Project Finance
Meaning
Project finance is the funding of long-term infrastructure, industrial projects, and public services
using a non-recourse or limited recourse financial structure. The debt and equity used to finance
the project are paid back from the cash flow generated by the project.
Project financing is a loan structure that relies primarily on the project's cash flow for repayment,
with the project's assets, rights, and interests held as secondary collateral. Project finance is
especially attractive to the private sector because companies can fund major projects off-balance
sheet (OBS).
• Project finance involves the public funding of infrastructure and other long-term, capital-
intensive projects.
• Project financing often utilizes a non-recourse or limited recourse financial structure.
• A debtor with a non-recourse loan cannot be pursued for any additional payment beyond
the seizure of the asset.
• Project debt is typically held in a sufficient minority subsidiary that is not consolidated on
the balance sheet of the respective shareholders, which makes it an off-balance sheet
item.
Project Financing is a long-term, zero or limited recourse financing solution that is available to a
borrower against the rights, assets, and interests related to the concerned project.
If you are planning to start an industrial, infrastructure, or public services project and need funds
for the same, Project Financing might be the answer that you are looking for.
The repayment of this loan can be done using the cash flow generated once the project is complete
instead of the balance sheets of the sponsors. In case the borrower fails to comply with the terms
of the loan, the lender is entitled to take control of the project. Additionally, financial companies
can earn better margins if a company avails this scheme while partially shifting the associated
project risks. Therefore, this type loan scheme is highly favoured by sponsors, companies, and
lenders alike.
In order to bridge the gap between sponsors and lenders, an intermediary is formed namely
Special Purpose Vehicle (SPV). The main role of the SPV is to supervise the fund procurement and
management to ensure that the project assets do not succumb to the aftereffects of project
failure. Before a lender decides to finance a project, it is also important that all the risks that might
affect the project are identified and allocated to avoid any future complication.
What Is Special Purpose Vehicle and Why Is It Necessary?
During Project Financing, a Special Purpose Vehicle (SPV) is appointed to ensure that the project
financials are managed properly to avoid non-performance of assets due to project failure. Since
this entity is established especially for the project, the only asset it has is the project. The
appointment of SPV guarantees the lenders of the sponsors' commitment by ensuring that the
project is financially stable.
Key Features of Project Financing
Since a project deals with huge amount funds, it is important that you learn about this structured
financial scheme. Below mentioned are the key features of Project Financing:
1. Capital Intensive Financing Scheme: Project Financing is ideal for ventures requiring huge
amount of equity and debt, and is usually implemented in developing countries as it leads
to economic growth of the country. Being more expensive than corporate loans, this
financing scheme drives costs higher while reducing liquidity. Additionally, the projects
under this plan commonly carry Emerging Market Risk and Political Risk. To insure the
project against these risks, the project also has to pay expensive premiums.
2. Risk Allocation: Under this financial plan, some of the risks associated with the project is
shifted towards the lender. Therefore, sponsors prefer to avail this financing scheme since
it helps them mitigate some of the risk. On the other hand, lenders can receive better
credit margin with Project Financing.
3. Multiple Participants Applicable: As Project Financing often concerns a large-scale project,
it is possible to allocate numerous parties in the project to take care of its various aspects.
This helps in the seamless operation of the entire process.
4. Asset Ownership is Decided at the Completion of Project: The Special Purpose Vehicle is
responsible to overview the proceedings of the project while monitoring the assets related
to the project. Once the project is completed, the project ownership goes to the concerned
entity as determined by the terms of the loan.
5. Zero or Limited Recourse Financing Solution: Since the borrower does not have ownership
of the project until its completion, the lenders do not have to waste time or resources
evaluating the assets and credibility of the borrower. Instead, the lender can focus on the
feasibility of the project. The financial services company can opt for limited recourse from
the sponsors if it deduces that the project might not be able to generate enough cash flow
to repay the loan after completion.
6. Loan Repayment With Project Cash Flow: According to the terms of the loan in Project
Financing, the excess cash flow received by the project should be used to pay off the
outstanding debt received by the borrower. As the debt is gradually paid off, this will
reduce the risk exposure of financial services company.
