Project Finance in a Nutshell
Project finance for large infrastructure is widely used in western developed countries. It represented more than $2 trillion of investments globally between 2003-2013; only around 3 per cent of this amount was dedicated to sub-Saharan Africa (IMF/Arnaud Dornel). The latter can partly be attributed to the low creditworthiness of African countries, their underdeveloped financial markets, and a relatively high foreign exchange risk (World Bank).
Despite being widely used, a comprehensive and uniformly accepted definition of project finance is difficult to frame (Investopedia). However, project finance has a set of common features or characteristics that help one understand what it is.
1) Common characteristics of project finance for infrastructure
a) Long-term, highly leveraged and capital-intensive infrastructure investments
The acquisition of brand new aeroplanes by a commercial airline, the construction of a new stadium or a mineral processing plant, and other public services with a guaranteed income stream like a dam (to generate electricity), are some examples of infrastructure investments that can be funded with project finance (Dentons). Indeed, infrastructure investments funded with project finance will span several years, are multimillion-dollar investments and have more debt than equity (usually 65 to 80 per cent of capital – Gordon M. Bodnar). However, the main reason why this method of financing is selected by sponsors (and that differentiates it from corporate financing) is the limited recourse nature of the loans (Corporate Finance Institute), which is discussed next.
b) Limited recourse (or non-recourse) loans
This means that the sponsors of the project and its shareholders cannot be liable for debt services default beyond the special purpose vehicle’s (discussed next) assets (Dentons). It may be relevant to mention that these loans are obtained strictly for the project (João Pinto). In other words, project finance is appealing to a company (or government) that wants to undertake large infrastructure investments and at the same time does not want its own company’s assets to be liable for debt default in case the project becomes a failure (Kimble McCraw).
c) Special Purpose Vehicle (SPV) with a finite life & off-balance sheet operations
These two are common characteristics of project finance too. That’s the creation of a special purpose vehicle with a finite life (until its original purpose is achieved) through which all the operations related to the project are conducted; and their recoding off- (sponsor’s) balance sheet (Gordon M. Bodnar).
d) Debts are repaid from cash flows generated from the project
This is another common feature of project finance. Debts will be repaid only from future cash flows generated from the project (E.R. Yescombe). In other words, sponsors and shareholders should be convinced of the project’s potential to generate enough positive cash flows in the future to be able to pay back its debt in full. This suggests that there is an optimum amount of debt sponsors can incur under project finance using among other things a cash flow analysis (Infocus International).
Next, we will discuss some advantages and disadvantages of project finance to conclude this article.
2) Advantages and disadvantages of project finance
As suggested above, there are three great benefits to project finance:
a) Effective risks management. Risks are shared between the sponsor(s) and shareholders. These risks should be allocated based on which party is best able to manage the relevant specific risk (Deloitte).
b) The potential to raise enough private funds for large infrastructure investments (World Bank-IFC)
c) Sponsor’s personal assets cannot be used as collaterals for debts owned by the SPV (Corporate Finance Institute).
However, some disadvantages include:
i) A higher cost of borrowing when compared to traditional corporate financing (João Pinto).
ii) There is a lot of paperwork involved, which take a great deal of time to write, from financing to operating agreements (João Pinto).
In conclusion, project finance can be defined as a method of financing long-term, highly leveraged and capital-intensive infrastructures; with a limited recourse on loans and managed via a special purpose vehicle with a finite life.
This article was written by Hugue Nkoutchou and published with permission.
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