what is project finance

what is project finance

Understanding Project Finance: Principles and Applications

1. Introduction to Project Finance

The first six chapters of Understanding Project Finance provide the reader with an introduction to and history of project finance, project analysis, lenders, debt covenants, and government assists. The last four chapters of the book consider how these methodologies apply to the major categories of project finance investment, infrastructure, oil, gas, and energy. Special consideration is given to the political and legal aspects of these investments and to the difficult and controversial problem of privatization.

No other field of international finance is as exciting and as far-reaching as project finance. Not only is this financial service important to the efficient operation of the free market system, but it also presents investors and international businessmen with some of the most challenging and historically significant opportunities and issues of our era. The enormous and steadily increasing volume of national and international financial transactions that are associated with project finance make it essential for anyone in the banking or investment field to understand the fundamental concepts of this relatively modern method of capital formation, investment, and, it is hoped, development. No book can cover all aspects of any field, and project finance is a particularly far-reaching field. However, the groundwork for a fair understanding of the principles of project finance – and at what occasions project finance is appropriate and inappropriate – in the main segments, infrastructure, oil, energy, and appearance in this book.

2. Key Concepts and Principles in Project Finance

The economic stability and performance of the project during its operating life must necessarily be guaranteed. This is exactly the reason why the necessary agreements dealing with the company’s banking covenants and pledges should ideally be set up from the start of the development stage, before completion, when risk is at its maximum. In particular, creditors wait for the EPC contract to be in place in order to scrutinize the project characteristics. The two most important economic figures in project finance of a new build project are first, repayment figures based on the underlying project revenues and costs and second, certain financial returns.

The key feature of project financing is the isolation of the project from the financial state of the sponsors, shareholders, and lenders. This can essentially be put into practice only if the project has a well-defined structure, that is, a special purpose vehicle (SPV) has been created to concentrate all the variables related to the project. The notion of limited or non-recourse plays a key role here. Limited recourse refers to the lenders’ right to claim damages only to the extent of the value of SPV assets. Non-recourse is the state of being denied access to the funds allocated to the project and allows responsibilities that may arise throughout the entire financing term. If the SPV is set up at the holding level, this normally leads to another concept, i.e., off-balance covenants, which may have a positive or negative impact on the overall project structure as compared to serial projects.

3. Structuring a Project Finance Deal

Risks have to be assessed and can frequently be allocated via the structuring of contracts, which provide the motivation for bearing such risks. The heart of the project finance process is the allocation of these risks to the participants in the project to whom such risks are more appropriately allocated. The risks that result from the uncertainty characterizing a project depend on the nature of the project. Some risks are generic, that is, they are associated with all types of projects. Such risks include the risks associated with financing and financial issues and are related to failure to secure the necessary financing for the project, particularly during construction and the risks associated with changes in interest rates or in exchange rates where revenues are denominated in a foreign currency. These risks are typically managed by utilizing specialized financial products such as an interest rate swap or a currency swap.

Project Risks and Contracting Choices

A well-structured project finance should begin with the answer to the fundamental question of why the project is being developed and what benefits it brings to the project sponsor and to the prospective participants in the various sectors served by the project. This question must necessarily take account of the responsibilities of the project sponsor in respect of the project before and after the construction period, and the obligations of the project’s participants over the period of the project’s life. The conception and the establishment of the project must, to a greater extent, reflect the sponsor’s vision of what the project should be, for how it should evolve, and of what interests and benefits flow to the participants at reasonable levels of risk and return, than the imaginative skills of the project developer to expand the concept and to initiate the project. Once the objectives have been outlined, the project structure and the connected contracting techniques can be examined, with an understanding that each project is to a lesser or greater extent unique.

4. Risk Management and Mitigation in Project Finance

A causal model of risk and project finance, distinguishing and identifying the nature of project risks, the nature of institutional risks, and the link between them has been developed. We also discussed the risk management and mitigation benefits of applying project finance techniques through a conceptual tour of the mechanisms inherent in infrastructure financing and development. The risk allocation and performance risk logic resulted in two methodological implications: an economic rational for the public sector to get involved, for example, through guarantees, and a necessity for risk classification and management to be an inherent analytic step in the political and financial structuring of infrastructure investment projects. Finally, we showed some empirical evidence that is consistent with the grant theory.

This chapter investigates the risk management aspect of private participation in infrastructure. The project finance technique for infrastructure development can be viewed as an approach for efficient risk management and mitigation. Infrastructure development is a risky activity, typically facing both project risks and institutional risks. Financing infrastructure, however, can also be used to manage and mitigate these risks. Specific contractual and financial arrangements in project finance show how the risks in infrastructure investment are allocated among the involved parties and how some of them can be managed, reduced, or even eliminated. Understanding these risk management functions of a project finance technique is essential in devising the best structure of private participation. It is also economically significant because the project finance technique forces the risks that have been recognized and can be efficiently borne by project participants to be allocated and exposed to them, thereby increasing the project viability and the common welfare.

5. Case Studies and Real-world Applications

Closing the operation is a matter of 15 minutes. Obviously, the operator knew what she was doing. For the passenger, it was an extraordinary experience: five flight attendants introduced themselves during the time slot before the airplane started to reach the docking station. Four of them added that it was a pleasure to serve you. Promises to visit the client’s seats were nothing out of the ordinary. Their look indicated that they wouldn’t mind establishing a very narrow definition of client servant.

In case there is a need for providing governmental guarantees and the private sector cannot organize an appropriate project company, there is hardly any viable alternative to the traditional concession agreement. The case study presented in the following pages demonstrates that unfavorable experience with nonconcession project connectivity does not alter the hierarchical sequence of private versus public damage rules. Even if the public choice community should come up with a theorem that would show the opposite, it should not be difficult to offer reasons why the theorem does not have practical relevance. While a new instruction on how to finance necessary infrastructure would be nice, reality does not seem to offer any workable options to strengthen the financial position of the sanctioned party.