7. Better Tax Treatment: If Project Financing is implemented, the project and/or the sponsors
can receive the benefit of better tax treatment. Therefore, this structured financing
solution is preferred by sponsors to receive funds for long-term projects.
8. Sponsor Credit Has No Impact on Project: While this long-term financing plan maximizes
the leverage of a project, it also ensures that the credit standings of the sponsor has no
negative impact on the project. Due to this reason, the credit risk of the project is often
better than the credit standings of the sponsor.
What Are the Various Stages of Project Financing?
1. Pre-Financing Stage
Identification of the Project Plan - This process includes identifying the strategic plan of the project
and analyzing whether its plausible or not. In order to ensure that the project plan is in line with
the goals of the financial services company, it is crucial for the lender to perform this step.
Recognizing and Minimizing the Risk - Risk management is one of the key steps that should be
focused on before the project financing venture begins. Before investing, the lender has every
right to check if the project has enough available resources to avoid any future risks.
Checking Project Feasibility - Before a lender decides to invest on a project, it is important to check
if the concerned project is financially and technically feasible by analyzing all the associated
factors.
2. Financing Stage
Being the most crucial part of Project Financing, this step is further sub-categorized into the
following:
Arrangement of Finances - In order to take care of the finances related to the project, the sponsor
needs to acquire equity or loan from a financial services organization whose goals are aligned to
that of the project
Loan or Equity Negotiation - During this step, the borrower and lender negotiate the loan amount
and come to a unanimous decision regarding the same.
Documentation and Verification - In this step, the terms of the loan are mutually decided and
documented keeping the policies of the project in mind.
Payment - Once the loan documentation is done, the borrower receives the funds as agreed
previously to carry out the operations of the project.
3. Post-Financing Stage
Timely Project Monitoring - As the project commences, it is the job of the project manager to
monitor the project at regular intervals.
Project Closure - This step signifies the end of the project.
Loan Repayment - After the project has ended, it is imperative to keep track of the cash flow from
its operations as these funds will be, then, utilized to repay the loan taken to finance the project.
(The process of development of a project consists of 3 stages:
• pre-bid stage
• contract negotiation stage
• fund-raising stage
Be it a long-term infrastructure, public services, or industrial project, sourcing funds to implement
and successfully run an undertaking is an integral part of the entire process.
With Project Financing, a company can arrange for a loan based on the cash flow generated at the
end of a project while using the assets, rights, and interests of the concerned project as collateral.
As this scheme provides financial aid off balance sheet, the credit of the Government contracting
authority or the shareholders is not affected. Since Project Financing shifts part of the risk
associated with the project to the lenders, this financial plan is one of the most preferred options
for private sector companies.
This structured financing technique is implemented mostly by the sectors that have low
technological risks and a predictable market. Therefore, the method of funding a project using
Project Financing is generally employed by companies in the telecommunication, mining,
transportation, and power industries. Sports and entertainment venue projects also often avail
the benefit of this financing scheme. Project Financing is also preferred by many financial services
organizations because they can earn better margins if a business chooses to opt this scheme as
opposed to any other financing technique.)
How Project Finance Works
As noted above, the term project finance refers to the financing of long-term projects industrial
and/or infrastructure projects—most commonly for oil and gas companies and the power sector.
It is also used to finance certain economic bodies like special purpose vehicles (SPVs). The funding
required for these projects is based entirely on the projected cash flows.
Types of Sponsors in Project Financing
In order to determine the objective of the project and the risks related to it, it is important to know
the type of sponsor associated with the project. Broadly categorized, there are four types of
project sponsors involved in a Project Financing venture:
• Industrial sponsor - These type of sponsors are usually aligned to an upstream or
downstream business in some way.
• Public sponsor - The main motive of these sponsors is public service and are usually
associated with the government or a municipal corporation.
• Contractual sponsor - The sponsors who are a key player in the development and running
of plants are Contractual sponsors.
• Financial sponsor - These type of sponsors often partake in project finance initiatives and
invest in deals with a sizeable amount of return.
The project finance structure for a build, operate, and transfer (BOT) project includes multiple key
elements. Project finance for BOT projects generally includes an SPV. The company’s sole activity
is carrying out the project by subcontracting most aspects through construction and operations
contracts. Because there is no revenue stream during the construction phase of new-build
projects, debt service only occurs during the operations phase.
