Corporate & Project

Financing Options
Project Financial Management

Ata ul Musawir
Corporate Finance structure vs.
Project Finance structure
Part 1: Corporate
Financing Options
Corporate Financing Types
Debt and Equity on the Balance Sheet

Debt Financing: loan capital

Equity Financing: share capital

and retained earnings
Debt Financing
Debt financing is where you borrow money from a lender that
you’ll eventually pay back, usually with interest

(1) Short-term debt (<1 year) includes:

• Bank overdrafts
• Lines of credit
• Trade credit from other organizations (e.g. suppliers)
• Short-term bank loans (notes)

(2) Long-term debt (>1 year) includes:

• Long-term bank loans
• Long-term bonds issued by an organization that are purchased by
individuals and other organizations
• Mortgage on property
Debt Financing
Senior vs. Subordinated Debt

• Difference between senior debt and subordinated debt is

the priority in which the debt claims are paid by a firm in
bankruptcy or liquidation

• If a company has both subordinated debt and senior debt

and has to file for bankruptcy or faces liquidation, the senior
debt is paid back first before the subordinated debt

• Once the senior debt is completely paid back, the company

then repays the subordinated debt
Equity Financing
Equity financing is where

(1) You trade ownership of your business to investors in return

for their capital:
• In a sole trader business, equity is the money invested by the
business operator (full ownership)
• In a partnership, equity is the money invested by partners
• In a private limited company, investors may be close friends and
family who invest money and acquire shares in the company
• In a public limited company, the shares are traded on a public stock
exchange where the public may purchase shares

(2) You reinvest profits back into the business:

• Some profits are paid as dividends to investors, rest are reinvested
into the business
The Concept of Limited Liability
 Equity Financing
Preferred Stock vs. Common Stock Equity

• First, preferred stockholders have a higher priority than common

stockholders:
• When a company has excess cash and distributes the cash as dividends, preferred
stockholders are paid before common stockholders
• When a company becomes insolvent and must liquidate assets, preferred
stockholders receive money before common stockholders

• Second, the dividends to preferred stocks are paid at regular intervals

whereas dividends to common stocks are paid when the Board of Directors
says so

• If a company skips a preferred stock dividend payment (e.g. if it faced a

loss), it becomes an accrued payment, i.e. the company must make that
payment first in the next profitable period before any additional dividends
on common stock are paid

• However, unlike common stockholders, preferred stockholders do not

have any voting rights regarding corporate policy or decisions of the board
Equity vs. Debt Financing
Financial Markets for Debt and
Equity Financing
A security is a generic name given to any tradeable financial asset,
which can be debt or equity

Equity and debt securities are traded through financial markets:

• The money market is concerned with the buying and selling of
short-term (less than one year original maturity) government and
corporate debt securities
• Stocks have an indefinite life so they are not traded here

• The capital market, on the other hand, deals with relatively long-
term (greater than one year original maturity) debt and equity
securities, includes bonds and stocks
• Bonds are debt where the lender receives interest payments at fixed
intervals, the principal amount is repaid to the lender at the end of the
bond’s term
Financial Markets for Debt and
Equity Financing
• Within capital markets there exist both primary and
secondary markets, i.e.:
• A primary capital market (e.g. IPOs)
• A secondary capital market (e.g. stock exchanges)

• Primary markets trade is new issues of securities. Here the

issuer of the security trades directly with the purchaser of
the security.

• Secondary markets trade is existing securities. Here,

individuals and firms may trade securities they currently
own with each other.
Financial Markets for Debt and
Equity Financing
Financial Markets for Debt and
Equity Financing
Investopedia’s Stock Simulator Game

https://www.investopedia.com/simulator/
Pakistan Stock Simulator Game

https://www.pakstockexchange.com/stock3/
Mezzanine Financing
• Mezzanine financing is a hybrid of debt and equity financing

• Takes the form of subordinated loans as a short-term project

financing solution that is paid back after the senior debt

• Gives the lender the rights to convert the debt to an ownership or

equity interest in the company in case of default

• Usually completed with little due diligence on the part of the

lender and little or no collateral on the part of the borrower

• Treated as equity on the borrower’s balance sheet

Comparison of Corporate Financing
Types: Risk & Payment Priority
Comparison of Corporate Financing
Types: Common Financing Conditions
KIBOR Rates Announced by SBP

LIBOR URL (non-official): http://www.global-rates.com/interest-rates/libor/libor.aspx

KIBOR URL (official): http://www.sbp.org.pk/ecodata/kibor_index.asp
Other Corporate Financing Options
• Factoring. Sometimes a business may find immediate short-term
financing by selling its receivables (e.g. invoices) to a specialized
third party entity known as a ‘factor’ (usually a bank or factoring
company) that charges a commission.

• Contractual (vendors/contractors) finance. A contractor,

subcontractor, or equipment and materials supplier may offer
finance as part of the bid (as a way to secure the contract).

