​PROJECT FINANCE DEFINITION

Project finance has traditionally been defined as the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure, in which project debt and equity used to finance the project are paid back from the cash flow generated by the project. Project financing is essentially a loan structure that relies primarily on the project's cash flow for repayment, with the project's assets, rights and interests held as secondary security or collateral. Project finance is especially attractive to the private sector because companies can fund major projects off balance sheet. Project Finance deals with financial aspects related to a particular project that involves analyzing the feasibility of a project and its funding requirements on the basis of the cash flows that the project is expected to generate, if undertaken, over the years.

Large projects, especially related to infrastructure, oil, and gas, or public utility, are highly capital intensive and require funding. Project finance acts as a means to fund these projects. It involves considering a project on a standalone basis. The project themselves are treated as financial entities (Special Purpose Vehicles or SPVs).
It is so because the financing of these projects usually remains off-balance-sheet of the company that is undertaking the project. It is done in order to reduce the risks involved and their possible impact on the company’s existing balance sheets.
Thus, all the liabilities of the project are paid off only from the cash flows generated by the project. Assets owned by the parent company can’t be used to pay off these debts.

Project Finance can be characterized in a variety of ways and there is no universally adopted definition but as a financing technique, a broad definition is:

“the raising of finance on a Limited Recourse basis, for the purposes of developing a large capital- intensive infrastructure project, where the borrower is a special purpose vehicle and repayment of the financing by the borrower will be dependent on the internally generated cashflows of the project”

This definition in itself raises a number of interesting questions, including:

1. What is meant by ‘Limited Recourse’ financing – recourse to whom or what?

2. Why is Project Finance typically used to finance large capital intensive infrastructure projects?
   

3. Why is the borrower a special purpose vehicle (SPV) under a project financing?
   

4. What happens if the internally generated cashflows of the project are not sufficient to repay the financiers of the project?
   

The terms ‘Project Finance’ and ‘Limited Recourse Finance’ are typically used interchangeably and should be viewed as one in the same. Indeed, it is debatable the extent to which a financing where the Lenders have significant collateral with (or other form of contractual remedy against) the project shareholders of the borrower can be truly regarded as a project financing. The ‘limited’ recourse that financiers have to a project’s shareholders in a true project financing is a major motivation for corporates adopting this approach to infrastructure investment. Project financing is largely an exercise in the equitable allocation of a project’s risks between the various stakeholders of the project. Indeed, the genesis of the financing technique can be traced back to this principle. Roman and Greek merchants used project financing techniques in order to share the risks inherent to maritime trading. A loan would be advanced to a shipping merchant on the agreement that such loan would be repaid only through the sale of cargo brought back by the voyage (i.e. the financing would be repaid by the ‘internally generated cashflows of the project’, to use modern project financing terminology).

Project finance is hence the process of financing a specific economic unit that the sponsors create, in which creditors share much of the venture’s business risk and funding is obtained strictly for the project itself. Project finance creates value by reducing the costs of funding, maintaining the sponsors financial flexibility, increasing the leverage ratios, avoiding contamination risk, reducing corporate taxes, improving risk management, and reducing the costs associated with market imperfections. However, project finance transactions are complex undertakings, they have higher costs of borrowing when compared to conventional financing and the negotiation of the financing and operating agreements is time-consuming.

Project Finance as the process of financing ‘a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan’. Thus, the funding does not depend on the reliability and creditworthiness of the sponsors and does not even depend on the value of assets that sponsors make available to financiers.

Definitions of Project Finance emphasize the idea that lenders have no claim to any other assets than the project itself. Therefore, lenders must be completely certain that the project is fully capable of meeting its debt and equity liabilities through its economic merit alone. The success of a Project Financing transaction is highly associated with structuring the financing of a project through as little recourse as possible to the sponsor, while at the same time providing sufficient credit support through guarantees or undertakings of a sponsor or third party so that lenders will be satisfied with the credit risk2. Finally, the allocation of specific project risks to those parties best able to manage them is one of the key comparative advantages of Project Finance.

