surroundings is the people who run the plant. The obvious problem always recognized but not always solved - is that of management. Most developing countries simply do not yet have people who can successfully run a pulp and paper plant.
One solution is to import know-how. However, this is more difficult than it might seem. Starting at the top with the general manager, someone is clearly needed who knows the business very well indeed, but such knowledge by itself is not enough. Experience has shown that during the early years of an operation, the leadership qualities of the manager are crucial, possibly more important even than technical qualifications. In the beginning phase, management has to deal constantly with unforeseen events and, at the same time, try to integrate the other managers and employees into a working team.
It is important that the management group work together well and that outside experts be recruited who can blend into the group. It is not always wise to entrust the task of recruitment to a consultant who advertises internationally and then screens the candidates, for one can end up paying the consultant a considerable sum for something that one could easily have done oneself. If the screening of candidates is a problem, various national pulp and paper associations will often be glad to help. Recruitment through international advertising will yield the required number of qualified individuals, but it does not ensure that they will be able to work together.
A more effective approach is to turn to a pulp and paper manufacturer that can assemble the necessary team from its own staff. In this case, the expatriate experts will share a common background and will tend to function as a homogeneous group.
Assembling a locally recruited workforce presents more serious problems still. While the need for training is clearly recognized, the nature of the task itself is nonetheless often overlooked. The challenge facing the managers of a new plant is not just to teach its employees certain skills-plants all over the world are doing that all the time. But a new mill in a developing country can bring about a complete transformation of the lives of the people depending on it for a livelihood. An almost inevitable consequence of building a plant is that a local population is sent down the road from a rural to an urban society. There have been cases where a paper project in a rural area has, within 10 years, completely transformed a small backward village into a bustling town.
Another thing that happens is that a large, sophisticated employer like a paper mill often becomes a training ground for surrounding industries. No sooner are workers trained in the paper mill - particularly electricians, turners, fitters and the like - than they are snatched away by other companies. There have been cases where the production of paper plants was significantly affected because the annual turnover of workers approached 100 percent.
Raw materials. Raw material supplies quite often present a problem in the early years of operations. Whereas feasibility studies tend to be optimistic about the availability of basic raw materials, actual supplies can fall short of predictions, for various reasons: forest inventories can be inaccurate; sugar mills may discover that they have less excess bagasse than originally indicated; or the transport network may not be able to handle the sudden increase in loads. There have been cases in which pulpwood was available as planned during the rainy season but it proved simply impossible to move the quantities needed to the plant.
Most of these problems can be traced to the fact that a pulp and paper mill represents a very large increment in a country's demand for the particular raw material in question. Time is usually needed for supply to respond to this extra demand.
Even imported raw materials used by a new plant can cause strains on the local environment. Theoretically, one just orders whatever raw materials are needed and waits until they are shipped to the plant. In practice, the goods have to pass through local ports and customs, which often present formidable bottlenecks. Moreover, foreign exchange is required to pay for the materials and an import licence may be needed.
Utilities. A plant as large as a typical pulp and paper mill cannot expect simply to plug itself into the existing utility grid. More often than not, it will have to supply its own electricity and water. However, there are cases - and they are not infrequent - where a new factory is timed to coincide with completion of a new power plant or transmission line. In such cases, it pays to remember that public investment projects follow a different set of priorities than industrial plants. One needs to be very conservative in one's assumptions as to when a new power plant or other major public investment will be completed. One large recent Latin American project, for instance, required a 70-km transmission line. That line, now under construction, was scheduled for completion in three years. A construction agreement was reached under which the power company would have to pay damages for every single day of delay beyond the scheduled completion date. In return, the plant had to pay the full construction cost for the line in advance even though such an agreement was very costly for them.
Spare parts. Even the best-managed plants have had to shut down frequently in the past because they have run out of some crucial spare part. For a capital-intensive plant, it is therefore well worth investing heavily in a spare-parts inventory, particularly if it takes weeks or months to obtain replacements. Beyond the safety margin afforded by a well-stocked inventory, it is crucial that there be an early-warning system, providing sufficient advance notice to allow restocking before a plant runs out of certain parts and has to be shut down. This is difficult in the early phases of production, when consumption patterns are not yet well established, but computer systems available today make it possible to introduce very sophisticated inventory management systems at a minimal price.
Even a minimum-sized pulp and paper plant will almost certainly cost at least $60 million and more likely close to $100 million.
A new mill in a developing country can bring about a complete transformation of the lives of the people depending on it for a livelihood.
Foreign exchange. For many of the developing countries, foreign exchange is a scarce resource - at times, extremely scarce. There is nothing new about this message, but it has been driven home with a vengeance during the last few years. Many pulp and paper projects are suffering the consequences.
The successive oil shocks of the 1970s were a severe blow, particularly for recently completed plants whose design was based on cheap oil. At a time when they were burdened with high financial charges, plants suddenly had to cope with a large increase in their energy costs. The usual solution was to raise new money somehow and to modify the plant design, either by including energy-saving devices or by switching entirely to other fuels. This added complication meant, more often than not, that the time needed to reach full capacity was lengthened by a few years.
The present decade has brought a variant of the same problem. As developing countries have slid into a debt crisis, devaluations of 100 percent or more have become common. Suddenly a whole range of supplies besides oil, all of them requiring foreign exchange, are affected.
A few years ago, it would not have been thought possible for most companies to withstand sudden devaluations of this magnitude, but we are witnessing cases of extraordinary adaptability. Producers who would never have thought of exporting are suddenly penetrating foreign markets. Either imported inputs are replaced by local products or a different product is used: in either case, the result is to cut down on import requirements.
One producer of box board, for example, had operated for about two years and was about to overcome the typical teething problems of a new plant when the country was seized by a balance-of-payments crisis. The supply of imported high-quality pulp and waste paper was virtually cut off and, as the industry turned to local raw materials, domestic waste paper of the required quality became scarce. The company has reacted by shifting its product mix and has now borrowed money to modify its plant in order to use low-quality local waste paper.
It is too early to come up with a final verdict on the impact of the foreign-exchange crisis on producers in many developing countries but, somewhat surprisingly, the results have so far not been as catastrophic as might have been expected.
Investment in pulp and paper in developing countries is by no means hopeless - quite the contrary. However, some useful lessons have been learned about making investments. In the simplest possible terms, here are some basic guidelines to follow.
· Be flexible. There will be a host of unforeseen problems you will have to cope with.· Choose a design that works under local conditions - in other words, keep it simple.
· If technical assistance or cooperation is needed, choose a partner with a stake in the success of your venture.
· Allow plenty of running-in time: three to four years would seem to be a good rule of thumb.