• Leasing. The organization performing the project may lease

vehicles and equipment needed to perform a project to cover up
for shortfalls in finance. Conversely, unused assets may be leased
to generate income.

• Asset-Backed Securitization (ABS). Organizations can sell the

rights to the future cashflows of the projects for capital to
perform the project. This is the principle behind project financing.
Mortgage-backed Securities and the 2008 Financial Crisis
An Artistic Use of Asset-backed Securitization
Weighted Average Cost of Capital (WACC)
• Each type of financing has some costs associated with it:
• Equity financing involves paying dividends to investors
• Debt financing involves paying interest to creditors

• A firm’s cost of equity and cost of debt can be calculated and

expressed in percentage terms

• These individual costs can then be weighted by the proportion of

capital that was financed through equity and debt (e.g. 70%
equity and 30% debt)

• The sum of their weighted costs is the Weighted Average Cost of

Capital (WACC)
Weighted Average Cost of Capital (WACC):
An Example

The WACC in this case is 11.40%

 Weighted Average Cost of Capital (WACC)
CAUTION!
• When calculating WACC, you are multiplying two percentage values.

1. Convert both percentages to decimal format, e.g.:

6.6% * 30% = 0.066 * 0.30

2. Then multiply, e.g.:

0.066 * 0.30 = 0.0198

3. Finally, convert the answer back to percentage, e.g.:

0.0198 * 100 = 1.98%
Weighted Average Cost of Capital (WACC)

• The WACC represents the minimum rate of return at which a company

produces value for its investors. Let's say a company or project produces a
return (IRR) of 20% and has a WACC of 11.40%. That means that for every
$1 the company invests into capital, the company is creating 8.6% or 8.6
cents of value/profit.

• By contrast, if the company’s or project’s IRR is less than WACC, the

company or project is losing value, which indicates that investors should
put their money elsewhere.

• Logic is that the return on a company or project investment should be

greater than the cost of financing the investment.
Weighted Average Cost of Capital (WACC)
• Securities analysts use WACC all the time when valuing and
selecting investments. In discounted cash flow analysis, for
instance, WACC is used as the discount rate applied to future cash
flows for deriving a business’s or project’s net present value.

• WACC and its equivalents can be calculated at multiple levels:

• WACC for the overall firm
• WACC-equivalent for a particular firm division
• WACC-equivalent for a particular project

• WACC (firm level or project level) is often used as the discount

rate for project investments.
• Project-level WACC-equivalent is necessary when project financing is used
Recall that the IRR is the discount rate where
NPV = 0

Net Present Value (NPV)

Weighted Average Cost of Capital (WACC)
When WACC is used as the discount rate:

• If the project’s IRR = WACC, this means returns = costs. NPV will
be 0 and the project will break-even, i.e. just cover it’s cost of
capital.

• If the project’s IRR > WACC, this means returns > costs. NPV will
be positive, i.e. the project will not only cover it’s cost of capital
but also generate a profit.

• If the project’s IRR < WACC, this means returns < costs. NPV will
be negative, i.e. the project will not be able to cover it’s cost of
capital and will generate a loss.
Corporate Financing may not Always
be Suitable

• Under some circumstances, corporate financing options are not

suitable for financing projects

• Project financing options need to be considered

Part 2: Project Financing
Large Projects involve Large Risks

https://theecologist.org/2014/apr/22/large-dams-are-uneconomic
What is Project Finance?
• A long-term financing technique to raise funds for an
economically separable capital-intensive project

• Fund providers look at cash flows from the project to repay their
loans and/or provide return on their equity invested on the
project

• Usually a mixture of debt and equity financing, but mostly debt

(typically 70%-90% debt)

• Whereas a typical loan is issued to an organization which is then

liable to repay the loan, in project financing the loan is issued
directly to the project itself
What is Project Finance?
Sources of funds:
1. Project finance-based debt, provided by one or more lenders
2. Equity, provided by investors in the project (often the
sponsoring organization is the main or only equity investor)

• Lenders have first right on the project’s net operating cashflows –

lower risk so expect a lower rate of return
• Cashflows generated by the project are used as both the source of
repayment as well as security for the loans
• Project’s assets may also be used as security for the loans

• Equity investors have second right so their return is more

dependent on the success of the project – higher risk so expect a
higher rate of return
Corporate Finance structure vs.
Project Finance structure
When to Use Project Finance?
• Project financing is usually for large, complex, and
expensive installations that might include:
• Power plants
• Chemical processing plants
• Mining infrastructure
• Transportation infrastructure
• Environmental infrastructure
• Telecommunications infrastructure

• Project finance may take the form of:

• Financing of the construction of a new capital installation, or
• Financing the renovation of an existing installation
When to Use Project Finance?
When the sponsoring organization wants to undertake projects that are:

• Highly risky
• more risk than the organization can/wants to bear
• organization wants to consider possibility of sharing risks with other organizations