There are five distinctive features of a Project Financing transaction. First, the debtor is a project company (special purpose vehicle – SPV) that is financially and legally independent from the sponsors, i.e., project companies are standalone entities. Second, financiers have only limited or no recourse to the sponsors – the extent, amount and quality of their involvement is limited. Third, project risks are allocated to those parties that are best able to manage them. Fourth, the cash flow generated by the project must be sufficient to cover operating cash flows and service the debt in terms of interest and debt repayment. Finally, collateral is given by sponsors to financiers as security for cash inflows and assets tied up in managing the project.

Commonly referred as “off-balance-sheet” financing, Project Finance is often used to segregate the credit risk of the project from that of its sponsors so that lenders, investors, and other parties will appraise the project strictly on its own merits. It involves the creation of an entirely new vehicle company, with a limited life, for each new investment project. Project companies are legally independent entities with very concentrated equity ownership and have higher leverage levels.

The core of Project Finance is the analysis of project risks, namely construction risk, operating risk, market risk, regulatory risk, insurance risk, and currency risk. There are risks related to the pre-completion phase such as activity planning risk, technological risk, and construction risk or completion risk. Then there are risks related to the post-completion phase such as supply risk, operating risk, and demand risk.  And then there are risks related to both phases such as interest rate risk, exchange risk, inflation risk, environmental risk, regulatory risk, political risk, country risk, legal risk, and credit risk or counterparty risk. These risks are allocated contractually to the parties best able to manage them. The process of risk management is usually based on the following interrelated steps:

1. risk identification;

2. risk analysis;
   

3. risk transfer and allocation;
   

4. residual risk management;
   

This process is crucial in Project Financing transactions and they must be identified and allocated to create an efficient incentivizing tool for the parties involved..

PROJECT FINANCE BENEFITS

Financing projects through the project finance route offers various benefits such as the opportunity for risk sharing, extending the debt capacity, the release of free cash flows, and maintaining a competitive advantage in a competitive market. Project finance is a useful tool for companies that wish to avoid the issuance of a corporate repayment guarantee, thus preferring to finance the project in an off-balance sheet manner. The project finance route permits the sponsor to extend their debt capacity by enabling the sponsor to finance the project on someone's credit, which could be the purchaser of the project’s outputs. Sponsors can raise funding for the project based simply on the contractual commitments.

Project finance also permits the sponsors to share the project risks with other stakeholders. The basic structure of project finance demands that the sponsors spread the risks through a network of security arrangements, contractual agreements, and other supplemental credit support to other financially capable parties willing to assume the risks. This helps in reducing the risk exposure of the project company.

The project finance route empowers the providers of funds to decide how to manage the free cash flow that is left over after paying the operational and maintenance expenses and other statutory payments. In traditional corporate forms of organization, corporate management decides on how to use the free cash flow — whether to invest in new projects or to pay dividends to the shareholders. Similarly, as the capital is returned to the funding agencies, particularly investors, they can decide for themselves how to reinvest it. As the project company has a finite life and its business is confined to the project only, there are no conflicts of interest between investors and the management of the company, as often happens in the case of traditional corporate forms of organization.

Financing projects through the project finance route may enable the sponsors to maintain the confidentiality of valuable information about the project and maintain a competitive advantage. This is a benefit of raising equity finance for the project (however, this advantage is quite limited when seeking capital market financing (project bonds). Where equity funds are to be raised (or sold at a later time so as to recycle capital) through market routes (for example, Initial Public Offerings [IPOs]), the project-related information needs to be shared with the capital market, which may include competitors of the project company/sponsors. In the project finance route, the sponsors can share the information with a small group of investors and negotiate the price without revealing proprietary information to the general public. And, since the investors will have a financial stake in the project, it is also in their interest to maintain confidentiality.

In spite of these advantages, project finance is quite complex and costly to assemble. The cost of capital arranged through this route is high in comparison with capital arranged through conventional routes. The complexity of project finance deals is due to the need to structure a set of contracts that must be negotiated by all of the parties to the project. This also leads to higher transaction costs on account of the legal expenses involved in designing the project structure, dealing with project-related tax and legal issues, and the preparation of necessary project ownership, loan documentation, and other contracts.

PROJECT FINANCE DYNAMICS
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From a broad perspective and general analysis, the financial viability (or commercial feasibility) of the project is assessed by determining whether the net present value (NPV) is positive. NPV will be positive if the expected present value of the free cash flow is greater than the expected present value of the construction costs. However, in addition to or in lieu of the NPV, lenders will use debt ratios such as the Debt Service Cover Ratio (DSCR) and Life Loan Cover Ratio (LLCR) as the main ratios to measure bankability.

