What is project finance?
The 20th century was marked by a reliance on the public sector for developing infrastructure projects. Historically, governments initiated infrastructure projects to develop or build essential facilities so that citizens and businesses could conduct various operations and experience economic growth. In the last two decades, however, there has been a shift in the model of development from the public sector to greater private sector participation. These public-private partnerships (PPP) have been instrumental in upgrading existing facilities and creating new infrastructure in various industries and in all parts of the world. The most common method of financing PPPs is project finance.
Most authors agree on defining project finance as financing that is basically a function of the project’s ability to repay the debt contracted, where the lender considers future cash flow revenues as being the primary source of loan reimbursement. It does not depend on the soundness and creditworthiness of the sponsors (parties investing equity in the project). Besides, approval does not even depend on the value of assets sponsors are willing to make available to financers as collateral.
Today, various sectors employ project finance, including power, transportation, oil and gas, telecommunications, renewables, mining, industry, water and sewage. The following graph confirms that the project finance market continues to be dominated by the power, oil & gas, renewables and transportation projects. These sectors are highly capital intensive, form essential pieces of national infrastructure, have long asset lives and typically have predictable revenue streams, making them ideal assets for project financing :
Examples of these sectors include:
- Energy. Project finance is used to build energy infrastructure in industrialized countries as well as in emerging markets.
- Oil & Gas. Development of new pipelines and refineries are also successful uses of project finance. Large natural gas pipelines and oil refineries have been financed with this model. Before the use of project finance, such facilities were financed either by the internal cash generation of oil companies, or by governments.
- Mining. Project finance is used to develop the exploitation of natural resources such as copper, iron ore, or gold mining operations in countries as diverse as Chile, Ghana and Australia.
- Transport. New roads are often financed with project finance techniques since they lend themselves to the cash flow based model of repayment.
- Telecommunications. The burgeoning demand for telecommunications and data transfer via the Internet in developed and developing countries necessitates the use of project finance techniques to fund this infrastructure development.
- Other. Other sectors targeted for a private takeover of public utilities and services via project finance mechanisms include pulp and paper projects, chemical facilities, manufacturing, hospitals, retirement care facilities, prisons, schools, airports and ocean-going vessels.
Project finance is an important tool for financing projects in developing and emerging economies, yet developed countries employ the mechanisms as actively as less developed countries. The following table showcases the top 10 countries using project finance :
The following list provides common features of project finance transactions :
Capital-intensive. Project financings tend to be large-scale projects that require a great deal of debt and equity capital, from hundreds of millions to billions of dollars. Infrastructure projects tend to fill this category.
Highly leveraged. These transactions tend to be highly leveraged with debt accounting for usually 65% to 80% of capital in relatively normal cases.
Long term. The tenor for project financings can easily reach 15 to 20 years.
Independent entity with a finite life. Project financings frequently rely on a newly established legal entity, known as the project company, which has the sole purpose of executing the project and which has a finite life. In many cases the clearly defined conclusion of the project is the transfer of the project assets.
Non-recourse or limited recourse financing. This means that there is no or limited recourse to the project sponsor’s assets for the debts or liabilities of an individual project. Financing therefore depends purely on the merits of a project (understand cash flow revenues here) rather than the credit- worthiness of the project sponsor.
Controlled dividend policy. The project has a strictly controlled dividend policy, though there are exceptions because the dividends are subordinated to the loan payments. The project’s income goes to servicing the debt, covering operating expenses and generating a return on the investors’ equity. Usually, no reinvestment is allowed.
Many participants. These transactions frequently demand the participation of numerous international participants. It is not rare to find over ten parties playing major roles in implementing the project.
Allocated risk. The goal of this process is to match risks and corresponding returns to the parties most capable of successfully managing them. For example, fixed-price, turnkey contracts for construction which typically include severe penalties for delays put the construction risk on the contractor instead on the project company or lenders.
Costly. Raising capital through project finance is generally more costly than through typical corporate finance avenues. The greater need for information, monitoring and contractual agreements increases the transaction costs. Furthermore, the highly-specific nature of the financial structures also entails higher costs and often include premiums for country and political risks.
Capital-intensive. Project financings tend to be large-scale projects that require a great deal of debt and equity capital, from hundreds of millions to billions of dollars. Infrastructure projects tend to fill this category.
Highly leveraged. These transactions tend to be highly leveraged with debt accounting for usually 65% to 80% of capital in relatively normal cases.
Long term. The tenor for project financings can easily reach 15 to 20 years.
Independent entity with a finite life. Project financings frequently rely on a newly established legal entity, known as the project company, which has the sole purpose of executing the project and which has a finite life. In many cases the clearly defined conclusion of the project is the transfer of the project assets.
Non-recourse or limited recourse financing. This means that there is no or limited recourse to the project sponsor’s assets for the debts or liabilities of an individual project. Financing therefore depends purely on the merits of a project (understand cash flow revenues here) rather than the credit- worthiness of the project sponsor.
Controlled dividend policy. The project has a strictly controlled dividend policy, though there are exceptions because the dividends are subordinated to the loan payments. The project’s income goes to servicing the debt, covering operating expenses and generating a return on the investors’ equity. Usually, no reinvestment is allowed.
Many participants. These transactions frequently demand the participation of numerous international participants. It is not rare to find over ten parties playing major roles in implementing the project.
Allocated risk. The goal of this process is to match risks and corresponding returns to the parties most capable of successfully managing them. For example, fixed-price, turnkey contracts for construction which typically include severe penalties for delays put the construction risk on the contractor instead on the project company or lenders.
Costly. Raising capital through project finance is generally more costly than through typical corporate finance avenues. The greater need for information, monitoring and contractual agreements increases the transaction costs. Furthermore, the highly-specific nature of the financial structures also entails higher costs and often include premiums for country and political risks.
The next chapter showcases the differences between traditional corporate finance et project finance.
Follow this link to Project Finance vs. Corporate Finance.
Follow this link to Summary.
Follow this link to Project Finance vs. Corporate Finance.
Follow this link to Summary.
In case you need more information, or are eager to get into the details of Project Finance, I recommend the following reads , that I personally bought as to create the summarized information of this Project Finance website (Amazon links) :
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