• Require a lot of capital

• exceeds the capital available or the amount the organization is willing to invest

• Are long-term investments

• usually 10-25+ years

• Involve multiple, often international parties

• often over 10 parties involved in various capacities

• Additionally, project financing may be preferred when sponsoring

organization does not want to increase debt on its own balance sheet
Real Examples of Project Finance
Some major project finance deals over the past few years:

• $10bn Caspian oilfields project

• $4bn Chad-Cameroon pipeline project

• $6bn Iridium global satellite project

• $1.4bn aluminum smelter in Mozambique

• €900m A2 Road project in Poland

Case: BP-Amoco and the Caspian oilfields
Case: BP-Amoco and the Caspian oilfields
Case: BP-Amoco and the Caspian oilfields

Background: In 1999, BP-Amoco, the largest shareholder in AIOC,

the 11 firm consortium formed to develop the Caspian oilfields in
Azerbaijan, had to decide the mode of financing for its share of the
$8bn 2nd phase of the project. The first phase cost $1.9bn.

Key Issues:
• Size of the project (both phases): $10bn
• Political risk of investing in Azerbaijan, a new country
• Risk of transporting the oil through unstable and hostile countries
• Industry risks: price of oil and estimation of reserves
• Financial risk: Asian crisis and Russian default
Case: BP-Amoco and the Caspian oilfields
Structural choice: Project finance
• Effective financing option for raising large amount of capital
needed

• Risk sharing: Increase the number of participants to 11 and

decrease the relative exposure for each participant. Since
partners are heterogeneous in financial size/capacity, use project
finance.
• SPV was a joint venture between the 11 participants

• Staged investment: 2nd phase ($8bn) depends on the outcome of

the 1st phase investment. Improves information availability for the
creditors and decreases cost of debt in the 2nd phase (as more
information is known, creditors will demand less returns).
Case: The Chad Cameroon Project
Case: The Chad Cameroon Project
Background: An oil exploration project sponsored by Exxon-
Mobil in Central Africa with two components:
• Field system: Oil wells in Chad, cost: $1.5bn.
• Export System: Pipeline through Chad and Cameroon to the
Atlantic, cost: $2.2bn.

Key Issues:
• Chad is a very poor country ruled by President De’by, a
‘warlord’ (risk of expropriation/forced takeover of field
system and pipeline)
• Possibility of hold up by Cameroon
• Possible environmental impacts and risks
Case: The Chad Cameroon Project
Structural choice: Hybrid (mix of corporate & project finance)
• ExxonMobil (40%), Petronas (35%), and Chevron (25%) acted
as joint sponsors for the project
• SPV was joint venture between these 3 corporations
• Contributed equity financing and shared risk

• 3% investment from governments of Chad and Cameroon

• $100M debt from World Bank

• $200M debt each from U.S. and France’s Export-Import

banks
Case: The Chad Cameroon Project
Structural choice: Hybrid (mix of corporate & project finance)

• Exxon-Mobil chose corporate finance for oil fields since

investment size is relatively small

• Exxon-Mobil chose project finance for the pipeline to

diversify and mitigate risk

• Involves the two nations of Chad and Cameroon to prevent

post opportunistic behavior with the export system
Case: Australia-Japan Cable
Background: 12,500km cable from Sydney, Australia to Japan via Guam
at a cost of $520m. Key sponsors: Japan Telecom, Telstra and Teleglobe.
Asset life of 15 years.

Key Issues:
• Limited growth potential
• Market risk from fast changing telecom market
• Risk from project delay
• Specialized use asset: Need to get buy in from landing stations and pre-
sell capacity to address issue of “Hold Up”
• Significant Free Cash Flow
Case: Australia-Japan Cable
Structural highlights:
• Avoid Hold up Problem through governance structure:
• Long term contracts with landing stations.
• Joint equity ownership of asset with Telstra and landing station
owners both as sponsors.
• High project leverage of 85%
• Concentrates ownership and reduces equity investment.
• Shares project risk with debt holders.
• Enforces contractual agreement by pre-allocating the revenue
waterfall. Enforces Management discipline.
• Short term debt allow for early disgorging of cash.
Case: Poland’s A2 Motorway
Case: Poland’s A2 Motorway
Background: AWSA is a special-purpose 18 firm consortium
with concession to build and operate toll road as part of
Paris-Berlin-Warsaw-Moscow transit system. Seeking
financing for the €1bn deal. Is being asked to put in
additional € 60-90m in equity (25% equity).

