Project Finance: How Private Capital Can Help Manage Risks
What is project finance?
Project finance is a way of meeting the costs of a major project over the long term, that can also help manage a variety of associated risks. Typically, project finance is a form of credit that is linked specifically to the project rather than its sponsors. Project finance is generally repaid through the cash flows the project eventually generates and is usually structured as ‘non-recourse debt’. This means that lenders only have recourse to borrowers and do not have any claims against any of the other assets of the sponsors in the event of a default.
Project financing can be used in a variety of industries which include: i) infrastructure development such as new roads or railway lines, ii) projects in the power and energy sector like wind farms, solar plants, and oil extraction platforms, and iii) other medium to large-scale construction projects. In general, these are transactions that require a significant amount of initial capital investment, but which can generate predictable long-term revenue streams in the future.
Why do companies use project finance?
Perhaps the most valuable aspect of project finance is its ability to help companies fund meaningful upfront costs and manage the risks associated with expensive, large-scale projects. Project finance allows sponsors to ring-fence specific projects and keep them off their balance sheets. This off-balance sheet approach means the project generally does not have a negative impact on the company’s creditworthiness or any regulatory requirements.
Project finance deals are designed to run over several years and even decades in some cases. Major infrastructure projects tend to be unique, and this form of lending is flexible enough to be tailored to the specific characteristics of the project. For example, project financing arrangements can be structured to account for the fact that a project may not generate any income until several years after the initial investment has been made.
Project finance and special purpose vehicles
Companies often use special purpose vehicles (SPVs) to manage major infrastructure, industrial, and commercial projects. SPVs are legal entities that are separate from the company implementing the project. They can help provide clarity around the ownership and control of the project while protecting companies’ other assets from any associated financial risks. SPVs can also be used in the securitization of the cash flows from the project, if required, and they can also make it easier to sell the ownership of the project at a later date.
The advantages and risks of project finance
While project finance has several advantages, sponsors should also be aware of the risks involved.
Working with private lenders in project finance
Given the complex and extended nature of the typical project finance deal, it is important to work with a private lender that has experience in establishing supportive, patient, long-term relationships with sponsors. The right lender can provide a variety of project finance options, for example a combination of senior and subordinated debt, as well as preferred equity. They can also offer access to follow-on capital that can be used to meet future requirements related to the project and underpin future growth.