Project Finance
Project finance involves a structure in which groups of investors can easily work together. This structure easily enables the risk of the investment to be divided up. Therefore, it’s good to have much knowledge of it and how it works to help you run your business well. As you read this article, you will become more familiar with the structure and related terminologies associated with key project finance. However, knowing the project finance lenders, their advantages, and their disadvantages will also aid in the completion of your business project, and this is what you will learn on this topic.
What is Project Finance?
It is simply the financing of long-term infrastructure, projects of an industry, and services of the public. This can be achieved by the use of a non or limited recourse financial structure. The debt and equity used in financing this project are repaid through the cash flow generated by the same project.
It’s also a kind of loan structure based primarily on the project’s flow for repayment, with the project’s rights, and assets. The structure’s interest comes as the second collateral. This especially attracts the interest of the private sector because the companies can finance major projects off-balance sheets.
Importantly, not all infrastructure investments are financed with project finance. Most companies issue traditional debt or equity in order to carry out some projects. But, meanwhile, several parties are involved in project finance and its transaction flow. These parties include the structure, related terminologies, advantages, and disadvantages of project finance, which will be discussed as you read on.
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What Is Project Finance Example?
Project finance is the long-term financing of independent capital investment. These are projects with clearly defined cash flows and assets. Examples include real estate project finance. Project finance also includes mining, oil and gas, and construction.
Who Is Responsible for Project Finance?
Financial project managers are accountable for an organization’s financial health. They are accountable for direct investment activities, financial reporting, and the development of strategies that take into account long-term/continuing financial objectives.
Parties Involved in Project Finance
There are several parties in project financing and structure, this only depends on the type and the scale of a project. But the most usual parties are as follows;
#1. Sponsors
This typically also includes equity investors and equity share capital holders of the parent company who wish to seek project finance. Two or more entities may also team up to float an SPV, likely to mutually benefit from the underlying SPV. Before they can float an SPV, they must obtain authorization from the shareholders of the parent company. This can be achieved via a shareholder’s agreement (SHA).
#2. Lenders
These include senior lenders or consortiums of financial institutions like banks. They make provisions for senior debt and hold precedence over debt extension by the sponsors if there is any. The loan is secured against the cash flow and assets of the SPV only. So, enough due diligence is carried out before the grant of any credit. Consider reading these 5 quick bad debt recovery strategies.
#3. Special Purpose Vehicle (SVP)
This refers to a separate legal entity floated by the sponsors of the project. The project finance obtained is directed exclusively toward this SPV. It also serves as a corporate veil between the lenders and the parent company. Thus, preventing seepage of credit and attachment of both parties’ property.
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#4. Host Government
This refers to the government of the home country where the SPV is located. However, SPV must be incorporated with government rules and regulations to provide different tax concessions, subsidies, and rebates.
#5. Off Takers
Offtakers is bound through an off-take agreement certainly to buy a certain quantity of products from the selling party. This agreement always resorts to mining, construction, and other industries of mass significance. It also ensures the seller of the existence of a market upon finishing.
#6. Contractor and Equipment Suppliers
In any construction job, contractors and equipment suppliers are much needed to execute a contract. they are the major suppliers of raw materials for production, and they also perform important functions like design and build, etc.
Advantages and Disadvantages of project finance
Though project finance is crucial in any organization with various parties joining hands to achieve its aim, it as well as its advantages and disadvantages.
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Advantages of Project Finance
Before we go over to the disadvantages of project finance, here are the advantages.
- Effective Debt Allocation
- Risk Management
- Economies of Scale
Disadvantages of Project Finance
Below are the major disadvantages;
- Complexity
- Compliance and Documentation
- Constant Expert Assistance
Here are some common terminologies related to project finance you should know;
- Reading Into Non-Recourse Finance – This type of loan is required to pay back from the cash generated by the project financed.
- Asset-Light Debt – Asset-light debt is a corporate debt where the amount of collateral is below standards.
- Lien – This is the legal right a creditor has to sell the collateral property of a debtor who fails to pay back.
- Limited Recourse Debt – When the creditor’s claim on the loan in the event of default when it is limited is referred to as limited recourse debt.
- Equity – This refers to the equity of shareholders that shows the value residual to shareholders after debts and liabilities have been settled.
- Deleveraging – Deleveraging refers to a company or individual attempts to reduce its overall financial leverage.
There are also other key terminologies related to project finance which include the following;
- Cash Available for Debt Service
- Debt Service Cover Ratio
- Reserve Accounts
- Loan Life Cover Ratio
- Debt Sculpting
- Cash Sweep
Types of Project Finance
The project finance structure for a build, operate and transfer (BOT) project includes multiple key elements. Below are some typical examples of terminologies of project finance you need to have knowledge of;
#1. Off-Balance Sheet
Project debt is mainly held in enough minority subsidiaries not joined to the balance sheet of shareholders respectively. This helps to minimize the project’s impact on the cost of the shareholder’s existing debt and debt capacity. Shareholders have the freedom to use their debt capacity for other investments.
#2. Non-Recourse Financing
Generally, loan-to-value ratios are normally limited to 60% in non-recourse loans if inadequate balances bidding is high. Lenders levy higher credit standards on borrowers to reduce the chance of default. Non-recourse loans, on account of their great risk, have higher interest rates than recourse loans.
#3. Recourse Versus Non-Recourse Loans
Financial institutions take action on borrowers based on the type of loan they received, either recourse or non-recourse. Consider the fact that debtors with a non-recourse loan cannot be pursued for any additional payment after the asset has been seized. Unlike people with recourse loans, the bank can go after the borrower if the collateral isn’t enough to cover the loan.
