Project Finance

Before starting to tell about project finance, let’s firstly define what is project and how important it is. According to the PMBOK, a project is defined as a “temporary endeavor with a beginning and an end and it must be used to create a unique product, service or result”. [1] This definition means  that projects are activities that cannot go on indefinitely and must have a certain purpose. Projects are very important in production of goods and services. From idea generation to final production of product or service, each step can be classified as individual projects. Any project need a project manager, who leads the project to its logical conclusion, but in any project is very important a project finance.

Project finance is the process of financing a specific economic unit created by sponsors, in which creditors share much of the venture’s business risk and funding is carried out just for the project itself.

Generally speaking, project finance (PF) is an economically significant growing financial market segment, that generally used for funding public and private capital-intensive facilities and utilities. Esty and Sesia report that a record $57.8 billion in PF funding was arranged in Western Europe (W.E.) in 2006, which compares with $35.0 billion invested in the United States (U.S.). [2] For instance, according to Thomson Reuters, in comparison with other financing mechanisms in W.E., as well as in the U.S., the PF market was smaller than both the corporate bond and the asset securitization markets in 2014.[3]

However, the amount invested in PF was larger than the amounts raised through IPOs (Initial Public Offering) or venture capital funds, which indicates that the financial crisis has had a small influence on the financing of large infrastructures and still represents a promising segment of global lending activity. On the other hand, PF can be presented as the process of financing a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan. So, the funding does not depend neither on the reliability and creditworthiness of the sponsors nor on the value of assets that sponsors make available to financiers. Some authors describe the PF in another way, by writing that PF is the structured financing of a specific economic unit that the sponsors create by means of share capital, and for which the financier considers cash flows as the source of loan reimbursement, whereas project assets only represent collateral. [4]

How does the PF create value?

 

There are three key decisions related to the use of PF:

  • investment decision – involving industrial assets,
  • organizational decision – creation of a legally independent company to own the assets,
  • financing decision – non-recourse debt.

Considering that debt repayment comes from the project only rather than from any other entity, PF interpreted as a transaction that includes the creation of a legally independent project company financed with equity from one or more sponsoring firms and non-recourse debt for the purpose of investing in a capital asset. This interpretation differs PF from other structured financing vehicles such as securitization, leveraged acquisitions, and structured leasing.

There are five distinctive features of a PF transaction.

 

There are three key decisions related to the use of PF:

  • investment decision – involving industrial assets,
  • organizational decision – creation of a legally independent company to own the assets,
  • financing decision – non-recourse debt.

Considering that debt repayment comes from the project only rather than from any other entity, PF interpreted as a transaction that includes the creation of a legally independent project company financed with equity from one or more sponsoring firms and non-recourse debt for the purpose of investing in a capital asset. This interpretation differs PF from other structured financing vehicles such as securitization, leveraged acquisitions, and structured leasing.

There are five distinctive features of a PF transaction.

 

These risks are divided contractually to the parties best able to manage them and also for the purpose of reducing cost and ensuring proper benefits. The risk management process is usually based on the following interconnected steps: risk identification; risk analysis; risk transfer and allocation. Actually, PF creates value by resolving agency problems and improving risk management.

 Three main reasons for using PF:

  • PF can be used to mitigate conflicts inside project companies and among capital providers. PF highly levered capital structures have an important disciplinary role, because they prevent managers from wasting free cash flow, and deter related parties from trying to assign it.
  • This type of transaction allows companies with little spare debt capacity to avoid the opportunity cost of underinvestment in positive NPV (Net present value) projects.
  • PF improves risk management and creates value by improving risk management inside the project.

Project finance can also help to reduce underinvestment due to asymmetric information problems. The separation of projects from the sponsoring firm or firms facilitates initial credit decisions and it is relatively easy to convey information that would be more difficult in a corporate financing framework, in which the joint evaluation of the project and existing assets can be more problematic.

Except the mentioned advantages, there are also some main problems related to the use of PF:

  • complexity in terms of designing the transaction and writing the required documentation;
  • higher costs of borrowing when compared to conventional financing;
  • the negotiation of the financing and operating agreements is time-consuming.

As a conclusion we can say that project finance (PF) is a form of financing based on a standalone entity created by the sponsors, with highly levered capital structures and concentrated equity and debt ownership. Being a nexus of contracts, PF also used to segregate the credit risk of the project from those of its sponsors so that lenders, investors, and other parties will appraise the project strictly on its own economic merits. The allocation of specific project risks to those parties best able to manage them is one of the key comparative advantages of PF.

Sources:

  1. https://www.managementstudyguide.com/what-is-project.htm
  2. https://link.springer.com/article/10.1007/s11301-017-0125-3
  3. Pinto, J. M. (2017). Investment Management and Financial Innovations.
  4. Gatti, S. (2008). Project finance in theory and practice.