Project Finance as Business Finance

I received today an email solicitation from Euromoney Books promoting a series of publications on Project Finance.



Topics covered include: modeling a base case and sensitivities; structures for allocating risk; and sector-specific considerations.

The last topic is the one of greatest interest, for this reason.  Project Finance as it is currently practiced is largely viewed as an alternative to governmental funding for infrastructure projects: transportation, energy, water and wastewater, telecommunications and the like.

The Capital Markets, not these private partnerships, are generally viewed as the financing solution of choice for general business activities.  Partnership are reserved for quasi-governmental finance.

Is that a technology choice, or an accident of history?

Project Finance is actually a more recent innovation in capital formation than the Capital Markets.  It is only really possible in this, our own Computer Age, where forward commitments, rather than past performance, can be used as the basis for establishing investment needs and return expectations using the powerful computerized spreadsheets that we take for granted today, but only came to be in our own life times; and where computerized information can be shared among multiple participants from remote locations in real time, using desktop/laptop computers, email, the Internet, the World Wide Web and cell phones.  All powerful inventions and innovations that have only become fully available for routine use for connecting Enterprise and Investment in our times.

The Capital Markets, by contrast, are a vestige of the 19th Century.  They are place-based solutions for making indirect connections between Enterprise and Investment in the days before technology made real-time, direct communication possible.

Project Finance is leading innovations in finance in the 21st Century, powered by technologies for computerized data collection, information construction and remote communication.

Right now, mostly, governments are using these innovative solutions.  It is only a matter of time, however, before they make their way into general business.  Not as Project Finance, but as Base Case Cash Flow Partnerships.

Proofs. Or hyberbole?

For Enterprise, the path to the money lies through the laying down of proofs that will attract Investment.  There are different grades of proof, beginning with the Emotional or Intuitive belief that drives Enterprise to create new value in the first place, and moving through logical analysis of emotional expectations, scientific validation of logical conclusions, engineering designs to implement the science and the logic, commercial commitments to a project, and ending with a history of financial performance, in the field, over time.

Each level of proof takes time and costs money to develop, which is the great conundrum for both Enterprise and Investment.  Enterprise needs Investment to prove its value creation thesis. Investment needs Enterprise to prove its worth.  It's a classic problem of trust and confidence that is the job of professional financiers to resolve.

Wall Street offers an interesting solution.  It promotes the buying and selling of shares in public companies that are already successful.  This gives Investment the opportunity to participate in Enterprise that doesn't really need the money. Historical proof of value, which takes time to build and skill to analyze, gets replaced by future projections of past results.  And these projections are never of sustained profitability.  They are always of growth (or decline) in share price.

Emotion takes over from reasoned analysis, and Enterprise is driven to play to that emotion.

In a system that is supposed to be built on Proof, what we end up with is hyperbole.

Liquidity becomes important, because Investors have to believe they can sell out when they want to get out, either to reap their profits (if they guessed right) or cut their losses (when they guess wrong).

Liquidity gives us volatility and instability, not the predictability of reliable proofs.

For the economy in general, we get booms that always, eventually, go bust!

First, Let's Ask the Question

Yesterday I had a very engaging conversation with a gentleman who is running a group for inventors.  I asked for the call to see if his group might be a good audience for my message about inventing an alternative to the Stock Exchange for capital formation.

The conversation covered many interesting topics, but as to my point, above, it went pretty much through three phases.

PHASE 1: All the money comes from Venture Capital and that is not how they do it.

PHASE 2: When it comes to investing, everybody always focuses right away on how to get out: exit-by-sale.

PHASE 3: That's not really what Investors want.  Investors want to protect their principal and generate cash flows to meet their own program goals.  Pension Investors, for example, whether self-directed or Institutional, want to protect principal and earn cash to meet the living expenses of their retirees.  Endowments want to protect principal, and earn cash to pay the costs of advancing their chosen cause. Insurance wants to protect principal and earn cash to pay benefits to their policyholders.

If you think about it, that is what Enterprise wants also: cash to run a business that will generate even more cash.

So why can't Enterprise and Investment get together, directly, to agree a deal that will give Enterprise the money it needs to runs its business, and give Investment cash flow to meet its programmatic needs (and maybe a little extra, to build wealth along the way)?

An interesting question.

Is Sustainability the Next Wall Street Bubble?

I received an email advertisement from Institutional Investor Magazine promoting a new study that shows "clean capital" companies outperforming various indices. I suspect performance means rise in share price. This is not the first time I have seen news items in the Investment media making the claim that investing in sustainability is also the way to invest in share price appreciation.

The question is, is this a self-fulfilling prophecy?

Wall Street is famous for booms-and-busts.  Booms always start out as self-fulfilling prophecies: a history of rising share price is seen as proof that share price will continue to rise, causing buyers to buy in at higher prices, continuing the historical trend of rising prices, and so on.  Until that is, the price gets so high that there is no one left to buy, and the bottom falls out.

