Project Finance: What You Need To Know

Thursday, 10 November 22, 06:25

Project finance is a funding model adopted by project owners to fund capital-intensive projects in public infrastructure, energy, and construction sectors. Unlike traditional financing, project financing is structured around the assets and cash flow of the project without sponsor guarantees.

Project finance is a funding model adopted by project owners to fund capital-intensive projects in public infrastructure, energy, and construction sectors. Unlike traditional financing, project financing is structured around the assets and cash flow of the project without sponsor guarantees.

The past two decades have seen an unprecedented economic boom, especially in emerging economies like China and India. Not to mention, project finance has paved a new wave of global interest and investments in projects that caused this economic boom.

Furthermore, regulatory reforms, improvements in corporate governance, and shifts in government policies for increased private investment have contributed to making the project finance model a preferred choice for long-term mega projects.

This article explains:

  • What is project finance?
  • How does project financing work?
  • How has project finance become a popular model for financing long-term risky projects?
  • How does project finance compare to other financing models like corporate finance and debt financing?

What is project finance?

In simple terms, the money borrowed to finance a project can be called project finance. Just like home finance is borrowed to purchase or construct a home, car finance is borrowed to purchase a car, similarly, project finance is the money borrowed from lenders to finance a specific project.

The projects that raise funding through project finance are highly capital-intensive, and the project development can take years. Large projects such as public infrastructure projects such as Highways, Railways, Ports, and Airports come under this category. Even private projects like oil and gas exploration and extraction, power generation and transmission, and telecommunication come under the category of mega projects that raise capital through project finance.

Project finance is different from traditional finance because the credit risk associated with the borrower is non-recourse. Unlike the traditional borrowing method, where the borrower bears the entire risk of repayment, in project finance, the borrower’s liability to repay is limited. This is because the debt funding is non-recourse or limited recourse in nature. That being said, the lenders can not claim the personal assets of the project owner in case the latter defaults on repayment or the project fails.

Global project finance statistics and what it says

project Finance Value in 10 Years

Source: Refinitiv

Project Finance Sector Wise

Source: Refinitiv

The above statistics show that the number of deals and value project finance is increasing each passing year. In the fiscal year 2021 alone, the project finance value has touched USD 97.3 B in the United States and the South and North America region, USD 148.8 B in the EMEA region, and USD 63 B in the Asia Pacific & Japan region.

There can be several reasons attributed to this YoY rise.

  • Reliance on market mechanisms: A market mechanism, also known as a price mechanism, is a dynamic free market system where the price and quantity of commodities are decided by supply and demand.
  • Regulatory reforms to attract private investment: Countries worldwide are now keener to reform their existing regulations and coming up with incentivization programs such as tax credits and special economic zones to attract private investors.
  • Large-scale privatization: As per large-scale privatization programs, governments worldwide allow private companies to take over public assets or participate as equity investors to raise capital.
  • Public Private Partnership: The Public Private Partnership Model or PPP model has been the most widely used vehicle for infrastructure investment. The private companies raise capital, build the facilities and recover its cost through revenue while the government grants concessions for the infrastructure project development.

Which types of projects are suitable for project finance?

Projects such as power plants, renewable energy projects, toll roads, exploration of natural resources, and airports are some of the sectors where the project cash flow starts only when the project is complete. That is why project finance reconciles the sharing of project risk among the project participants.

Projects in the following sectors are suitable for project finance:

  1. Energy projects (power generation and transmission)
  2. Public infrastructure projects (metro rail, roads, and airport)
  3. Manufacturing
  4. Construction
  5. Telecommunication
  6. Education
  7. Healthcare

Project finance structure

Project financing depends on the creation of a special project vehicle (SPV). This SPV oversees the project from the planning to the completion stage. Often the SPV becomes the operating company of the new project.

The SPV structure gives project financing two important characteristics: off-balance sheet recording of liabilities and non-recourse financing.

Off-balance sheet liabilities

Debts and liabilities incurred as a result of project finance transactions are not directly reported on the balance sheets of the companies that sponsor the project. They are instead held by the subsidiary SPV. This helps companies maintain healthy credit ratings or make them eligible to secure financing outside the project finance.

Since the liabilities in SPV have no effect on the main balance sheet of the project sponsor companies, embarking on other ventures without directly incurring project debt becomes fairly easy for the companies.

Non-recourse financing

Project finance is a sort of non-recourse financing structure. This means that sponsors will often have recourse solely to assets owned by the SPV rather than the parent company in the case of debt default on the loans used to fund the project. In other words, a non-recourse loan agreement does not allow the creditors or lenders to go after the debtor’s other assets/personal assets if there is a default of payment. That is why non-recourse financing is offered at higher interest rates to reflect the additional risk assumed by lenders.

On the contrary, a recourse structured finance agreement allows creditors or lenders to go after the debtor’s other assets/personal assets if there is a default of payment.

Role of SPV in project finance

The project financing model requires the establishment of a new and independent legal entity, called a Special Purpose Vehicle (SPV), which is used to develop an investment project, raise the required capital, and service debt for the project. This SPV serves as the project company that also manages the project's building, operation, and maintenance.

The project sponsors transfer the assets and debts to this SPV, and the debt remains off balance in their own balance sheet. For private entities, this off-balance holding helps maintain the debt ratio. Similarly, the government keeps the project off-balance sheet to have more room for its fiscal expenditure.

How is project finance different from corporate finance?

After a fair understanding of project finance, it’s time to see how it differs from corporate finance. Corporate finance is backed by the entire balance sheet of the sponsoring company. The sponsor company may utilize its own balance sheet to repay the creditors. Conversely, project finance is backed by the assets of the SPV or project company.

