Benefits of Project Finance
Project finance as a method of infrastructure development is attractive to stakeholders for a number of reasons peculiar to each stakeholder. For sponsors, the following are the benefits/advantages of undertaking project finance as a method of infrastructure investment:
- Achieving diversification of revenue and providing a vehicle for companies to hedge risks of their core businesses.
- Ability to maximise leverage, and lower initial equity injection requirements, thereby making the project investment a less risky proposition
- Ability to raise larger amounts of long-term, foreign equity and debt capital for a project.
For governments and procuring authorities, the following are the benefits of adopting project finance techniques as a method of infrastructure procurement:
- The responsibility of infrastructure financing, as well as the risk of constructing and operating the asset, are transferred to the private sector thereby allowing the government to focus on other areas of public service.
- The need for the government to borrow funds or use its own funds is greatly reduced or eliminated
- Procuring essential public infrastructure in a robust and transparent manner, thereby maximising the potential pool of investors and lenders
- For lenders in project financing transactions, the benefits accruing to them are that:
- They exercise a great level of control over the project and project company
- They extract a return commensurate with the level of risk
- They also extract additional returns through the provision of the associated products and services required by the project company (e.g. project accounts, trustee roles, hedging and advisory services)
Disadvantages of Project Finance
- The Project financing technique also presents certain disadvantages. Some of these disadvantages are as follows:
Documentation is lengthy and complex, and it costs a great deal to put into place
- An adequate risk-sharing structure is often difficult to put in place and almost always creates unanticipated delays in achieving financial closing
When a government intends to provide infrastructure such as roads, bridges or public health institutions for its citizens, it will usually finance such projects by drawing funds from the public purse.
When a company intends to undertake any business venture such as telecommunication or oil and gas, to finance and set in motion such business, the company spends its own money or may issue equity shares or debentures in return for money or money’s worth.
But sometimes, the infrastructure or business project intended to be carried on is larger or especially costlier than what the government or company or other business entity can pull off or raise funds for on its own, and so they may resort to alternative means like Project Finance.
Distinguishing Project Finance From Corporate Finance
Another means of understanding project finance is to relate it to corporate finance.
Traditionally, lenders finance large corporate undertakings through a loan backed by the full faith and credit of the corporate balance sheet, and this is referred to as corporate finance. Under this financing technique, the lending decision is based on the prospects of the project to be built and also the general credit standing of the corporate borrower, i.e., its sponsor(s).
Even if the project is not generating as much cash flow as originally anticipated, the lenders can expect to get paid if the cash flows from the various other commercial activities of the corporate entity remain robust.
With project finance, by contrast, the lending decision is only based on the prospects of projects in terms of viability and profitability; the lenders’ sources of debt repayment are limited to the discrete cash flow and other assets belonging to the project vehicle.
There are other differences between Corporate Finance and Project Finance. The latter involves the incorporation of a new company to execute the new project, hence it is sometimes referred to as a Greenfield Financing, whereas the former does not require the incorporation of a new company. The new project or business idea may be run by the same company that proposes the idea.
As opposed to corporate finance, the costs of project finance transactions are relatively higher due to the frequently high cost of the project, volume of professional services involved, documentation and longer gestation period.
Project finance transactions also have highly-tailored structures which cannot generally be re-used or easily duplicated like corporate finance structures.
When it comes to capital investment decisions, they are highly transparent to creditors in project finance settings as opposed to corporate finance where such decisions are opaque to creditors.
Project Finance is distinguished additionally from Corporate Finance in various aspects: the capitalization and revenue structure of the borrower is commercially segregated from that of its sponsor(s); the sponsor(s) pledges all of the assets of the project vehicle to the lender; and very importantly, a project finance transaction involves a complex risk-sharing and mitigation structure that involves the allocation of individual risks to any one of several major parties in the transaction.
Common Features In Project Finance
Not every project financing transaction will have each of the following characteristics, but the following provides a preliminary list of common features of project finance transactions.
Projects requiring this kind of financing tend to be large projects with intense up-front capital requirements. They require a great deal of debt and equity capital, from hundreds of millions to billions of dollars. Raising capital through project finance is generally more costly than through typical corporate finance avenues. Further, the greater need for information, monitoring, and contractual agreements increase the transaction costs.
b. Highly leveraged
Project financing typically has two sources of funds: debt and equity. Debt capital is usually provided by lenders e.g. commercial banks. While equity capital is usually provided by project sponsors and outside equity investors. A project is typically a highly leveraged transaction. It is rare to see a project financed with less than a 60/40 debt/equity ratio and in certain sectors such as social infrastructure, it is not uncommon for projects to be 90% debt-financed. The key advantage of this high leverage to sponsors includes enhanced shareholder equity returns; and lower initial equity injection requirements, thereby making the project investment a less risky proposition.
c. Separate Incorporation
Project financing frequently requires the formation of a separate special-purpose vehicle (SPV) solely for the purpose of executing the project. The SPV also referred to as the “borrower” or “project company” is usually a new and independent legal entity/corporation although it may also be a limited partnership or a contractual joint venture structure. The SPV is the centre of the project; it has a single purpose and a finite life so it cannot outlive its original purpose.
d. Off-balance sheet financing
From the sponsor’s perspective, the advantage of project finance is that it represents a source of off-balance-sheet financing. Thus it allows the shareholders to book debt off-balance sheet. This essentially means a sponsor financing a project without having to show any borrowing for the project among its own borrowings in its consolidated accounts. Too high a level of borrowing will result in a sponsor having an unfavourable gearing ratio (the ratio of (consolidated) borrowings to net worth) and make it more difficult for that sponsor to raise funds on the capital markets.
e. Many participants
These transactions frequently demand the participation of numerous international participants. It is not rare to find over ten parties playing major roles in implementing the project.
6. Equitable Allocation of Risks
Because of the amount of risk in such transactions, often, the crucial element required to make the project go forward is the proper allocation of risk. This allocation is achieved and codified in the contractual arrangements between the project company and the other project stakeholders. The goal of this process is to match risks and corresponding returns to the parties most capable of successfully managing them.
There are clear advantages to using Project Finance as a tool for financing large infrastructure projects. If the necessary financial and legal due diligence is carried out and the risks are equitably allocated, there is a good chance that project financing for an infrastructure asset is achievable.