What is Project Finance ?

Definition And Basic Characteristics

Project finance structure differ between various industry sectors and from deal, since each project has its own unique characteristics. Somehow, there are common principles underlying the project-finance approach.

The Export-Import Bank of the United Stated defines project finance as :

"...the financing of projects that are dependent on project cash flows for repayment, as defined by contractual relationships within each project. By their very nature , these types of projects rely on a large number of integrated contractual for successful completion and operation. The contractual relationships must be balanced with risks distributed to those parties best able to undertake them, should reflect a fair allocation of risk and reward. All project contract must fit together seamlessly to allocate risks in manner which ensures the financial viability and success of the project."

The Organization for Economic Cooperation and Development (OECD) provides another ‘official’ definition of project finance in the context of the Export-Credit Consensus :

1. The financing of a particular economic unit in which a lender is satisfied to consider 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.
2. Financing of export transactions with an independent (legally and economically) project company, e.g. special purpose company, in respect of investment projects generating their own revenues.
3. Appropriate risk-sharing among the partners of the project, e.g. private or creditworthy public shareholders, exporters, creditors, offtakers, including adequate equity.
4. Project cash flow sufficient during the entire repayment period to cover operating costs and debt service for outside funds.
5. Priority deduction from project revenues of operating costs and debt service.
6. A non-sovereign buyer/borrower with no sovereign repayment guarantee (not including performance guarantees, e.g. offtake arrangements).
7. Asset-based securities for proceeds/assets of the project, e.g. assignments, pledges, proceed accounts;
8. Limited or no recourse to the sponsors of the private sector shareholders/ sponsors of the project after completion.”

The principles of project finance can be summarized as :

• The project usually relates to major infrastructure with a long construction period and long operating life.
• Lenders rely on the future cash flow projected to be generated by the project to pay their interest and fees, and repay their debt.
• There is a high ration of debt to equity ('leverage' or ' gearing')-- roughly speaking, project finance debt may cover 70%-90% of the capital cost of a project.
• The project company's 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 project involving public infrastructure they cannot be sold anyway.
• The project has a finite life, based on such factors as length of the contracts or licenses, or reserves on natural resources.
• There are no guarantees from the investors in the Project Company for the project-finance debt

Elements of A Project-Finance Structure

To look in more detail at structure of a project financing, this usually has two elements:

• Equity, provided by investors in the project
• Project Finance-based debt, provided by one or more groups of lenders.

The project-finance debt has first call on the project's net operating cash flow; the investors' return is thus more dependent on the success of the project. So as the investors are taking a higher risk, they expect a higher return on their investment, and the reverse is true for lenders.

A nexus of contracts signed by the Project Company provide support for the finance. A ‘Project Agreement’ is often at the center of this contractual structure. This may take two main forms:

either an ‘Offtake Contract’, under which the product produced by the project will be sold on a long-term pricing formula to an ‘Off-taker’

or a contract with a central government department, regional or state government, county or municipality, or another public agency (‘Contracting Authority’ will be used to cover all of these),10 which gives the Project Company the right to construct the project and earn revenues from it.

Examples of Project-Finance Structures

Process Plant Projects

These are project where there is an input at one end of the project, which goes through a process within the project and emerges as an output, e.g:

• Thermal Power Generation : input - coal or gas ; process - burning/conversion to steam ; output - electricity (and sometimes heat)
• Water Treatment : input - untreated water ; process - treatment of the water; output --potable water
• Waster Incineration; input - household or commercial waste ; process - incineration ; output - electricity (and sometimes heat) and as residue
• LNG (Liquid Natural Gas) Terminal : input - LNG, brought in by sea in an LNG Carrier; process - regasification; output - gas to pipeline

Typical basic element of thus type of project, using a gas fired power station as an example

In this case the Project Agreement is in the form of a type of Offtake Contract, namely a Power Purchase Agreement (PPA) , under which an electricity-distribution company purchases the project's output based on a pre-agreed 'Tariff'. This Off-taker may be either a public or private sector entity, depending on whether the electricity industry is privatized in the country concerned.

The key Sub-Contracts are :

• an Engineering Procurement and Construction Contract (EPC Contract) for design and construction of the power plant
• an Input-Supply Contract, in this case Gas Supply Agreement under which the gas to fuel the plant is supplied
• an Operation and Maintenance Contract (O&M Contract) with an experience power-plant operator

Infrastructure Projects

There are three main categories here

Privatized and Private-Sector Infrastructure. Economic infrastructure such as ports and airports may be privatized. In such cases the infrastructure company may raise debt on a corporate-finance basis, with lenders relying on cash flow from the business as a whole, and security over the company’s assets, or a particular self-contained new investment may be financed on a project finance basis (e.g. a new terminal at an existing privatized port or airport). Typically in the latter cases there will be no Project Agreement but there may be one or more Sub-Contracts with users of the facilities, e.g. airlines or shipping companies, which are very similar to Offtake Agreements since the contract counterparties agree to pay for their use of the facilities’ services.

Public–Private Partnerships. These are projects in which the private-sector Project Company finances, operates and maintains public infrastructure, and is paid for its use; the asset concerned usually reverts to public-sector control/ ownership at the end of the contract term. These are known as Public-Private Partnerships (PPPs or 3Ps), and are based on a contract between the Project Company and a Contracting Authority. There are two main PPP models :

• ‘Concessions’: construction or refurbishment of public infrastructure such as a road, bridge, tunnel, airport, port, railway, etc., with revenue derived from tolls, fares or similar payments by users (User Charges)
• ‘PFI Model’: construction or refurbishment of a public building (such as a school, hospital, prison, public housing or government office), or other public infrastructure (such as a road, railway line, water-treatment facility or sewage plant), with revenue derived from payments by a Contracting Authority (‘Service Fee’).

Revenue Bonds. This structure (only found in the U.S. market) makes it possible for a project owned and managed by the public sector to use private finance on a project-finance basis

Figure 2.2 sets out the typical basic structure for a toll-road Concession. The Project Agreement here is a ‘Concession Agreement’, which provides for User Charges (tolls) to be paid by road users to the Project Company.

The key Sub-Contracts are:

• a Design & Build Contract (‘D&B Contract’) to design and build the road
• an Operating Contract to operate the tolling system
• a Maintenance Contract for the continued maintenance of the road.

Figure 2.3 sets out a typical basic structure for the PFI Model as used in a social infrastructure project such as a school or hospital. The term Project Agreement is usually used for the contract with the Contracting Authority, under which Service-Fee payments are made to the Project Company.

The key Sub-Contracts in this case could include:

• a Design & Build Contract (‘D&B Contract’), to design and build the building
• Maintenance Contract, 21 for maintenance of the building’s physical structure and key equipment
• One or more ‘Building-Services Contracts’, for the provision of services such as cleaning, catering and security. (Or this may be dealt with as part of one contract covering both maintenance and services.)