All About Project Finance

Project Finance - Infrastructure

Project Finance Business

Most of the people in the project finance business have dedicated their lives to implementing around the world, big changes and great ideas such as supplying energy, water, transportation, and other infrastructure. Through private sector investment, they aim to do good for the world including alleviation of poverty through economic development and creating businesses for other industries. Massive amounts of capital have flowed around the world in support of this as big companies pursue this idea as well as the public and private equity markets with the vision of growth and profitability.

However, as time passed by, big changes also happened where it affected the emerging markets infrastructure. These cases are the following:

  • Project in some cases do have benefits for the public (e.g. public transport, roads, public water supply) but in most cases, are better off when executed through private companies (e.g. Electricity plants, real estate developments, oil & gas drilling, mining, refineries, etc.)
  • Most projects are large in size requiring millions if not billions of Dollars of funding
  • Public sector turns to the private sector for funding but also for launching and managing such projects
  • Project risk should be born or shared with the private sector

Such cases will most likely to continue in private infrastructure investment, hence, the emergence of public-private partnerships became common. The private build-own-transfer (BOT) or build-own-operate (BOO) model does not appear to be the right answer that the infrastructure industry needs as it was supposed to be. New models have arisen for partnerships between public and private sectors to provide greater assurance of project viability and greater incentives for performance by other parties.

As the struggle for infrastructure projects continue, it is likely that project financing will continue to play a major role in the sound and creditworthy structuring of projects. Basically, projects fill an important social need so it’s fundamentally sound and low-cost, have sponsors with financial resources and patience to work through hitches. Thus, it enabled investors and lenders to recover a much higher rate of their investment compared to similarly rated corporate investments.

What is Project Finance?

Project finance is the financing of long-term infrastructure, industrial projects, and other public services based on a non-recourse or limited recourse financial structure. It is when the project pays back the debt and equity incurred by the project, by making use of the project’s generated cash flow. Basically, Project Financing is a loan structure that is dependent on using the project’s cash flow while using the project’s assets, rights, and interests as collateral.

According to its definition, it is clear to see that project finance is only possible when the project itself has the ability to generate cash to cover all the expenses incurred for the project and at the same time have enough cash to pay off the debt. Hence, project finance is more popular and attractive to private sectors because companies are guaranteed to fund certain major projects off balance sheet. Thus, this will not affect the credit of the stockholders or government regulators and shift some of the project risks to the debtors, resulting in a gain of a higher rate compared to normal corporate lending.

In conclusion, project finance is generally defined as the provision of funds for a single purpose facility or facilities that generate cash flow to repay the debt. Debt is secured by the project’s assets and cash flows, not by the assets or general credit of the project’s investors. Therefore, the debt is issued with no recourse, or, in some cases, with limited recourse, to the project sponsors.

Key Concepts of Project Finance

Project finance is often used for capital-intensive facilities such as power plants, toll roads, telecommunications facilities, industrial plants, refineries, etc. For the entities providing the financing, the essence of project finance is the analysis of project risks such as construction risks, operating risks, market risks, regulatory risks, insurance risks, and currency risks. Presumably, a sponsor’s investment in a project and the related income or losses would be combined with other items on its balance sheet and income statement. It would be then considered a good practice to include some footnotes emphasizing on disclosure and transparency towards the project and the parties involved.

Now, you might be wondering what is the typical project finance structure? What is non-recourse or limited recourse financial structure? What is off balance sheet? Let’s discuss it one by one.

(1) Typical Project Finance Structure

As an example, we’ll use the B.O.T. or build, operate, and transfer project as the basis of showing a typical project finance structure.

BOT projects usually include a special purpose vehicle (SPV). The company’s sole activity is generally carrying out the project, which involves subcontracting such as the construction contract and operations contract. When building new projects, it is clear that there won’t be any revenue stream generated. So, the debt service won’t be effective until the project is capable once it starts its operations phase. This shows that the trust between parties involved, taking great risks during the construction phase. Which is why the sole revenue stream is likely under a power purchase agreement. And since, there is limited and no recourse to the shareholders of the project, the project remains off-balance sheet.

(2) Non-Recourse/ Limited Recourse Financing

The difference between non-recourse financing and recourse financing is, in recourse financing, the lenders are given a full recourse to the assets or cash flow of the shareholders to repay the loan in the case of failure by the SPV. Once the project or the SPV fails to provide the lenders the agreed repayments, this will give the lenders the right to possess the assets and revenue of the shareholders with no limitation.

On the other hand, in project financing, it follows non-recourse or limited financing. The project is basically given a limited liability SPV. Therefore, giving the lenders a limited recourse primarily and entirely to the project’s assets, including the guarantees, bonds, and completion, in the case of project defaults.