The DSCR measures the protection of each year’s debt service by comparing the free cash flow (more precisely, the cash flow available for debt service – CFADS) to the debt service requirement. The DSCR requires that the cash flow available for debt service is at least a specified ratio (for example, 1.2 times) of the scheduled debt service for the relevant year. The LLCR compares the overall amount of free cash flow projected for the life of the loan, duly discounted with the amount of debt under analysis. The LLCR also reflects the capacity of the SPV to meet the debt obligations over the life of the loan (considering potential re-structuring).

On the basis of the projected cash flows of the SPV, including the debt profile under analysis, lenders and their due diligence advisors will observe the value of such ratios, and accommodate the debt amount so as to meet them, considering the maximum term at which they are ready to lend. Subsequently, they will run sensitivities analysis (including break-even analysis) on the project cash flows to test the resistance of the project to adverse conditions or adverse movements of the free cash flow figures from the base case.

In determining financial viability, and related to the reliability of cash flows and the guarantees offered by the contract (especially termination provisions), the lenders will analyze the risk structure of the contract. This will include determining how achievable the performance standards in "government-pays" projects, or the contractual guarantees in "user-pays" projects, actually are. Lenders will exercise tight control of all cash flows, limiting the ability of the private partner(s) to dispose of them — through “covenants” (for example, no distributions may be made if the actual DSCR of the previous year has not meet a certain threshold). The bank accounts through which cash flows pass will be pledged and held with a bank within the syndicate; this is in addition to other provisions to be adapted in the loan agreement. 

PROJECT FINANCE RISKS

Costs of Project: During the financial and technical analysis of a project, a certain cost of raw materials would have been assumed. If the costs exceed the assumptions, it will get difficult to repay the capital.
Timeliness: Missing the deadlines associated with the project can result in penalties.
Performance: Even if the project gets completed on time, it is necessary that it meets the expectations so that it can generate expected cash flows.
Political Risks: Government related projects always have huge political risks involved as a change in political policies can impact funding, feasibility, requirements of the project.
Currency Exchange: If the lenders are not local, the capital will involve exchange rate risks as interest payable can go up.  

PROJECT FINANCE KEY FEATURES

Risk Sharing: The company shares the risks associated with the project failure with the other participating entities by keeping the project off the balance sheet.
Involvement of Multiple Parties: As the projects are large and capital extensive, multiple parties often provide capital in the form of debt or equity.
Better Management: As the whole project is a different entity in itself, often, a dedicated team is assigned to look after the completion of the project, which results in better efficiency and output.

PROJECT FINANCE SPONSORS

Sponsors associated with a special purpose vehicle can be of following types:
Industrial: These are mainly those whose business gets impacted in some way (positive impact) with the project been executed.
Public: These include the sponsors that have the public interest in mind. These can be associated with government or other cooperative societies.
Contractual: These sponsors are mainly involved in the development, operations, and maintenance of the project.
Financial: These include the sponsors that participate in project financing, looking for high returns.

PROJECT FINANCE STRUCTURE

The structuring of project financing is a framework in which ownership structure, project structure, risk structure, and financial structure decisions are made and tied together in the project's legal structure which, in turn, forms a foundation for funding the project on a limited recourse basis. A simplified project financing structure includes multiple key elements:

1. The ownership structure is how the special purpose company/vehicle (SPC/SPV) is organized; that is, as a corporation, unincorporated joint venture, limited liability partnership, etc. Project structure on the other hand refers to the agreements defining responsibilities and transfer of rights and/or ownership of the SPC/SPV such as build, operate, and transfer of ownership (BOT), build, own, operate, and transfer (BOOT), build, lease, and transfer (BLT), etc.
   

2. Risk structure is the prioritization and mitigation of risks after the identification, assessment, and allocation process is completed.
   

3. The project's legal structure is the web of contracts and agreements negotiated to make financing possible.
   

4. Financial structure refers to the mix of financing used to fund a project, which includes equity, short‐ and long‐term loans, bonds, trade credits, etc. and the cash flows to equity providers and the lenders.
   
