Rationale for project finance

Project finance is a useful tool for segregating, managing and allocating project risks to those parties best able to manage them. It allows for the development, construction, and operation of a specific project to be funded through a combination of equity investments and debt financing, and is commonly used in PPP and BOO projects. However, it can be complex and time-consuming to arrange so the assistance of specialist financial advisors is advisable, and projects must have the capacity to generate sufficient cash flows to service the debt and pay dividends to the equity investors, which the financial model will help to assess.

Project finance is the funding of long-term infrastructure, industrial projects, and public services using a non-recourse or limited recourse financial structure. The debt and equity used to finance the project are paid back from the cash flow generated by the project. Identifying the common elements of project finance is a worthy exercise to determine if project finance is really the best type of financing for your deal. If you cannot envision all of these elements of project financing being part of your deal, project finance is not the right financing. In the alternative, you should consider trade finance, contract finance, monetization or traditional corporate finance.

It must be realized that project finance is bedeviled with a lot of challenges: It is considerably more expensive than corporate financing. In addition to being significantly more expensive, project finance takes a great deal more time to organize and involves a significant commitment of time and management expertise to implement, monitor and administer the loan during the life of the project. Despite all these challenges, Project finance is still attractive to the private sector because companies can fund major projects off-balance sheet (OBS). The listed elements of project financings are common in every project finance transaction. Some of these are:

Project Financings Are Capital-Intensive

A less visible element of project finance is that it involves huge amounts of financing because it is used to finance major international development and infrastructure projects. Project Financings Have Numerous Participants

Another feature of project financings is that they always involve many, many participants. Beginning with the project sponsors, the vast amounts involved in project finance usually require equity investors, project finance providers like Global Trade Funding, project lenders which frequently become a consortium of lenders, to share the risk, and so on..

Project Financings Are Non-Recourse

Project finance is either non-recourse or very limited recourse as to individual shareholders, including the project sponsors. Non-recourse financing means the borrowers have no personal liability in the event of monetary default. Project companies are generally limited liability special purpose entities, so any recourse the lender may have will be limited to the project assets if the project defaults on the debt.

Project Financings Are Off-Balance Sheet

Project finance is off-balance-sheet financing. In project finance transactions, the project company that owns the project is a stand-alone company known as a special purpose entity. Because there are numerous participants and stakeholders in the project and ownership of the projected is a Special Purpose Entity, the ownership interest of the project sponsor or other project participant is a sufficiently minority subsidiary interest. As such the balance sheet of the project company is not consolidated onto the balance sheets of the project sponsors or shareholders.

The off-balance-sheet element of project finance is attractive to project sponsors because project loans do not negatively impact the sponsor’s balance sheet, nor does it impact their available borrowing capacity. Government entities also find the off-balance-sheet feature of project finance attractive because project debt and liabilities don’t impact their balance-sheets, relieving pressure on an increasingly stressed fiscal space.

Project Finance Documents

One of the most important features of project finance is the extent of project documents. Project financings are so complex, involve such vast amounts and so many participants, projects necessarily must also involve extensive, complex project finance documents if they are to be successful. Project

Financings Allocate Risk:

International project financing transactions tend to be riskier than ordinary corporate finance deals. Because of the risk exposure, allocation of the risk in the deal is often critical for approval of the project finance loan. Risk allocation, which is accomplished in the project documents, attempts to match risks and corresponding returns to the deal participants most capable of successfully managing them.

Project Financing Cash Flow Waterfall:

Again, due to the SPE and non-recourse financing, loan documents will typically contain a contractual obligation to apply excess cash flow from the project to debt service. Thus, any excess cash flow applied in this manner will accelerate loan amortization and reduce the lender’s risk exposure.

Cost of Project Financings

One of the most common features of project finance is it is generally a more expensive financing structure than is typical corporate finance options. Further, project finance involves the use of highly-specialized financial structures which also drives costs higher and liquidity lower.

What compels sponsors to choose this route to finance a particular project. The following are some of the more obvious reasons why project finance might be chosen:

  • The sponsors may want to insulate themselves from both the project debt and the risk of any failure of the project.
  • A desire on the part of sponsors not to have to consolidate the project’s debt on to their own balance sheets. This will, of course, depend on the particular accounting and/or legal requirements applicable to each sponsor. However, with the trend these days in many countries for a company’s balance sheet to reflect substance over form, this is likely to become less of a reason for sponsors to select project finance (the implementation in the UK of the recent accounting standard on “Reporting the Substance of Transactions” (FRS 5) is an example of this trend).
  • There may be a genuine desire on the part of the sponsors to share some of the risk in a large project with others. It may be that in the case of some smaller companies their balance sheets are simply not strong enough to raise the necessary finance to invest in a project on their own and the only way in which they can raise the necessary finance is on a project financing basis.
  • A sponsor may be constrained in its ability to borrow the necessary funds for the project, either through financial covenants in its corporate loan documentation or borrowing restrictions in its statutes.
  • Where a sponsor is investing in a project with others on a joint venture basis, it can be extremely difficult to agree a risk-sharing basis for investment acceptable to all the co-sponsors. In such a case, investing through a special purpose vehicle on a limited recourse basis can have significant attractions.
  • There may be tax advantages (e.g. in the form of tax holidays or other tax concessions) in a particular jurisdiction that make financing a project in a particular way very attractive to the sponsors.
  • Legislation in particular jurisdictions may indirectly force the sponsors to follow the project finance route (e.g. where a locally incorporated vehicle must be set up to own the project’s assets). This is not an exhaustive list, but it is likely that one or more of these reasons will feature in the minds of sponsors which have elected to finance a project on limited recourse terms.