Vol. 6, No. 2, pp. 171-181, April 2008 Project Finance DEJAN ROMIH 2 ABSTRACT Project finance is enjoying renewed attention as a financing technique in which the lenders look primarily to the cash-flow of a project as the main source of loan reimbursement, whereas assets represent only collateral. Owing to the general misunderstanding of the terms used in respect of project finance, the purpose of the paper will be to provide clear definitions, drawing attention to different project finance transactions that can be placed on a continuum, with recourse to project sponsors ranging from non-recourse to almost complete recourse. Several characteristics of project finance will also be addressed. KEY WORDS: financial economics structured finance project finance non-recourse and limited recourse debt special purpose vehicle highly leveraged capital structure CORRESPONDENCE ADDRESS: asisst. Dejan Romih, BSc, University of Maribor, Faculty of Economics and Business, Razlagova 14, SI-2000 Maribor, Slovenia, e-mail: dejan.romih@uni-mb.si. ISSN 1581-5374 Print/1855-363X Online 2008 Lex localis (Maribor, Graz, Trieste, Split) UDK: 336.6 Avaliable online at http://pub.lex-localis.info.
172 LEX LOCALIS - JOURNAL OF LOCAL SELF-GOVERNMENT Introduction Public-sector projects were traditionally financed by public-sector debt. This had begun to change as privatization and deregulation changed the approach to financing investment in major public-sector projects, transferring a significant share of the financing burden to the private sector (Yescombe, 2002: 1). In recent years financing through the creation of an independent project company or financing by non-recourse or limited recourse debt has become an important part of public-sector financing decisions. The paper is organized as follows. Section 2 defines some of the terms used in respect of project finance. Section 3 addresses the project finance structure, whereas section 4 briefly concludes. Questions of definition Many of the terms used in the forthcoming sections are widely used, but often they are not clearly defined, in part, due to the complexity of the project finance structures. Project finance Project finance generally results in the creation of a new cash-flow producing asset, the value of which is a function of its capacity to generate cash-flows in the future and the uncertainty associated with these cash flows. It is illusive in terms of precise definition because there is no single technique that is immutably used each facility is tailored specifically to suit the individual project and the needs of the parties sponsoring it (Buckley, 2003: 587). Existing literature suggests several definitions of project finance. One of them defines project finance as the structured financing of a specific economic entity the special purpose vehicle, also known as the project company created by sponsors using equity or mezzanine debt and for which the lenders consider cash flow as being the primary source of loan reimbursement, whereas assets represent only collateral (Gatti, 2008: 2). 1 This definition highlights some key features of project finance which will be explained in detail in the forthcoming sections. A common misconception is that project finance means the same as financing projects. This is partly due to the lack of knowledge and experiences with project management. In theory at least, any given project can be financed in many different ways involving different combinations of senior debt, mezzanine and equity finance. 2
173 Project finance may be achieved through a variety of financial vehicles. 3 although it can be applied to a project within an existing company, typical applications involve the creation of a joint-venture with no sponsor being a majority owner and high levels of limited or none-recourse debt. In the case of large projects, different vehicles may be established to perform specific functions (e.g. construction, maintenance and actual ownership), but this is rarely the case. However, a vehicle may not always be required for a project. 4 Non-recourse project finance Non-recourse project financing is a common form of project finance. It limits the lenders recourse to the assets of the project in case of default by the project company. Because the debt is non-recourse, the project sponsors are removed from any obligation to repay the project debt or make interest payments if the project cash flow proves inadequate to service debt (Cf. Buljevich & Park, 1999: 122). Limited recourse project finance Limited recourse project financing permits project sponsors to limit their accountability for the debt financing of a project company to certain specific situations. It provides the lenders with recourse to the assets of the project sponsors up to a limited maximum amount and over a limited period (Delmon, 2005: 85). The amount of recourse necessary to support financing is determined by the unique risks presented in a project and the willingness of lenders to accept those risks (Hoffman, 2007: 5). Where the project does not provide sufficient protection to the lenders, they may want access to non-project assets to protect their interests. The purpose of various forms of shareholder support is to provide the lenders with a guarantee or undertaking from the project sponsors giving the lenders either access to further security or comfort that the project sponsors are committed to the project (Delmon, 2005: 90). Generally, the project company will be prohibited from transferring or assigning the assets backing the debt to any other entity, unless the assets assigned remain subject to the prior claims of the asset-backed debt holders (Rosenthal, 1988: 45). It is essential for the project company to have the power to give the lenders a security interest in the assets of the project for the purposes of project financing. Step-in provisions Under the project finance structure, the granting authority typically grants a concession to a project company under which the concessionaire will have the right to build, operate and maintain the project facility.
