Project finance refers to the funding of long-term projects, such as public infrastructure or services, industrial projects, and others through a specific financial structure. Finances can consist of a mix of debt and equity. The cash flows from the project enable servicing of the debt and repayment of debt and equity.
Understanding Project Finance
The structure of project financing relies on future cash flows for repayment of the project finances. The assets or rights held under the project act as collateral for the finance. Governments or companies prefer project finance for long gestation projects or for joint venture arrangements or collaboration arrangements.
Project finance model adopted in BOT (build, operate, and transfer) model contains multiple key elements. The funds are arranged through a special purpose vehicle (SPV). A company may carry the project themselves or subcontract a portion of the project. In the absence of revenues during the construction phase, the interest on debt capital is paid after the commencement of operations.
Project financing is for projects which carry high risks on the capital employed. There is no revenue for the companies participating until the commencement of operations. During the construction phase, there may be one or two offtake agreements, but no revenue streams. There is no recourse available to the parties funding the projects.
The project generally remains off the balance sheet for the financing parties and the government. Companies typically hold the project debt in a subsidiary with a minority holding. This helps in maintaining the debt ratios of the company. For the government, they may wish to keep the project off their balance sheet to have more fiscal room.
Why Do Sponsors Use Project Finance?
A sponsor (the entity requiring finance to fund projects) can choose to finance a new project using two alternatives:
- The new initiative is financed on the balance sheet (corporate financing)
- The new project is incorporated into a newly created economic entity, the SPV, and financed off-balance sheet (project financing)
#1 Corporate Finance
Alternative 1 means that the sponsors use all the assets and cash flows from the existing firm to guarantee additional credit provided by lenders. If the project is not successful, then all the remaining assets and cash flows can serve as a source of repayment for all the creditors (old and new) of the combined entity (existing firm plus new project).
#2 Project Finance
Alternative 2 means instead that the new project and the existing firm live two separate lives. If the project is not successful, project creditors have no (or very limited) claim on the sponsoring firm’s assets and cash flows. The existing shareholders then benefit from the separate incorporation of the new project into an SPV.
How Is Project Finance Difference from Corporate Finance?
Now that we have a basic understanding of what project finance means, let us understand how it differs from corporate finance. The table below outlines important differences between the two types of financing that need to be taken into account.
In project financing, the lenders have limited recourse. This means that in the case of a default, the lenders have recourse to the assets under the project, securing completion and using performance guarantees under the project.
The project financing is contrary to recourse financing, where the lenders get a full claim to the owner’s assets or cash flows. Hence, project financing requires sound financial and relevant technical knowledge.