project finance structure

project finance structure

An In-depth Exploration of Project Finance: Principles, Strategies, and Applications

1. Introduction to Project Finance

This book is about financing long-term development and adding a much-needed integrated approach to the sound operation of financial markets, investment design, and project finance principles, and analysis and government policies as seen from the perspective of life insurance companies. In recent years, the attention of investors and of financial intermediaries such as investment funds has increasingly shifted away from mature industries towards highly dynamic industries. The capital market has started to be used as a source of financing for long-term infrastructure, transportation, telecommunications, energy, and industrial projects and companies. Companies and projects in advanced, newly industrialized or developing countries that have shown a track record of efficiency, have been through a due diligence process from professional investment banks, and have been involved in well-structured public tendering mechanisms are able to access directly or indirectly capital market through issuing corporate bonds, asset-backed securities, and securitization instruments.

1.1 Introduction

By adopting a highly innovative view of financing, namely project finance, and by proposing new and flexible product structures of project bonds, we believe that a practical solution can be proposed to the capital market to provide a useful financial instrument for long-term investment either to life insurance companies or to financial intermediaries such as investment funds investing in projects. Our investigation also provides useful information and policy implications for the demand for and supply of regulations of the capital market in view of stimulating investment in infrastructure, designing investment and pension policies, and regulating the investment behavior of institutional investors. The issue of project finance is an indeed vast and interdisciplinary research field and capital market is playing an increasing role in stimulating growth and development of countries. The solutions we will try to provide should be viewed as part of an overall approach aiming at harnessing efficient, liquid, and highly informative capital markets in a new perspective.

2. Key Concepts and Principles

When a transaction is specifically referred to as “project finance” or a party to the transaction is described as a “project finance lender” or “project sponsor”, however, it seems that there’s an expectation that something special and unique is going on that distinguishes this particular deal from other similar, simpler arrangements. What are the distinguishing features and components of this unique area of governance and finance, and why are financial products and services associated with such a seemingly arcane and idiosyncratic set of legal activities? Moreover, what kinds of activities and projects does the term “project finance” refer to? Finally, what sorts of law and legal skills are involved in the regulation and practice of project finance?

“Project finance” is a term often used to describe legal arrangements under which funds are raised and managed for use directly by a legal entity or “project” of some sort. This kind of transaction is given special attention because raising and using money are seen as inseparable from the particular economic use to which they are put in a project finance context. Essentially, project finance is a way to raise money for and then manage a complex legal arrangement governed specifically by the cash flow from a separate set of economic activities and any available ancillary security. Although project finance is not the only way to raise money for a particular set of legal activities, its methods and principles are universally employable. Consequently, when financial strategies are designed to secure funding for particular activities or projects, project finance is often an integral part of an overall strategy that also involves public finance, corporate finance, or individual consumer finance.

3. Structuring Project Finance Deals

This chapter explains the structure of a project financial transaction. It shows that the investment structures of private equity, project finance, and traditional finance have serious implications in terms of the way that deadweight agency costs can arise in these types of deals. The chapter then goes on to explain project finance. It provides an introduction by giving the bird’s eye view of the project and its life cycle. It then sets the scene for the description of a project financing transaction. Finally, the chapter provides an SVG case study to elaborate on the key financial features illustrated in the bird’s eye view.

Project finance is no ordinary type of finance. A key feature is that the project is separated from the sponsors, allowing it to finance its operations almost entirely with debt securities. Only by putting strong legal controls in place at the inception of the transaction can that separation survive the onslaught of forces trying to tear down the boundaries. This chapter explores the motivations behind editing together a special agreement to govern the dealings between the project and the financial world, drawing on core aspects of intellectual property rights theory and transaction cost economics to illustrate this need.

4. Risk Management and Mitigation Strategies

The allocation and management of project risks is the essence of project financing, a feature that is frequently overlooked when considering how to control project implementation. Traditional project management approaches, and project organization and management theory, have tended to focus on control from the perspective of the contractual relationships between the parties involved, and of thorough project planning and clear definition of project deliverables. This approach is directed at controlling the actions and ensuring the performance of the contractors who are responsible to deliver the project’s components, and on administering the processes of directing, coordinating, and controlling materials, services, and finances to ensure that the various parties work together at the right time and in the right sequence, to achieve the contractual project deliverables. While these activities are crucial for successful project implementation and the achievement of the project’s goals, project control does not equate with project risk management.

The purpose of project finance is to ensure that the revenues generated by new projects, or by existing projects undergoing expansion, are fully available to ensure the repayment of the funds advanced for investment. The principles underpinning project finance form the planning and the legal structuring of the projects, enabling them to gain access to funding at the lowest possible cost. The required minimization of the cost of funding can only be achieved through the precise allocation and management of all risks to those parties that are able to manage the risks at the lowest cost. The careful management of risks allows project financing to be conducted at a relatively low cost; risky projects require unusually high returns and such financing is usually not available, given the wide range of investment alternatives.

5. Case Studies and Real-world Applications

By applying modern variations of project finance to these and other transactions, the proper risk/return will accrue, and investment needs will be satisfied most efficiently in order to assist with economic and social development. The key issues that are inherent in these solutions are political risk, capital maintenance risk, “user” risk, macroeconomic risk, and effective risk allocation. If the project company, its shareholders, the commercial banking sector, the bond markets, and various support organizations concentrate on these critical elements and collaborate effectively in providing solutions, a new era of project finance would ensue.

In this section, we present four detailed case studies on project financing: a greenfield mining project in Chile (Case Study 1), a port expansion in Egypt to increase its capacity (Case Study 2), a hospital project in the Philippines operated under a long-term concession signed with government bodies (Case Study 3), and an oil refinery company’s debt restructuring in India (Case Study 4). These case studies illustrate how project finance is applied in practice and what the salient issues are in structuring and executing the financing of these projects.