eBusiness Weekly
Jacob Mutevedzi
The previous instrumental dubbed “What is Project Finance?” gave an outline of the nature of project finance and listed its basic characteristics.
To those who read the previous article, the advantages of project finance as a financing mechanism are self-evident. It can raise large amounts of long-term, foreign equity and debt capital for a project.
For the sake of context, the definition of project finance warrants repetition. Project finance is a non-recourse financing method in terms of which project lenders can only be paid from the special purpose vehicle’s revenues without recourse to the equity investors.
The special purpose entity’s obligations are ring-fenced from those of the equity investors, and debt is secured on the cash flows of the project.
The financing is a combination of the sponsors’ equity and debt provided by lenders such as commercial banks. The usual financial structure has a debt to equity ratio of between 60:40 and 80:20.
As noted from the previous discussion, a sponsor can employ two alternative methods to finance a new project.
The new project can be financed on balance sheet. Alternatively, the new initiative can be incorporated as a stand-alone special purpose vehicle and be financed off balance sheet. The former method is known as “corporate financing”, while the latter mechanism is called “project financing”.
The use of project finance has an assortment of advantages which are discussed below.
- Off balance sheet debt treatment
The use of corporate finance means that sponsors use all the assets and cash flows from the existing entity to secure financial obligations. In the event that the project fails, creditors can have recourse to all the remaining assets and cash flows of both the existing entity and the new project.
Project finance, on the other hand, isolates the risk of the project from the existing entity.
It takes the new project off balance sheet thus insulating the owner’s financial condition from ruin if the project falters. The main reason for choosing project finance is to isolate the risk of the project, taking it off balance sheet so that project failure does not damage the owner’s financial condition. The new project and the existing entity exist separately.
- Non-recourse/limited recourse financing
Non-recourse project financing does not burden the project sponsor with any obligation to guarantee repayment of the project debt.
This allows the existing entity to maintain its financial structure, credit rating and ability to access funds in the capital markets. Credit ratings and capital adequacy requirements may inhibit entities from taking on financial commitments to a huge project. With project finance, the existing company’s financial structure and credit rating remains unscathed.
- Lender’s oversight of project governance and performance
The project will benefit from the lender’s oversight over the project governance and performance. Such oversight is inherent in this technique of financing. Cash flow reliability lies at the core of project finance as project cash flows are the sole source of repayment. Lenders always bring an additional layer of due diligence.
- Leveraged debt
Another clear advantage of project financing is that the sponsors can avoid share issues and the consequent dilution of equity. When you finance business operations with equity financing the disposal of a portion of your ownership in the company is inevitable.
Project finance allows sponsors to retain full ownership of their company. High leverage ratios permit sponsors to apply their equity capital resources to a larger number of projects, limit downside risk in any given project and substantially improve returns on invested capital.
- Avoiding restrictive covenants in other transactions
By reason of the fact that the project is removed and distinct from the sponsor’s other operations, existing negative covenants are not usually applicable to the project financing. Therefore, a project sponsor can circumvent restrictive covenants, like debt coverage ratios and provisions that cross-default for a failure to pay debt, in the existing loan agreements and indentures at the project sponsor level.
- Favourable tax treatment
Governments have been known to offer tax allowances and tax breaks for capital investments. Such favourable tax treatment can be taken advantage of to increase profits.
- Diversification of political risk
The incorporation of special purpose entities for projects in specific jurisdictions segregates the project risks and insulates the sponsor or the sponsor’s other ventures from adverse occurrences.
- Sharing risk
Project finance permits for a high level of risk allocation among participants in the transaction. As a result, the deal can support a debt-to-equity ratio that could not be achieved under normal circumstances.
This has a significant impact on the return of the transaction for sponsors. The distribution of risk can improve the possibility of project success since each project participant accepts certain risks.
- Collateral limited to project assets
In non-recourse project finance, collateral is confined to the project assets. The result is advantageous for sponsors since their assets can be used as collateral in case further recourse for funding is needed. However, sometimes, limited recourse to the assets of the project sponsor is required as a way of incentivising the sponsor.
- Lenders are less likely to foreclose
On account of its non-recourse or limited recourse nature, the collateral in project finance is of little or no value in the event of liquidation. If a project runs into difficulties, therefore, rather than foreclosing, the lenders will be motivated to work on a solution to make the project succeed.
Conclusion
The incorporation of a special purpose vehicle, therefore, enables the sponsors to insulate themselves, almost totally, from adverse events involving the project if financing is done on a non-recourse basis.
On account of proper risk allocation, project finance allows a sponsor to undertake a project with more risk than the sponsor is willing to underwrite independently.
Project finance lends strong discipline to the contracting process and operations through proper risk allocation and private sector participation.
The involvement of a number of global players, including multilateral institutions, also provides some sort of de facto political insurance.
Jacob Mutevedzi is a commercial lawyer and commercial arbitration practitioner contactable on [email protected], on Twitter @jmutevedzi_ADR and on +263775987784. He writes in his personal capacity.