   

A special purpose vehicle (SPV) project company with no previous business or record is necessary for project financing. The company’s sole activity is carrying out the project by subcontracting most aspects through construction contract and operations contract. Because there is no revenue stream during the construction phase of new-build projects, debt service is possible during the operations phase only. For this reason, parties take significant risks during the construction phase. Sole revenue stream is most likely under an off-take or power purchase agreement. Because there is limited or no recourse to the project’s sponsors, company shareholders are typically liable up to the extent of their shareholdings. The project remains off-balance-sheet for the sponsors and for the government.)

A special purpose company/vehicle (SPC/SPV) project company with no previous business or record is necessary for project financing. The company’s sole activity is carrying out the project by subcontracting most aspects through construction contract and operations contract. Because there is no revenue stream during the construction phase of new-build projects, debt service is possible during the operations phase only. For this reason, parties take significant risks during the construction phase. Sole revenue stream is most likely under an off-take or power purchase agreement. Because there is limited or no recourse to the project’s sponsors, company shareholders are typically liable up to the extent of their shareholdings. The project remains off-balance-sheet for the sponsors and for the government.

There are multiple parties involved in a typical project and there are multiple configurations of the “capital stack” used to finance the development, construction and operations during the project’s life. In contrast, corporate finance is carried out by the corporation as a whole rather than by an entity created specifically to hold ownership of the new facility. Lenders in a corporate financing agreement evaluate the cash flow and assets of the entire corporation to service the debt and provide risk mitigation.

An alternative to corporate financing is the formation of a project company to develop, construct and operate a plant or facility. In a project financing, investments in the plant are considered assets of the project company, and funding is provided in the form of equity, debt or a combination of the two. The project’s assets and cash flow secure the debt, and creditors do not have recourse to the sponsors’ other available resources.

This type of borrowing is called non-recourse. Since the repayment of the loan is primarily dependent on the success of the project, lenders pay special attention to project risks and risk mitigation.

Loan Origination is the process of assembling a project package that describes how funding is organized  in the form of equity and how much in debt. Equity is put into the project company by shareholders who then receive dividends and capital gains based on net profits of the project company.

Project debt refers to the funds loaned by lenders such as commercial banks, insurance and pension funds and multilateral institutions. These loans are secured by the project’s assets and the lenders receive payments for principal and interest whether the company is profitable or not. Debt lenders examine projected cash flow carefully to insure there is sufficient financial capacity for debt service and repayment.

To raise project funding, sponsors issue or sell securities which represent a claim on the future cash flow of the project and a contingent claim on the assets of the project.

The type of security determines the order in claim of the debts over the cash flow and the assets of the project. Senior debt ranks highest and are normally in the form of loans from commercial banks, investment banks, development agencies, pension funds and export credit agencies.

Next in order comes subordinated debt which is a second claim on the assets of the project. Subordinated debt is assumed by lenders willing to take greater risks, and they can in turn, receive greater returns on their investment.

Equity involves the highest risk and can be contributed by project sponsors, investment funds or multilateral institutions. Public equity is an option and can come from governments or a host of lending agencies such as the World Bank, regional banks, export credit or trade agencies.

Financial flows in any project can be categorized as public and/or private. Public flows include technical assistance, loan guarantees and borrowing from multilateral agencies under government sponsorship.

Private flows include debt and equity:

1. Debt includes bonds and bank borrowing

2. Equity includes foreign direct investment or portfolio equity
   

​​The core of Project Finance is the analysis of project risks, namely construction risk, operating risk, market risk, regulatory risk, insurance risk, and currency risk. There are risks related to the pre-completion phase such as activity planning risk, technological risk, and construction risk or completion risk. Then there are risks related to the post-completion phase such as supply risk, operating risk, and demand risk.  And then there are risks related to both phases such as interest rate risk, exchange risk, inflation risk, environmental risk, regulatory risk, political risk, country risk, legal risk, and credit risk or counterparty risk. These risks are allocated contractually to the parties best able to manage them. The process of risk management is usually based on the following interrelated steps:

1. risk identification;

2. risk analysis;
   

3. risk transfer and allocation;
   

4. residual risk management;
   

Essential to structuring a project finance package are the crucial elements of successful identification, analysis, mitigation and allocation of project risks. These risks are related to events that could endanger the project during development, construction and operation.