Key Issues:
• Assessment of project risk and allocation of risks.
• How can project risk best be managed?
• Developing a structuring solution given the time
pressure.
Case: Poland’s A2 Motorway
Structure for allocation of Risk
• Construction Risk:
• Best controlled by builder and government.
• Fixed priced turnkey contract with reputed builder.
• Government responsible for procedural delay and support infrastructure.
• Insurance against Force Majeure, adequate surplus for contingencies.
• Operating Risk:
• Best controlled by AWSA and the operating company.
• Multiple analyses by reputable entities for traffic volume and revenue
projections.
• Comprehensive insurance against Force Majeure.
• Experienced operators, road layout deters misuse.
 Case: Poland’s A2 Motorway
Structure for allocation of Risk
• Political Risk:
• Best controlled by Polish Government and AWSA.
• Assignment of revenue waterfall to government: Taxes, lease and profit
sharing.
• Use of UK law, enforceable through Polish courts.
• Counter guarantees by government against building competing systems,
ending concession.
• Financial Risk:
• Best controlled by Sponsor and lenders.
• Contracts in € to mitigate exchange rate risk.
• Low senior debt, adequate reserves and debt coverage, flexible principle
repayment.
• Control of waterfall by lenders gives better cash control.
• Limited floating rate debt with interest rate swaps for risk mitigation.
Case: Petrolera Zuata, Petrozuata C.A.
Background: $2.4bn oil field development project in Venezuela
consisting of oil wells, two pipelines and a refinery. It is sponsored by
Conoco and Marvan who intend to raise a portion of the $1.5bn debt
using project bonds.

Key Issues:
• What should be the final capital structure to keep the project viable?
• What is the optimum debt instrument and will the debt remain
investment grade?
• How can the project structure best address the associated risk?
 Case: Petrolera Zuata, Petrozuata C.A.
Operational Risk Management
• Pre Completion Risk
• Includes resource, technological and completion risk.
• Resource and technology not a major factor ( 7.1% of resources consumed and
proven technology).
• Sponsor’s guarantee to mitigate completion risk.
• Post Completion Risk
• Market risk and force majeure.
• Quantity risk is mitigated by off-take agreement with CONOCO. However price
risk not addressed due to secure deal fundamentals.
• Sovereign Risk
• Key risk is of expropriation. Exchange rate volatility is a minor consideration.
• Fear of retaliatory action on expropriation. Government ownership of PDVSA.
 Case: Petrolera Zuata, Petrozuata C.A.
Financial Risk and Capital Structure
• Financial Risk:
• Optimum leverage at 60% for investment grade rating.
• Evaluation of Debt Alternatives
• BDA/ MDA: Reduced political insurance, and loan guarantees at higher
cost and time delay.
• Uncovered Bank Debt: Greater withdrawal flexibility at a fee. Shorter
maturity, size and structure restrictions, variable interest rate.
• 144A bond market: Longer term, fixed interest rates, fewer restrictions
and larger size. Relatively new and negative carry.
• Equity returns:
• Equity can be adjusted within reason to get better rating.
Case: Calpine Corporation
Background: $1.7bn company with 79% leverage seeking
over $6bn in financing to construct 25 new power plants.
Changing Regulatory Environment allows for selling of
power at wholesale prices over existing transmission
systems with no discrimination in price or access. Firm
wants to change from IPP to Merchant power provider.

Key Issues:
• Seizing the initiative and exploiting first mover’s advantage
• Possible alternative sources for finance
• Limited corporate debt capacity
Case: Calpine Corporation
Options for Project Structure:
• Corporate Finance:
• Public Offering of senior notes.
• Project Finance :
• Bank loans 100% construction costs to Calpine subsidiaries for each plant.
• At completion 50% to be paid and rest is 3-year term loan.
• Revolving credit facility:
• Creation of Calpine Construction Finance Co. (CCFC) which receives
revolving credit.
• Debt Non-recourse to Calpine Corp.
• High degree of leverage (70%).
• 4 year loan allowing construction of multiple plants.
Case: Calpine Corporation
Comparison of Financing Routes:
• Corporate Finance:
• Higher leverage: violates debt covenant for key ratios.
• Issuance of equity to sustain leverage would dilute equity.
• Debt affected by the volatility in the high yield debt market.
• Project Finance:
• Very high transaction costs given size of each plant.
• Time of execution: potential loss of First Mover advantage.
• Hybrid Finance:
• Best of Corporate and Project Finance.
• Low transaction costs and shorter execution time.
• New entity can sustain high debt levels: ability to finance.
• Non-recourse debt reduces distress cost for Calpine Corp.
 Case: Iridium LLC
Background: A $5.5bn satellite communications project backed by
Motorola which went bankrupt in 1999 after just one year of operations.
Had partners in over 100 countries.

