What Is Project Finance?
The term “project finance” refers to the practice of analyzing a project’s finances throughout its whole lifecycle. If the project’s economic advantages are expected to outweigh its economic costs, a cost-benefit analysis is performed.
Project finance refers to the funding (financing) of long-term infrastructure, industrial projects, and public service projects via the use of a financial framework that is either non-recourse or limited recourse. The cash flow created by the project is used to repay the loans and equity that were used to fund the project.
The first phase in the study is to define the financial structure, which will be a combination of debt and equity to fund the project. The next step is to calculate the project’s net economic benefit to see whether it’s worth undertaking.
Cash flow from the project itself is the primary source of repayment for project financing, with the assets, rights, and interests of the project serving as secondary collateral. Due to the ability to finance large projects off-balance-sheet (OBS), project financing is very appealing to the private sector.
Project financing is often utilized in the oil and gas extraction, power generation, and infrastructure industries. Given their minimal technical risk, reasonably predictable markets, and potential for selling to a single or a small number of major clients on the basis of multi-year contracts, these industries are ideal for the development of this structured financing strategy.
Why do Sponsors Use Project Finance?
As previously said, project finance is appropriate for ventures that demand a considerable upfront expenditure but will not yield an immediate income stream and, therefore, ROI. Project finance may be appropriate for large-scale endeavors in a variety of sectors, including the energy, infrastructure, and real estate development industries.
The following criteria should be used to determine whether or not a project would be eligible for financing:
- How risky is it to proceed with the project? If the project’s failure may jeopardize your whole business, financing it via project finance is a wise strategy to mitigate risk.
- How much money will be needed to complete the project? Project finance might be an option if you need more money for the project than you can realistically get via other means of funding.
- What is the estimated completion date? Project financing lets your business get the money it needs for long-term endeavors without adding those costs to the books.
Now let’s delve a bit deeper into the advantages of project financing that make it so worthwhile for your business.
Off-Balance Sheet Projects
Debts and liabilities incurred as a result of project financing agreements are not directly reported on the balance sheets of the companies that sponsor the project.
Project debt is often carried in a suitable minority subsidiary that is not consolidated on the individual business’s financial statements. This lessens the effect of the project on the cost of the shareholders’ current debt and debt capacity. The shareholders may utilize their debt capacity for other purposes.
To some degree, the government may employ project finance to keep project debt and obligations off the balance sheet, freeing up fiscal space. Fiscal space refers to the amount of money that the government may spend in addition to what it currently spends on public services such as health, welfare, and education. The idea is that if the economy is doing well, the government will be able to afford to spend more money on things like infrastructure and social programs since more people will be working and paying taxes.
Recourse finance grants lenders complete claim to a defaulting company’s assets or cash flow. Project funding creates a limited-liability SPV. In case the project company defaults, the lenders’ recourse is limited to the project’s assets, including completion and performance bonds.
A key issue in non-recourse financing is whether lenders can have recourse to shareholder assets. Shareholders’ deliberate breach may give the lender asset recourse.
Applicable law may restrict the extent to which shareholder liability may be limited. Personal injury or death liability isn’t usually eliminated. Non-recourse debt has high capital expenditures (CapEx), long loan periods, and uncertain revenues. These loans require expertise in financial modeling and technical knowledge of a project’s moving parts.
Non-recourse loans limit loan-to-value ratios to 60% to avoid deficiency balances. Lenders raise credit standards to reduce defaults. Non-recourse loans are riskier and have higher interest rates.
Recourse vs. Non-Recourse Loans
For example, if two people want to buy expensive property but one gets a recourse loan and the other gets a non-recourse loan, the lender has various options for dealing with the defaulting borrower in each case.
In both circumstances, the residences might be used as collateral, which means the lender could take possession of them if the borrowers stopped making payments. In the event of a borrower default, the financial institution may try to recuperate some of its losses by selling the collateral property and applying the proceeds to the outstanding loan balance. For a recourse loan, lender has only the debtor to go after if the collateral is sold for less than what is due on the loan. If an asset is seized in connection with a non-recourse loan, the lender cannot go after the debtor for any further repayment.
Project Finance vs. Corporate Finance
Direct loans to businesses, which are shown as liabilities on financial statements, are a key component of corporate finance. With its own set of benefits and downsides, it stands as a formidable alternative to traditional project financing. Corporate finance is a recourse form of borrowing, which means that if a creditor is not repaid, they may go after any asset or source of income belonging to the company.
Let’s imagine your firm decided to acquire a new fleet of vehicles and utilize corporate finance to do so by taking out a loan from a corporate bank. The trucks and other assets would be subject to seizure by the bank if you defaulted on the loan payments. Businesses who are looking for funding for a project have less to lose by using project financing. As was mentioned, however, sponsors take on a disproportionately large amount of risk, which results in higher lending costs.
Other Project Funding Sources
Of course, project and corporate finance aren’t the only options to choose from. Your business should investigate any and all potential funding sources. Just a few of the most prevalent are:
If your company generates enough money in net sales, it might be able to start a new venture without seeking outside funding.
Your company can take advantage of positive cash flows by putting the money aside and investing it when it has enough cash on hand. There’s a risk that by the time you’ve saved enough money, the opportunity to take on the project will have passed.
Cooperating with other companies to split the price and risk of a project is yet another choice. When this includes vertical or horizontal integrations that improve project efficiency, it may be very compelling.
Selling stock to investors is one way to raise money for a project. Due to the fact that ownership shares are not loans, you will not be exposed to the liability risks associated with project financing. While this strategy will dilute ownership to a lesser extent for large corporations, it does give outside parties a significant say in your company’s affairs.
Funding a project by issuing bonds to financial institutions and individuals is a form of debt financing. Bonds issued by private companies or by local governments are examples. Investors’ interest rates are set in part by the credit rating given to these companies, which is an indicator for the perceived riskiness of the investment.
Crowd-funding refers to the practice of raising money for a project from a large number of individuals rather than a single investor. This method can be effective in some situations, but it won’t help you raise the large amounts of money required for major construction or expansion projects.
Public infrastructure projects, which are typically very large and complex, frequently involve partnerships between private companies and government agencies. After construction is finished, the private company recoups its initial investment through ongoing business operations. Of course, this isn’t the only way government entities contribute to project funding; businesses can also apply for federal, state, and local grants.
These methods are most appropriate for use when a project requires less capital than usual, or when the company in question has a very strong cash flow and few liabilities. When one source of funding is insufficient, businesses can instead use a combination of approaches.