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What Are the Stages of Project Finance?
Three distinct phases make up the project development process: the pre-bid phase, the contract negotiation phase, and the funding phase.
Project Finance Structure
The most usual structure is a mix of equity or money from the shareholders of the Project Company. It also involved debt in the form of bank loans. Some of the relevant parameters required to correctly estimate the financial structure are as follows;
#1. The level of leverage
This refers to the percentage of the total capital required for the project that will be acquired through debt.
#2. The debt repayment term
This is also a very important market condition that needs to be clearly estimated. The longer the debt term, the higher the overall amount of interest paid through the life of the loan. But the smaller the debt repayment is in each period.
#3. The repayment profile
This refers to the differences in the proportion of debt paid in each period of time. The common profiles include a flat repayment schedule and a constant amortization repayment (with decreasing total debt service). In addition to this, to meet the financer’s covenants, the repayment profiles can also be designed to meet up.
#4. The cost of debt
The project finance lenders charged an interest rate called the cost of debt, which consists of an interest base rate and a margin.
Sectors Suitable For Project Finance
Project finance may work in all sectors of life, but there are major sectors suitable for it. Those major sectors are what we are about to look at in this section. Below are some suitable sectors that project finance lenders can come in;
- Water: Under this sector, we have the following; Water treatment, Wastewater, Desalination, and Inside the fence. As we know water serves both nature and humanity, therefore consider one of the major suitable sectors.
- Power and Energy: Under this sector, we have the; IPPs/PPA project, Merchant plants, Inside the fence, District heating, Oil, and Gas.
- Transport: Transport sectors include; Light rail, Roads, Bridges, Rail, Airports, and Ports.
- Housing: When you talk about the housing sector you look into, Low income, Affordable, and Defence accommodations.
- Healthcare: Having standard healthcare in a community helps to improve the lives of its inhabitants and this includes; Provision of new facilities, Refurbishment, and Facilities management.
- Education: This sector is another major sector suitable for a project finance loan, as it’s essential to living. But, there are requirements to make this sector function well, which include; Provision of new facilities, Refurbishment, and Facilities management.
- Prison: Prisons are equal to enjoy the following benefits; Provision of new facilities, Refurbishment, and Facilities management.
- Other Sectors: Sports infrastructure, Properties, and Real Estates are other form of sectors suitable for project finance.
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What Types Of Project Are Suitable Fit For Project Finance?
Oil extraction, power production, and infrastructure sectors are basically involved in project finance, with advantages and disadvantages. Below talks more of the main types of projects suitable fit for project finance. These projects have low technological risk, a reasonably predicted market, and the possibility of selling to a single or few large buyers. This is based on a multi-year contract (e.g. take-or-pay contracts).
- Financing of long-term infrastructure.
- Industry Projects
- Public Services
Project Finance Lenders
There are many types of project finance lenders and a variety of debt finance products that can be applied to project financing. The specific mix of products available to a project will depend on the sector, jurisdiction, and project size. It also depends on the Sponsor profile, transaction risk profile, and source of capital equipment. But, below are the principal lenders in a project financing;
#1. Commercial Banks
Commercial banks, like international banks, serve as the primary sources of funds for project financing. However, they are the largest providers of debt capital for project financing. But, lending to a project exposes banks to great risk, so they pay particular attention to the project’s feasibility. The banks also pay attention to the evaluation of credit risk. They also render financial advice on the project, because the failure of the project may lead to their damage.
#2. Export Credit Agencies (ECAs)
An ECA is a public agency or entity that provides a loan guarantee or funding to projects. Basically owned by a government. They provide loans for an amount that does not exceed the value of exports that the project will generate. The value that the project will generate is for ECA’s home country. Notable examples of ECAs are the Export-Import Bank (Ex-Im Bank) of the United States. Also the Export Credit Guarantee Department (ECGD) in the United Kingdom.
#3. Multilateral Agencies
Countries promote international and, regional economic cooperation via multilateral agencies. These agencies include organizations such as the World Bank, the International Finance Corporation (IFC), and the Multilateral Investment Guarantee Agency (MIGA). They also include regional development banks such as the African Development Bank (AfDB), the Asian Development Bank (ADB), and also the Inter-American Development Bank (IADB).
How Do You Do Project Finance?
- Here Are the Five Easy Ways to Get Your Project Funded
- Find the Project First.
- The next thing to do is check if the project is even possible.
- Third, determine where this technology is coming from.
- fourth Identify potential funding sources for the project.
- Project risk mitigation is the fifth step.
Project Finance PDF
Lastly take a look at this project finance pdf below, to bring more light to your understanding of this topic and its structure.
- Project Financing: an Economic Overview by Robert F. Bruner
Conclusion
Talking about terminologies related to project finance, its structure, and transactions, they are governed by the laws of contract, case law, and company law. Fiscal legislation (related to stamp duties on secured transactions) and insolvency legislation also apply to project finance transactions in usa. Meanwhile, the advantages and disadvantages are very important to understand to build your financial knowledge.
What Are the 5 Sources of Finance?
- Assistance by the Government.
- Commercial Bank Loans and Overdraft.
- Buyouts.
- Financial Bootstrapping
- Personal Investment or Personal Savings.
What Is the Role of Project Finance?
Project finance helps pay for new investments by building the financing around the operating cash flow and assets of the project, without the need for additional sponsor guarantees. So, the method can reduce investment risk and raise money at a low cost, which is good for both the sponsor and the investor.
What Are the Main Features of Project Finance?
- Non-Recourse Financing.
- Off-Balance Sheet Financing.
- Numerous Project Participants.
- Capital-Intensive Projects.