For this reason, parties take significant risks during the construction phase. The sole revenue
stream during this phase is generally under an offtake agreement or power purchase agreement.
Because there is limited or no recourse to the project’s sponsors, company shareholders are
typically liable up to the extent of their shareholdings. The project remains off-balance-sheet for
the sponsors and for the government.
Not all infrastructure investments are funded with project finance. Many companies issue
traditional debt or equity in order to undertake such projects.
Off-Balance Sheet Projects
Project debt is typically held in a sufficient minority subsidiary and is not consolidated on the
balance sheet of the respective shareholders. This reduces the project’s impact on the cost of the
shareholders’ existing debt and debt capacity. The shareholders are free to use their debt
capacity for other investments.
To some extent, the government may use project financing to keep project debt and liabilities
off-balance sheet so they take up less fiscal space. Fiscal space is the amount of money the
government may spend beyond what it is already investing in public services such as health,
welfare, and education. The theory is that strong economic growth will bring the government
more money through extra tax revenue from more people working and paying more taxes,
allowing the government to increase spending on public services.
Non-Recourse Project Financing
When a company defaults on a loan, recourse financing gives lenders full claim to shareholders’
assets or cash flow. In contrast, project financing designates the project company as a limited
liability SPV. The lenders’ recourse is thus limited primarily or entirely to the project’s assets,
including completion and performance guarantees and bonds, in case the project company
defaults.
A key issue in non-recourse financing is whether circumstances may arise in which the lenders
have recourse to some or all of the shareholders’ assets. A deliberate breach on the part of the
shareholders may give the lender recourse to assets.
Applicable law may restrict the extent to which shareholder liability may be limited. For example,
liability for personal injury or death is typically not subject to elimination. Non-recourse debt is
characterized by high capital expenditures (CapEx), long loan periods, and uncertain revenue
streams. Underwriting these loans requires financial modeling skills and sound knowledge of the
underlying technical domain.
To preempt deficiency balances, loan-to-value (LTV) ratios are usually limited to 60% in non-
recourse loans. Lenders impose higher credit standards on borrowers to minimize the chance of
default. Non-recourse loans, on account of their greater risk, carry higher interest rates than
recourse loans.
Recourse Loans vs. Non-Recourse Loans
If two people are looking to purchase large assets, such as a home, and one receives a recourse
loan and the other a non-recourse loan, the actions the financial institution can take against each
borrower are different.
In both cases, the homes may be used as collateral, meaning they can be seized should either
borrower default. To recoup costs when the borrowers default, the financial institutions can
attempt to sell the homes and use the sale price to pay down the associated debt. If the
properties sell for less than the amount owed, the financial institution can pursue only the debtor
with the recourse loan. The debtor with the non-recourse loan cannot be pursued for any
additional payment beyond the seizure of the asset.
Project Finance vs. Corporate Finance
Project and corporate finance are very important concepts in the world of financing. Both of
these funding methods rely on debt and equity in order to help businesses reach their financing
goals. Having said that, they are very distinct.
Project finance can be very capital-intensive and risky and relies on the project's cash flow for
repayment in the future. Corporate finance, on the other hand, is focused on
boosting shareholder value through various strategies like the investment of capital and taxation.
Unlike project financing, shareholders receive an ownership stake in the company with corporate
financing.
Some of the key features of corporate financing include:
• A company's capital structure, which is a company's funding of its operations and growth.
• The distribution of dividends. Dividends represent a portion of the profits generated by a
company and are paid to shareholders.
• The management of working capital, which is money used to fund a company's day-to-
day operations.
What Is the Role of Project Finance?
Project finance is a way for companies to raise money to realize opportunities for growth. This
type of funding is generally meant for large, long-term projects. It relies on the project's cash
flows to repay sponsors or investors.
What Are the Risks Associated With Project Finance?
Some of the risks associated with project finance include volume, financial, and operational risk.
Volume risk can be attributed to supply or consumption changes, competition, or changes in
output prices. Inflation, foreign exchange, and interest rates often lead to financial risk.
