Project finance

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Project finance is the long term financing of infrastructure and industrial projects based upon
the projected cash flows of the project rather than the balance sheets of the project sponsors.
Usually, a project financing structure involves a number of equity investors, known as sponsors,
as well as a syndicate of banks that provide loans to the operation. The loans are most
commonly non-recourse loans, which are secured by the project assets and paid entirely from
project cash flow, rather than from the general assets or creditworthiness of the project sponsors,
a decision in part supported by financial modeling.[1] The financing is typically secured by all of
the project assets, including the revenue-producing contracts. Project lenders are given a lien on
all of these assets, and are able to assume control of a project if the project company has
difficulties complying with the loan terms.

Generally, a special purpose entity is created for each project, thereby shielding other assets
owned by a project sponsor from the detrimental effects of a project failure. As a special purpose
entity, the project company has no assets other than the project. Capital contribution
commitments by the owners of the project company are sometimes necessary to ensure that the
project is financially sound. Project finance is often more complicated than alternative financing
methods. Traditionally, project financing has been most commonly used in the mining,
transportation, telecommunication and public utility industries. More recently, particularly in
Europe, project financing principles have been applied to public infrastructure under public–
private partnerships (PPP) or, in the UK, Private Finance Initiative (PFI) transactions.

Risk identification and allocation is a key component of project finance. A project may be
subject to a number of technical, environmental, economic and political risks, particularly in
developing countries and emerging markets. Financial institutions and project sponsors may
conclude that the risks inherent in project development and operation are unacceptable
(unfinanceable). To cope with these risks, project sponsors in these industries (such as power
plants or railway lines) are generally completed by a number of specialist companies operating in
a contractual network with each other that allocates risk in a way that allows financing to take
place.[2] The various patterns of implementation are sometimes referred to as "project delivery
methods." The financing of these projects must also be distributed among multiple parties, so as
to distribute the risk associated with the project while simultaneously ensuring profits for each
party involved.

A riskier or more expensive project may require limited recourse financing secured by a surety
from sponsors. A complex project finance structure may incorporate corporate finance,
securitization, options, insurance provisions or other types of collateral enhancement to mitigate
unallocated risk.[2]
Project finance shares many characteristics with maritime finance and aircraft finance; however,
the latter two are more specialized fields.

Contents
[hide]

 1 Basic scheme
 2 Complicating factors
 3 History
 4 See also
 5 References
 6 External links

[edit] Basic scheme

Hypothetical project finance scheme

Acme Coal Co. imports coal. Energen Inc. supplies energy to consumers. The two companies
agree to build a power plant to accomplish their respective goals. Typically, the first step would
be to sign a memorandum of understanding to set out the intentions of the two parties. This
would be followed by an agreement to form a joint venture.

Acme Coal and Energen form an SPC (Special Purpose Corporation) called Power Holdings Inc.
and divide the shares between them according to their contributions. Acme Coal, being more
established, contributes more capital and takes 70% of the shares. Energen is a smaller company
and takes the remaining 30%. The new company has no assets.

Power Holdings then signs a construction contract with Acme Construction to build a power
plant. Acme Construction is an affiliate of Acme Coal and the only company with the know-how
to construct a power plant in accordance with Acme's delivery specification.

A power plant can cost hundreds of millions of dollars. To pay Acme Construction, Power
Holdings receives financing from a development bank and a commercial bank. These banks
provide a guarantee to Acme Construction's financier that the company can pay for the
completion of construction. Payment for construction is generally paid as such: 10% up front,
10% midway through construction, 10% shortly before completion, and 70% upon transfer of
title to Power Holdings, which becomes the owner of the power plant.