It is critical to take note that in non-recourse financing, there might be circumstances that will arrive in which the lenders will have opportunities to gain recourse to some or all of the shareholders’ assets. This is obviously a breach of contract on part of the agreement between the parties. Hence, applicable laws may restrict the extent where shareholder liability can be limited.

(3) Off Balance Sheet Items

In project financing, it is allowed for the shareholders to keep the financing and liabilities of the project off balance sheet. Generally, the project debt held is not consolidated onto the balance sheet of the respective shareholders. Thus, reducing the impact of the project on the cost of the existing debts of the shareholders and their debt capacity, allowing them to be capable of issuing other investments. Obviously, any project structure that conducts off balance sheet needs to be considered carefully under applicable law and accountancy rules.

The government can also use project finance to keep the debt and liabilities incurred by the project off balance sheet, but of course only to a certain extent to take up less fiscal space. Keeping debt off balance sheet does not reduce the actual liabilities of the government, but merely disguising its condition, reducing the effectiveness of the government debt monitoring mechanisms.

As a reminder for policy issue, using off balance sheet debt needs to be scrutinized properly and prepare for protective mechanisms to be implemented together with it.

Why Project Finance is Used

Project finance can be more leveraged than traditional on-balance-sheet financing, resulting in a lower cost of financing. In some countries with power, project finance allows governments to provide support without taking additional direct debt. For sponsor companies, project finance may accomplish one or more of the following cases:

  • Financing a joint venture
  • Undertaking a huge project too big for one sponsor
  • Assigning risks to parties which can control them
  • Insulating corporate assets from project risk
  • Keeping debt off the corporate balance sheet
  • Protecting the corporate borrowing capacity
  • Maintaining credit rating
  • Improving the Return on Equity (ROE)
  • Restricting information to a limited number of investors
  • Avoiding double taxation
  • Sharing ownership of projects with employees
  • Establishing a business venture outside the country

Sources of Capital for Project Finance

Bank and other Financing Sources

Based on past events, commercial banks have provided most of the construction financing for projects while the insurance companies have provided take-out financing with terms or 20 years or more. Relatively, banks were more familiar with construction risks and short-term loans, while the insurance companies handled the long-term operating risks. However, the investor base for project finance began to broaden for now it includes institutional investors such as pension and mutual funds, investors in the public bond markets, and other private sectors. Others have also been able to get their financing through public markets in exchange for securities and grew rapidly. Such case became an important source of funding for project finance as of today.

Preparing a Project Finance Model XLS

As investors and lenders became more familiar with project finance, it is no wonder that they showed increasing risk tolerance as well as vigilance towards the feasibility of the project. How do companies, investors (public or private equity), lenders, banks, etc., assess the economic feasibility and ability of the project to pay back? It is none other than preparing a financial model to help assess the economic feasibility of the project. This will be used in creating a proper framework for a project finance deal. Most importantly, it is used to determine the maximum amount of debt the project can incur and a proper repayment plan.

Generally, the framework of any financial model is very simple: input – calculation algorithm – output. While in the project finance model, it is more or less uniform and the calculation algorithm is predetermined by the accounting rules, where the input is highly project-specific. It is subdivided into categories such as:

  • Variables for forecasting revenues
  • Variables for forecasting expenses
  • Capital expenditures
  • Financing

Did you notice that most financial models end with an xls file extension? XLS file extension stands for an excel file. To have a better outlook or view on a structured model, using Excel is preferable. Since building a project finance model xls typically consist of the usual accounting spreadsheets like balance sheet, income statement, cash flow, retained earnings, taxes, present values, etc.

You might have heard of the term Debt Sculpting as it is common in project finance modeling. Basically, it calculated the principal repayment liability to make sure that the principal and interest liabilities are matched properly to the expected pattern of the cash flows in each period. The calculation algorithm will be easily understood and done by making use of the excel tool features.

A project finance model xls is usually build to serve as a base and conducting a sensitivity analysis is critical, to determine the effects and changes in input variables on key outputs such as internal rate of return, net present value and payback period.

Financial Modeling Project Finance – Downloading Financial Model Project Finance Templates

Financial modeling project finance is, of course, not an easy task. Building a financial model project finance will require one the know-how behind the industry as well as how to build the model itself. If you are interested in project finance modeling, then you can try out our financial model templates related to project finance such as: Infrastructure Industry Financial Model Templates.

Since financial modeling project finance involves a complex structure as well as huge amount of funds, the need to conduct a proper risk analysis is needed especially for ensuring the rate of return. If you plan to build a financial model project finance analysis targeting the IRR, you can check out this model template as well: IRR Project Finance Analysis. This template will allow you to forecast the expected financials for a greenfield project and calculate the levered and unlevered IRR.

Below is a screenshot of the said template:

IRR Project Finance Analysis
IRR Project Finance Analysis

Our model templates are downloaded and used by various users from different countries such as Australia, Japan, Germany, Switzerland, Singapore, and many more who are in need of help with their tasks in financial modeling.