Project finance is the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure, in which project 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 security or collateral. Project finance is especially attractive to the private sector because companies can fund major projects off the balance sheet.
Special Purpose Entity
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 debt is typically held in a sufficiently minority subsidiary 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 finance 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.
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.
When defaulting on a loan, recourse financing gives lenders full claim to shareholders’ assets or cash flow. In contrast, project financing provides the project company as a limited liability SPV. Therefore, the lenders’ recourse is limited primarily or entirely to the project’s assets, including completion and performance guarantees and bonds, in case the project company goes into default.
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.
Parties to Project Finance
There are several parties in a project finance depending on the type and the scale of a project.
– Sponsors – Lenders – Contractors and equipment suppliers – Operator – Financial advisors – Technical advisors – Legal advisors – Equity investors – Regulatory agencies – Multilateral agencies / Export credit agencies – Insurance providers – Hedge funds
– Shareholder/sponsor documents – Project documents – Finance documents – Security documents – Other project documents e.g. business plan
A loan agreement is made between the project company (borrower) and the lenders. Loan agreement governs relationship between the lenders and the borrowers. It determines the basis on which the loan can be drawn and repaid, and contains the usual provisions found in a corporate loan agreement. It also contains the additional clauses to cover specific requirements of the project and project documents.
Basic terms of a loan agreement include the following provisions.
– General conditions precedent – Conditions precedent to each drawdown – Availability period, during which the borrower is obliged to pay a commitment fee – Drawdown mechanics – An interest clause, charged at a margin over base rate – A repayment clause – Financial covenants – calculation of key project metrics / ratios and covenants – Dividend restrictions – Representations and warranties – The illegality clause
Minority owners of a project may wish to use off-balance-sheet financing, in which they disclose their participation in the project as an investment, and excludes the debt from financial statements by disclosing it as a footnote related to the investment. In the United States, this eligibility is determined by the Financial Accounting Standards Board.
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