Acme Coal and Energen form Power Manage Inc., another SPC, to manage the facility. The
ultimate purpose of the two SPCs (Power Holding and Power Manage) is primarily to protect
Acme Coal and Energen. If a disaster happens at the plant, prospective plaintiffs cannot sue
Acme Coal or Energen and target their assets because neither company owns or operates the
plant.
A Sale and Purchase Agreement (SPA) between Power Manage and Acme Coal supplies raw
materials to the power plant. Electricity is then delivered to Energen using a wholesale delivery
contract. The cashflow of both Acme Coal and Energen from this transaction will be used to
repay the financiers.

[edit] Complicating factors

The above is a simple explanation which does not cover the mining, shipping, and delivery
contracts involved in importing the coal (which in itself could be more complex than the
financing scheme), nor the contracts for delivering the power to consumers. In developing
countries, it is not unusual for one or more government entities to be the primary consumers of
the project, undertaking the "last mile distribution" to the consuming population. The relevant
purchase agreements between the government agencies and the project may contain clauses
guaranteeing a mimimum offtake and thereby guarantee a certain level of revenues. In other
sectors including road transportation, the government may toll the roads and collect the revenues,
while providing a guaranteed annual sum (along with clearly specified upside and downside
conditions) to the project. This serves to minimise or eliminate the risks associated with traffic
demand for the project investors and the lenders.

Minority owners of a project may wish to use "off-balance-sheet" financing, in which they
disclose their participation in the project as an investment, and excludes the debt from financial
statements by disclosing it as a footnote related to the investment. In the United States, this
eligibility is determined by the Financial Accounting Standards Board. Many projects in
developing countries must also be covered with war risk insurance, which covers acts of hostile
attack, derelict mines and torpedoes, and civil unrest which are not generally included in
"standard" insurance policies. Today, some altered policies that include terrorism are called
Terrorism Insurance or Political Risk Insurance. In many cases, an outside insurer will issue a
performance bond to guarantee timely completion of the project by the contractor.

Publicly-funded projects may also use additional financing methods such as tax increment
financing or Private Finance Initiative (PFI). Such projects are often governed by a Capital
Improvement Plan which adds certain auditing capabilities and restrictions to the process.

[edit] History
Limited recourse lending was used to finance maritime voyages in ancient Greece and Rome. Its
use in infrastructure projects dates to the development of the Panama Canal, and was widespread
in the US oil and gas industry during the early 20th century. However, project finance for high-
risk infrastructure schemes originated with the development of the North Sea oil fields in the
1970s and 1980s. For such investments, newly created Special Purpose Corporations (SPCs)
were created for each project, with multiple owners and complex schemes distributing insurance,
loans, management, and project operations. Such projects were previously accomplished through
utility or government bond issuances, or other traditional corporate finance structures.
Project financing in the developing world peaked around the time of the Asian financial crisis,
but the subsequent downturn in industrializing countries was offset by growth in the OECD
countries, causing worldwide project financing to peak around 2000. The need for project
financing remains high throughout the world as more countries require increasing supplies of
public utilities and infrastructure. In recent years, project finance schemes have become
increasingly common in the Middle East, some incorporating Islamic finance.

The new project finance structures emerged primarily in response to the opportunity presented
by long term power purchase contracts available from utilities and government entities. These
long term revenue streams were required by rules implementing PURPA, the Public Utilities
Regulatory Policies Act of 1978. Originally envisioned as an energy initiative designed to
encourage domestic renewable resources and conservation, the Act and the industry it created
lead to further deregulation of electric generation and, significantly, international privatization
following amendments to the Public Utilities Holding Company Act in 1994. The structure has
evolved and forms the basis for energy and other projects throughout the world.

[edit] See also

 Power Purchase Agreement
 Mandated Lead Arranger

[edit] References
1. ^ See generally, Scott Hoffman, The Law & Business of International Project Finance (3rd ed.
2007, Cambridge Univ. Press).
2. ^ a b Marco Sorge, The nature of credit risk in project finance, BIS Quarterly Review, December
2004, p. 91.

[edit] External links

 HBS Project Finance Portal http://www.people.hbs.edu/besty/projfinportal/

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