Project Finance—A Contemporary Alternative to Conventional Financing
Project finance refers to the private funding of an economically separable investment project with limited recourse or non-recourse alternatives. Recourse holds the debtor obligor liable for default payments, whereby creditor obligee recovers debt to finance
Recourse holds the debtor obligor liable for default payments, whereby creditor obligee recovers debt to finance the project.
Non-recourse loans typically use property as collateral to secure payment—seizing property if debtor defaults—without holding debtor liable. [i]Project finance assumes a contract among privy parties to finance the project. Basic project finance features include:
- Agreement that obligates financially responsible parties to fund the project as a precondition for completion;
- Agreement with specifications that enable financially responsible parties to satisfy all reasonably foreseeable requirements—generating sufficient cash flows—for project completion;
- Assurances assumed by responsible parties in contract that incorporate force majeure risk provisions to remedy:
- Unforeseeable, impracticable events—e.g., natural disasters as earthquakes, hurricanes, tornadoes, etc.
- Assumptions neglected which may frustrate purpose of finance project—i.e., parties overlooking potential production supply shortages.
These assurances mitigate liability by considering such contingencies.
Conversely, conventional financing employs lenders to service loans by generating cash flow from the “firm’s entire asset portfolio.” [ii]
Project Financing v. Conventional Financing
Project financing distinguishes from conventional financing in the following:
Unlike project finance, which solicits private funding independently by committing responsible “sponsors” under contract, conventional financing relies on a firm’s asset portfolio to recompense loans. Project financing assumes a contract with privy parties. The project commits independent sponsors under contract for outside funding. Additionally, unlike conventional financing, project financing pays cash flows directly to investors. [iii] In conventional financing, the sponsor reinvests cash flows. [iv]
However, the use of asset portfolios in conventional financing to repay loans assumes no need for a contract. Therefore, conventional financing assumes no collateral to secure loans because firms presumably need no extrinsic funding since the firm’s asset portfolio may suffice for loan reimbursement. Evidently, the asset portfolio provides a sufficient source of cash for repayment in conventional financing.
Since project financing assumes a contract, various interested parties presumably share financial risks. Not so with conventional financing, since the firm generally relies on its asset portfolio for financing. Furthermore, project financing, unlike conventional financing, assumes a finite life due to its contractual commitments because contracts expire as per the statute of limitations in each jurisdiction. Because conventional financing assumes no contracts, the firm’s project entity may perpetuate in perpetuity unless it otherwise specifies.
Project Financing & Conventional Financing—Distinguishing Features
The firm’s general credit distinguishes project financing from conventional (direct) financing. But project finance critically distinguishes from conventional financing as follows:
- Legal entity;
- Assets related to contracts;
- Cash flows segregated from sponsoring entity.
Other Distinguishing Features:
Contractual arrangements with “unquestioned ability to generate cash flow,” for debt repayment support project financing because contracts entail specifications unambiguously stipulated and mutually exchanged among privy parties. The contracts also promise “reasonable return” to equity holders. Equity funds stem from special purpose vehicles, with banks, bondholders, and other institutions (commercial lenders) subsidizing debts.
In project financing, creditworthiness depends on project’s anticipated profitability and indirect third party credit support. Therefore, fund availability for project financing depends on sponsor’s ability to convince fund providers of a technically feasible and economically viable option. Not so with conventional financing because the firm ostensibly requires no contract, which perhaps assumes no outside financial support.
|Distinguishing Features||Project Financing||Conventional Financing|
|Organization||LLC/Partnership (though LLC legally preferred).||Corporate.|
|Control & Monitoring||Fund providers.||Corporate directors monitor funds.|
|Debt structure||Secure debt as per requisite specifications.||Unsecure debt due to no contract, greater risks without certain terms specified.|
|Risk Allocation||Distributes risk through contract arrangements;|
|Manages risks; full recourse; thus no risk sharing.|
|Financial Structures||Time consuming because of contractual provisions to accommodate all privy party needs in preparing services/outside funding.||Quick because firm may easily duplicate common forms without the formality of securing specific commitments, legal arrangements, etc.|
|Free Cash Flow||Managers with limited cash flow discretion as per contractual distribution specifications for equity investors.||Managers maintain broad discretion as per company policies.|
|Agency Costs||Reduced exposure.||Equity investor’s greater exposure to agency cost of free cash flow.|
|Debt Capacity||Extended to outside support.||Limited to firm’s entire asset portfolio.|
|Bankruptcy||Less costly & expeditious with contract provisions guiding liability measures.||Costly & time consuming with no formal specifications memorialized.|
Project Financing Advantages:
Project Financing may offer the following advantages to conventional financing:
- Debt carried by project itself under contract specifications rather than balance sheet, which may help to transfer financial risks. The option of limited or no recourse may also increase legal flexibility options to collect debts from defaulting debtors.
- Investors maintain control over cash flow because contract specifications vest certain rights and obligations unlikely afforded in non-contractual conventional financing, which relies on the firm’s entire asset portfolio.
