WHAT IS PROJECT FINANCE ?
Project finance refers to the financing of long term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project. There is no universally accepted definition of project finance. However, a typical definition of project finance may be :
“The financing of the development or exploitation of a right, natural resource or other asset where the bulk of the financing is to be provided by way of debt and is to be repaid principally out of the assets being financed and their revenues”.
Project finance is used by private sector companies as a means of funding major projects off balance sheet. A typical project finance structure is outlined below:
At the heart of the project finance transaction is the concession company, a special purpose vehicle (SPV) which consists of the consortium shareholders who may be investors or have other interests in the project (such as contractor or operator). The SPV is created as an independent legal entity, which enters into contractual agreements with a number of other parties necessary in a project finance deal.
The SPV normally ownership of a specified facility or asset. In some cases the rights are awarded through a concession from a public authority for a fixed number of years. At the end of the concession (sometimes known as the implementation or project agreement) is the primary contract between the granting authority and the SPV and forms of the contractual basis from which other contracts are developed in the project structure. The concession normally entitles the SPV to build, finance and operate the facility for a fixed period although there are other variants.
1.2 PROJECT FINANCE – MERITS AND DEMERITS
before examining how projects are structured and financed, it is worth asking why sponsors choose project finance to funs their projects. Project finance is invariably more expensive than rising corporate funding. Also, and importantly, it takes considerably more time to organize and involves a considerable dedication of management time and expertise in implementing, monitoring and administering the loan during the life of the project. There must, therefore, be compelling reasons for sponsors to choose this route for financing a particular project.
The following are some of the key reasons why project finance might he chosen;
The sponsors may want to insulate themselves from both the project debt and the risk of any failure of the project;
A desire on the part of sponsors not to have to consolidate the projects debt on to their own balance sheets. This will, of course, depend on the particular accounting and/or legal requirements applicable to each sponsor. However, with the trend these days in many countries for a company’s balance sheet to reflect substance over form, this likely to invest in a project on their own and the only way in which they can raise the necessary finance is on a project financing basis:
A sponsor is investing in a project with others on a joint venture basis, it can be extremely difficult to agree a risk sharing basis for investment acceptable to all the co-sponsors. In such a case, investing through a special purpose vehicle on a limited recourse basis can have significant attractions;
There may be tax advantages (e.g. in the form of tax holidays or other tax concessions) in a particular jurisdiction that make financing a project in a particular way very attractive to the sponsors; and
Legislation in particular jurisdiction may indirectly force the sponsors to follow the project finance route (e.g. where a locally incorporated vehicle must be set up to own the projects assets).
This is not an exhaustive list, but it is likely that one or more of these reasons will feature in the minds of sponsors who have elected to finance a project on limited recourse terms.
Project finance, therefore, has many attractions for sponsors. It also has attractions for the host government. These might include the following:
Attraction of foreign investment
Acquisition of foreign skills and know-how;
Reduction of public sector borrowing requirement by relying on foreign or private funding of projects;
Possibility of developing what might otherwise be non-priority projects; and
Education and training for local workforce.
1.3 APPLICATION OF PROJECT FINANCE
project finance is issued extensively in the following sectors:
Oil and Gas
From the financing of oil and gas rigs to oil refineries and pipelines, oil & gas companies are increasingly using project financing as a method of reducing corporate debt by taking heavy capital investment off balance sheet.
In Latin America and parts of Africa, mining companies are using project financing techniques to fund their mining development and reduce company debt and shareholder exposure.
As electricity markets are liberalized and government monopolies removed, private sector companies are playing a pivotal role in funding new power stations using project finance with offtake agreements guaranteeing electricity sales. Project finance has enabled competition to flourish in the electricity markets with the end result that consumers enjoy lower prices and guaranteed supplies. In emerging countries, the electricity is the key area of industry that helps to kickstart growth of an economy. Private energy suppliers are investing on a project finance basis through government concessions in many countries helping to stimulate and provide reliable and consistent source of energy for industry and business, increasing growth and raising standards of living. Coal, oil and gas fired power, plants hydro-electric combined heat and power and renewable energy plants are being successfully delivered on a project finance basis around the world.
Throughout the world, private sector investment and expertise are redefining the water industry. project finance is helping companies to invest on a long term basis by modernizing existing water facilities as well as providing the finance to build and operate new water plants and waste water disposal facilities on a concession basis.
The recent telecom boom has witnessed a rapid advancement in the field of mobile telecom and a growing trend of using project financing techniques to fund and rollout new telecom infrastructures.
Roads and Highways
National road networks are cracking under the strain of increased under demand and falling government budgets for maintenance and future expansion. Private sector companies are now encouraged to build, fund and operate new existing roads on toll basis using public authority concessions.
Railways and Metro Systems
Outdated railways require massive and urgent investment. Project finance is playing a central role in the funding required for the modernisation of and development of new railway infrastructure. This method funding is also being used to provide new city transit systems, both coach and rail.
1.4 STRUCTURING A PROJECT VEHICLE
One of the first, and most important, issues that the project sponsors will face in deciding how to finance a particular project will be how to invest in, and fund, the project. There are number of different structures available to sponsors for this purpose. The most common structures used are:
A joint venture or other similar unincorporated association;
A limited partnership;
An incorporated body, such as a limited company (probably the most common).
