What Is Project Finance?

What Is Project Finance?

Let me explain project finance directly: it's a way to fund long-term infrastructure, industrial projects, and public services through a nonrecourse or limited-recourse financial structure. You repay the debt and equity solely from the cash flow the project generates.

In this setup, the loan relies mainly on the project's cash flow for repayment, with the project's assets, rights, and interests as secondary collateral. This is particularly useful for the private sector because you can fund major projects off-balance sheet, so the debt doesn't show up on your company's balance sheet and doesn't affect your credit rating or borrowing capacity.

Here in the U.S., project financing gives businesses a straightforward way to secure funding for big projects like infrastructure, telecommunications, and energy.

How Project Finance Works

When I talk about project finance, I'm referring to financing long-term industrial and infrastructure projects, especially in sectors like oil and gas, power generation, and transportation. It's also used for economic bodies like special purpose vehicles (SPVs), which you create to manage a single project. The funding is based entirely on the projected cash flows.

You should know about the common sponsors in project finance. Contractor sponsors provide subordinated or unsecured debt and/or equity and are key to the project's establishment and operation. Financial sponsors are investors focused on big returns. Industrial sponsors are companies with a strategic interest aligning with their core business. Public sponsors include governments at various levels.

Project Finance Structure for BOT Projects

For a build, operate, and transfer (BOT) project, the structure includes multiple key elements, generally involving an SPV. The SPV's sole activity is carrying out the project by subcontracting construction and operations. Since new-build projects don't generate revenue during construction, debt service starts only in the operations phase.

This setup creates significant risks during construction, as revenue might only come from an offtake agreement or power purchase agreement. With limited or no recourse to sponsors, shareholders are liable only up to their investment. This keeps the project off the balance sheets of sponsors and the government, minimizing financial risk.

Important Note on Infrastructure Investments

Keep in mind that not all infrastructure investments use project finance. Many companies issue traditional debt or equity for such projects.

Off-Balance Sheet Projects

Project debt is typically held in a sufficient minority subsidiary and not consolidated on shareholders' balance sheets. This reduces the project's impact on your existing debt and debt capacity, freeing you to use that capacity for other investments.

Governments use project financing to keep debt and liabilities off their balance sheets, preserving fiscal space. Fiscal space is the money available for spending beyond current public services like health, welfare, and education. You can create it by raising taxes, cutting lower-priority spending, or securing grants, but do so carefully for long-term sustainability. The idea is that strong growth boosts tax revenues, allowing more spending on services.

Nonrecourse Project Financing

In recourse financing, if a company defaults, lenders can claim shareholders' assets or cash flow. But in project financing, the project company is a limited liability SPV, so lenders' recourse is limited to the project's assets, including guarantees and bonds.

Consider if lenders could access shareholders' assets, like in cases of deliberate breach. Applicable laws may restrict liability limits, such as for personal injury or death. Nonrecourse debt involves high CapEx, long loan periods, and uncertain revenues, requiring financial modeling and technical knowledge.

To reduce deficiency risks, lenders limit LTV ratios to 60% in nonrecourse loans. This means stricter credit standards and higher interest rates than recourse loans, due to the greater risk.

Recourse Loans vs. Nonrecourse Loans

If two people buy large assets like homes, one with a recourse loan and one with nonrecourse, the outcomes differ on default. Both use the asset as collateral, which can be seized. If sold for less than owed, the recourse borrower can be pursued for the difference, but the nonrecourse borrower isn't liable beyond the asset seizure.

Project Finance vs. Corporate Finance

Project and corporate finance both use debt and equity, but they're distinct. Project finance is capital-intensive and risky, relying on future cash flows for repayment. Corporate finance boosts shareholder value through capital investment and taxation, giving shareholders ownership stakes.

Key corporate finance features include capital structure for funding operations and growth, dividend distribution from profits, and working capital management for daily operations.

What Is the Role of Project Finance?

Project finance helps companies raise money for growth opportunities, especially 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?

Risks include volume risk from supply, consumption, competition, or price changes; financial risk from inflation, foreign exchange, and interest rates; and operational risk from performance, raw materials costs, and maintenance.

Why Do Firms Use Project Finance?

Firms use it to fund long-term projects with nonrecourse or limited-recourse structures. It's ideal for those with weak balance sheets, like smaller companies or startups with large projects, rather than raising capital independently.

The Bottom Line

Project finance suits large, long-term projects like infrastructure or industrial developments, relying on estimated future cash flows for repayment with minimal recourse. This lets companies tackle big projects without harming their balance sheets. It carries higher risks due to future income reliance, but it's a viable option where traditional corporate finance isn't suitable.