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What is project finance?
Project finance refers to the funding of industrial production, infrastructure and public services — using a fully bespoke financial structure. Any borrowed money is then paid back from the cash flows generated — from the project.
A range of different financial instruments, are involved in any project financing deal including loans, equity and guarantees.
Project finance is popular with the private sector, as it enables projects to be funded — while keeping debt off the balance sheet. It also allows companies to fund ventures — which their own capital base would not have otherwise permitted.
Syndicated loans are an important part of project finance. Islamic finance also plays an ever growing role, in project financing.
Project finance — considerations
Project finance is key to satisfying the need for new infrastructure — globally. From social to energy and economic infrastructure, project finance gives access to large-scale debt funding — that brings complex projects to life.
As well as in the infrastructure sector — project finance is prominent in the oil, power and mining industries. These industry sectors, are the most suitable for the structured financing approach — required of project finance. This is due to relatively low technological risk, having a predicable market and the chance of selling (to off-takers) based on multi-year contracts.
Project finance primarily relies on a project’s cash flows for repayment. The collateral to the debt comes in the form of the project’s assets, rights and/or interests.
An organization has two options when it comes to financing a project. The first is corporate financing — where the new undertaking is financed on the balance sheet. The second option is to use project financing, where a special purpose vehicle (SPV) is created — financing the project off the balance sheet.
Consequently, where corporate finance takes interest in a company as a whole — project finance is mainly concerned with the project at hand.
The initiative for a business idea or a project, comes from a sponsor — the project sponsor. These sponsors can be established businesses, developers or government entities. Alternatively, a consortium of sponsors may be formed — with a common interest e.g. public private partnership (PPP).
Regardless of the sponsors, the prevailing theme is — not having the financial capabilities to deliver a project.
Instead, these sponsors seek lenders — capable of funding a project. There can be multiple lenders (a syndicate) involved in a project finance transaction. Their role is to provide the long-term debt and equity — required to get a project up and running. Lenders are also prepared to take on the risks involved in a new venture.
Lenders may be commercial banks, investment banks, institutional investors, multilateral agencies and export credit agencies.
How does project finance work?
If your business has a project it wants funded — a financial analysis of the life-cycle of the project is needed. Cost-benefit analysis would be used to evaluate the feasibility of the project i.e. if the economic benefits outweighs the costs.
In the process of doing a cost-benefit analysis — a financial structure (financial model) would need to be worked-out. This financial structure would normally be a mix of both debt and equity, and will underpin the project’s finances.
The resulting financial structure, together with the economic benefits, will then be compared to the costs. In doing so, a conclusion would be reached — as to the economic viability of the project.
Should the project financing be approved — it would finance a special purpose vehicle (created by the project sponsors). It is this SPV, that eventually pays off any debt — with the cash flow generated from project operations.
Accordingly, the cash flow generated by the SPV — must be able to cover operating costs, and be able to service the debt.
The assets of the SPV serve as collateral to the loan — meaning there is limited or no recourse to the sponsors. In other words, your business’s assets are typically not liable — should there be a default.
Benefits of project finance
- Able to raise the funds required — for very costly projects
- Allows for the effective management of risk
- Can still access funding separately from the project
- Limits a company’s liabilities i.e. the recourse nature of financing
- Can set up and run multiple projects simultaneously
Limitations of project finance
- Highly complex form of funding
- Compliance and regulatory hurdles
- Expensive — as due diligence is costly
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