Of these structures the joint venture and limited company structure are the most universally used. Joint venture is a purely contractual arrangement pursuant to which the number of entities pursue a joint business activity. Each party will bring to the project not only its particular expertise but will be responsible for funding its own share of project costs, whether from its own revenues or an outside source. Practical difficult may arise as there is no single project entity to acquire or own assets or employ personnel, but this is usually overcome by appointing one of the parties as operator or manager, with a greater degree of overall responsibility for the management and operation of the project. This is the most common structure used in the financing of oil gas projects in the United Kingdom Continental Shelf.
artnerships are, like joint ventures, relatively simple to create and operate but in many jurisdictions partnership legislation imposes additional duties on the partners, some of which (such as the duty to act in the utmost good faith) cannot be excluded by agreement. Liability is unlimited other than for the limited partners in a limited partnership, but these are essentially “sleeping partners who provide project capital and are excluded from involvement in the project on be half of the firm. In many cases it will be convenient (or may not be possible) for the project assets to be held directly (whether by an operator or the individual sponsors). In these cases it may be appropriate to establish a company or other capital vehicle which will hold the project assets and become the borrowing vehicle for the project. The sponsors will hold the shares in this company or other vehicle in agreed proportions. In most cases where this route is followed, the company or other vehicle would be a special purpose vehicle established exclusively for the purpose of the project and the use of the special purpose vehicle for any purposes unconnected with the project in question will be published. In addition to the constitutional documents establishing the vehicle, the terms on which it is to be owned and operated will be set out in a sponsors or shareholders agreement.
Whether sponsors follow the joint venture (direct investment) route or the special purpose vehicle (indirect investment) route will ultimately depend on a number of legal, tax, accounting and regulatory issues, both in the home country of each of the sponsors and the host country of the project (and, perhaps, other relevant jurisdictions). Some of the relevant influencing factors might include the following:
A wish on the part of the project sponsors to isolate the project (and, therefore, distance themselves from it) in a special purpose vehicle. If the project should subsequently fail, the lenders will have no recourse to the sponsors, other than in respect of any completion or other guarantees given by the sponsors. The sponsors are effectively limiting their exposure to the project to the value of the equity and/or subordinated debt that they have contributed to the project;
The use of a joint venture or partnership, as opposed to a special purpose vehicle, can often mean that the sponsors must assume joint and several liability when contracting with third parties on behalf of the joint venture or partnership, this is likely to result in each sponsor having to show the full amount of the project debt on its balance sheet – not a particularly attractive proposition for most project sponsors;
By contrast, the use of a special purpose vehicle may mean that the sponsors do not have to consolidate the project debt into their own balance sheets (if it is not a ‘subsidiary’ or ‘subsidiary undertaking’ or equivalent). This may also be important for cross default purposes for the sponsor. A sponsor would not want a default by a project company (even if it is a subsidiary) to trigger a cross default in respect of other contract or projects at sponsor level. The corporate lenders to the sponsor may agree to this, provided there is no recourse by the project’s lenders to the sponsor in the event of a project company default, eliminating the risk that the project company default will damage or further damage the sponsors balance sheet (note the wide definition of project finance borrowing used earlier in this section that typically might be used in such a case);
On a similar note, negative pledge covenants in a sponsor’s corporate loan documentation may prohibit or limit the sponsor from creating the necessary security required in connection with a project financing. As with the cross default clause, he corporate lenders to the sponsor may agree to exclude security interests created by the sponsor (or a subsidiary or subsidiary undertaking of the sponsor) in connection with a specific project from the terms of the sponsors negative pledge;
It may be a host government requirement that any foreign investment in channeled through a local company, particularly where the granting of a concession might be involved. This may be for regulatory or tax reasons or, in the case of a strategically important industry, for security or policy reasons;
The use of a joint venture or partnership can have a significant tax advantages in some jurisdictions (e.g. each participant may be taxed individually and may have the ability to take all tax losses on to its own balance sheet) which may make such a vehicle attractive for some sponsors. On the other hand, a limited liability company’s profits are in effect taxed twice, once in the hands of the company and gain in the hands of the individual shareholders;
A special purpose vehicle will be attractive where different sponsors require to fund their investment in the project in different ward (e.g. one may want to borrow whilst others may wish to fund the investment from internal company sources) or one may want to subscribe equity whereas another might wish to contribute debt (e.g. and subordinate the repayment of this debt to the right of project lenders) as well; and
Practical considerations may also be relevant. Partnerships and contractual joint ventures are less complicated (and cheaper) to establish and operate. Registration requirements in respect of limited companies and limited partnerships eliminate confidentially. It should also be remembered that it is easier for a company to grant security, in particular floating charges and his may be an important consideration for the raising of finance.
In practice, the choice will never be a straightforward one and it is often the case that sponsors will have conflicting requirements. This, however, will be one of the many challenges for those involved in project financing. It is, however, important to establish the appropriate vehicle at the outset, as it can be difficult to change the vehicle once the project proceeds and especially, once the funding structure is in place.
1.5 RISK SHARING
The essence of any project financing is the identification of all key risks associated with the project and the apportionment of those risks among the various parties participating in the project. There are some ground rules that have to be observed by the parties involved in a project when determining which party should assume a particular risk:
A detailed risk analysis should be undertaken at an early stage:
Risk allocation should be undertaken prior to detailed work on the project documentation;
As a general rule, a particular risk should be assumed by the party best able to manage and control that risk, e.g. the risk of cost overruns or delay on a construction project is best managed by the main contractor; in a power project, the power purchaser is in a better position than others to assume the risks associated with a grid failure and consequent electricity supply problems for any reason;
Risks should not be parked with the project company where the project company is a SPV
Further risks associated with a project changes over the project life. The association of project life and related risks (typical) are depicted below:
Main Risks Main Risks
Completion Risk performance Risk
Cost overrun Risk Regulatory Risk
Performance Risk Environmental Risk
Environmental Risk Offtake Risk
Once the various risks have been identified, the risks are apportioned and allocated through various contractual arrangements between parties and insurance. A general risk mitigating mechanism is depicted.