Issues:
• Scope of the project: 66 satellites, 12 ground stations around the world and
presence in 240 countries.
• High technological risk: untested and complex technology.
• Construction risk: uncertainty in launch of satellites.
• Sovereign risk: presence in 240 countries.
• Revolving investment: replace satellites every 5 years.
 Case: Iridium LLC

Structural highlights:
• Stand alone entity: Size, scope and risk of the project in comparison to
Motorola. Allows for equity partnerships and risk sharing.
• Target D/V ratio of 60%:
• Cannot be explained by trade off theory since tax rate is 15% only.
• Pecking order theory and Signaling theory also do not explain the high D/V
ratio.
• Agency theory best explains the D/V: Management holds only 1% of equity and
the project has projected EBITDA of $5bn resulting in high agency cost of
equity. Also, since Iridium has no other investment options, risk shifting and
debt overhang do not increase agency costs of debt.
• Partners participating through equity and quasi equity to deter
opportunistic behavior and align partner incentives.
Case: Iridium LLC

Financing choices:
• Presence of senior bank loans:
• lower issue costs.
• Act as trip wire.
• Easier to restructure.
• Avoids negative arbitrage (disbursed when required).
• Duration aligned with life of satellites.
• Provide external review of the project.
• Sequencing of financing:
• Started with equity during the riskiest stage (research) since debt would be
mispriced due to asymmetric information and risk.
• In development, brought in more equity, convertible debt and high yield debt.
This portfolio matches the risk profile then.
• For commercial launch, got bank loans: agency motivations emerge.
Case: Iridium LLC

Contention: The Structuring and financing of Iridium was

faulty and partially responsible for its demise.

Reality: Since Iridium was incorporated as an independent

entity and not corporate financed, its prime sponsor
Motorola is still solvent inspite of Iridium’s bankruptcy.
Moreover, the Bank loan default which seemingly triggered
the bankruptcy also avoided fresh capital from being
ploughed into what was essentially a technologically
doomed project.
Case: Bulong Nickel Mine
Background: In July 1998 Preston Resources bought the Bulong Nickel
Mine in the pre-completion phase and financed it with a bridge loan. The
bridge loan was financed with a 10 year project bond in December 1998.
Within one year, Bulong defaulted on the notes after operational problems.

Issues:
• Concentrated and weak equity ownership: Preston Resources.
• Cash flows very close to debt service.
• Processing technology is unproven.
• The output faces severe market risk and currency risk.
• The company has exposure to currency risk through forward
contracts.
Case: Bulong Nickel Mine
Structural / financing highlights:
• Project finance: the right choice given the nature of the project and its
size relative to the sponsor.
• 72% D/V ratio: very high given the projected cash flows of the project.
Severely limits flexibility.
• Optionality: financial structure resembles an out of the money call
option from the sponsors perspective.
• Importance of completion guarantees: EPC agency guarantees
commissioning of plant and not ramp up. This misinterpretation of
completion guarantee results in project exposure to technology risk.
• Project Bonds instead of bank loans: Motivation is flexibility in future
investment (Preston has a similar project on the cards which it wants to
“facilitate” with Bulong cash flows). However bonds limit flexibility
during restructuring and delays it by 2 years.
Panama Canal Expansion Project
2007 - 2016
Panama Canal Expansion Project
2007 - 2016
• Price tag of USD 5.25 billion

• Includes design, administrative, construction, testing,

environmental mitigation, and commissioning costs, as well
as contingencies to cover risks and unforeseen events

• How was this project financed?

• Who was handling the project and its finances?
• Where did the money come from?
• How did they earn the money back, if at all?
Panama Canal Expansion Project
2007 - 2016
• Who was handling the project and its finances?
• The Panama Canal Authority (Spanish: Autoridad del Canal de Panamá
(ACP)), under Government of Panama

• Where did the money come from?

• Approx. USD 3.0 billion invested by ACP
• Remaining USD 2.3 billion borrowed (not backed by Panama govt.):
• Japan Bank for International Cooperation (JBIC) $ 800 million
• European Investment Bank (EIB) $ 500 million
• Inter-American Development Bank (IDB) $ 400 million
• International Finance Corporation (IFC) $ 300 million
• Corporación Andina de Fomento (CAF) $ 300 million

• How did they earn the money back, if at all?

• Increased toll payments from greater ship traffic
CPEC 2013-ongoing
CPEC 2013-ongoing

• Who is handling the projects and their finances?

• Where is the money coming from?

• How will they pay the money back?

CPEC 2013-ongoing
• Who is handling the projects and their finances?
• Depends on sponsoring organization, varies by project
• Pakistan govt.
• Chinese corporations
• Pakistani corporations
• A combination of the above
CPEC 2013-ongoing
• Where is the money coming from?
China to invest total USD 62 billion, of which USD 35 billion to be invested
in 21 power plants. So far:
• USD 15.5 billion in loans from Exim Bank of China at 5%-6% interest rate
(for energy projects developed jointly by Chinese-Pakistani firms)
• USD 11.0 billion in loans from Chinese banks as per agreements with
China’s government at 1.6% interest (for projects developed by Pakistan
govt.)
• USD 757 million in loans at 0% interest (for Gwadar projects)
• USD 230 million grants from Chinese govt. (for Gwadar Airport)

Others so far:
• USD 397 million in loans from Asian Infrastructure Investment Bank and
Asian Development Bank (E-35 Expressway, M-4 Motorway)
• Various investments by Public Sector Development Programme of the
Pakistani government
CPEC 2013-ongoing
• How will they earn the money back, if at all?
• By selling outputs (e.g. power projects)
• Toll revenue (e.g. highways)
• Operating profits (e.g. airport, seaport, university, hospital)
• etc.

