project finance pdf

project finance pdf

The Role and Impact of Project Finance in the Global Economy

1. Introduction to Project Finance

The paper then surveys the principal legal and transactional forms of risk mitigation embodied in long-term contract-based finance, and outlines the resulting transactional process. This decision analysis leads to the primary contributions of the article – first, an explication of the transactional anchor needed to make long-term contracts relevant to finance a distinct class of “transaction anchored project debt;” and second, some rules of thumb for the do’s and don’ts of higher risk (non-investment grade) transaction legal structures. The most important do’s are to use a combination of onerous legal contract provisions around transactional partner shortcomings actual equity participation by the senior lender-counterparties. The most important don’t is: don’t let the projects against which the loan is made control the lender’s collateral.

This paper explicates the important role project finance can play in economic development and the resultant policy conclusions. The paper begins with a summary description of project finance, its historical use from the Middle Ages to its growing importance in the current era, and the benefits and risk allocation issues generally associated with its use. The paper then compares project finance to traditional forms of corporate financing in the world as well as in the United States, where it is apparently less widely used. The paper then catalogs the key economic risks of long-term project finance and lays these risks against the public sector’s core borrowing advantage of long-term obligations secured by general tax resources.

2. Key Concepts and Principles of Project Finance

In the medium to long term, the only sustainable source of finance is the earnings of the project. Project finance is designed to help raise these earnings. To achieve this end, the prospective project company, typically also the borrower (initially at least), must have a creditworthy and sometimes bankable product, which reflects the secured nature of the underlying off-take agreements. Earnings are often, but not exclusively, considered to be bankable when they arise from secure and easily quantifiable off-take agreements with creditworthy counterparties. The project’s partners must also have a clear ability to undertake a brief and dedicated job, and there must be some tangible means by which the sponsors can influence the successful project company in achieving the milestones during the construction and consequently the safe, timely, and efficient commencement of the project itself.

2.1 Background

Project finance is an innovative and timely financing technique that has been used on many high-profile corporate projects. A project finance transaction typically involves a number of complex contracts, which are, in effect, the “reason” for the project. These are described as the project’s “enabling agreements” or “project documents.” Some examples are the facility agreement, construction contract, supply agreement, off-take agreement, conditions precedent agreement, and finance documents. The structure of a typical project finance transaction is also discussed briefly.

3. Benefits and Challenges of Project Finance

In the 21st century, project finance has become the primary way of financing the world’s substantial infrastructure, such as the construction of world-scale refineries, road and bridge programs in the United States and Canada, numerous telecommunication deals, the Ramu nickel-cobalt project in Papua New Guinea, the Konohana Bridge toll road project in Japan, the Sual coal-fired power project in the Philippines, the China Resources Building in Hong Kong, and most other significant infrastructure projects in most countries. The appeal of project finance as a financing tool is its ability to reduce entrepreneurs’ risk.

The main benefits of project finance as a financing tool are the following: risk sharing, bundling & allocation of risks, off-balance sheet financing, and non-recourse to the parent company. The consequent proposed benefits result in the following: a bigger pool of potential market lenders, largely based on the specific cash flow of the project, high debt-equity proportion due to the high security by nature of the allocation of risks, potential for an increase in the project’s expected rate of return, and tax efficiency. This paper aims to present the most common risks and, where possible, to support them with a typical organizational structure of a project financing.

Although project finance is a highly complex and time-consuming process, owing to its characteristics, it has become an increasingly popular and indispensable mode of financing enormous infrastructure projects and other undertakings with anticipated long-term cash flow. Project finance benefits various participants involved in the deal. On the opposite side, there are challenges and risks that come as complimentary to the above-mentioned benefits. The paper concentrates on the advantages and risks of this niche area, which are merely coordinated by extreme expertise on contextual fundamentals, prudent risk identification, and keen rationalization.

4. Case Studies and Success Stories in Project Finance

Project Finance is best known for its use in the provision of private or public infrastructure such as toll roads, prisons, and airports. Indeed, much of the current interest in this area is a byproduct of the decade-long trend of deregulation and privatization in which the private sector replaced governments as owners and operators of power plants, water treatment plants, bridges, toll roads, airports, seaports, prisons, and the public utilities. Water is a public utility. Desalination plants are used to desalinate seawater for use by the public. Faced with the prospect of retooling obsolescent or decommissioning obsolescent equipment, commercial banks also began to originate or fund increasingly large corporate project finance deals such as independent power projects and production sharing agreement-generated oil and gas projects whose total investments generally exceed a billion dollars. With the cessation of the Cold War, a greater emphasis has been placed on reducing governmental satellite and telecommunication assets, creating opportunities for structure, and lease financing.

The following table includes examples of successful project finance transactions in a variety of sectors such as infrastructure, energy, and natural resources. Some represent creative means of providing liquidity to an asset class such as lease or infrastructure bonds. The geographical scope of the table is diverse. This list includes projects in emerging markets with explicit or implicit guarantees such as A/BBB rated municipalities but which would otherwise have problems accessing bank financing or obtaining alternative conventional or structured sources of funding from the private capital market. The potential use of political risk insurance, the multilateral development banks, and export credit agencies to raise the credit rating of such projects to BBB or higher is a favored solution. Throughout the decade-long trend to privatization, deregulation, and liberalization, the willingness of state governments to take risks and to provide such guarantees can facilitate the transfer of such assets from the public market into the private sector, reduce the cost of long-term financing, and provide price and currency stability to their regenerate groups.

5. Future Trends and Innovations in Project Finance

Market-based financing and sources remain the university campus and railway systems may expand in the future to include such other essential facilities as bridges, environmental remediation schemes, pipelines, civil aviation yards, water treatment and sewage plants, and hospitals. The problems of construction take-out commitments would, however, continue to depress intercreditor conflicts in and risks of institutional defaults at the senior and junior lenders’ level, respectively. The international markets for non-recourse project financing may also grow in relation to the national ones, as they would be further stimulated by the remarkable ability of consumers to support essential private and public infrastructural investments. Finally, first-phase, conventional, energy-based, and Remote Location projects may gradually offer to the public, in addition to their anticipated venture capital-type payoffs, a steady stream of dividends as a means to attract greater investor interest.

The project finance techniques considered above may continue to develop and advance in the future, responding to changing legal, technological, and economic challenges. Governments and sponsors may always prefer to design and utilize new and more specialized techniques, allowing consortiums and owners to best allocate operating, regulatory, and financial risks, in particular by means of the high leverage and fixed rates of return inherent in project finance. Improved political risk insurance should better facilitate the participation by international businesses in the economic development of the less developed countries, though sovereign ratings would increasingly function. Economic stabilization mechanisms could achieve the same result if they were associated with more “intelligent” stabilization formulas.