Sustainability may be the Next Big Thing, but is sustainability sustainable?

By definition, the value choices commonly referred to collectively as sustainability are share price externals.  They are values that promote the greater good, not shareholder value.

It will be something if it turns out that corporations that adopt sustainable values also consistently deliver higher share prices, but I am skeptical.

It will be interesting to see if Wall Street can pull this off!

The New Frontier of New Ideas

Expansion is sustainable as long as there is a New Frontier

Evolution is sustainable as long as there are New Ideas

The Old Patterns (Growth)	The New Patterns (Sustainability)
Trend Lines	Cash Flow Waterfalls
Org Charts	Knowledge, Networks, Routines
Flow Charts	Contributors to Prosperity

Economics today are pretty much about looking back on innovations that were cutting-edge in the 1800s, and trying to make them fit our needs as we move into the 21^st Century.

But our world today is very different place.

In the 19^th Century, America invented the Exchange-Traded Corporation as a technology for organizing value creation, capital formation and wealth distribution to meet the unique requirements of American Industrial Expansion along our Western Frontier, driven by innovations in Economies of Scale.

This innovation of Exchange-Traded Corporations proved to be the right thing for those times.

Throughout the 20^th Century and right up to our own time, much thought and effort has been invested in understanding, expressing and applying the basic patterns of Exchange-Traded Corporation finance.  There seems little we don’t now know about historical trend lines, management of organizations, and processes for scale and efficiency.

But our mastery of these patterns seems to be unable to deliver the one thing we seem increasingly to value most: sustainability.

Why?  An economy built on expansion can only deliver sustainable prosperity if there is a New Frontier into which that economy can expand.  Even then, the truth is, expansion economics have consistently delivered alternating cycles of booms that always, eventually, go bust, as investment creates jobs that commerce will not support.

This observation may not resonate with those of us who are personally and professionally invested in the ecology of growth, but those of us who have already come to grips the simple fact that we have reached the geographic limits of our world see that this continued obsession with Growth is really just giving us ever bigger booms that more frequently go bust, with increasingly devastating consequences to both personal prosperity and the public good.  We just cannot keep doing this.

Nor do we have to.

The economics of growth have done much to reveal to us that the real driver of our prosperity is not actually growth, but the innovations that made growth possible.

It is investment in innovation that really drives value creation.  The fact that innovation in 19^th Century American focused on economies of scale is more an accident of history than an economic universal.  When European genius for mechanization took root on US soil, it had lots and lots of running room.  And run it did!

Now we in America are catching up with our European cousins (and pretty much the rest of the World) in having to live within the limits of geographical boundaries.  Some of these limits are physical; others, political.  But they are all, nonetheless, real.

Good news is, geopolitical expansion is not the cause of innovation.  The cause of innovation is disappointed expectations that lead people, as individuals, to think there has to be a better way, and the inspiration that leads us, as individuals, to seek until we find that better way.  So, even without a Frontier, we can continue to have Ideas.  And it is ideas that drive innovation.

The patterns of innovation are not the patterns of expansion, they are the patterns of inquiry and insight that lead to the invention of new knowledge that lets us do work in new ways, providing ourselves with a wealth of better options for how we choose to live our lives.

The old patterns of investment in expansion are not the right patterns for investment in innovation.  The patterns of expansion are circumstantial.  The patterns of evolution are more elemental.

They include:

1.     The cash flow waterfall, that captures the way Items of Value are delivered in commercial exchanges that generate the Revenues to pay the costs of delivery, including returns to Investor and profits to the Enterprise drivers;

2.     The Knowledge, Networks and Routines that allow the Enterprise to initialize and sustain its cash flow waterfalls (Routines are what get scaled according to the principles of Economies of Scale); and

3.     The Contributors to Prosperity, who each must do their part to keep the cash flow flowing.

These are the new patterns that we need to master as we build a new economy of sustainability in our times.

What are we doing?

I have been investing a lot of time over the last while surfing the Web and learning about the thought leaders and early adopters who are driving what I have come to talk about as the "money, plus..." movement.

The ellipse in the "money, plus..." moniker is intentional and important.  It points to the idea that whatever particular agenda, in addition to making money, any given investor wants to pursue is, and should be, individual to that investor.  It may be everything from a generalized desire to invest in a way that encourages a more sustainable prosperity (see CALPERS, for example), to something more programmatically specific, like farming local (see Slow Money, as a "for instance").

As I get more familiar with the themes and players in this movement, however, an opinion is forming that this movement is still rather poorly defined in its goals and objectives.  Like Occupy Wall Street, it seems to be unified by a widely shared sense that things are not working right, and something has to be done.  But there is less of a consensus on what, exactly, is not working, which means we cannot even begin to agree on what can and should be done to fix it.

