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PF - A Note on Project Finance
Project finance is not exactly a newcomer to the international finance scene. Indeed in 1856 financing for the building of the Suez Canal was raised by a variant of this technique. But it was not until some sixty years ago that early project finance techniques were used in the United States to fund the development of oilfields. Small Texan and Oklahoman wildcat explorers lacked sufficient capital to develop their oilfields and could not raise sufficient straight debt on their own credit standings. The bankers developed a form of production payment finance – instead of looking to the company’s balance sheet for security, the banks relied on the specific reserves themselves with the direct proceeds of oil sales earmarked for the loan’s repayment.
A number of variations on this theme developed, but it was not until the expansion in North Sea oilfields that project finance grew beyond production payment financing and assumed some of the variety that it has today. Subsequently international banks have used project finance concepts first for major mineral developments, then for infrastructural development, and then in the manufacturing sector. Toll roads, tunnelling projects, theme parks, production facilities in the utilities industries, shipping and aircraft finance have also received funding via project finance techniques, although the popularity of particular industries waxes and wanes from time to time.
Project finance is illusive in terms of precise definition because there is no single technique that is immutably used – each facility is tailored specifically to suit the individual project and the needs of the parties sponsoring it. In essence, the expression project finance describes a large-scale, highly leveraged financing facility established for a specific undertaking, the creditworthiness and economic justification of which are based upon that undertaking’s expected cash flows and asset collateral. It is the project’s own economics rather that its sponsor’s (usually the equity owners) financial strength that determines its viability. In this way, the sponsor isolates this activity from its other businesses. Through careful structuring, the sponsor may shift specific risks to project customers, developers and other participants, thus limiting the financial recourse to itself.
This process of sharing risk is not without costs. Project finance borrowing is normally more expensive than conventional company debt and the very large number of contracts that must be specified between the relevant parties entails additional time and expense. But the ultimate result may be more acceptable to the sponsors. Compared with direct funding, it is usually off-balance sheet and this may better reflect the actual legal nature of non-recourse finance.
Lenders may be attracted to project finance. In addition to higher fees, they can be sure that cash generation will be retained within the project rather than diverted to cross-subsidize other activities. The lenders further benefit in terms of their first claim to these funds. They are protected by a range of covenants from the sponsor and other parties. Spreading project risks over several participants lessens their dependence on the sponsor’s own credit standing too. The typically large capital requirement necessitates syndication to a group of institutions, so that the credit exposure is shared across many lenders. A properly structured project finance facility does not necessarily entail more risk exposure than a normal corporate advance.
It can be seen that in project lending the focus is entirely upon the project being financed. The lender looks, mainly (often wholly), to the project as a source of repayment. Its cash flows and assets are dedicated to service the project loan. Clearly, the project cannot start to repay a loan until it is operational and continuing to operate soundly, so analysis by lenders is critical. If any major part of the project fails, lenders probably lose money. Projects lack a variety of products and their assets are highly specialized, equipment may be of relatively little value outside the project itself and may, sometimes be geographically remote. A project’s assets may provide little in terms of the second exit route that bankers usually like in respect of a loan facility. Because of this, project finance is regarded by bankers as high risk/high reward money – although the risk may be reduced by careful structuring. The other side of the coin is that project cash flows are dedicated to debt repayment.
The owner’s risk is often confined to whatever equity or guarantees are needed to make the project viable. Having said this, where the owner plays another role – perhaps contractor or operator – then the owner bears the normal risks associated with these roles. In recompense for the limited risk, the owner will often take nothing out of the project until debt has been repaid – only the strongest of projects can accommodate early withdrawal. Once the project becomes debt-free, then everything that remains is the owner’s.
The specific features below distinguish project finance from conventional corporate borrowing. They may not all be present in a particular project financing instance.
§ The project is usually established as a distinct, separate entity.
§ It relies considerably on debt financing. Borrowings generally provide 70–75 per cent of the total capital with the balance being equity contributions or subordinated loans from the sponsors. Some projects have been structured successfully with over 90 per cent debt.
§ The project loans are linked directly to the venture’s assets and potential cash flow.
§ The sponsors’ guarantees to lenders do not, as a rule, cover all the risks and usually apply only until completion (coming on-stream).
§ Firm commitments by various third parties, such as suppliers, purchasers of the project’s output, government authorities and the project sponsors are obtained and these create significant components of support for the project credit.
§ The debt of the project entity is often completely separate (at least for balance sheet purposes) from the sponsor companies’ direct obligations.
§ The lender’s security usually consists only of the project’s assets, aside from project cash generation.
§ The finance is usually for a longer period than normal bank lending.
Project finance is most frequently used in capital-intensive projects which are expected to generate strong and reasonably certain cash flows and which may consequently support high levels of debt. Many oil companies, which are small relative to the sums involved in the development of major fields, have used project finance to enable them to pursue major new developments using a production payment loan on an existing field already in production to pay for the further development of a new field – rather as a property developer can mortgage existing properties to provide finance for new developments. These kinds of production payment loan tend to be on a limited recourse basis – that is, if the field fails to produce sufficient revenue, the lender has no recourse to the oil company itself except in limited circumstances, such as failure of the oil company to operate the field competently. In this way, the company sheds some of its risk while retaining the long-term benefits of its new discovery.