During the development stage the main risk is rejection by the host government or by the financiers – for reasons including commercial weakness, failure to obtain licenses, permissions and clearance. Sponsors can hedge their risks by obtaining technical assistance grants for project preparation and planning.

During the construction stage the main risk is failure to complete the project with acceptable performance levels and within an acceptable time frame and budget. Sponsors can hedge construction risks by purchasing various forms of insurance and obtaining guarantees from contractors with regard to costs, completion schedule and operational performance.

After construction, the main risk is ongoing operations and performance and include technical failures, availability of funds, market demand, prices, foreign exchange rates or environmental issues. The sponsors can hedge these risks through contractual and guarantee agreements that transfer some of the risk to other parties.

Financial due diligence requires that, during loan preparation and processing, sufficient analysis is undertaken to enable an informed assessment to be made with respect to project financial viability and long-term sustainability, and that the borrowers’ financial and project management systems are, or will be, sufficiently robust to ensure that funds are used for the purpose intended and that controls will be in place to support monitoring and supervision of the project.

There are Guidelines that provide the framework for financial due diligence, namely completion of a financial management assessment (FMA) of the executing agency (EA) and/or implementing agency (IA), financial evaluation of the project, and assessment of implementation arrangements (from a financial perspective, including disbursement and auditing arrangements).

The methodology note provides specific guidance in four primary aspects of financial due diligence:

1. financial management assessment,
   

2. project cost estimates and financing plan,
   

3. financial analysis, and
   

4. financial evaluation.​
   

It also provides guidance on assessing disbursement auditing arrangements. This financial due diligence methodology note offers a suggested approach for operationalizing the standard project preparation and loan processing requirements of the Guidelines. the Guidelines, together with the methodology note, should be seen as a reference guide to assist staff in conducting an appropriate degree of financial due diligence during project  preparation and processing, and should guide staff in determining the appropriate level of financial management  safeguards required for a given project and/or EA and/or IA. 

Effective financial management within the EA and/or IA is a critical success factor for project sustainability, both in the effective use of funds and in the safeguard of assets once created. Irrespective of how well a particular project or program is designed and implemented, if the EA and/or IA does not have the capacity to effectively manage its financial resources, the benefits of the project are unlikely to be sustainable.
The objective of the financial management assessment (FMA) is to ensure that the EA and/or IA has, or will have, sufficiently strong and robust financial management systems and procedures in place to ensure sustainability of project investments and benefits over time.
The FMA is a review of the entity’s systems for financial and management accounting, reporting, auditing, and internal controls. It also involves an assessment of the entity’s disbursement and cash flow management arrangements, and governance and anticorruption measures. The FMA is not an audit; it is a review designed to determine whether or not the entity’s financial management arrangements are sufficient for the purposes of project implementation. 

The first step is to determine whether an FMA has recently been completed by any other credible financial institution (Bank, NBFC, VC or PE agencies) , the objective being to avoid duplicating diagnostic work that already exists. If an FMA exists, this should be reviewed and, in particular, any work done to overcome previously identified weaknesses should be checked. The original FMA can then be updated accordingly.
If an FMA has never been completed, or if there have been significant on-ground changes which render an existing FMA obsolete, then the following approach to the FMA is recommended:
Review the Economic Sector diagnostic studies specific to the country where the project is located, including the country financial accountability assessment, country procurement assessment report, country governance assessment, and diagnostic study on accounting and auditing.
Early in project preparation, have the borrower/project promoter complete a Financial Management Assessment Questionnaire (FMAQ).
Review responses to the FMAQ, determine what (if any) additional information is required in order to be able to conclude whether or not the financial management arrangements (a) are capable of recording all transactions and balances, (b) support the preparation of regular and reliable financial statements, (c) safeguard the entity’s assets, and (d) are subject to audit.
Review past audit reports and audit management letters to assess what concerns have previously been raised on systems and internal controls.
Form a conclusion with respect to whether or not the financial management arrangements and financial and project accounting systems can be relied upon for the purposes of the project.
If issues and/or weaknesses are identified, determine the most appropriate mitigation measures (e.g., restructuring finance sections, increasing finance staff, filling vacant posts, developing new systems, developing financial reporting, training, etc.).
Determine whether, given the findings, it is necessary to include a project component to strengthen financial management in the EA and/or IA and/or establish or strengthen a project implementation or project management office via either technical assistance or consultant support within the project.