174 LEX LOCALIS - JOURNAL OF LOCAL SELF-GOVERNMENT Where the project company has failed in its obligation and the granting authority intends to terminate the concession agreement signed between those parties involved, the lenders often require some form of right to take over the project. Step-in provisions give lenders the right to step into the project company s rights and obligations in case of default under the project documents. However, the lenders themselves will not want to be involved in the actual step-in. They will generally mandate a substitute entity to step in for them (Delmon, 2005: 90). The step-in provisions give the lenders certain rights to intervene, including cure rights, step-in rights, substitution rights and novation. 5 Structured project finance Structured project finance may be defined as a financing technique in which the project sponsors assume some uncertainty in the project for a reduction in the risk premium otherwise payable to various contracting parties (Hoffman, 2007: 6). In this case, the financing is not without recourse to the project sponsors, because the lenders will require the risks not allocated to the various contracting parties to be retained by the project sponsors (Ibid.). Pooled project finance Pooled project finance may be defined as a financing technique in which a synthetic balance sheet is effectively created. Here the debt from a number of individual projects is pooled into a single debt security resulting in the crosscollateralization of cash-flow from the projects whereby the assets are not crosscollateralized (Filipenko, 2001: 3). Differences from corporate finance The choice of project finance over corporate finance essentially entails making trade-offs among many different characteristics. 6 Table 1 summarizes what some of those trade-offs might be.
175 Table 1: Main trade-offs between corporate and project finance Criterion Corporate finance Project finance Guarantees for Assets of the borrower Project assets. financing (already-in-place companies). Effect on Reduction of financial financial elasticity for the borrower. elasticity Accounting treatment Main variables underlying the granting of financing Degree of leverage utilizable Source: Gatti (2008: 4). Questions of structure On-balance sheet. Customer relations, solidity of balance sheet, and profitability. Depends on effects on borrower s balance sheet. No or heavily reduced effect for sponsors. Off-balance sheet (the only effect will be either disbursement to subscribe equity in the project company or for subordinated loans). Future cash flows. Depends on cash flows generated by the project (leverage is usually much higher). The key objective of using project finance is to create a structure that is bankable (i.e. of interest to potential investors) and to limit the stakeholders risk by diverting some forms of it to parties best able to manage them. Participants and contracts Project finance is essentially a nexus of contracts among various participants. 7 A typical project finance structure is presented diagrammatically in Figure 1.
Figure 1: Typical project finance structure GRANTING AUTHORITY SUPPLIERS Supply contract Concession agreement Off-take contract USERS LENDERS Loan agreement PROJECT COMPANY O&M contract OPERATORS SHAREHOLDERS Shareholders agreement Construction contract CONSTRUCTORS Other contracts OTHER CONTRACTORS
e 177 Participants As shown in Figure 1, project finance transactions involve a variety of participants: the granting authority (e.g. government); the shareholders of the project company ( project sponsors ); the project company; the lenders; the suppliers; the constructors; the operators; the users; various other contractors. The above participants will not be examined in detail since this would exceed the framework of the paper. An exception will be made only in the case of the project company due to the role it has in project finance. Project company The project company may be defined as a legal entity created to perform specific acts that are necessary for the purpose of performing a particular task the realisation of a single project. It is usually structured as a bankruptcy-remote entity 8 that is unlikely to become insolvent as a result of its own activities and is adequately insulated from the consequences of a sponsors bankruptcy. However, there is always a possibility, albeit a remote one, that it will become insolvent or otherwise does not comply with its obligations. The purpose of the project company is to invest in a self-contained asset which can exist on the market as an independent unit. In contrast to non-project financed companies which may invest in many projects simultaneously, the project company invests only in the particular project for which it was created. This is due to prevent its cash-flow from risk contamination or distress costs from any other project. However, the project company should always have the possibility to invest in other projects when failure to do so could lead to the failure of the general project. Key participants objectives Project finance participants have different objectives. Table 2 summarizes what some of those objectives might be.