The table below compares the two financing models: corporate finance vs project finance.

Project Finance and Corporate Finance Comparison

Source: CFI

Sources of project finance

The largest share of project finance normally consists of debt. However, private equity investor may also put their resource into the project during its financing stage. Here are the main sources of project finance.

Debt: It is the capital borrowed from banks and non-banking financial institutions at a fixed maturity with a fixed rate of interest. The common forms of debt are mentioned below.

  1. Commercial Loans: This is the main source of debt finance borrowed from a commercial bank or financial institution. The creditors here have the first priority when claiming the project's income and assets.
  2. Bridge Finance: This is a short-term debt raised for a particular period of the project.
  3. Bonds: Bonds are long-term debt instruments issued by governments and large corporations.
  4. Subordinate loans: These loans are similar to commercial loans, but the creditors have a second priority when claiming the project's income and assets.

Equity: The project sponsors also raise capital through equity. Government, private equity investors, and institutional investors may provide funding in exchange for shares.

Sponsors of project finance

A project finance venture can have various project participants who are called project sponsors. The objectives and roles of each project sponsor vary depending on the type of sponsor. Largely the project sponsors can be categorized into four groups:

  1. Industrial sponsors – Industrial sponsors see the project finance venture as an opportunity to integrate it into their core business.
  2. Public sponsors – The local or central government and government agencies whose aims are to provide social welfare through the project.
  3. Contractor sponsorsGeneral Contractors, EPC companies, and construction businesses who design, build, and in some cases, operate the facilities come under this category. They may also provide funding in the form of an equity investment or subordinated debt.
  4. Financial sponsors – Private investors or financial institutions who infuse capital into the project to gain substantial RoI (Return on Investments).

Various stages of project financing

1. Pre-financing stage

  • Identifying project plan — In this stage, a detailed project plan is charted out. Then a detailed analysis is performed to check if the project plan is plausible. If required, the strategy is changed to bring it in line with the goals of the lenders.
  • Risk assessment — Risk assessment and management are crucial steps to avert any future roadblocks. That is why risk-mitigating strategies and contingency plans are worked out before making the final investment decision.
  • Feasibility study — Before investors make the final investment decision, it is crucial to check if the project is technically and financially viable. That is why all the associated factors are scrutinized in the feasibility study.

2. Financing Stage

  • Fund arrangement — In this stage, the project sponsor looks for potential investors to secure funds from a financial institution whose investment goals align with theirs.
  • Negotiation — Once investors show interest in the project, the sponsors and investors negotiate and reach a unanimous decision regarding the amount and other terms and conditions.
  • Documentation — The agreed terms and conditions of the loan are mutually decided by both parties and then documented.
  • Disbursement — Once successful project financing negotiation and documentation are completed, the borrower receives the loan amount to proceed with the project's operations.

3. Post-Financing Stage

  • Project monitoring — A project manager or project management entity is appointed to oversee the operations regularly once the project commences.
  • Project closure — This is when the objectives of the project are met, and the project is closed.
  • Loan repayment — After the project ends, the cash flow from its operations are utilized to repay the loan.

Project finance benefits

Raising funds through project finance has several advantages, including sharing risk, increasing debt capacity, releasing free cash flows, and preserving a competitive advantage in a competitive market. Project finance is a valuable strategy for businesses who want to avoid issuing a corporate repayment guarantee and instead finance the project off-balance sheet.

  • Other than the assets held under the SPV, the sponsor's assets are protected from the lender’s recourse.
  • It permits the creation of SPV, which can hold the assets and liabilities related to the project in an off-balance sheet.
  • It can raise capital irrespective of the project sponsor’s financial obligations or creditworthiness.
  • It also avoids the negative impacts of a project on the credit ratings of the sponsors.
  • The project risk is shared by the investors and sponsors alike.
  • It obtains better tax and regulatory treatments from the government, especially in PPP projects.
  • Political risks are less likely to impact the project.

Complexities of project finance

Despite the benefits, project finance is a complicated and expensive process to put together. The cost of capital arranged through this route is higher than capital arranged through traditional routes. The complexity of project finance negotiations stems from the requirement to build a series of contracts that all project stakeholders must negotiate.

This results in greater transaction costs due to the legal fees associated with developing the project structure, dealing with project-related tax and legal concerns, and preparing essential project ownership, loan documents, and other contracts.

Risks associated with project finance

Projects that are financed by the project finance mechanism do not generate revenue until the construction completes and operation starts. As discussed in the complexities of such projects, the cash flow after operation might be impacted due to several factors, including geo-political and economic factors.

Therefore, several risks always hover above such projects. Below is a brief description of the risks associated with project finance.

  • Uncertainty in project costs: A certain input cost for raw materials and other expenses at the beginning might have been assumed during the financial and technical assessment of the project. If the costs surpass expectations, repaying becomes challenging.
  • Timeliness: Failure to meet project deadlines may result in penalties.
  • Performance: Even if the project is completed on time, it might not generate the predicted cash flows.
  • Political risks: Changes in political policy and environment can dent the funding, feasibility, and operability of projects where the government is a stakeholder.
  • Currency exchange rate: In projects where foreign investors are associated, the capital will be subject to floating exchange rates which might make the interest payments difficult, especially when the local currency depreciates.

Wrapping Up

Project financing is a method of funding infrastructure-heavy, capital-intensive, or public utility-related projects. During their lifespan, these projects are treated as separate legal entities and except for the project’s own cash flow, there are no or limited other means to repay the investors.

In other words, the project finance structuring depends on the project's own strength. Hence, assessing the project's economic, financial, technical, and environmental viability is paramount before investing. Any weak links in the project could weaken the cash flow, thereby impacting the financial returns of its investors and creditors.

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