FINANCING MECHANISMS
Similar to the traditional finance model, a project finance model allows an entity to use equity or debt financing. Most entities in search of investment funds prefer debt financing to equity financing because they retain full control over the project and earn a greater return through the use of debt financing. Debt financing refers to funding a project with a loan, where the SPV takes out a loan and no other investors are involved. In contrast, equity financing requires the project sponsors of the SPV to either contribute cash needed for the project or sell ownership in the SPV to raise capital. In addition to maintaining full control, debt financing is attractive because project sponsors do not have to contribute extra capital to the project.
Equity. Often host governments and debt lenders will require that the entity building the project obtain some equity funding in order to demonstrate project viability in the market and to offset initial costs. There are a number of factors that influence the level of equity in the SPV that will be made available by the sponsoring companies via equity funding and how much of the construction costs the SPV will solicit in the form of loans. Those factors include how the project is organized, who the players are, what the particular risks are in that country, and what legal requirements there may be in the host country. Typically, equity comprises a smaller share compared to debt (although equity-to-debt ratios range from 5% to 50% in project finance).
Debt. There are two main types of debt: Mezzanine and Senior Debt.
Mezzanine Debt : Mezzanine Debt is a special type of debt, which has priority over equity, but is subordinate to other types of loans. Recall the example above of the CBK hydropower station. The mezzanine debt lenders were providing capital in order for one project sponsoring company to purchase the existing project company. If the project fails, senior lenders who were lending to the SPV rather than to the new sponsor company will be paid off first. The important fact to bear in mind is that mezzanine debt refers to debt that is riskier, because there are other outstanding loans that have priority over the mezzanine loan in the case of a default.
Senior Debt : As the name suggests, senior debt has seniority in the event of default. A lender may stipulate that it is a senior debt lender, as the World Bank does for example. This means that in the case of default, that lender will receive payment before other creditors of the project. There are several types of debt available to sponsoring companies :
- Commercial financing (commercial banks, pension funds, insurance companies, and other financial institutions), where the lender requires the borrower’s promise of repayment to be collateralized (backed by some asset).
- Subsidized loans, where the interest rate is below the market rate. Development institutions, governments, and regional development banks (such as a loan from the African Development Bank) typically provide such subsidized loans.
- Credit enhancing arrangement from bilateral and multilateral organizations and regional banks, where those organizations provide a guarantee to the lender. If the SPV cannot make payments on its debt, then the guarantor will make payments to the lender on behalf of the SPV.
- Bond financing, where the bondholder provides capital in return for a promise by the SPV to repay the initial amount with interest.
Leasing. One other unique method of financing is lease financing where the SPV rents equipment relying on future revenue stream of the project to pay the lease. That is, the SPV does not make immediate payments on the leased equipment, but promises to pay for the equipment once the project begins to generate revenue. Because construction costs are significant, this sort of financing can play an important role in enabling a project to proceed. The company leasing the equipment has a security interest in the equipment and can repossess the equipment in the case of a default. In return for the financing, the SPV may be required to pay additional interest or pay a premium on the cost of renting the equipment.
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