Project Finance or Structured Financing is a mechanism of leveraged financing with limited resources. What does this mean? That financing depends mainly on generating cash flows from the project used to repay the debt versus traditional financing. The most important thing is the value of the assets that serve as collateral.
It is used for large investment projects and is tailored to the project in terms of terms, shortfalls, amounts, and the sole guarantee of commercial operations (income) and project assets.
The financing, when Project Finance is used, does not depend so much on the value of the assets that the sponsors can place as a guarantee of the project, but rather on the capacity of the project to generate own resources that allow it to pay the contracted debt and remunerate the invested capital.
The Distinctive Features:
Among its distinctive features, we can highlight the following:
- The high amount (applies to projects from around 20M dollars but can have volumes of up to tens of billions).
- Through an independent company created for this purpose, it finances investment projects that require large disbursements and are guaranteed by the expected cash flows, that is to say, due to its economic robustness.
- Cash flows must be predictable with a high degree of certainty since they are the ones that guarantee the viability of the project.
- It is off-balance-sheet financing for the promoters of the investment, which is materialized by creating an independent company of the same, formed by industrial partners and financial partners.
- The risks are assigned to those in a better position to assume it through the adequate structuring of the main project contracts.
With Project Finance, a structure tailored to each need is designed to balance financing, cost, and associated risk. Project finance limits risks and allows companies to free up resources to allocate to other investment projects.
SPV:
The most used structure to carry out this project is to create a company dedicated exclusively to this purpose, called the Special Purpose Vehicle (SPV). In this way, it is possible to individualize the risk of the projects of the promoters avoiding the potential contagion in case of the non-viability of a certain project.
The vehicle company is the issuer of the debt that uses the cash flows generated by the project to repay the financing. These types of projects can achieve a significant level of financial leverage (indebtedness).
Advantages:
Many advantages exist in Project Finance, but the main ones are the following:
- It is off-balance-sheet financing (the SPV assumes the debt), limiting the risks assumed by the promoters and the financial guarantees. This implies that the promoters do not see their debt ratio modified, maintain the capacity of new indebtedness, and preserve their credit rating (rating).
- The project obtains higher levels of financing and indebtedness, which will be determined by the new Independent Vehicle Company, which will be greater than that which would have to be financed directly by the sponsoring company.
- This financing formula allows for longer repayment terms of the debt and much higher financing figures than the promoter company would achieve on its own.
- One of the main advantages for banks is in the price since being a leveraged structure, the margins and commissions are higher. This also entails great requirements on their part, such as the issuance of qualified certificates and the requirement of numerous ” covenants ” to the project (conditions of mandatory compliance, such as terms, margins, revenues, risks, financial ratios, etc.).
- In addition, banks can sell their participation in the project.
- Another advantage is the “customized” design of the operations based on the intrinsic characteristics of the project.
- The partners can increase their debt capacity while maintaining their credit quality or rating despite the greater indebtedness.
But what is the difference between project finance and syndicated loans?
The main differences are the following:
- The main difference between a Project Finance and a corporate syndicated loan is the structure of the Project Vehicle Company. In syndicated loans, the company assumes the debt at the corporate level, which entails less risk of default. In Project Finance, it is also common to organize among several banks, depending on the size of the project and the volume of the debt.
- Financing in Project Finance is related to the investment project itself and is guaranteed by the financial flows of the project itself. At the same time, the Independent Vehicle Company obtains high financing, which makes its debt ratio soar. It is an operation with high risk, but it is guaranteed with the cash flows expected from the investment, with a high degree of certainty, making late payment almost non-existent.
- In Project finance, you can use many instruments. It is not a financial instrument; it is a structure in which syndicated loans are often used, or a combination of syndicated loans, bilateral loans, share issues, bond issues, convertible bonds, depending on the market situation, project characteristics, location, etc.
Is this financing more expensive?
Generally, yes, due to more risk for creditors due to the absence of guarantee by the promoters. In addition, its complex financial, legal, technical, and fiscal structuring makes it necessary to face high costs in fees of professionals, consultants, lawyers, etc., which make operations more expensive, which is why they only apply to large-scale operations.
Thus, Project Finance is more expensive than Syndicated Corporate Credit since the repayment capacity depends directly on the project’s feasibility, and the guarantees are limited. The banks do not have access to other activities carried out by the promoters.
Therefore, at the time of its origination, Project Finance requires a more in-depth study of its viability and the cash flows it will generate, which also generates costs and the requirement of banks to receive periodically qualified reports and continuous reports monitoring of the project.
The expenses and financial costs of Project Finance are greater than in traditional financing due to greater risk and a more complex financial structure. In the case of Project
In what types of projects do you usually invest?
The projects that are likely to use this financing formula can be framed in the following:
- Energy, renewable energy, refineries, tunnels, railways, oil platforms, wind farms, solar, oil, and gas pipelines.
- Infrastructures such as highways, airports, fishing ports.
- Great civil works such as hospitals, bridges, universities, etc.
- Communications, fiber optic networks, satellites, cables, airplanes.
- Industrial, chemical, steel, and other heavy industries.
- Its use has been extended to other sectors, such as real estate or hotels, in recent years.
How do these types of projects contribute to the economy?
Project Finance constitutes financial forms or models for obtaining external resources to carry out large-scale projects. Within the Financial Economic, this financing model introduces new forms of risk assessment to realize investments, constitutes an efficient way of financial intermediation and operation of capital markets for large projects, and a new valuation model of investments and decision-making within the company.
The Public-Private Partnership is common for Project Finance (projects in which private initiative joins the public sector in different proportions).
The Administration, for the construction of public infrastructures, cedes the management of the construction and exploitation rights through the transmission of the concession rights without losing influence on the activities of the SPV. This allows you not to increase public indebtedness. At the end of the concession period, private financing and management can be reversed. Thus, society benefits from the know-how and the economies of scale that promoters have.
In short, it allows the development of large infrastructures, in many cases linked to basic services (transport, health) that otherwise would have been difficult to obtain the necessary financing to develop them. On the other hand, its complexity allows the development of innovation in the financial sector and the appearance of financial entities, consultants, advisors, and banking divisions specialized in this type of operations.
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