What is Project Finance?
Suppose an Investor has an idea : To build a powerplant, or an Airport, or a Highway, these projects are called Infrastructurre Projects and Infra structure projects are expensive to build.
Another type of Project that we have Consulted on is the Building of a Hotel complex for the value of $500 Million.
These are capital intensive projects that require a lot of money. It is rare that a single Company or person can finance these projects with their own money. There are instances where an Ultra High Net Worth Individual (UHNWI), or a family office has the means to finance the project, but they may wish to spread the risk and invite partners or consider some form of debt financing.
It is rare that a single Company or person can finance these projects with their own money. There are instances where an UHNWI ( Ultra High Net Worth Individual ), or a Family Office has the means to Finance the Project, but they may wish to spread the risk and invite Parnters or consider some form of debt Financing.
The Solution is Project Finance. Project Finance is basically raising capital to finance such capital-intensive infrastructure projects..
Project Finance has several distinct features :
- It is long-term debt financing of a specific project. The Projects assets and cash flows are isolated.
- The Projects Company are incorporated in an SPV ( Special Purpose Vehicle).
- The Project has to cover sufficient cash flows to cover debt repayments and dividend payments, after covering operating expenses and Capital Expenditures.
- Debt is secured by the assets of the Project Company ( SPV )
- The Project has a finite life.
What is a SPV ( Special Purpose Vehicle )?
An SPV is a legal entity (usually a limited liability company of some type) created to fulfil a narrow, and specific objective.
What are the steps involved in Project Finance?
- An Investor{ also called a project sponsor } sets up a SPV for the sole purpose of designing, building and managing a specific project.
- The Project sponsors develop the project. They carry out necessary technical and economic studies, and obtain the necessary permits, and acquire the land where the Project will be built.
- They conclude the necessary contracts, such as Off-Take agreements, and construction contracts. When all the studies, permits and contracts have been concluded the project reaches a Financing stage.
- The Financing stage. At the Financing stage the Project sponsors negotiate with lenders on the debt financing of the specific project.When Project sponsors and Lenders reach and agreement they inject the equity and debt into the SPV to Finance the Construction of the Project. This stage is knownn as Financial Close in Project Finance.
- Typically the Construction costs are Financed with 70% Debt and 30% equity. So, Project Finance is a highly leveraged transaction.
As has been pointed out, the assets and the cashflows of the project have are isolated in an SPV, so therefore lenders rely on the projects cash flow only.
In case something goes wrong,and the projects cash flow decreases, resulting in the SPV not being able to service the debt, the lenders cannot go after the project sponsors other assets.
Therefore Project Financing is called a Non-Recourse Finance. Lenders have no recourse to claim the projects sponsors other assets.
So, how is this different from Corporate Finance.?
In Corporate Finance. Investors and Lenders inject capital into a Holding Company which .then initiates multiple different projects. These different projects serve as a collateral for a debt. In the case where there is problem with debt repayment or interest payments, the Lenders can go after all the assets of the Holding Company and recover the debt through the sale of those assets that the Company owns.
To review : in Project Finance the Project Sponsor can have multiple different SPV's, with a specific Project in each SPV..The Project sponsor can be a Holding company too. When there is a problem with a specific Project, the Lenders cannot go after a Projects Sponsors other Assets.They must rely on the Assets and cashflows,from that specific SPV.
To Summarize: Project Financing is financing of a long term infrastructure project, using a non-recourse financial structure, which relies only on the Projects cash flows for debt repayment, with the projects assets held as a collateral.
So, why does Project Financing make sense for an Investor?.
- Project Finance enhances an Investors equity return because of the high leverage. Infrastructure Industry is typically a regulated Industry so Project returns are usually low and are not sufficient to attract equity finance.So, high leverage is necessary to enhance the equity investment returns.
- Due to the high leverage the required equity committment is significantly lower than the projects costs, which reduces the risk for an investor.
- Because the Project is carried out by the Special Purpose Vehicle ( SPV ) the Investor only risks losing the equity investment made into the SPV. High leverage also introduces significant tax savings, as the interest expense is a tax deductible item.
- The risk allocation in Project Finance is highly structured, meaning that risk is allocated to the party which is the most capable at managing it, thus the risk of the overall project decreases.
When it comes to property investing or property investment in the UK, investors could use Project Finance strategies to get access to high value, capital-intensive projects with structured risk management.