PF1 Limited recourse finance
At this point, it is worth distinguishing between limited recourse and non-recourse financing. In project finance terms, non-recourse financing occurs when lenders do not, at any stage during the loan, including the pre-production period, have recourse for repayment from other than project cash flows. In practice, such financing is almost unobtainable. Limited amounts of debt are structured on this basis, and it is becoming more common for major foreign corporate investors buying into energy projects to provide a guarantee to finance the project on a basis that is non-recourse to the original sponsors.
The essential difference between non-recourse and limited recourse finance is highlighted when a project is abandoned prior to becoming operational. In the non-recourse case, the sponsors can, in principle, walk away from the project without liability to repay the debt; this is almost never the case in limited recourse financing. Limited recourse financing is a more accurate description of most project financing involving bank lenders. Such instances include a very wide spectrum of arrangements which restrict the ability of lenders to look to project sponsors for repayment of debt in the event of problems with the loans. Typically, lenders have narrowly defined claims against sponsors for loan repayment prior to completion – that is, until the construction is complete and the project operational. On completion, lenders have recourse only to project cash flows and assets. Completion is thus a vital issue for lender and project borrower alike; this topic is discussed later in this note.
PF2 Ownership structures
Many projects undertaken using project financing techniques are jointly owned or jointly controlled. Reasons for joint ownership or control vary widely between projects but major factors influencing such joint ownership include:
§ project development risks may be too large for one participant only and are thus shared by partners;
§ benefits from the combination of skills and other resources may be substantial;
§ the project development outlays and other considerations (as well as risk tolerance) may be beyond the financial and managerial capacity of a single owner.
The development of a financing plan for a large project involves three key phases – these embrace:
§ establishment of an appropriate ownership and operation structure for the project;
§ formulation of a suitable financing structure which meets the sponsors’ objectives;
§ development of appropriate borrowing mechanisms which best meet the capital and cash flow requirements of the project.
The selection of an appropriate ownership structure by sponsors is determined by their objectives and financial, legal, accounting and taxation constraints. Structures vary from project to project. There are four main types of entity used for jointly owned projects. These are set out below.
§ Incorporated entities. When a corporation is used to own and develop the project, each sponsor holds shares in this company rather than in the project itself. While its corporate structure allows greater flexibility in raising debt capital, tax losses and allowances resulting from the project can usually only be used within the project company itself. Since many projects do not generate profits in the early years, such tax benefits can remain unused for some time. This structure may also result in higher funding costs due to the limited liability and non-recourse features created. Nonetheless it is one of the most popular ownership structures in project finance.
§ Trusts. Similar to a project company structure, in the trust the sponsors hold units instead of shares in the company. A nominally capitalized company would usually be established to act as trustee and it would handle all of the contracts and hold the legal title to the trust’s assets. A trust can be readily dismantled and the project assets transferred back to the sponsors at any time. But there can be some loss of flexibility due to the trustee’s strict legal obligations. In project financing, trusts may suffer from the same tax disadvantages as companies.
§ Partnerships. Here, the project is owned and operated by the partnership and the partners benefit in accordance with the partnership agreement. As the partnership is not usually a taxable entity, partners can gain immediate access to any tax advantages but there is the major disadvantage that the partners have unlimited liability for all of the partnership debts. Sponsors might form separate subsidiaries to shield themselves from this direct liability problem and still retain many tax advantages, but it is not the most popular of ownership structures in project finance.
§ Joint ventures. An unincorporated joint venture is a common ownership structure for projects. The joint venture is evidenced by a legal agreement between the sponsors which defines the obligations of the sponsors in the venture. In terms of setting off losses, this structure has tax advantages.
The choice of ownership structure involves a trade-off between the risk exposures of the sponsors and the returns from the project. These include commitments by the sponsors and other third parties to satisfy syndicate lenders’ concerns that the project can support, in its own right, a substantial amount of debt. Lenders have a general preference for conventional incorporation of a project venture. In practice, though, the only differences between borrowing through an unincorporated joint venture project and through an incorporated one are the legal costs, tax effects and complexity of the security arrangements.
PF3 Financing structures
With an appropriate ownership structure agreed, it is necessary to choose a financing structure that meets the sponsors’ funding objectives. One of these is usually to arrange finance on a limited recourse basis. The degree of recourse may vary from project to project and, indeed, between different sponsors in the same project. Where limited recourse finance is sought, a separate borrowing vehicle is usually established for the financing and this clearly separates the project liability from the general liabilities of the sponsor. A much less frequently used alternative is for the loan to be extended to the sponsor, with limited recourse being achieved through the terms of the loan agreement.
Another key objective concerns the sharing of project risks between sponsors and other parties. Since sponsors may wish to shed certain project risks, the financing structure might ensure that their impact is shifted to other parties. For example, bank lenders may assume most of the project risks following completion on the condition that marketing risk is covered by pre-arranged sales contracts. Floor pricing arrangements are also a means of risk sharing. In such circumstances, the purchaser takes the commercial risk that it is able to perform given the floor price arrangement, and the bank takes the risk that the loans may not be repaid if the purchaser is unable or unwilling to perform. Also, marketing risks may be reduced by the introduction of minority participants who are buyers of the project’s production. In some projects, individual sponsors may have specific objectives which affect the financing structure. The most frequently encountered structures in project financing include:
§ project sponsors borrowing through a project subsidiary;
§ project sponsors borrowing direct;
§ a structure based upon production payments;