project finance banks

project finance banks

The Role of Project Finance in Investment Banking

1. Introduction to Project Finance and Investment Banking

Project finance is the technique of financing a single purpose capital investment through the use of a specially created off-balance sheet (i.e. separate legal entity) limited recourse project company. The financing of the venture is raised against the future cash earned by the project. Since project cash flow can be uncertain and cyclical, the promoter of the project (the equity owner of the project company) is expected to invest in the project. By placing a large stake in the project, the promoter signals to lenders an intent to act in the best interest of the project, thereby aligning his interest with them. This is in total contrast to other types of capital investments where funds are raised through the balance sheet, and potential losses in value are borne by the shareholders and not passed onto the project lenders.

1.1. Overview of Project Finance

2. Key Players and Stakeholders in Project Finance Deals

Key players include the investor, who is usually the sponsor’s highest equity provider; the sponsor, who controls the day-to-day management of the project; the operator, who is responsible for running the project and is often controlled by the sponsor; and the engineering, procurement, and construction (EPC) contractor, who is responsible for building the project. Other key players include the public sector and government, who grant the necessary licenses, permits, and consents and may also provide infrastructure; a lender who provides management support and due diligence; and a bank who provides project finance. Other stakeholders of the project finance deal include the customer, who pays the primary revenue stream to the project; the subordinated/compromised creditor who defines the risk equity-return trade-off and protects the returns of the primary debtholders; and the general public.

When a project begins, it is often not yet producing a good or a service. But over the life of the project, it will do so. Initially, the project is all risk, not being capable of meeting its financing needs by using internally generated cash. Project financings are undertaken to facilitate the construction of big, long-lasting projects, such as a gas field or an airport. In project finance, lenders are repaid out of future revenues. A financing package for the project includes equity from the developer, project debt that is repaid from cash generated by the project, as well as other financial products, including letters of credit and performance guarantees.

3. Structuring and Valuation of Project Finance Transactions

Project finance structures are contrived to enhance the credit quality of the project instead of enhancing the credit quality of the borrower. Through various forms of insulation, including the incorporation of the specific project into a discrete capital structure that allows cash flow of the project to be directed only to the issuing and related projects, the lenders obtain the right to the flow of funds associated with the revenues generated by the project. This specificity of the revenue and the cash flow generation to the project is what allows lenders to gain comfort and provides them with recourse to the receivables from the specific project without having to reach into the general assets of the borrower.

In some respects, the structuring and valuation of the lenders’ position in project financings requires more sophisticated financial modeling than is typical of other lending markets. Where the repayment pattern and the credit risk of a more conventional term loan depends solely upon the creditworthiness and corporate structure of the borrower, the repayment of project finance is greatly influenced by the cash flow and the risk-return characteristics of the project itself. In a successful project finance, non-recourse lending, on a stand-alone basis, the lender is typically not betting on the borrower. Instead, the lender is assuming the risks and is modeling the strength of the asset or the project.

4. Risk Management and Mitigation Strategies in Project Finance Deals

Business risks can be mitigated through fixing tariffs with multiple price escalations, having sensitivity analysis that test the viability of project vis-a-vis low operating rate levels, raw material prices that are based on long-term contracts, cost-plus contracts, multiple EPC contractors, and stringent warranties. Business risks can also be shared by fixing thresholds in the contracts and sharing a percentage over some in case these risks happen through incentives. Correlation is an important risk as some risks are correlated and they only show when they happen and therefore it is quite logical that the sponsor of the project will have to come up with guarantees and mitigation strategies. On the other hand, political risks can be mitigated with insurance or guarantees from the government, while currency risk can be mitigated using the tactics from the forex market. Of course, there are completion risks and performance risks that can be mitigated using guarantees and project insurance.

One of the main risks associated with many project finance deals is the lack of operating history and track record of the company and of the project itself. As many such projects come into existence in developing countries, there is a lot of unknown and unusual risks that the project has to face on its way to garnering cash inflows. Most of the time, these are pure business risks related to operations of the borrower with respect to market demand, competition, and production, and business risks associated with cost overruns, schedule delays, and technology performance. The simple formula to identify such business risks and what the project finance techniques are is presented in Table 3.

5. Case Studies and Best Practices in Project Finance Investment Banking

With the fundamental techniques of valuation, capital budgeting, and corporate strategy founded, you will now implement these financial principles in the realm of project finance. In real-world project finance, the investment banking professional must intertwine the peculiarities of risk analysis, government intervention, and international financial markets to allow a transaction’s financial success. In the final culmination of this course’s studies begins with a thorough examination of selected project finance case studies and best practices. To enable such insight, guest practitioners will visit to share their particular experiences occurring in project transactions structured consistently with the predominant organizational structures found in real-world project finance, ultimately leading to a better understanding of how project finance can be put to task for vital infrastructure and industrial growth in the sometimes risky world around us.