Project Finance

            BASICS OF PROJECT FINANCE

Definition

Project finance involves the creation of a legally independent project company financed with non-recourse debt (and equity from one or more sponsoring firms) for the purpose of financing a single purpose capital asset, usually with a limited life1.

Main parties in project financing

Lenders

Sponsors

Contractors

Project Company

Customers

Host Government

Characteristics of Project Finance

• A project is established as a separate company
• A major proportion of the equity of the project company is provided by the project manager or sponsor, thereby tying the provision of finance to the management of the project.
• The project company enters into comprehensive contractual arrangements with suppliers and customers
• The project company operates with a high ratio of debt to equity, with lenders having only limited recourse to the equity-holders in the event of default

Project Finance Investment

An illustration    

Total Project Finance Investment (US$ billions)

Year    Bank Loans     Bonds     Total     % change     BLA & MLA Finance    Equity Finance     Total

2004   116.44              28.65      145.09   43%             18.75                               70.22                    234.06

Debt-to-total-capitalization ratio of 70%

Banks provided shorter-term financing (over 60% of bank loans mature in less than 10 years)

Bonds provided longer-term financing (over 75% of bonds mature in more than 10 years)

There has been a dramatic increase in the use of project bonds

Source: see footnote 1 and references therein.

Project Debt Credit Rating

Most project bonds have “negotiated” ratings

• Sponsors adjust leverage, covenants, and deal structureto reach investment grade
• Investment grade is important due to institutional restrictions against investing in sub-investment grade securities

Standard & Poor’s Rated Project Debt Distribution

Percent of Total Ratings by Number of Bonds

S&P Ratings             December 2003

AAA                         10%

AA+, AA, or AA-     1%

A+ or A 12% A-        4%

BBB+                        10%

BBB                          6%

BBB-                         14%

BB+                           4%

BB                             3%

BB-                            2%

B+                              9%

B                                16%

B-                               1%

CCC and below          8%

            Total 100%

Total Rated Volume

(US$ billions)                  $ 120.60

Number of Bonds            221

% investment grade         64%

Comparison between Project Finance and Traditional Lending

In traditional lending:

• Projects are generally not incorporated as separate companies
• Contractual arrangements are not as comprehensive
• Debt to equity ratios are not as high
• Loans offer lenders recourse to the assets of borrowers in case of default

Fundamental Differences Between a Project Company and a Typical Company2

• Overriding importance of the contractual and financing arrangements that exist between the various parties involved
• These are designed to allocate every major risk presented by the project to the party that is best able to appraise and control that risk

Risks and Contracts

• The project sponsor bear the risks of project completion, operation and maintenance
• The project lenders require the usual assurance from the project company, including security of their loans
• The main contractor is best able to ensure that construction is completed within cost and on schedule
• When there is a major supplier to the project, there will be a contract to ensure that (1) he does not abuse his possible monopoly power and (2) he produces efficiently
• When there are only a few potential customers for the project’s output, revenue risk is likely to be transferred to those customers by means of long term sales contracts
• When the government grants a concession to a project company, there will need to be a concession agreement that gives the company the right to build and operate the project facility
• If there is currency risk, the government may be asked to provide guarantees of currency convertibility at a given rate, otherwise the project company might not be able to honor its debt

Ownership, Capital Structure and Incentives in Project Finance

• Why are projects incorporated in separate companies?
• Why are the operators and the main project contractors typically the main equity-holders in that company?
• Why are project companies highly leveraged?
• Why does this leverage take the form of non-recourse financing?

Benefits of Project Finance 

When Does Project Finance Make Sense?

(Agency Effects)

• To specialize and decentralize management
• To make possible the provision of separate incentives for project managers
• To preclude the waste of project free cash flow
• To increase the outside scrutiny of projects
• To improve incentives for the production of information

Project Finance Benefits

When Does Project Finance Make Sense?

(Ownership Structure)

• To allow joint ventures without requiring the exhaustive mutual evaluation of the creditworthiness of potential partners
• To limit the liability of project sponsors
• To limit the exposure of creditors to well-defined project risks
• To distribute project risks efficiently

Project Finance Costs

When Does Project Finance Not Make Sense?

• When there are complex interactions of the project with the rest of the firm
• When project default is costly
• When optimal project leverage is low
• When project contracting costs are high

Footnotes:

1. B. C. Esty and A. Sesia Jr., “An Overview of Project Finance-2004 Update”, Harvard Business Review, 9-205-065.

2. The rest of the presentation is based on the paper by Brealey, R.A., I. A. Cooper, and M.A. Habib, 1996, “Using Project Finance to Fund Infrastructure Investments”, Journal of Applied Corporate Finance 9:3, pp. 25-38.

Adapted from a number of sources by Prime Fund Inc.

Contact Person: Suhardiyoto Haryadi, Email address: suhardiyoto@gmail.com