project finance an overview

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Project Finance

An Overview

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Sunday, February 9, 2014
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What is Project Finance?

Project finance is the raising of funds ona limited recourse or non-recourse basistofinance an economically separable capitalinvestment projectin which the providersof the funds look primarily to the cash flowfrom the projectas the source of funds toservice their loans and provide the return

of and return on their equity invested inthe project. (Finnerty, 2007)

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A financing of a particular economic unitin which a lender is satisfied to look initiallyto the cash flow and earnings of thateconomic unitas the source of funds fromwhich a loan will be repaid and to theassets of that economic unit as collateralfor the loan. Nevitt and Fabozzi (2000)

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Project Finance involves the creation of alegally independent project companyfinanced with non recourse debt(andequity from one or more sponsors) for thepurpose of financing a single purposeindustrial asset. (Esty, 2004)

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Elements of Project Finance

Investment Decision Stock type projects such as oil or copper rely

on extraction and sale of the resources toservice the debt and equity

Flow Type projects such as toll roads andpipelines rely on asset use to service the debtand equity

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Organisational Decision To create an independent entity

Can be an off balance sheet financing sincethe assets and liabilities will be off the balancesheet of the sponsors

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Financing Decision Non recourse debt

Implies no recourse to the sponsor

Capital providers have a clear claim on theproject assets and cash flows without concernfor the sponsors financial conditions

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Comparing Project Financing andCor orate Financin

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The Rationale for Project Financing

Criterion Direct Financing Project Financing

Organization !Large businesses are usually organized incorporate form.

!Cash flows from different assets andbusinesses are commingled.

!The project can be organized as a partnership or limitedliability company to utilize more efficiently the tax benefitsof ownership.

!Project-related assets and cash flows are segregatedfrom the sponsors other activities.

Control andmonitoring

!Control is vested primarily in management.

!Boardof directors monitors corporateperformance on behalf of the shareholders.

!Limited direct monitoring is done byinvestors.

!Management remains in control bur is subject to closermonitoring than in a typical corporation.

!Segregation of assets and cash flows facilitates greateraccountability to investors.

!Contractual arrangements governing the debt and equityinvestments contain covenants and other provisions thatfacilitate monitoring.

Allocation of risk !Creditors have full recourse to the projectsponsor.

!Risks are diversified across the sponsorsportfolio of assets.

!Certain risks can be transferred to others bypurchasing insurance, engaging in hedgingactivities, and so on.

!Creditors typically have limited recourse-and in somecases, no recourse-to the project sponsors.

!Creditors financial exposure is project-specific, althoughsupplemental credit support arrangements can at leastpartially offset this risk exposure.

!Contractual arrangements redistribute project-relatedrisks.

!Project risks can be allocated among the parties who arebest able to bear them.

Financialflexibility

!Financing can typically be arranged quickly.

!Internally generated funds can be used tofinance other projects, bypassing thediscipline of the capital market.

!Higher information, contracting, and transaction costs areinvolved.

!Financing arrangements are highly structured and verytime-consuming.

!Internally generated cash flow and be reserved forproprietary projects.

Figure A Comparison of Direct Financing and Project Financing

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Criterion Direct Financing Project Financing

Free cash flow !Managers have broad discretion regarding theallocation of free cash flow between dividendsand reinvestment.

!Cash flows are commingled and then allocatedin accordance with corporate policy.

!Managers have limited discretion.

!By contract, free cash flow must be distributed to equityinvestors.

Agency costs !Equity investors are exposed to the agencycosts of free cash flow.

!Making management incentives project-specificis more difficult.

!Agency costs are greater than for projectfinancing.

!The Agency costs of free cash flow are reduced.

!Management incentives can be tied to projectperformance.

!Closer monitoring by investors is facilitated.

!The underinvestment problem can be mitigated.

!Agency costs are lover than for internal financing.

Structure ofdebt contracts

!Creditors look t the sponsors entire assetportfolio for their debt service.

!Typically, debt is unsecured (when the borroweris a large corporation).

!Creditors look to a specific asset or pool of assets fortheir debt service.

!Typically, debt is secured.

!Debt contracts are tailored to the specific characteristicsof the project.

Debt capacity !Debt financing uses part of the sponsors debtcapacity.

!Credit support from other sources, such as purchasers ofproject output, can be channeled to support projectborrowings.

!The sponsors debt capacity can be effectively expanded..

!Higher leverage (which provides valuable interest taxshields) than the sponsor would feel comfortable with if itfinanced the project directly can be achieved.


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Th R ti l f P j t Fi i
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The Rationale for Project Financing

Criterion Direct Financin Pro ect Financin

Bankruptcy !Costly and time-consuming financialdistress can be avoided.

!Lenders have the benefit of the sponsorsentire asset portfolio.

!Difficulties in one key line of business could

drain cash from ood ro ects.

!The cost of resolving financial distress is lower.

!The project can be insulated from the sponsors possiblebankruptcy.

!Lenders chances of recovering principal are morelimited; the debt is generally not repayable from the

roceeds of other unrelated ro ects.


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Structure of Project Finance

Non RecourseDebtWho?

Equityfrom

Sponsors

Project Company

InputContract

Outputcontract

Construction

contract

O & M

Contract

Adapted from Esty, 2004, p.28

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What is the rationale for Project

The alternative to Project Financing isCorporate Financing.

The choice of Project Financing over

Corporate Financing can be seen as: The decision by a firm to partner with others inpursuing a project and/or

The decision by a firm to de-link its investment

in the project from the rest of its business.

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Capturing an Economic Rent Achieving Economies of Scale

Scale economies might require a large investment which couldbe possible when two or more parties come together.

Risk Sharing:

This advantage comes into play when the project is too large fora single firm or a government to take handle on its own.

Expanding Debt Capacity: A tight contract with the buyers of the project output allows the

project company to raise debt based on the expected cash flows.

Lower overall cost of funds: This would be the case when the buyers of the project output

have a better credit rating than the project sponsors.

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Release Free cash flows A project company has a finite life. The free cash flows are allto be distributed to sponsors thus reducing Agency Costs.

Reduced Cost of Resolving Financial Distress Costs of resolving financial distress increases with the number of

claimants and the complexity of the borrowers capital structure.Project Finance companies have limited number of claimantsand less complexity in their capital structure.

Reduced Legal or Regulatory costs Experienced sponsors may be better at handling regulatory and

legal issue compared to an inexperienced operator.

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The relative importance of Project

Funds raised through Project Finance: 19 bn USD

Corporate Bonds: 612 bn USD

Asset Backed Securities: 397 bn USD

IPOs: 27 bn USD

Venture Capital funds: 26 bn USD

Esty (2004) using US data for 2002

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What is Special about Large

Project Financing is particularly attractivefor sponsors of large projects because:

The greater risk of large projects

The nature of the business such as oilextraction which is characteristic of largeprojects can make the projects even riskier.

Large project are often too large for a single

firm to finance on its own balance sheet.

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The players in Project Financing

The Lead Arrangers The Lead Managing Underwriters

The Lead Project Financial Advisers

The Lead Project Finance Law Firms

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project finance an overview

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