• Cash inflows from projects have to cover costs and repay

loans (including interest)

• Do you think it will work out?

Cashflows in Traditionally-financed
Projects
Cashflows in Project Financing Projects

+
+
Key Parties in Project Financing
• Project sponsor (typically also the only equity investor) – the party
providing oversight and bearing accountability for the project, also the
parent organization of the project Special Purpose Entity (SPE)

• Project itself – a SPE created by the project sponsor and partners (if
any) that is also referred to as the Project Company

• Lenders – the party or parties issuing loans to the Project Company

• Operators – the party or parties operating the project asset (sponsor(s)

may also be operator(s) in some cases)

• Off-taker(s) – the party or parties that have agreed to purchase the

outputs of the project (such as electricity generated by a power plant)

• Contractors and suppliers – any parties that provide inputs to the

project and/or are appointed for undertaking some portion of project
work (e.g. designing and building the project asset, providing
maintenance services)
Principles of Project Finance
1. The project usually relates to major infrastructure with a
long construction period and long operating life.
• So the financing must also be for a long term (typically 10–25
years).
Principles of Project Finance
2. Lenders rely on the future cash flow projected to be
generated by the project to pay their interest and fees, and
repay their debt.
• Therefore the project must be ‘ring-fenced’ (i.e. legally and
economically self-contained) and independent from the parent org.
• So the project is usually carried out through a special-purpose legal
entity (usually a limited company) whose only allowed business is
the project.

• This legal entity is referred to as a Special Purpose Entity

(SPE) or Special Purpose Vehicle (SPV).
• An SPE/SPV is a legal entity created to fulfill narrow, specific or
temporary objectives. SPEs are typically used by companies to
isolate the parent company from financial risk.
• A fenced organization having limited predefined purposes and a
legal personality.
• Loans taken are ‘off balance sheet’ of the parent company.
 Enron’s Misuse of SPEs
• Enron developed hundreds of SPEs under
the name of its CFO, Andrew Fastow

• SPEs assets and liabilities were off

Enron corporation’s balance sheet

• SPEs would buy or take on debts and expenses from Enron

• This way, Enron was not only able to hide its debts and
expenses but also ‘convert’ them into revenues

• As a result, Enron’s balance sheet understated liabilities and

overstated equity, thus overstating earnings
Principles of Project Finance
3. There is a high ratio of debt to equity (‘leverage’ or
‘gearing’) – roughly speaking, project finance debt may cover
70–90% of the capital cost of a project.
• The effect of this high leverage is to reduce the blended cost of
debt and equity, thereby reducing the overall financing cost of the
project (due to tax deductions on interest payments).
Principles of Project Finance
4. There are no guarantees from the investors in the SPE/SPV
(the sponsoring company and any partners in the venture) for
the project finance debt.
• The sponsoring organization(s) do not guarantee any party who
lends money to the project.
• Hence, this is ‘non-recourse’ finance: a loan where the lender is
only entitled to repayment from the profits of the project the loan
is funding, not from other assets of the borrower.
• ‘Recourse’ means the legal right to demand compensation or
payment.
• Naturally, lenders expect higher interest rates than in traditional
financing types.
Principles of Project Finance
5. The SPE/SPV physical assets are likely to be worth much
less than the debt if they are sold off after a default on the
financing – and in projects involving public infrastructure they
cannot be sold anyway.
• Depends on asset specificity, i.e. the degree to which an asset can
have use across multiple situations and purposes.
• So the main security for lenders is the Project Company’s contracts,
licenses, or other rights, which are the source of its cash flow.
• Therefore lenders carry out a detailed analysis of the project’s risks,
and how these are allocated between the various parties through
these contracts.
Principles of Project Finance
6. The project has a finite life, based on such factors as the
length of the contracts or licenses, or reserves of natural
resources.
• So the project finance debt must be fully repaid by the end of the
project’s life.
• May need to refinance the loans if project life exceeds loan term.
• Need to balance operational expenses, maintenance costs, and
debt repayments.
Historical Development of Project
Finance
Project finance historical developments:

• 1970s: natural-resources sector – cash flows generated by extracting

resources

• 1978: independent power producers (‘IPPs’) in the electricity sector –

cash flows generated by selling electricity to public utilities
organizations

• Mid-1980s: economic infrastructure (especially transportation-related)

– cash flows generated by toll payments

• Early 1990s: social infrastructure (schools, hospitals, prisons, public

housing, govt. offices, police stations, etc.) – creates economic and
social benefits, cash flows generated by service fees from the
government
Project Finance Structure Types
A ‘Project Agreement’ states how the project will generate cash flows:
• (i) ‘Offtake Contract’, under which the product produced by the project
will be sold on a long-term pricing agreement to an ‘Offtaker’. Projects
using these contracts may or may not involve a public agency.

