You can find project finance techniques employed in a range of industries across the world today. As a funding framework, project financing has become more desirable and valuable in infrastructure across a wide spectrum of industries, especially in fast-developing countries and emerging markets.
What is project finance? It’s not easy to answer as there is no universally accepted definition. Nevertheless, each project financing has common features. Understanding these features will help you know what project finance is.
Project finance is the funding of long-term industrial projects, public infrastructure, and public services via a financial structure, which includes a combination of debt and equity. Here the lending company uses a cost-benefit analysis to compare the economic costs and economic benefits.
It primarily determines the cash flow from the project to cover the operating costs and service the debt through reimbursement of the capital with interest. Any residual funds will be used to pay dividends on the equity invested by the sponsors on the project.
Get to know some common features of project finance
Project finance is generally utilized in industrial sectors like power, water, sanitation, renewable energy, and transport. Most of them are public utility projects and public infrastructure. Companies that want to have off-balance-sheet financing, avoiding the issue of repayment guarantee prefer project finance. The sponsor of the project can extend the debt capacity by financing the project on a company’s credit, which may buy the project’s output.
Here are some common features of project finance.
Non-recourse or limited financing
Project finance is a non-recourse debt to borrowers, shareholders, and project sponsors, and it is one of its most essential features of it. With non-recourse financing, shareholders and borrowers are not personally liable in the event of a default in payment. Project companies, on the other hand, have liability mainly or largely limited to the project assets in the event of a default by them. The project assets include performance and completion guarantees and bonds.
The project company is a special-purpose entity formed for the project, and therefore it doesn’t have any assets or credits to evaluate by a project lender when underwriting the project for its viability. Project loans are non-recourse financing and project companies have no assets to meet the deficiencies in the event of default. Hence, the underwriting is completely focused on the project’s viability. If the lender is doubtful about the project’s repayment capacity, it may require the investors or sponsor to have limited recourse.
Risk distribution
A project finance’s approval to a great extent depends on the risk allocation owing to its higher exposure to risk. The deal participants can reduce the investment cost of the project by spreading the risk. For instance, a turnkey contract or engineering, procurement, and construction (EPC) contract has the construction risk of severe penalties on the contractor and not on the project sponsors, special-purpose entity, and lenders.
Generally, the sponsors of product finance share the risk through contractual agreements and security arrangements with other parties capable of taking risks.
Project finance documents
The project documents are critical to the success of project financing, which includes a lot of money and deal participants. All these ask for professional project documents, which are well-prepared and organized.
Off-balance-sheet financing
Project finance is known for off-balance-sheet financing. A special-purpose entity or project company owns the project though there are several participants in the deal. This makes the ownership interest of participants a minority subsidiary interest. Hence the project finance features off-balance-sheet financing.
Most regions like Asia have huge infrastructure development needs. Some leading project finance bankers are in the race to assist in developing the region’s infrastructure. For instance, DBS is one of them providing expert advice and structuring and arranging finance in several deals.