What is Project Finance?
So, what is project finance? project financing is essentially raising necessary equity and debt financing to build the infrastructure asset.
To understand the specificity of the project finance, let’s first take a look at a more conventional financing method which is corporate finance.
Suppose that we are looking at a large energy company such as Duke Energy, which is a company with 60 billion in market capitalization and operations in the United States and Canada.
Duke Energy may have numerous divisions such as gas power generation, coal power generation, and energy transmission divisions.
To finance its operations, Duke Energy sells its shares to investors and raises equity financing and raises debt financing from its bank.
This capital raising happens at the parent company level, and once the capital is raised, it is distributed to its divisions.
The divisions may also have a direct relationship with banks and raise debt financing directly, however, it would always carry the parent company guarantee, which would essentially mean financing at the parent level.
Now, suppose that Duke Energy wanted to invest in renewable energy projects and raise financing using project finance method.
Duke Energy would have to set up a special purpose vehicle as a project company. Special purpose vehicle or SPV is a limited liability company with a specific purpose such as building and operating a wind farm.
Furthermore, the SPV we will have to be ring-fenced, which means that it has to operate as a separate company from Duke Energy.
Ring-fencing is achieved when SPV has its own board of directors, its own bank accounts, its own financial reports, and accounting.
This SPV then would raise debt financing from the banks, and, equity financing from its sponsor. The assets that the project will build will serve as collateral for the loan the project company raises.
The debt would be repaid and dividends paid from the cash flow the project generates.
Since the SPV is a limited liability company, a sponsor, which is Duke Energy, in this case, would only risk losing the investment made in the project, so its risk would be limited.
This means that the debt financing provided to SPV is provided on a non-recourse basis. And, this means that if the SPV goes bankrupt, the bank cannot go after the project sponsor, there is no recourse to the project sponsor.
Another comparison that can be made to better understand project financing, is to compare project finance to mortgage financing.
In mortgage financing, the bank lends money to the property buyer to purchase the property. Typically, the bank would lend to the buyer 70% of the value of the property and would ask the buyer to finance the remaining 30% with his own money.
The bank would take the purchased property as collateral and in case the buyer has problems with loan repayment, the bank would sell the property to recover the mortgage loan.
There is significant collateral value in mortgage financing, therefore, mortgage is collateral-based financing.
In the project finance, as we saw in example with Duke energy, the assets of the project company will serve as a collateral.
These assets without the secured stream of revenue provided by the PPA, are not worth that much. The bank can still dismantle the wind turbines or solar panels and sell the equipment, but it will recover only a fraction of the loan value.
Hence, in project financing, there is very limited collateral value and project financing represents a cash flow based financing. The lenders will look only to cash flows of the project company to recover their loan interests and loan principal amount, and if those cash flows cease, it is highly likely that the bank will not recover its loan.
Let’s summarize the features of the project financing:
- We said that project financing is the financing of the ring-fenced SPV;
- It involves non-recourse debt financing;
- And, it is cash flow based financing.
Summing these all together, the definition of the project financing is:
Project finance is the financing of a long-term infrastructure project using a non-recourse financial structure, which relies only on the project’s cash flows for debt repayment, with the project’s assets held as collateral.
So if the lending to and investment in the project depend on the cash flows that the project generates, how can a newly formed project company generate those cash flows?
What happens is that the project company allocates all of the works that need to be done to achieve the cash flow generation to experienced third-parties who are “contractually obligated” to perform the work allocated to them (network of contracts). This includes construction and operation of the project, performing project maintenance, purchase of the project’s output and etc.
In this article, we learnt about the basic characteristics of project finance and how it is different from corporate finance. To learn about financial modelling for project finance please enroll in our courses:
Project Finance Modeling for Infrastructure Assets – https://www.financialmodelonline.com/p/project-finance-modeling-course
Project Finance Modeling for Renewable Energy – https://www.financialmodelonline.com/p/project-fin…