• (ii) ‘Concession Agreement’ )’ contract with a government or public

agency (‘Contracting Authority’) which gives the Project Company the
right to construct the project and earn revenues from it. Projects using
these contracts are typically Public-Private Partnerships (PPPs).
• Cash flows in a concession agreement come from user charges, e.g. toll
payments on a highway

• (iii) ‘Private Finance Initiative (PFI)’ is similar to the concessions

agreement in that it involves PPPs. However, cashflows come from
service fees paid by the contracting authority itself.
• Cash flows in a PFI agreement come from the contracting authority itself, e.g.
govt. pays the project organization service fees for building and refurbishing a
water treatment plant (eventually plant is returned to public sector control)
(i) Process-Plant Offtake Project Example

the ‘offtaker’
(i) Process-Plant Offtake Project
Example (assuming project financing)
(i) Process-Plant Offtake Project Example (assuming project financing)
e.g. Zonergy, e.g. Chinese Banks
also the sponsor

e.g. Pakistan Govt. e.g. CPPA

SPE/SPV
created by Zonergy

e.g. a Pakistani or Chinese e.g. gas supplier(s) (energy for e.g. a Pakistani or Chinese power
construction firm, alternatively running the plant), solar panels plant operator, alternatively
Zonergy itself supplier(s) Zonergy itself
(i) Process-Plant Offtake Project Example –
Subcontracts
• Engineering Procurement and Construction Contract (‘EPC
Contract’) for design and construction of the power plant

• Input-Supply Contracts, in this case a Solar Panels Supply

agreement and a Gas Supply Agreement under which the
gas to fuel the plant is supplied

• Operation and Maintenance Contract (‘O&M Contract’) with

an experienced power-plant operator
Project Finance Structure Types
A ‘Project Agreement’ states how the project will generate cash flows:
• (i) ‘Offtake Contract’, under which the product produced by the project
will be sold on a long-term pricing agreement to an ‘Offtaker’. Projects
using these contracts may or may not involve a public agency.

• (ii) ‘Concession Agreement’ )’ contract with a government or public

agency (‘Contracting Authority’) which gives the Project Company the
right to construct the project and earn revenues from it. Projects using
these contracts are typically Public-Private Partnerships (PPPs).
• Cash flows in a concession agreement come from user charges, e.g. toll
payments on a highway

• (iii) ‘Private Finance Initiative (PFI)’ is similar to the concessions

agreement in that it involves PPPs. However, cashflows come from
service fees paid by the contracting authority itself.
• Cash flows in a PFI agreement come from the contracting authority itself, e.g.
govt. pays the project organization service fees for building and refurbishing a
water treatment plant (eventually plant is returned to public sector control)
Public-Private Partnership (PPP)

• Public-private partnerships between a government agency

and one or more private-sector companies can be used to
finance, build and operate projects, such as public
transportation networks, parks, and hospitals

• The asset concerned usually reverts to public-sector

control/ownership at the end of the contract term

• PPPs are based on a contract between the Project Company

and a Contracting Authority

• Due to the large scale of investments, project financing is

useful for PPP projects
 Public-Private Partnership (PPP)

Public-private partnerships (PPPs) take a wide range of forms varying in the extent of
involvement of and risk taken by the private party. The terms of a PPP are typically
set out in a contract or agreement to outline the responsibilities of each party and
clearly allocate risk. The graph below depicts the spectrum of PPP agreements.
Public-Private Partnership (PPP)
(ii) Toll-Road Concession Project Example
(ii) Toll-Road Concession Project Example –
Subcontracts
• Design & Build Contract (‘D&B Contract’) to design and
build the road

• Operating Contract to operate the tolling system

• Maintenance Contract for the continued maintenance of

the road
Project Finance Structure Types
A ‘Project Agreement’ states how the project will generate cash flows:
• (i) ‘Offtake Contract’, under which the product produced by the project
will be sold on a long-term pricing agreement to an ‘Offtaker’. Projects
using these contracts may or may not involve a public agency.

