project finance meaning

project finance meaning

Understanding Project Finance: Concepts and Applications

1. Introduction to Project Finance

It will be no surprise to the reader that the central feature of project finance is simply financing of projects. However, in order that investors are properly remunerated on their investment, such projects must return to the shareholders (and other debt and mezzanine creditors) the appropriate combination of rewards and payment of capital. These sources of payment of return and capital must be from non-recourse or limited recourse financing raised against the assets and liabilities directly related to the project’s development. Any such recourse to the project’s sponsors and shareholders will be based on the ability to rely on the guarantees in place, or on the host governmental undertaking that certain agreed parameters essential to the project’s development will be met. The term ‘undertaking’ is not misused in this context, for it is rare for a host government to provide any sort of ‘guarantee’ for political and other non-project related risks.

Too many of those who are not directly involved, the world of project finance in the power and energy sector has, in the past, appeared complex and somewhat forbidding. Over the years, the techniques, analysis tools, financing concepts, and legal framework have become more familiar, especially to the group of specialists involved in putting such deals together. The need for all the participants to work closely together, sharing knowledge of their own particular skills, and to understand the finance implications of their actions is paramount. This is as true for the legal consultant as it is for the power engineer. The aim of this chapter is, therefore, to present project finance in a format that will enable those involved in both long- and short-term roles in such projects to grasp not only their own, but also the overall principles of project finance.

2. Key Players and Stakeholders in Project Finance

The objective of this chapter is to discuss two primary objectives and several related secondary objectives. The primary objectives are the following: first, identify and define the key players and stakeholders in project finance; and second, to differentiate between various types of project finance transactions. The secondary objectives are the following: first, to provide a classification for different categories of project finance, based upon objectives, results, and the degree of financing and operating risks involved; and second, to provide a classification for various types of project participants, based upon differences in legal relationships and contractual performance.

When considering any project, it is important to define the key players or stakeholders. In project finance, this consideration is typically complex because there can be many and varied forms of private, public, domestic, and foreign involvement. If it is a single entity, such as an independent power producer, the situation is relatively simple. The project company meets all obligations on its own, whether these are to employees, owners, contract parties, or third parties. However, if one considers the State of Oman as the sponsor of the large study for an Egyptian fertilizer complex (discussed in more detail below), the number of stakeholders could be considerably higher. Since various types of commercial banks could lend to such a sponsor, these groups would also be stakeholders, as would the owners of and workers in the foreign joint-venture partner. To such groups and individuals, one could add the estimated 240 contractors, suppliers, and labor sources that were expected to be involved in such a large project.

3. Structuring a Project Finance Deal

– Achieve capital budgeting, planning, and accounting objectives. – Maximize the after-tax return to the sponsor. – Limit financial liability and repatriate profits. – Ensure compliance with sector-specific laws and regulations.

The sponsors are the owners or developers of the project. The project sponsor approaches a financial advisor to assess potential financial structures for their project based upon an assessment of project risks and the climate of the financing market. The specific objectives of a sponsor in structuring a project finance deal are to:

Sponsors → Company (Special Purpose Vehicle) → Lenders

A simplified project financing deal structure is represented below:

II. Structure of a Project Financing Deal

Structuring a project finance deal is the most complex and cross-disciplinary task confronting a project financier. This is because there are often a multitude of objectives to cater for, and its objectives are to bring together participants of differing risk perceptions. This chapter will explore a typical project finance structure, consider the motivation for project finance, identify the risks attached to project finance and its structure deal.

I. Introduction

4. Risk Management in Project Finance

In project financing, the lenders’ security interest is confined to the assets and income of the project. The Project Company cannot leverage other projects, some other asset, or a balance sheet that is not created. The key feature of project finance is that lenders do not have, and generally do not seek, any recourse against the project sponsors. Both primary and secondary risks can be managed by proper structuring of project finance transactions. Some of the risk management techniques include Cost Linked Loans, Graduated Repayment Schedule, and Use Of Various Instruments. The Sponsors and Lenders undertake numerous obligations in Project Finance that are related to risk management. Among the Sponsors, these obligations relate to Equity funding, Performance guarantee, Minimum thresholds, Negative pledge, and Pledge of shares. The obligations related to the Lenders are very specific as well and include obligations regarding status and assured rate of return, negation of excess leverage, and immense restriction on asset disposals.

In any project, the main risks are revenue risk, cost risk, and technical risk. Even after mitigation of these risks, the project might experience difficulties in the form of financial distress. In infrastructure financing, pre-completion risks arise from unexpected budget overruns or delays in construction. These cost overruns can increase the requirement for external funds due to loss of equity and unused credit lines. Once the construction is completed, the project can still have problems like ridership risk for infrastructure projects and volumetric risk for natural resource projects. To ensure that construction happens according to the schedule and cost, protective covenants are included in the loan documentation which provides conditions that require the Project Company to achieve certain financial or commercial objectives.

5. Case Studies and Real-World Applications

The YTONG-Izmir Project is a symbol, representing as it does a combination of economic, financial, and political problems. YTONG is a pre-cast concrete company with plants in central Europe and Tunisia, and it is a recognized leader in the provision of real estate concrete materials. Since it was unable to grow in key world markets without plants in Turkey, Israel, and Russia, management set about arranging an $82 million deal with the contribution of the Turkish partner to build a plant in Turkey. Energy supply and water disposal are being provided by the same state syndicate, and the Turkish equity investor was interested in a maximum contribution of around $6 million. This would consequently maximize the debts, liabilities, and guarantees which were carried on the plant and operation side of the equation. The question was, “How could YTONG construction and operation financing remain independent from the inherent risks that fed back from its two affiliate service companies?”

In this section, we review four real-world applications of project finance. We selected the first two applications: the financing of the YTONG-Izmir Project in Turkey, under the aegis of the then-Dresdner East Project Finance Group (now Commerzbank), and the APF project in Nigeria, which brought together a syndicate of four European ECAs based on the work carried out by IFTRIC, as the most representative of the issues discussed in Section 3. We also discuss the Dabhol Power Project in India, a US$3.2 billion limited-recourse deal supported by a multilateral and the Fenchugan Power Project in the Philippines, a US$22.4 million mini-hydroelectric project with COFACE guaranteed financing backstopped by Sumitomo.