178 LEX LOCALIS - JOURNAL OF LOCAL SELF-GOVERNMENT Table 2: Key participants objectives what might they include? Government to satisfy the public interest and have the project completed to achieve better valuefor-money than would be the case if the government procured the project in questions itself in a conventional manner to bring the project back into public ownership once the private sector has received an acceptable return on its investment to have adequate safeguards and assurances that the project will be operated properly and in the public interest to reduce or eliminate the need to use the government's own funds or borrowings to limit the undertakings given by the state to be able to offer the ownership and/or operation of the project to other private sector entities should the original private sector participants fail to provide the required level of service or run into financial difficulties to fetter the government's discretion as little as possible generally to transfer risk from the public to the private sector Source: Vinter (2005: 3-7). Private sector sponsors to satisfy a strategic objective by completing the project to extract profit to share the risk in carrying out a project to carry out a project offbalance sheet to retain control of the project for as long as possible in times of hardship Lenders to make profits to assume only measurable or measured risks to have control over key project decisions to take control of the project as soon as possible in times of hardship
179 Contracts As noted previously, the relationship among various participants in project finance is established through a variety of contractual arrangements. These primarily address and allocate risks associated with the project to the party best able to manage them (Merna & Njiru, 2002: 11). The contractual arrangements are based on the following agreements or contracts: the concession agreement; the shareholders agreement; the loan agreement; the supply contract; the construction contract; the operation and maintenance contract; the off-take contract; various other contracts. Capital structure Project finance permits the use of a highly leveraged capital structure for the financing of a project (Buljevich & Park, 1999: 123). Indebtedness levels acceptable in project finance structures vary from project to project, but debt-toequity ratios of seventy percent or more are commonly accepted (Ibid.). Although project sponsors will want to decrease the amount of investment they will need to supply, they are often required to contribute a reasonable amount of equity to the project company to ensure a high degree of involvement in, and commitment to, the success of the project and to reduce the project s overall debt service obligation to acceptable levels (Ibid.). While the project sponsors will prefer a higher debt-to-equity ratio, the lenders will prefer a lower one in order to obtain a greater investment from the project sponsors, and thus ensure the sponsors will not abandon the project when the first setback occurs; the reasonable equity commitment on behalf of the project sponsors can be the best way to mitigate this risk. Thus the actual debt-to-equity ratio will be the result of a compromise between those parties involved, based on various risk factors. 9 Conclusions The purpose of this paper has been to define some of the terms used in respect of project finance. Our attention has been drawn to different project finance transactions that can be placed on a continuum, with recourse to project sponsors ranging from non-recourse to almost complete recourse, as it is increasingly common in structured project finance. Several characteristics of project finance have also been addressed.
180 LEX LOCALIS - JOURNAL OF LOCAL SELF-GOVERNMENT We found that project finance enables projects to be built in markets using highly leveraged capital structure. In fact, the project company has usually the minimum equity required to issue debt at a reasonable cost, with equity generally averaging between ten and thirty percent of the total capital. Notes 1 Other definitions have been suggested. See, e.g., Finnerty (1996: 2). See generally Rowey et al. (2008), Hoffman (2007), Sullivan (2007), Esty (2004), Nevitt & Fabozzi (2000), Tinsley (2000), Pollio (2000), Buljevich & Park (1999). 2 For overview, see Delmon (2005: 82-85). 3 For overview, see Vinter (2005: 63-76). 4 For explanation, see Vinter (2005: 57-59). 5 For definition and detailed explanation, see Huse (2002: 69-70). 6 For overview, see Gatti (2008: 4), Bruner, Langohr & Campbell (1995: 4-5). 7 For detailed explanation, see Bruner, Langohr & Campbell (1995: 2-4). 8 For definition, see Marshall (2001: 17), Jenkison (2003: 327). 9 For detailed explanation, see Delmon (2005: 85). References Bruner, R. F. & Langohr, H. & Campbell, A. (1995). Project Finance: An Economic Overview, (Charlottesville: University of Virginia/Darden School Foundation). Buckley, A. (2003). Multinational Finance, 5 th Edition, (Harlow: Financial Times/Prentice Hall). Buljevich, E. & Park, Y. S. (1999). Project Financing and the International Financial Markets, (Norwel: Kluwer Academic Publishers). Delmon, J. (2005). Project Finance, BOT Projects and Risk, (The Hague: Kluwer Law International). Esty, B. C. (2004). Why Study Large Projects? An Introduction to Research on Project Finance. European Financial Management, 10(2), pp. 213-224. Filipenko, O. (2001). Financial Flexibility and Limited Recourse Project Finance, (New York: New York University, Stern School of Business). Finnerty, J. D. (1996). Project Financing: Asset-Based Financial Engineering, (New York: John Wiley & Sons). Gatti, S. (2008). Project Finance in Theory and Practice: Designing, Structuring, and Financing Private and Public Projects, (Burlington: Academic Press/Elsevier). Hoffman, S. L. (2007). The Law and Business of International Project Finance, 3 rd Edition, (Cambridge: Cambridge University Press). Huse, J. A. (2002). Understanding and Negotiating Turnkey and EPC Contracts, 2 nd Edition, (London: Sweet & Maxwell). Jenkison, T. (2003). Private Finance. Oxford Review of Economic Policy, 19(2), pp. 323-334. Marshall, J. F. (2001). Dictionary of Financial Engineering, (Chichester, New York: John Wiley & Sons). Merna, T. & Njiru, C. (2002). Financing Infrastructure Projects, (London: Thomas Telford). Nevitt, P. K. & Fabozzi, F. J. (2000). Project Financing, 7 th Edition, (London: Euromoney).
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