Project Finance: Definition & Meaning
Being able to properly finance projects is a key part of any business strategy. If a project doesn’t have sufficient funding, then the chances are that it will end up in failure. That’s where project finance comes into play.
But what exactly is project finance? And why is it important for businesses and private sector companies? Read on as we give you an overview of the definition and meaning behind everything to do with project finance.
Table of Contents
- Project finance is the process of getting public funding for capital-intensive, long-term projects such as infrastructure.
- This frequently makes use of a restricted or non-recourse financial framework.
- The only payment that may be made to a debtor with a non-recourse loan is the asset’s seizure.
- Typically, project debt is not reported on the balance sheets of the individual shareholders but rather retained in a sufficiently small minority company.
What Is Project Finance?
Project finance is the process of funding, or financing, a long-term project. This may be infrastructure, industrial, or public services using a non-recourse or limited recourse financing. The equity debt that is used to finance the project is then paid back with the revenue that is generated by the project. A non recourse loan does not allow the creditor to go after anything other than the collateral in case of a default.
Essentially, project financing is a type of loan structure. It relies mainly on the project’s cash flow as a form of repayment, while the project’s assets, interests, and rights are held as secondary collateral. This is known as the collateral to back up the original collateral.
Project finance is an especially attractive method to private sector companies. This is because they can fund large projects off-balance sheet (OBS).
Types of Project Finance
Project finance can come from a variety of different sources. The main sources are as follows:
- Government grants
Features of Project Finance
There are a number of different features of project financing. Here are some of the main ones:
- Non-recourse financing: In the case of a financial default, non-recourse financing means that neither the borrowers nor the borrowers’ shareholders are personally liable. The lender can only seize the collateral.
- Off-balance sheet financing: In transactions involving project financing, the project’s owner, or project company, is a separate business or subsidiary known as a special purpose entity (SPE) or special purpose vehicle (SPV).
- Capital intensive: Due to the fact that it is used to fund significant infrastructure and international development projects, project finance requires enormous amounts of funding.
- Project participants: There are frequently many project parties involved in project finance. Project sponsors frequently need to add equity investors to the list of project stakeholders due to the enormous sums that are normally involved in project financings.
- Risk allocation: Due to the increased risk exposure, international project financing transactions are typically riskier than regular corporate finance transactions.
Advantages of Project Finance
There are a number of advantages that come with project finance. Here are some of the main ones:
- The joint venture helps the partners in lowering project costs.
- The project sponsor can use reliable sources of funding thanks to the company’s project finance.
- Project finance helps address overhead costs and specific issues.
- It helps achieve economies of scope.
Disadvantages of Project Finance
There are also disadvantages to project finance. Let’s take a look at some of the main ones:
- The act of negotiating for the project’s finance can be exceedingly difficult and expensive.
- Due to indirect credit support, the loan cost is higher for all lenders.
- Due to its intricacy, direct financing requires higher funding costs than those required by indirect financing.
How Do You Manage Project Finance?
There are five steps that you should follow to manage your project finance. They are as follows:
- Estimate the costs of the project
- Set the budget for the project
- Figure out whether you can gain access to contingency funding
- Track your spending and resource allocation on a weekly basis
- Make sure that the expectations of the project are properly managed
Project Finance Example
Let’s say that Company X wants to invest in a long-term project. They decide to take out a bank loan of $300,000 with 10% interest over 5 years to help pay for this project.
As the project develops, Company X uses the funds that are being generated from the project to incrementally pay back their loan with interest.
By the end of the 5 years, the project had gained an income of $600,000. That means that the original loan of $300,000 has been paid off, plus the $30,000 of interest, leaving the company with $270,000 of profit.
Project Finance and Build, Operate, and Transfer Projects
For a build, operate, and transfer (BOT) project, the project finance structure has a number of key elements. It will generally tend to include a special purpose vehicle (SPV), which is a subsidiary that is created in order to isolate financial risk.
The single activity of the company throughout the project is subcontracting. Subcontractors are used on almost all of the project’s aspects through operations and construction contracts. The debt service will only happen during the operations phase. This is because there isn’t a revenue stream during the construction phase of any new-build project.
Because of this, a party can take significant risks during this initial construction phase. The only source of revenue during this phase tends to be through a power purchase agreement or an offtake agreement. A power purchase agreement allows the buyer to get electricity at a low cost with no upfront payment. In an offtake agreement, the buyer agrees to purchase goods generated from the project.
Company shareholders are normally liable up to the extent of their shareholdings. This is because there is no or limited recourse to the sponsors of the project. The project would remain off-balance-sheet for the government and for the sponsors.
Project Finance and Off-Balance Sheet Projects
The debt of a project, or project debt, is normally held in a sufficient minority subsidiary. As a result, the debt would not be consolidated on the respective shareholder’s balance sheet. This in turn reduces the impact of the project on the cost of the shareholders’ existing project debt and debt capacity. The shareholders themselves are also free to use their project debt capacity for any other means, such as further investments.
The government can use project financing to some extent in order to keep project liabilities and debt off-balance-sheet and take up less fiscal space. Fiscal space is the total amount of money that the government can spend beyond what it is already investing in public services. That would include services such as welfare, health, and education.
In theory, strong economic growth would bring more money to the government through extra tax revenue generated from more people working and paying taxes. Therefore allowing the government to increase their spending on public services.
Project Finance and Non-Recourse Financing
When a business defaults on one of its loans, recourse financing gives the lender a full claim on the shareholders’ cash flow or assets. Whereas in project financing a project company is set up as a limited liability special purpose vehicle (SPV). Therefore, the lenders’ recourse is limited entirely or primarily to the assets of the project. This includes performance guarantees and bonds, as well as completion in case of a possible default of the project company.
An important issue in non-recourse financing are specific situations, where the lender will be able to hold shareholders personally liable for the loan. This would be where the lender has recourse to all or some of the shareholders’ assets. This may happen when there is a deliberate breach on the part of the shareholders, giving the lender recourse to their assets.
The law can restrict shareholder liability to some extent. For example, the liability in case of default due unexpected death or personal injury. Non-recourse debt is best characterized by a high level of capital expenditures (CapEx), uncertain revenue streams, and long loan periods. For these loans to be underwritten, sound knowledge and financial modeling skills are required.
In an attempt to preempt deficiency balances, loan-to-value (LTV) ratios tend to be limited to 60% in non-recourse loans. A lender would impose a higher credit standard on borrowers in order to minimize the chance of them defaulting. Non-recourse loans carry higher interest rates than a recourse loan would. This is because they carry a much higher risk to lenders.
When trying to obtain project finance for a particularly ambitious project, it’s important to make sure that your business can handle the debt. Some businesses will look to project sponsors for this. These project sponsors will be in charge of the overall success of the entire project and will help ensure a positive outcome.
FAQs on Project Finance
In a business setting, the financial project manager would be responsible for the financial resources and health of the project. Their main jobs would be managing investment activities. As well as helping develop strategies and long-term financial goals. Project managers are also responsible for putting together financial reports.
The model of project finance is used to secure long-term financing for infrastructure projects using the project’s expected future cash flows.
A project lawyer works with the finance and corporate lawyers to ensure a successful completion of the project.
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