Operational risk is often defined by a company's operating performance, the cost of raw
materials, and the cost of maintenance, among others.
Why Do Firms Use Project Finance?
Project finance is a way for companies to fund long-term projects. This form of financing uses a
non- or limited recourse financial structure. Firms with weak balance sheets are more apt to use
project finance to meet their funding needs rather than trying to raise capital on their own. This
is especially true for smaller companies and startups that have large-scale projects on the horizon.
The Bottom Line
Companies need capital in order to begin and grow their operations. One of the ways that certain
companies can do so is through project financing. This form of funding allows businesses that
may not have a strong financial history to raise capital for larger, long-term projects. Sponsors,
which invest in these projects, are paid using cash flows from the project. This is unlike corporate
finance, which is less risky and concentrates on maximizing shareholder value.
FAQs
1. What are the main features of non-recourse/recourse financing?
Some of the main features of non-recourse/recourse financing are mentioned below:
2. What are the main features of non-recourse/recourse financing?
a. Government guarantee may be provided.
b. Retention and Use of Trust
c. Financing via Special Purpose Vehicles
3. What are the main features of non-infrastructure financing?
The main features of Non-Infrastructure Financing are mentioned below:
4. What are the main features of non-infrastructure financing?
a. The loan can be availed in foreign currency.
b. The proposals are disposed of fast.
c. Depending on the bank, the repayment tenure may be up to 84 months.
d. Funds are provided for setting up industrial/manufacturing units.
e. Loans are provided for the expansion of existing units.
5. What are the main characteristics of Infrastructure Financing?
The main characteristics of Infrastructure Financing are mentioned below:
6. What are the main characteristics of Infrastructure Financing?
a. You may be able to borrow in foreign currency.
b. The capital costs are large.
c. The revenues can only be in local currency.
d. Any services that are provided cannot be traded.
e. It is not easy to transfer the assets.
f. The gestation periods are long.
Project finance modeling
Project finance modeling is an excel based analytical tool used to assess the risk-reward of lending
to or investing in a long-term infrastructure project based upon a complex financial structure. All
financial evaluations of a project depend upon projections or expected future cash flows
generated by activities of a completed project and a financial model is built to analyze this.
A project finance model is built to be:
• Easily used
• Flexible but not overly complex
• Suitable for assisting the client in making better and more informed decisions
Evolution of a Project Finance Model:
A project finance model is used throughout the project term and will need to get updated
depending on the phase of the project. Below is an illustrative example of the evolution of a project
finance model:
Key Components of a Project Finance Model
Project finance models are built in excel and need to follow standard industry best practices which
have the following minimum contents:
A. Input
• Derived from technical studies, financial market expectations, and understanding of
the project to date
• Model should be set up to run multiple scenarios using different inputs and
assumptions
B. Calculations
• Revenue
• Construction, operating and maintenance costs
• Accounting and Tax
• Debt financing
• Distributions to equity
• Project IRR (internal rate of return)
❖ The internal rate of return (IRR) is the annual rate of growth that an investment is
expected to generate. IRR is calculated using the same concept as net present value
(NPV), except it sets the NPV equal to zero.
❖ NPV = The difference between the present value of the future cash flows from an
investment and the amount of investment
C. Outputs
• Contain a summary of project metrics important to management for informed decision
making
• Included financial statements (Income statement, balance sheet, cash flow statement)
Project Finance Model Scenario Analysis
After an initial financial model is built, scenario analysis is conducted based on variations to model
inputs and assumptions.
• Scenarios might include a ‘base case’, ‘upside case’, and ‘downside case’
• Variations might be a fixed amount or % change to inputs
• Scenarios should be compared side by side
Model Users Likely information analyzed
Company • Financial statements
Management • Profitability ratios
• Breakeven analysis
• EPS impact
Debt Financiers • Debt coverage ratios (e.g.: DSCR, ICR, LLCR, PLCR)
• Gearing ratios
• Financial statements
• Cash waterfall
Project Sponsors • Financial statements
• Debt service, bankability, yield
• Sensitivity analysis
Equity Financiers • Pre and post-tax IRR
• Running yield, payback
• Tax position
