the project finance courses

the project finance courses

Analyzing the Role of Project Finance in Infrastructure Development

1. Introduction to Project Finance

In order to accelerate infrastructure investment in developing countries, capital markets need to be developed. These markets have to be efficient and provide long-term finance at a reasonable cost. Unfortunately, capital markets in these countries are less developed because financial systems are generally weak and lack the ability to provide long-term debt financing. As a result, financial repression, inadequate supervision, and regulation in developing countries have added to rigid money-credit markets, contributing to create a financial system ill-equipped to channel potentially high “savings” into more productive long-term investments.

One of the main challenges in developing countries is creating the infrastructure necessary for enhancing standards of living and attracting foreign direct investment. Despite high demand, developing countries are unable to invest in such infrastructure due to financing difficulties. This lack of financing can be traced back to developing countries’ high sovereign risk, especially in cases where the assets cannot be owned by the government. Most developing countries are already highly indebted and international financial institutions have limited resources to lend them. Given that political risk is an unavoidable fact in the development of the affected countries, commercial banks and host countries’ government are not willing to undertake a long-term commitment to support such projects by providing long-term debt.

2. Key Concepts and Principles of Project Finance

As a result, much of the rhetoric in the current projects/infrastructure debate is simplistic in the extreme. Typically, this leads to the determination of the solution without the problem being clearly formulated. In attempting to inverse this situation, we argue that there has been some degree of confusion about what project finance is and is not. The remainder of this section is, therefore, devoted to a disquisition of basic concepts. In so doing, we have not endeavored to be exhaustive in the coverage of the technical content. Rather, we have selected what we consider to be the key fundamental concepts and principles of project finance. Our hope is to familiarize infrastructure managers with some of the most important technical terms and issues in project finance. Only by understanding the techniques and concepts should a meaningful understanding of its applicability be expected. With a thought that the concepts and principles will be understood, we conclude the section with a brief exposition of the key inapplicability of project finance to infrastructure. We also contrast the project finance concept with other alternative techniques.

One critical consideration for every sector of every economy is financing. With the dramatic shift from development to market orientation throughout the world and the growing realization of the role of the private sector in economy-wide development, the issue of finding financing for private projects has become even more critical than ever. In the last few years, infrastructure has taken center stage in the debate over ways to induce the private sector into the investment and financing decision-making loop. Project finance is seen as a technique to help involve private finance effectively in the infrastructure sector decision-making process. The incipient interest in the technique for infrastructure has not, however, been matched by the gaining of deeper understanding and appreciation of fundamental and deeper project finance concepts by the decision-making community in the infrastructure sector.

3. Analyzing the Financial Structure of Project Finance Deals

Project finance seems to be a good way of organizing the financial structure for the companies investing in infrastructure projects. It separates project risks, isolates project abuses from the rest of the corporate life, conserves project cash to protect the creditors providing the long-term funds the project company requires, and so on, as detailed in Section 2. These advantages have driven the remarkable $13 trillion growth in project finance in the 25 years to 1998. During the last quarter of the 20th century, project finance seems to have become the best method of financing long-term infrastructure investments and, unsurprisingly, the logical method of corporate organization for those bargaining to build and operate these assets for service recipients.

To understand the role of project finance in infrastructure development, we need to scrutinize its financial structure and assess the benefits and costs of that financial structure. In this section, we examine the three phases in corporate organization: raising the capital, designing the capital structure, and paying the capital providers. We ask who can provide the various types of financial capital and how project company owners decide who to choose? In solving this puzzle, we need to reconcile the differences in the way the financial market operates in reality with everyman’s perception of how they work.

4. Case Studies and Best Practices in Project Finance

Project finance, comprising non-recourse financing of projects implemented, is increasingly popular in infrastructure investment in developed and developing countries. This study investigates the synergies for successful project finance for infrastructure investments. The risks and transaction costs inherent in infrastructure investments have made it hard for countries to rely on public sector investment alone. Consequently, private sector participation in infrastructure, in a regulatory and economic framework that ensures the benefits of infrastructure investment outweigh its costs. Mutatis mutandis, therefore, the right policy framework can promote investment in infrastructure and the delivery of services and assets that are the building blocks of growth.

Case studies provide insight into the successes, failures, and risks encountered in project finance for infrastructure investments. Three case studies of projects, vis-à-vis the COMAIR Project Superhighway in Lagos State, the Illisu Dam, and the Third Bosphorus Bridge Project, both in Turkey, examine how project finance was applied to achieve successful outcomes. The allocation of project risks and its implications in the project finance process are receiving increased attention.

5. Future Trends and Innovations in Project Finance

Fifthly, with increasing expertise in the formation and operation of special purpose companies and well-structured loans for both new projects and existing project companies, the role of contractors and sponsors connected with project finance may be transformed into that of financial engineers and this trend suggests that the financial engineering techniques developed for project finance shall gradually move into the overall corporate finance mainstream. In conclusion, with increasing refinement in project finance cases and classification and data designs, it is hoped that our study will continue to contribute to the practice of project finance and foster the use of project finance as an important means of public and private-sector development finance and supply of infrastructure and social services.

Fourthly, a further diversification of the industry will be seen as commercial banks play different types of roles in project finance. Depending on the credit risk profiles of lenders, investment banks may be able to structure and arrange for high-yielding loans for a higher rate of return compared to conventional loans. The existence of an extensive institutional investor base and capital markets which accept new financial instruments and increase offerings of project finance bonds also allows structural and warehousing investment banks to exit their positions in project finance loans.

Thirdly, project finance for small-scale projects is likely to expand both in the number of projects and the size of loans to such projects in order to respond to the global needs for social infrastructure (including health, education, water supply, sanitation, housing and urban services). According to the World Bank, the unmet financial needs of poor clients shared by the nine major Microfinance Institutions (MFIs) in Africa and the four major MFIs in Latin America is estimated at $2000 million. There are over 700 MFIs worldwide and the microfinance industry is expected to grow.

Secondly, the increasing importance of housing finance, especially in developing countries, is evidenced by the composition of the borrower structure. The increasing relative roles of governmental agencies such as housing and mortgage finance institutions and private financial intermediaries suggest the emergence of new sources of finance and support for housing projects.

This survey of the practice of project finance and analysis of over 9,000 international project finance loans suggests a number of interesting areas of innovations and future trends in project finance. First, regarding the parties in project finance, some development finance institutions such as the World Bank may lose their centralized role in project finance and be replaced by other financial intermediaries and national government agencies. Private Participation in Infrastructure (annual) reports, however, suggest increasingly important roles of the private sector in infrastructure development. Even if fewer governmental agencies such as export-import banks and multilateral development institutions are involved in direct lending or provision of partial guarantees for project finance, the roles of national development policies continue to be important in the process.