Project Finance

An Overview

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Sunday, February 9, 2014

What is Project Finance?

Project finance is the raising of funds on a limited recourse or non-recourse basis to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and return on their equity invested in the project. (Finnerty, 2007)
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Sunday, February 9, 2014

What is Project Finance?

A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of that economic unit as collateral for the loan. Nevitt and Fabozzi (2000)

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Sunday, February 9, 2014

What is Project Finance?

Project Finance involves the creation of a legally independent project company financed with non recourse debt (and equity from one or more sponsors) for the purpose of financing a single purpose industrial asset. (Esty, 2004)

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Sunday, February 9, 2014

Elements of Project Finance

Investment Decision
Stock type projects such as oil or copper rely on extraction and sale of the resources to service the debt and equity Flow Type projects such as toll roads and pipelines rely on asset use to service the debt and equity

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Sunday, February 9, 2014

Elements of Project Finance

Organisational Decision
To create an independent entity Can be an off balance sheet financing since the assets and liabilities will be off the balance sheet of the sponsors

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Sunday, February 9, 2014

Elements of Project Finance

Financing Decision
Non recourse debt Implies no recourse to the sponsor Capital providers have a clear claim on the project assets and cash flows without concern for the sponsors financial conditions

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Sunday, February 9, 2014

Comparing Project Financing and Corporate Financing

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The Rationale for Project Financing

Criterion Organization

Direct Financing ! Large businesses are usually organized in corporate form. ! Cash flows from different assets and businesses are commingled.

Project Financing ! The project can be organized as a partnership or limited liability company to utilize more efficiently the tax benefits of ownership. ! Project-related assets and cash flows are segregated from the sponsors other activities. ! Management remains in control bur is subject to closer monitoring than in a typical corporation. ! Segregation of assets and cash flows facilitates greater accountability to investors. ! Contractual arrangements governing the debt and equity investments contain covenants and other provisions that facilitate monitoring. ! Creditors typically have limited recourse-and in some cases, no recourse-to the project sponsors. ! Creditors financial exposure is project-specific, although supplemental credit support arrangements can at least partially offset this risk exposure. ! Contractual arrangements redistribute project-related risks. ! Project risks can be allocated among the parties who are best able to bear them.

Control and monitoring

! Control is vested primarily in management. ! Board of directors monitors corporate performance on behalf of the shareholders. ! Limited direct monitoring is done by investors.

Allocation of risk

! Creditors have full recourse to the project sponsor. ! Risks are diversified across the sponsors portfolio of assets. ! Certain risks can be transferred to others by purchasing insurance, engaging in hedging activities, and so on.

Financial flexibility

! Financing can typically be arranged quickly. ! Internally generated funds can be used to finance other projects, bypassing the discipline of the capital market.

! Higher information, contracting, and transaction costs are involved. ! Financing arrangements are highly structured and very (Continued) time-consuming. ! Internally generated cash flow and be reserved for proprietary projects.

Figure A Comparison of Direct Financing and Project Financing

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Sunday, February 9, 2014

Criterion Free cash flow

Direct Financing ! Managers have broad discretion regarding the allocation of free cash flow between dividends and reinvestment. ! Cash flows are commingled and then allocated in accordance with corporate policy.

Project Financing ! Managers have limited discretion. ! By contract, free cash flow must be distributed to equity investors.

Agency costs

! Equity investors are exposed to the agency costs of free cash flow. ! Making management incentives project-specific is more difficult. ! Agency costs are greater than for project financing.

! The Agency costs of free cash flow are reduced. ! Management incentives can be tied to project performance. ! Closer monitoring by investors is facilitated. !The underinvestment problem can be mitigated. !Agency costs are lover than for internal financing.

Structure of debt contracts

! Creditors look t the sponsors entire asset portfolio for their debt service. ! Typically, debt is unsecured (when the borrower is a large corporation).

! Creditors look to a specific asset or pool of assets for their debt service. ! Typically, debt is secured. ! Debt contracts are tailored to the specific characteristics of the project. ! Credit support from other sources, such as purchasers of project output, can be channeled to support project borrowings. !The sponsors debt capacity can be effectively expanded..
(Continued) tax ! Higher leverage (which provides valuable interest shields) than the sponsor would feel comfortable with if it financed the project directly can be achieved.

Debt capacity

! Debt financing uses part of the sponsors debt capacity.

Figure A Comparison of Direct Financing and Project Financing

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The Rationale for Project Financing

Criterion Bankruptcy

Direct Financing ! Costly and time-consuming financial distress can be avoided. ! Lenders have the benefit of the sponsors entire asset portfolio. ! Difficulties in one key line of business could drain cash from good projects.

Project Financing ! The cost of resolving financial distress is lower. ! The project can be insulated from the sponsors possible bankruptcy. ! Lenders chances of recovering principal are more limited; the debt is generally not repayable from the proceeds of other unrelated projects.

Figure A Comparison of Direct Financing and Project Financing

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Structure of Project Finance

Non Recourse Debt Who? Equity from Sponsors

Project Company Input Contract Construction contract O&M Contract Output contract

Adapted from Esty, 2004, p.28 sundar.venkatesh2008@gmail.com

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What is the rationale for Project

The alternative to Project Financing is Corporate Financing. The choice of Project Financing over Corporate Financing can be seen as:
The decision by a firm to partner with others in pursuing a project and/or The decision by a firm to de-link its investment in the project from the rest of its business.

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What is the rationale for Project

Capturing an Economic Rent Achieving Economies of Scale
Scale economies might require a large investment which could be possible when two or more parties come together.

Risk Sharing:
This advantage comes into play when the project is too large for a single firm or a government to take handle on its own.

Expanding Debt Capacity:

A tight contract with the buyers of the project output allows the project company to raise debt based on the expected cash flows.

Lower overall cost of funds:

This would be the case when the buyers of the project output have a better credit rating than the project sponsors.

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What is the rationale for Project

Release Free cash flows
A project company has a finite life. The free cash flows are all to be distributed to sponsors thus reducing Agency Costs.

Reduced Cost of Resolving Financial Distress

Costs of resolving financial distress increases with the number of claimants and the complexity of the borrowers capital structure. Project Finance companies have limited number of claimants and less complexity in their capital structure.

Reduced Legal or Regulatory costs

Experienced sponsors may be better at handling regulatory and legal issue compared to an inexperienced operator.

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The relative importance of Project

Funds raised through
Project Finance: 19 bn USD Corporate Bonds: 612 bn USD Asset Backed Securities: 397 bn USD IPOs: 27 bn USD Venture Capital funds: 26 bn USD

Esty (2004) using US data for 2002

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What is Special about Large

Project Financing is particularly attractive for sponsors of large projects because:
The greater risk of large projects The nature of the business such as oil extraction which is characteristic of large projects can make the projects even riskier. Large project are often too large for a single firm to finance on its own balance sheet.

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The players in Project Financing

The Lead Arrangers The Lead Managing Underwriters The Lead Project Financial Advisers The Lead Project Finance Law Firms

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