- The contract specifications in project financing may also encounter underinvestment problem because parties agree to specific projections with guarantees and force majeure remedies for protection.
- Contract specifications in project financing may also help mitigate agency costs with provisions that may restrict management’s use of cash flows from projects.
- Project financing may also enhance shareholder value, furnishing flexibility to advantage attractive information-sensitive investment projects.
- Contractual ability to negotiate fair prices with limited disclosure of symmetric information among all responsible parties and securities reinforcing specifications.
- Project financing may expand debt capacity with its reliance on extensive extrinsic support rather than just the firm’s asset portfolio.
- The contractual commitments established for external funds may also allow sponsoring firm’s ability to advantage interest tax shields. Thus, project financing may (may not) achieve a lower after-tax, risk-adjusted cost of capital than conventional financing.
- Contracts in project financing may produce specifications to reduce legal/regulatory costs.
- The extensive outside support from multiple cross-functional sources may facilitate economies of scale to broaden project influence/exposure.
- The risk sharing element afforded by contractual arrangements may protect shareholders in large projects from any one individual/party bearing significant losses.
- More effective organizational structure—LLC v. conventional corporation—which reduces formality, double taxation, etc.
- Lowered financial distress costs with many seasoned specialists under contract available to craft cost reduction options.
- Feasible profit sharing plans guaranteed under contract, again promised certainty, flexibility, and accountability as well with force majeure risk provisions for protection.
- In extreme cases, a sponsor’s weak credit might leave the firm under conventional financing under-equipped to finance project at reasonable costs on its own, without outside support. Thus, project financing may offer the advantage of financial support in such an instance.
However, project financing may not always lead to lower after-tax risk adjusted cost of capital. If so, project financing costs may not outweigh the aforementioned advantages enumerated. Therefore, project financing may present risk factors to lenders and investors, given the legal expense associated with many contracting parties over extended time. Those risk factors include:
- Complexity of Project Financing;
- Indirect Credit Support;
- Higher Transaction Costs.
Complexity of Project Financing
Project financing depends on a set of contracts negotiated by all parties privy to the project. If true, the dependence on “all” parties may require time, assuming schedule flexibility challenges. Likewise, cost arrangements may prove challenging for the multiple external parties. Thus, these costs may offer greater challenges than conventional financing, where the firm need not rely on all parties, but simply consider its internal resources for payment. If so, project financing may create some ambivalence for lenders and/or investors, perhaps dubious of the risk that perhaps not all parties may commit. If so, lenders and/or investors may fear not receiving the returns promised, assuming they choose a project financing arrangement.
Indirect Credit Support
The cost of debt increases in project financing compared with conventional financing due to indirect credit support. In other words, the contracts entailed in a financing project typically assume many contingencies from contractual commitments, rather than a direct promise to repay. Consequently, lenders and/or investors may become concerned about possible contractual commitment failures, which might not provide an uninterrupted flow of debt service due to unforeseen events. Force majeure risks happen, and even if triggered from provisions, the liabilities associated with unfulfilled obligations may take many years of legal dispute/litigation, assuming courts rule in creditors’ favor. Furthermore, to compensate for this risk, lenders often take a 50-100 basis point cost in yield premiums. The added costs to compensate for the indirect credit support risks may dissuade lenders and/or investors even further from pursuing project financing, perhaps if conventional financing omits these costs, without contingency risk issues.
Higher Transaction Costs
Again, project financing assumes greater complexity compared to conventional financing. This higher complexity may assume additional higher transaction costs to reflect contingencies implied from legal expense in designing projects and/or project related legal/tax issues. The requisite documentation in contracts for loans, project ownership, and legal services may entail much needless expense, perhaps further dissuading lenders/investors from project financing alternatives.
[i] Investopedia, Non-recourse Debt Definition, Investopedia, LLC, 2016, http://www.investopedia.com/terms/n/nonrecoursedebt.asp, p.1.
[ii] Finnerty, John D., Project Financing, Asset-Based Financial Engineering, John Wiley & Sons, Inc., 3rd Edition, 2013, p. 2.
[iii] See Finnerty John D., at 30-31.
[iv] See Id. at 30-31.
Finnerty, John D., Project Financing, Asset-Based Financial Engineering, John Wiley & Sons, Inc., 3rd Edition, 2013.
Ehrlich, Everett M., Public Works, Public Wealth, Center for Strategic & International Studies, 2005.
Khan, M.F.K., and R.J. Parra, Financing Large Projects: Using Project Finance Techniques and Practices, Pearson Education, Prentice Hall, 2003.
Nakagava, D., Funding Transport Systems, Pergamon, 1998.
National Academies Press, Guidance for Communicating the Economic Impacts of Transportation Investments, 1999.
OECD Publishing, Transport Infrastructure Investment, 2008.
OECD, Infrastructure to 2030, July 2006.
Pollic, Gerald, International Project Analysis and Financing, University of Michigan Press, 1999.
Urban Land Institute, Infrastructure 2008: A Global Perspective, September 2008.