3.1. Introduction to Project Finance

• “The financing of a project or other asset or undertaking which is repaid principally from cashflow generated by the project or asset being financed” (Mills & Taylor, 1994).

• “Project finance is asset-based financing, meaning that the project lenders have recourseonly to the underlying assets of a project” (Goldman, McKenna & Murphy, 2005).

• “A Project Finance transaction involves the mobilization of debt, equity, contingent equity, hedges and a variety of limited guarantees through a newly organized company, partnershipor contractual joint venture (a project vehicle)” (Khan & Parra, 2003).

1. Concrete purpose

2. Creditworthiness

3. Special Purpose Copany and off-balance-sheet financing

4. 4. Non-o-limited recourse

5. Risk allocation and sharing

Investment into an industrial or infrastructural asset with a clearly defined purpose

The creditworthiness analysis of banks concentrates on the expected cash-flows ofthe venture only. The assets are of less interest and may at best function as an additional collateral.

• The contractor is usually a special purpose company (SPC). The SPC is liable up to its assets and thecontractually agreed contributions only.

• The foundation of a SPC usually allows for off-balance-sheet projects.

• Consolidation (may depend on country and accounting standard):

  • More than 50%: Subsidiary/Consolidated statements necessary

  • 20% to 50%: Associate company/Consolidation by equity method

  • 20% or less: Treated as common stock

The creditor have usually no or only limited recourse rights to the project initiators. Only the SPC andits assets may be liable.

Risk allocation is key in project finance. The goal is a balanced risk sharing to the parties concerned

• Sponsor(s)

• Project Vehicle

• Construction Contractors

• Lenders

• Insurance Providers

• An individual or company.

• Usually has some previous experience in the implementation and operation of similar project.

• Sponsor(s) generally organize a special-purpose vehicle, registered in the host country for the purposeof implementing and operating a given project.

• Sponsor(s) are required to make capital investments in the project vehicle.

• There is usually a designated lead sponsor.

• In the case of a corporate joint venture, the lead sponsor is the leader of the consortium and in thecase of a partnership, it is the dominant partner under the venture arrangements.

• The construction contractor is the entity that builds the project under an engineering procurement andconstruction contract (which guarantees the fixed-price, required specifications and schedule ofconstruction and commissioning associated with the facility).

• Lenders prefer a single contract because it gives them a single responsible party for all subcontractorsand activities.

• Multilateral and bilateral agencies: encompass organizations such as the World Bank, InternationalFinance Corporation (IFC) and Multilateral Investment Guarantee Agency (MIGA). Also includesregional development banks such as the Asian Development Bank (ADB). Multilateral institutions areoften present, through their loan and guarantee products, particularly in Project Finance transactionslocated in developing/emerging countries.

• Commercial lenders: are commonly private banks, insurance companies, credit corporations and otherfinancial institutions, based either abroad or in the host country.

• ECAs (export credit agencies): assist in supporting exports from their country generally through theuse of direct loan and guarantee mechanisms. Six of the more important of these agencies are the USEximbank, Export Credit Guarantee Department (ECGD) of the UK, Japan Bank for InternationalCooperation (JBIC), Compagnie Francaise d’Assurance pour la Commerce Exterieur (COFACE) ofFrance and Kreditanstalt für Wiederaufbau (KfW) of Germany.

• Private placement and bond market: Investors generally shy away from projects that are not able toachieve an investment grade rating. Established bond markets are in US, UK, Germany and Japan.

• Project sponsor(s) will procure all insurance coverage required by applicable law.

• In addition, the terms of the service agreement and the requirements of lenders often result in the needto obtain a broader portfolio of insurance policies and coverage.

• In some cases, sponsor(s) may seek additional insurance coverage, such as political-risk insurance, toprotect their investment.

Depending on the project, there may be other parties involved, e.g. third party equity sources (straightequity provided by parties which are unaffiliated with the sponsor(s)), or mezzanine investors orlenders (whose participation may take the form of convertible debt).

• Off-taker: entity that is the single purchaser of all project output subject to a formal contract.

• Third-Party Operator: responsible for the operations and maintenance (O&M) of the project.

• Resource Supplier: responsible for the delivery to the project of necessary fuel, bulk water supply, orutility services.

• Government: If the government is involved at all, it is at the municipal level.

1. Full recourse financing

2. Limited recourse financing

3. Non-recourse financing

The creditors have full recourse to sponsors. Despite the project having its own SPC, theconstruct sponsors are fully liable for project risks.

-> Not much of a difference to classic debt financing.

Most frequently applied structure. The creditors have only very limited rights of recourse.The limitations can be in terms of time or money.

• Sponsors are usually liable during construction. Banks regularly demand completionguarantees. In later stages, sponsors are usually no longer liable

In this case, creditors have absolutely no recourse rights to sponsors (sometimes calledpure project finance). Debt service comes solely from SPC. Creditors take full businessrisk.

• Minimizing and tailoring the equity commitment to be delivered to any one particular project.

• Negotiating risk-sharing arrangements that are appropriate to the project being developed (primarypurpose being to move risk away from the project as well as its sponsor(s) and reallocating it to someother party and improving the potential for project leverage).

• Segregating project’s liabilities from the corporate balance sheet from a commercial andaccounting perspective (generally by creating a special-purpose vehicle to undertake the project).

• Reducing taxes by using a limited partnership or contractual joint venture structure to implement theproject.

• Avoiding restrictive covenants on the corporate balance sheet arising from the projects’ debtfinancing.

• Achieving diversification of exposure and revenue among a portfolio of projects.

• Matching each commercial undertaking with the specific assets and liabilities required to build andoperate it.

• An adequate risk-sharing structure is often difficult to put in place and almost always createsunanticipated delays in achieving financial closing.

• Lender may consider this type of finance to be riskier and therefore charge a higher risk premiumfor associated loans.

• Lenders insist on having greater oversight of the project and therefore the sponsor(s) or projectmanagement has less managerial discretion over it. Significantly, project finance lenders, rather thanproject managers, control the application of cash flows from the project to meet operating expensesor pay dividends.

• Lenders view the insurance arrangements as part of the risk-sharing structure and require morecomprehensive and costlier cover than would be alternatively required for a normal commercialloan.

• Documentation is lengthy and complex and hence expensive to put into place. As a result, thistype of financing is cost-effective only for relatively large deals.