• (ii) ‘Concession Agreement’ )’ contract with a government or public

agency (‘Contracting Authority’) which gives the Project Company the
right to construct the project and earn revenues from it. Projects using
these contracts are typically Public-Private Partnerships (PPPs).
• Cash flows in a concession agreement come from user charges, e.g. toll
payments on a highway

• (iii) ‘Private Finance Initiative (PFI)’ is similar to the concessions

agreement in that it involves PPPs. However, cashflows come from
service fees paid by the contracting authority itself.
• Cash flows in a PFI agreement come from the contracting authority itself, e.g.
govt. pays the project organization service fees for building and refurbishing a
water treatment plant (eventually plant is returned to public sector control)
(iii) Hospital PFI Project Example

includes
service fees
(iii) Hospital PFI Project Example –
Subcontracts
• Design & Build Contract (‘D&B Contract’), to design and
build the building

• Maintenance Contract, for maintenance of the building’s

physical structure and medical equipment

• One or more ‘Soft-Services Contracts’, for the provision of

services such as cleaning and security
Other Project Finance Structures
• There are many variations on the structures set out above, and all
of the ‘building blocks’ shown in previous examples are not found
in every project financing arrangement

Some examples:
• Projects with little or no subcontracting (Project Company
handles most or all matters)

• Projects that do not have an offtake contract but still have a

licensing agreement (e.g. oil & gas extraction projects where
output is sold in the open market)

• Projects that do not require an Input-Supply contract (e.g. some

renewable energy projects)

• Multi-stage projects (involve multiple Project Agreements, e.g.

telecommunications projects)
Achieving Financial Close
 Achieving Financial Close
• Signature of the financing documentation alone does not mean
that the lenders will sending funds to the project.

• In order to ‘drawdown’ or obtain any funds, the project must

first reach financial close.

• Financial close occurs when all the project and financing

agreements have been signed and all the required conditions
contained in them have been satisfied or waived.

• Once these conditions are met, funds can start flowing and the
project implementation can actually start.
 Achieving Financial Close
Typically, the following Conditions Precedent (CP) are included in financing
agreements. These must be met to achieve financial close:

• the main permitting and planning approvals have been secured

• the key land acquisition steps have been achieved

• the outstanding technical design issues have been clarified

• any remaining key project and financing documents have been finalized
and signed

• all funding approvals from relevant authorities are in place

• proper registration of the security for the loans has been confirmed
 Achieving Financial Close
• A considerable amount of work is required to reach financial close

• The time required to achieve financial close varies based on the context and
complexity of the project and its financing agreements

• Below are some examples of time periods between contract signature and
financial close:
Benefits of Project Finance to Investors
• High leverage (i.e. high debt to equity ratio) = higher rate of
return for investors
Benefits of Project Finance to Investors
• Limited risk to sponsoring organization due to non-recourse
debt and use of SPEs/SPVs

• Risk spreading across project investors and possibility of

introducing joint ventures partners (multiple sponsors)

• Allows companies with different financial strengths to work

together

• No dilution of ownership or loss of control due to outside

investors

• Debt may be kept off sponsor’s balance sheet

Drawbacks of Project Finance
• A Project Company has no business record to serve as the
basis for a lending decision: lenders need to be given lots of
assurance leading to a lengthy ‘due diligence’ process

• Lenders may try pressurize project managers and try to

interfere with management of the project

• Lenders expect a higher rate of return – may be 2-3 times

that of corporate finance
Summary: Corporate vs. Project Finance
Corporate Finance Project Finance

Financing
Multi-purpose organization Single-purpose entity
Vehicle

Permanent - an indefinite Finite - time horizon

Type of Capital
time horizon for equity matches life of project

Repayment Corporate management

Fixed repayment policy -
policy and makes decisions
immediate payout; no
Reinvestment autonomous from investors
reinvestment allowed
Decisions and creditors

Capital Not visible to creditors except

Highly transparent to
Investment those voluntarily disclosed in
creditors
Decisions financial statements
 Summary: Corporate vs. Project Finance
Corporate Finance Project Finance
Relatively lower costs due to Relatively higher costs due
Transaction costs for competition from providers, to documentation and
financing routinized mechanisms and longer development and
short turnaround time negotiation period
Usually only feasible when a
Size of financing Flexible large amount of financing is
required
Overall financial health of Technical and economic
Basis for credit corporate entity: focus on feasibility: focus on project’s
evaluation company’s financial assets, cashflows and
statements contractual arrangements
Relatively lower – depends Relatively higher – non-
Cost of capital on company’s financial recourse finance and no
position and track record prior history
Typically broader
Typically smaller group:
Investor/Lender base participation: deep
limited secondary markets
secondary markets
Summary: Corporate vs. Project Finance
Corporate Finance Project Finance
Does not impact parent
Capital Structure Impacts debt capacity company’s debt capacity as it
is ‘off balance sheet’
High – loans secured against Limited – loans secured
Risk Exposure against company balance against expected project cash
sheet and expected earnings flows only
Company’s physical assets Project physical assets alone
Collateral
can be used as security for cannot be used as security for
Options
loans loans
Companies have an Projects have a finite life
Loan Repayment
indefinite life and may keep during which debt must be
Period
renewing loans repaid
Summary: Corporate vs. Project Finance
in PPP Projects
Video by United Nations Economic and Social Commission for Asia and the
Pacific (UNESCAP)

PPP Structure and Financing:

https://www.youtube.com/watch?v=rvKgU1bfnNw
Activity
Based on the preceding discussion, under which
circumstances would project finance be preferred over
corporate finance?