Project finance


Project finance is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the project rather than the balance sheets of its sponsors. Usually, a project financing structure involves a number of equity investors, known as 'sponsors', and a 'syndicate' of banks or other lending institutions that provide loans to the operation. They are most commonly non-recourse loans, which are secured by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modeling; see Project finance model. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets and are able to assume control of a project if the project company has difficulties complying with the loan terms.
Generally, a special purpose entity is created for each project, thereby shielding other assets owned by a project sponsor from the detrimental effects of a project failure. As a special purpose entity, the project company has no assets other than the project. Capital contribution commitments by the owners of the project company are sometimes necessary to ensure that the project is financially sound or to assure the lenders of the sponsors' commitment. Project finance is often more complicated than alternative financing methods. Traditionally, project financing has been most commonly used in the extractive, transportation, telecommunications, and power industries, as well as for sports and entertainment venues.
Risk identification and allocation is a key component of project finance. A project may be subject to a number of technical, environmental, economic and political risks, particularly in developing countries and emerging markets. Financial institutions and project sponsors may conclude that the risks inherent in project development and operation are unacceptable. "Several long-term contracts such as construction, supply, off-take and concession agreements, along with a variety of joint-ownership structures are used to align incentives and deter opportunistic behaviour by any party involved in the project." The patterns of implementation are sometimes referred to as "project delivery methods." The financing of these projects must be distributed among multiple parties, so as to distribute the risk associated with the project while simultaneously ensuring profits for each party involved. In designing such risk-allocation mechanisms, it is more difficult to address the risks of developing countries' infrastructure markets as their markets involve higher risks.
A riskier or more expensive project may require limited recourse financing secured by a surety from sponsors. A complex project finance structure may incorporate corporate finance, securitization, real options, insurance provisions or other types of collateral enhancement to mitigate unallocated risk. Go to take a self guided course on this topic with real world examples and a breakdown of the entire process.

Origin

Limited recourse lending was used to finance maritime voyages in ancient Greece and Rome. Its use in infrastructure projects dates to the development of the Panama Canal, and was widespread in the US oil and gas industry during the early 20th century. However, project finance for high-risk infrastructure schemes originated with the development of the North Sea oil fields in the 1970s and 1980s. Such projects were previously accomplished through utility or government bond issuances, or other traditional corporate finance structures.
Project financing in the developing world peaked around the time of the Asian financial crisis, but the subsequent downturn in industrializing countries was offset by growth in the OECD countries, causing worldwide project financing to peak around 2000. The need for project financing remains high throughout the world as more countries require increasing supplies of public utilities and infrastructure. In recent years, project finance schemes have become increasingly common in the Middle East, some incorporating Islamic finance.
The new project finance structures emerged primarily in response to the opportunity presented by long term power purchase contracts available from utilities and government entities. These long term revenue streams were required by rules implementing PURPA. The policy resulted in further deregulation of electric generation and, significantly, international privatization following amendments to the Public Utilities Holding Company Act in 1994. The structure has evolved and forms the basis for energy and other projects throughout the world.

Parties to a project financing

There are several parties in a project financing depending on the type and the scale of a project. The most usual parties to a project financing are:
  1. Sponsor
  2. Lenders
  3. Off-taker
  4. Contractor and equipment supplier
  5. Operator
  6. Financial Advisors
  7. Technical Advisors
  8. Legal Advisors
  9. Market Advisors
  10. Environmental Consultants
  11. Equity Investors
  12. Regulatory Agencies
  13. Multilateral Agencies / Export Credit Agencies
  14. Insurance Providers
  15. Hedge providers

    Project development

Project development is the process of preparing a new project for commercial operations. The process can be divided into three distinct phases:
  • Pre-bid stage
  • Contract negotiation stage
  • Money-raising stage

    Financial model

A financial model is constructed by the sponsor as a tool to conduct negotiations with the investor and prepare a project appraisal report. It is usually a spreadsheet designed to process a comprehensive list of input assumptions, and to provide outputs that reflect the anticipated "real life" interaction between data and calculated values for a particular project. Properly designed, the financial model is capable of sensitivity analysis, i.e. calculating new outputs based on a range of data variations.

Contractual framework

The typical project finance documentation can be reconducted to six main types:
The most common project finance construction contract is the engineering, procurement and construction contract. An EPC contract generally provides for the obligation of the contractor to build and deliver the project facilities on a fixed price, turnkey basis, i.e., at a certain pre-determined fixed price, by a certain date, in accordance with certain specifications, and with certain performance warranties. The EPC contract is quite complicated in terms of legal issue, therefore the project company and the EPC contractor need sufficient experience and knowledge of the nature of project to avoid their faults and minimize the risks during contract execution.
The terms EPC contract and turnkey contract are interchangeable. EPC stands for engineering, procurement and construction. Turnkey is based on the idea that when the owner takes responsibility for the facility all it will need to do is turn the key and the facility will function as intended. Alternative forms of construction contract are a project management approach and alliance contracting. Basic contents of an EPC contract are:
An operation and maintenance agreement is an agreement between the project company and the operator. The project company delegates the operation, maintenance and often performance management of the project to a reputable operator with expertise in the industry under the terms of the O&M agreement. The operator could be one of the sponsors of the project company or third-party operator. In other cases the project company may carry out by itself the operation and maintenance of the project and may eventually arrange for the technical assistance of an experienced company under a technical assistance agreement. Basic contents of an O&M contract are:
  • Definition of the service
  • Operator responsibility
  • Provision regarding the services rendered
  • Liquidated damages
  • Fee provisions

    Concession deed

An agreement between the project company and a public-sector entity is called a concession deed. The concession agreement concedes the use of a government asset to the project company for a specified period. A concession deed would be found in most projects which involve government such as in infrastructure projects. The concession agreement may be signed by a national/regional government, a municipality, or a special purpose entity set up by the state to grant the concession. Examples of concession agreements include contracts for the following:
  • A toll-road or tunnel for which the concession agreement giving a right to collect tolls/fares from the public or where payments are made by the contracting authority based on usage by the public.
  • A transportation system
  • Utility projects where payments are made by a municipality or by end-users.
  • Ports and airports where payments are usually made by airlines or shipping companies.
  • Other public sector projects such as schools, hospitals, government buildings, where payments are made by the contracting authority.

    Shareholders Agreement

The shareholders agreement is an agreement between the project sponsors to form a special purpose company in relation to the project development. This is the most basic of structures held by the sponsors in a project finance transaction. This is an agreement between the sponsors and deals with:
  • Injection of share capital
  • Voting requirements
  • Resolution of force one
  • Dividend policy
  • Management of the SPC
  • Disposal and pre-emption rights