project finance

project finance

The Role of Project Finance in Driving Economic Development

1. Introduction to Project Finance

Project finance is a complex technique and has come to take on a broad range of meanings. The considerable diversity of project finance transactions and the lack of a universally accepted definition complicate analysis of its techniques. Major projects generally have a significant number of both legal and technical issues that are very different from those contained in traditional corporate financing. In fact, the differences between corporate and project funding are numerous. Consequently, a project’s financial structure generally requires more creativity and a very different approach to the overall debt and security packaging. However, at the simplest level, project finance is a technique of corporate financing in which debt lenders look primarily to the future cash flows from a specific project to satisfy the promised loan repayments and interest, and allocate risk and rewards accordingly. Such projects are not financed on the standing or the creditworthiness of the sponsors or their firms.

Project finance is a common method of transaction in Australia, the United Kingdom, and the United States. Internationally, it has been used in the financing of such projects as oil mining activities in Africa and the North Sea, mineral processing projects in Australia, the U.S. and South Africa, and public infrastructure construction throughout the world. Project finance is either the predominant loan structure or is downright essential for the timely completion of many of the world’s production facilities and other projects, particularly in developing and emerging economies. The use of project finance has assisted countries in achieving their established economic and infrastructural goals. A drawing force behind the use and success of project finance is that many of the world’s projects, due to their nature, must be separated from their sponsors.

2. Key Players and Stakeholders in Project Finance

Lender: Provides long-term senior debt to the project company. Banks or bond market investors, including institutional and multilateral organizations. Equity Sponsor: Invests a portion of the funds required for the project; provides management expertise. Developer: Responsible for project development activities; brings the project to market. Also, is often an equity sponsor. Offtaker: Contractually obligates to buy the project’s products or services. Operations and Maintenance Contractor: Operates and maintains the project. Engineer, Procure, and Construct Contractor: Designs and constructs the project. Advisers: Provide specialized consultancy services, including legal, financial, environmental, risk, permit, and engineering advice.

At the most basic level, what project finance requires is that all parties involved in the project receive something that they are unable to achieve without project finance. Indeed, it is this “value add” question that helps us to understand not only why these players are going to get involved in the project and make available funds and expertise, but the different types of agreement contracts and risk allocations that are present in a project finance arrangement.

There are a number of key players in a project finance transaction. Each of these parties is involved in the project because they derive some value from their engagement with it. To understand how project finance works, it is important to understand what each of these parties wants from the project company or indeed how they create value for the project company. Some, the shareholders and the lenders, I expect you will be quite familiar with. For others, such as the offtaker or the construction contractor, this form of financing is key to their decision to get involved in the project.

3. Risk Management Strategies in Project Finance

In the meantime, there needs to be enough flexibility in the financial structure to allow the price and targeted levels of risk involved in the guarantees, together with the structure of the construction contracts and the design, to be fully integrated into the financial model. The costs and targeted risks can all be readily set. It is the financial structure that currently needs to be flexible enough to neutralize the performance of the guarantees as far as the debt service is concerned from the point of view of the banks. The project finance model must therefore allow changes in the level of the construction period and the operating period in order to match the period required to call on the coverage without thereby affecting the results of the financial viability test. It must also set the coverage of the guarantees so as to ensure that the surfaced risk is no wider than the risk during the construction period.

Though the project finance concept allows the project risks to be managed separately from the corporate risks of the sponsor, the traditional debt service reserve account type of debt structure does not really support this concept fully. The cost of buying the insurance policy required to manage the project risks to international standards will be too expensive and indeed may not be available from the current insurance market at all. However, there are a great variety of contracts that can be negotiated so that for different levels of cost different combinations of project risks will be managed. Both sponsors and lenders need to be involved in a negotiating process to determine the combination that is the minimum acceptable to all parties. As the number of organizations willing to provide the necessary guarantees under the contract increases and the cost of accepting the coverage also falls, it will be possible to eliminate the use of the DSRA account and to focus the flexibility of the project finance concept on managing the project risks.

4. Case Studies of Successful Project Finance Initiatives

In recent years, commercial banks have shown increased willingness to finance projects late in the development process. The typical situation today sees the commercial banks financing the construction period and stretching the term-loan repayment period while simultaneously selling off as much of their long-term risk exposure as possible. Substantial political risk is assumed by political risk insurance companies, and some commercial banks have significant renewable debt facilities. The objective for banks is to have their project loans paid off or further reduced as soon as feasible so as to minimize their political risk and to earn a significant return on their capital while minimizing exposure to exchange, interest rate, and credit risks.

The vast size and complexity of many project finance deals have made the traditional areas of credit analysis and law insufficient. The financial services industry has evolved to a point where its most knowledgeable and experienced professionals often form categories of expertise that are separate from those of credit and legal analysis. Even in the credit areas of investment banking firms, banks, and specialized project finance banking organizations, the analytical skills needed can exceed the limits of accountants and general lending professionals. This chapter examines recent experiences of project finance in developing countries in the hopes of drawing a wider picture that investors and other participants may then use in connection with their concerns.