eBusiness Weekly
Jacob Mutevedzi
Are you tired of hearing your lawyer or investment banker friend speak, with an air of self importance, about project finance?
Day in, day out you read, but fail to understand, newspaper articles about larger than life infrastructure projects and public and private venture capital requirements.
You always wonder how governments, sub-sovereign entities and companies are able to finance huge infrastructure projects like roads, border posts upgrades, railway systems or ports.
Well, you need not wonder anymore. The next time you are speeding on that brand new highway, just remember that its construction was made possible by a unique method used to mobilise large amounts of capital.
That technique of raising staggering amounts of cash to fund all these impressive projects is called project finance.
It is not unusual to notice, in trade literature and in speeches made at industry conferences, project finance being alluded to as a new financing method.
Nothing could be further from the correct position. According to Kensinger and Martin (1993) project financing methods can be traced as far back as 1299 AD when the English monarchy funded the exploration and development of the Devon silver mines by repaying Frescobaldi, the merchant bank from Florence, with product from the mines.
The Florentine bankers were granted a one-year lease and mining concession in terms of which they could mine as much silver as they possibly could during the subsistence of the lease.
Using the mines’ output to secure funding is a classic attribute of project finance.
In 17th century England, trading expeditions to distant corners of the globe were funded through project finance. Investors funded trading expeditions by ships on a voyage by voyage basis.
On successful return, both ship and cargo would be disposed of and the proceeds of the voyage distributed among investors.
Project finance as we know it today, therefore, is the result of hundreds of years of evolution.
The modern product, primarily, is a vehicle for bringing together a group of investors, lenders and other players to undertake infrastructure projects which would, ordinarily, be too massive to underwrite for individual investors.
What then, in modern times, is an acceptable definition of project finance?
In his book “Introduction to Project Finance (2006)”, Fight defines project finance as “a non-recourse or limited recourse financing structure in which debt, equity and credit enhancement are combined for the construction and operation, or the refinancing, of a particular facility in a capital-intensive industry.”
Wynant, not to be outdone, in the “Harvard Business Review (1980)”, defined project finance as “a financing of a major independent capital investment that the sponsoring company has segregated from its assets and general purpose obligations.”
In his comprehensive work, “Project Finance in Theory and Practice (2008)”, Gatti defines project finance as “the structured financing of a specific economic entity — the SPV, or special-purpose vehicle, also known as the project company — created by sponsors using equity or mezzanine debt and for which the lender considers cash flows as being the primary source of loan reimbursement, whereas assets represent only collateral.”
Being a huge participant in sponsoring infrastructure projects in developing countries, the World Bank has weighed in with its own definition of project finance in the following terms: “use of non-recourse or limited-recourse financing . . . the financing of a project is said to be nonrecourse when lenders are repaid only from the cash flow generated by the project or, in the event of complete failure, from the value of the project’s assets.
Lenders may also have limited recourse to the assets of a parent company sponsoring a project.”
From the definitions of project finance given above one can already glean the main characteristics of project finance.
However, to foster a better understanding of the phenomenon, it is beneficial to present a detailed list of the characteristics of project finance and to contrast it with corporate finance.
Project finance differs from corporate financing in two main ways.
Firstly, the creditors do not have a claim against profits from other projects if the project falters. Corporate finance bestows this right on investors.
Secondly, project finance takes priority on the cash flows from the project over any corporate claims.
The following is a list of the distinctive characteristics of project finance.
1. Capital-intensive
Project finance is usually handy for large scale projects which require hundreds of millions or even billions of dollars in capital. Infrastructure projects usually require these staggering amounts of capital. For example oil pipelines, highways and mining projects.
2. Highly leveraged
These transactions tend to be highly leveraged with debt usually constituting 65 percent to 80 percent of capital.
3. Long term
The duration for project financings is usually long drawn out and can stretch from anything between 15 to 20 years.
4. Independent company
with a finite life
The debtor is a project company set up on an ad hoc basis which is financially and legally independent from the sponsors. The singular purpose of the project company is to execute the project.
5. Non-recourse or limited recourse financing
The lenders have only limited recourse or no recourse at all to the sponsors post the completion of the project. The financing is not primarily dependent on the credit support of the sponsors or the value of the physical assets involved.
Lenders place their faith in the performance of the project itself. Consequently, they will often obsess over the feasibility of the project and its sensitivity to the impact of potentially adverse factors.
6. Controlled dividend policy
Cash flows generated from the project must be adequate to cover payments for operating costs and to service the debt in terms of capital repayment and interest. The project’s income, as a matter of priority, is channelled towards servicing the debt, covering operating expenses and generating a return on the investors’ equity. Dividends are subordinated to the loan payments.
7. Numerous participants
Usually, transactions of this nature involve a lot of players. It is not unheard of to find more than ten participants in the thick of a project.
8. Allocated risk
Project risks are allocated equitably among all parties involved in the transaction. The objective of this process is to match risks and corresponding returns to the parties most capable of successfully controlling and managing them.
9. Costly
Raising capital through project finance is invariably more costly than through corporate finance.
Transaction costs are compounded by the greater need for information, monitoring and contractual agreements. Moreover, the highly specific nature of the financial structures also results in higher costs and can reduce the liquidity of the project’s debt.
Margins for project financings also frequently include premiums for country and political risks because most of these projects are in relatively high risk jurisdictions.
Conclusion
The advantages of project finance are self-evident. The project sponsor’s balance sheet is protected. Incorporating a project company makes it possible to isolate the sponsors almost completely from events involving the project if financing is done on a non recourse basis.
Project finance permits 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 otherwise be achieved. This has a significant impact on the return of the transaction for sponsors.
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.