Yesterday, for example, I came upon a blog post on CSRwire.com by Jim Epstein and Alicia Epstein Korten.  They make the point that there are too many labels floating around this space, and proposed "Common Good Enterprise" as a single label that could encompass all these different nuances. Common Good to me sounds too much like Common Wealth -- or public governance. Instead, I suggested the term Blended Value Enterprise.  To me, this is a combination of Jed Emerson's theme of blended value investing, and my own idea of repurposing tax partnerships, aka Special Purpose Entities, as a more generalized tool for aligning the interests of Enterprise and Investment along multiple points of value: money, plus...  Alicia thinks this label is too investment-y.  Which caused me to ask, what is it, really that this movement is all about?  Who is the audience?  What is the message?

Are we working to re-invent finance?
Or, are we working to re-invent philanthropy?

If the former, then I have something to contribute to the conversation, especially when the discussion turns to the topic of how we need to move beyond 19th Century technologies of corporate finance and Exchange-traded capital that are fundamentally incompatible with the emerging ethos of sustainability in the 21st Century.

If the latter, that is a very different conversation.

What do you think?

Blended Value and the Liquidity Thing

Blended Value is a widely recognized way of referring to the well-known, but hard-to-express, desire of many, if not most, investors, both institutional or individual, to put their wealth to work in ways that make a positive impact, not only on their portfolio, but also on the larger world in which we all live.

It's part of the movement towards Socially Responsible Investing, or just Social Investing. This has, in turn, given rise to discussions about Social Entrepreneurship.

Social as used here does not mean disguised philanthropy. It means making investments that are calculated to deliver returns that can be measured in both financial goods and other goods.

In this regard, I contend that almost all Entrepreneurship is really Social Entrepreneurship. There may be some people who start a new business just to pump it up and sell it off, but I don't think most entrepreneurs feel like that. I think most are really trying to make a positive improvement in their lives and the lives of others by bringing new and needed goods and services to the market at affordable prices.

And, I contend that most investors are really Social Investors. There may be some people who just care about making a buck, and don't really care how, but most people want to do right both by themselves and by others. After all, at the end of the day, we're all in this together!

But then there is the liquidity thing.

When we think about finance and investing, for social impact or otherwise, we have all been trained to think about the Market. What is meant by the Market is the public equity and other financial markets, or what is more commonly known as Wall Street (although, really how common is real knowledge of how Wall Street really works?).

The Market (or Wall Street) is really a system of Exchanges for trading in financial instruments. As with so many things, the great strength of the Exchanges is also their greatest weakness: they are built to provide instant liquidity. Their whole reason for being is to constantly attract “the next new buyer”. Even when we look beyond the public equity markets, to such innovations as Venture Capital or Private Equity, we are still looking at models built for liquidity. It’s just that in VC/PE models, liquidity is deferred.

We pay a high price for all this liquidity. First, there is the volatility it engenders, and the instability that comes with volatility. But there is also a more subtle, but more pervasive skewing of our values. Once an Enterprise enters an Exchange (or commits to entering the Exchange markets, by going the VC/PE route first), it goes to work for that Exchange. Every decision that Enterprise makes has to be calculated to please the Exchange. If an Enterprise tries to run its business without regard for the Exchange, it does so at its peril!

The same is true for Investors. When an investor commits to an Exchange-traded instrument, it is not making an investment in the underlying Enterprise that issued that instrument. It is making an investment in the Exchange on which that instrument is traded. The returns to be realized depend on the liquidity of the Exchange, which is at least one step removed from the fundamental prosperity of the underlying Enterprise.

The Exchange stands between Enterprise and Investment, and imposes its values on both. And those values are not blended. They are singular.

The Exchanges are built to optimize one single point of value: the market clearing price. It's best if the price goes up, but it's OK as long as there is a price. The Exchanges, after all, make their money on the trade.

There are times when Enterprise and Investment both need liquidity, and for those times, there is no better option than the Exchange.

But when our focus turns to making real, meaningful, long term, sustainable impact for the better, do we really need that much liquidity? In this context, liquidity is at best, a distraction. At worst, it can be disruptive (see the story of microfinance as Antony Bugg-Levine and Jed Emerson tell it in their new book, Impact Investing)

There is another choice. That choice is to follow the example of the tax partnership. Tax partnerships are the granddaddy of impact investing, bringing billions of dollars of socially responsible institutional equity into social enterprises in affordable housing, renewable energy and community development. We’ve been using them successfully for decades.

The problem with tax partnerships is, of course, the "tax" part of the partnership. But the tax part is not essential. We can redeploy the tax partnership structure as something I call the Base Case Partnership, and voila, we have a field-proven, reliable structure for bringing Enterprise and Investment together in shared pursuit of longer term, stable, sustainable prosperity; prosperity that can be measured financially, but that can also be measured in other ways.

If you're interested in Blended Value, consider the whole liquidity thing, and then consider the option of a Base Case Partnership for blending your values into your investments.

Let's discuss.

Tim