July 21, 2024

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Definition, How It Works, and Types of Loans

What Is Project Finance?

Project finance is the funding of long-term infrastructure, industrial projects, and public services using a non-recourse or limited recourse financial structure. The debt and equity used to finance the project are paid back from the cash flow generated by the project.

Project financing is a loan structure that relies primarily on the project’s cash flow for repayment, with the project’s assets, rights, and interests held as secondary collateral. Project finance is especially attractive to the private sector because companies can fund major projects off-balance sheet (OBS).

Key Takeaways

  • Project finance involves the public funding of infrastructure and other long-term, capital-intensive projects.
  • Project financing often utilizes a non-recourse or limited recourse financial structure.
  • A debtor with a non-recourse loan cannot be pursued for any additional payment beyond the seizure of the asset.
  • Project debt is typically held in a sufficient minority subsidiary that is not consolidated on the balance sheet of the respective shareholders, which makes it an off-balance sheet item.

How Project Finance Works

As noted above, the term project finance refers to the financing of long-term projects industrial and/or infrastructure projects—most commonly for oil and gas companies and the power sector. It is also used to finance certain economic bodies like special purpose vehicles (SPVs). The funding required for these projects is based entirely on the projected cash flows.

Some of the common sponsors of project finance include the following entities:

  • Contractor Sponsors: These sponsors provide subordinated or unsecured debt and/or equity. They are key to the establishment and operation of business units.
  • Financial Sponsors: These sponsors include investors and are usually in the pursuit of a big return on their investment.
  • Industrial Sponsors: These sponsors generally believe that the project is related to their own businesses.
  • Public Sponsors: These sponsors include governments from various levels.

The project finance structure for a build, operate, and transfer (BOT) project includes multiple key elements. Project finance for BOT projects generally includes an SPV. The company’s sole activity is carrying out the project by subcontracting most aspects through construction and operations contracts. Because there is no revenue stream during the construction phase of new-build projects, debt service only occurs during the operations phase.

For this reason, parties take significant risks during the construction phase. The sole revenue stream during this phase is generally under an offtake agreement or power purchase agreement. Because there is limited or no recourse to the project’s sponsors, company shareholders are typically liable up to the extent of their shareholdings. The project remains off-balance-sheet for the sponsors and for the government.

Not all infrastructure investments are funded with project finance. Many companies issue traditional debt or equity in order to undertake such projects.

Off-Balance Sheet Projects

Project debt is typically held in a sufficient minority subsidiary and is not consolidated on the balance sheet of the respective shareholders. This reduces the project’s impact on the cost of the shareholders’ existing debt and debt capacity. The shareholders are free to use their debt capacity for other investments.

To some extent, the government may use project financing to keep project debt and liabilities off-balance sheet so they take up less fiscal space. Fiscal space is the amount of money the government may spend beyond what it is already investing in public services such as health, welfare, and education. The theory is that strong economic growth will bring the government more money through extra tax revenue from more people working and paying more taxes, allowing the government to increase spending on public services.

Non-Recourse Project Financing

When a company defaults on a loan, recourse financing gives lenders full claim to shareholders’ assets or cash flow. In contrast, project financing designates the project company as a limited liability SPV. The lenders’ recourse is thus limited primarily or entirely to the project’s assets, including completion and performance guarantees and bonds, in case the project company defaults.

A key issue in non-recourse financing is whether circumstances may arise in which the lenders have recourse to some or all of the shareholders’ assets. A deliberate breach on the part of the shareholders may give the lender recourse to assets.

Applicable law may restrict the extent to which shareholder liability may be limited. For example, liability for personal injury or death is typically not subject to elimination. Non-recourse debt is characterized by high capital expenditures (CapEx), long loan periods, and uncertain revenue streams. Underwriting these loans requires financial modeling skills and sound knowledge of the underlying technical domain.

To preempt deficiency balances, loan-to-value (LTV) ratios are usually limited to 60% in non-recourse loans. Lenders impose higher credit standards on borrowers to minimize the chance of default. Non-recourse loans, on account of their greater risk, carry higher interest rates than recourse loans.

Recourse Loans vs. Non-Recourse Loans

If two people are looking to purchase large assets, such as a home, and one receives a recourse loan and the other a non-recourse loan, the actions the financial institution can take against each borrower are different.

In both cases, the homes may be used as collateral, meaning they can be seized should either borrower default. To recoup costs when the borrowers default, the financial institutions can attempt to sell the homes and use the sale price to pay down the associated debt. If the properties sell for less than the amount owed, the financial institution can pursue only the debtor with the recourse loan. The debtor with the non-recourse loan cannot be pursued for any additional payment beyond the seizure of the asset.

Project Finance vs. Corporate Finance

Project and corporate finance are very important concepts in the world of financing. Both of these funding methods rely on debt and equity in order to help businesses reach their financing goals. Having said that, they are very distinct.

Project finance can be very capital-intensive and risky and relies on the project’s cash flow for repayment in the future. Corporate finance, on the other hand, is focused on boosting shareholder value through various strategies like the investment of capital and taxation. Unlike project financing, shareholders receive an ownership stake in the company with corporate financing.

Some of the key features of corporate financing include:

  • A company’s capital structure, which is a company’s funding of its operations and growth.
  • The distribution of dividends. Dividends represent a portion of the profits generated by a company and are paid to shareholders.
  • The management of working capital, which is money used to fund a company’s day-to-day operations.

What Is the Role of Project Finance?

Project finance is a way for companies to raise money to realize opportunities for growth. This type of funding is generally meant for large, long-term projects. It relies on the project’s cash flows to repay sponsors or investors.

What Are the Risks Associated With Project Finance?

Some of the risks associated with project finance include volume, financial, and operational risk. Volume risk can be attributed to supply or consumption changes, competition, or changes in output prices. Inflation, foreign exchange, and interest rates often lead to financial risk. Operational risk is often defined by a company’s operating performance, the cost of raw materials, and the cost of maintenance, among others.

Why Do Firms Use Project Finance?

Project finance is a way for companies to fund long-term projects. This form of financing uses a non- or limited recourse financial structure. Firms with weak balance sheets are more apt to use project finance to meet their funding needs rather than trying to raise capital on their own. This is especially true for smaller companies and startups that have large-scale projects on the horizon.

The Bottom Line

Companies need capital in order to begin and grow their operations. One of the ways that certain companies can do so is through project financing. This form of funding allows businesses that may not have a strong financial history to raise capital for larger, long-term projects. Sponsors, which invest in these projects, are paid using cash flows from the project. This is unlike corporate finance, which is less risky and concentrates on maximizing shareholder value.