PROJECT FINANCING

Definitions:
Project Financing may be defined as the raising of a fund on a limited recourse or non – recourse basis
to finance an economically separable capital investment project in which the providers of the funds
look primarily to the cash flow from the project as the source of funds to service their loans and
provide the return of and a return on their equity invested on a project.
- John D. Finnerty
A financing of major independent capital investment that the sponsoring company has segregated
from its assets & general-purpose obligations.
- Larry Wynant
Use of non-recourse or limited recourse financing.
- World Bank
Economically separable capital investment - Project financing is used to large infrastructure projects
where there is a requirement of large funds. Separate project company (known as project company or
special purpose vehicle (SPV)) from their own company is formed, for the purpose of project
financing, through which funds are raised which does not has its own assets.
Recourse financing – The lenders will have the full recourse to the assets or the cash flow of the
shareholders with no limitation for the purpose of repayment on loan if they were unable to pay the
loan amount.
Limited recourse basis(pic) – Lender may have certain recourse to the assets of the project company.
It
Non-recourse basis – Lender, in case of default, will have limited recourse to the project assets.
Lender, before providing loan, checks the cash flow of the project in order to assess whether to
provide the loan or not. The interest and the principle amount are going to be paid form that cash flow
in the future.
Difference:

i. The main difference that exists between limited recourse & non-recourse basis project financing is
on the basis of the ability of the lender to take the assets of the borrower if the debt is not
paid. In limited recourse a lender is given recourse rights in a borrowing arrangement, it
means that the lender can pursue repayment of the debt from the borrower by seizing
designated borrower assets. However, a recourse arrangement may only allow the lender to
attach specifically identified borrower assets, beyond which the lender has no ability to
obtain additional borrower assets. In this case, the existence of a recourse feature may not
provide complete risk mitigation for the lender.
On the contrary, under non-recourse basis a lender does not have any recourse to borrower’s
assets.
ii. Non-recourse debt favors the borrower, while recourse debt favors the lender.
iii. Non-recourse – High risk
Limited recourse – Low risk
Features:
1. Capital intensive – These projects require huge amounts of capital in order to start the project.
Project Financing is ideal for ventures requiring huge amount of equity and debt, and is
usually implemented in developing countries as it leads to economic growth of the country.
Being more expensive than corporate loans, this financing scheme drives costs higher while
reducing liquidity. Additionally, the projects under this plan commonly carry Emerging Market
Risk and Political Risk. To insure the project against these risks, the project also has to pay
expensive premiums.
2. Highly leveraged – The portion of debt will be higher in comparison to equity. The percentage of
debt in such projects can range from 65%-85%.
3. Long term independent entity- A SPV is formed which will have independent existence. Such SPV
is formed for a long period of time generally between 10-15 years. Such SPV has finite life i.e. they
exist only till the completion of project.
4. Non-recourse or limited recourse basis - Since the borrower does not have ownership of the
project until its completion, the lenders do not have to waste time or resources evaluating the
assets and credibility of the borrower. Instead, the lender can focus on the feasibility of the
project. The financial services company can opt for limited recourse from the sponsors if it
deduces that the project might not be able to generate enough cash flow to repay the loan
after completion.
5. Many participants- As Project Financing often concerns a large-scale project, it is possible
to allocate numerous parties in the project to take care of its various aspects. This helps in
the seamless operation of the entire process. They are many participants involved in building
such projects. They could be project company, government, project sponsors or owners, contractor,
operator, supplier, customers and lenders.
6. Allocated risk – In such kind of projects involve huge investment & huge risk. All the risks are
being allocated to different participants involved in the projects. To give the effect to the same, the
participants enter into an agreement under which they have to complete their tasks & duties within a
stipulated period of time. In case of failure, they can be penalised for the same. This also helps in risk
mitigation. Lenders provide loan on the basis of allocated risk. Under this financial plan, some of
the risks associated with the project is shifted towards the lender. Therefore, sponsors prefer
to avail this financing scheme since it helps them mitigate some of the risk. On the other
hand, lenders can receive better credit margin with Project Financing.
7. Dividend policy –In such projects a restrictive dividend policy is followed. Lenders enter into an
agreement with the project company

8. Costly - One of the most common features of project financings is the cost which is
generally more expensive than typical corporate financing options. Additionally, project
finance frequently involves the use of highly-specialized financial structures which drives
costs higher and liquidity lower. The cost of underwriting a project financing is
significantly higher than is any other field of finance.
Participants:
1. SPV- Going to take care about commencement of project & operations of the project. The project
company is the special-purpose entity that will own, develop, construct, operate, and maintain
the project. The precise nature of organization for this entity is dependent upon a myriad of
factors.

2. Government – Government can also play an important. In such kind of projects government
generally issues tenders to build large infrastructure project. Government can also sponsor such
projects (Concessionaire agreement). The SPV must be incorporated in accordance with the
government’s rules and regulations. It also often acts as a guardian angel in providing
various tax concessions, subsidies, and rebates.
3. Project sponsors or Owners- Going to fund the project. They are going to earn returns & they will
be liable for operations of the project. They may play the role of operator or contractor also.
The project sponsor is the entity, or group of entities, interested in the development of the project
and that will benefit, economically or otherwise, from the overall development, construction, and
operation of the project. It is sometimes called the developer. The project sponsor can be one
company or a group of companies.

4. Contractor – Responsible for construction of the project. As in any construction job, suppliers
and contractors are necessary for the execution of a contract. They are the key suppliers of
raw material. They also perform crucial functions such as design and build (D&B), operations
and maintenance (O&M), etc.
5. Operator – They ensure project runs smoothly. They also ensure that the project should generate
revenue. They are also responsible for maintenance of the project.
6. Suppliers – One who is going to supply raw materials in an uninterrupted manner.
7. – Customers/off takers – They enter into long term agreement with project company to provide
with products or services. Off-takers are bound via an off-take agreement to mandatorily
purchase a certain minimum quantity of produce from the selling party. An off-take
agreement is a frequently resorted to in mining, construction and other industries of mass
significance. The vendor (SPV) incurs a huge amount of capital expenditure. An off-take
agreement ensures the seller of the existence of a market upon completion.
8. Lenders – Provides funds. It may be a single lender or a consortium of financial institutions.
They are the providers of senior debt and hold precedence over debt extended (if any) by
the sponsors. The loan is secured strictly against the cash flows and assets of the SPV only.
Therefore, sufficient due diligence is performed before the grant of any credit.

Difference between corporate finance & project finance:

Corporate finance -
1. Financing Vehicle – SPV isn’t formed in case of corporate finance.

2. Type of capital – CF- more of equity PF- more debt. In

project finance, there also is
financing activity, but it is tied to the creation of some large project. Financing
involves mostly debt — often high amounts of it — but some equity might be
used as well.
3. Dividend policy - CF – no restrictions, PF – restriction
4. Financial structures – CF – same financial structures (not innovative, well-defined), PF – unique
financial structures (cannot be same for two projects).
5. Transactions costs for financing – CF – low interest rate (low risk), PF- high interest rate (high risk)
6. Basis for credit evaluation – CF – owner/ project assets(balance sheet of the company), PF – on the
basis of various visibility reports coz generally there are no assets. There is a degree of risk
associated with both corporate finance and project finance. Those risk factors
can be higher in project finance because this form of financing relies on
revenues that have not yet been generated for the repayment of debt. Corporate
finance also introduces an element of risk. The key difference is that the merits
of project finance are based on a project's potential, and in corporate finance,
capital might be extended based on the credit quality and profitability of a
business.