What is Project Finance?
Project Finance deals with financial aspects related to a particular project that involves analyzing the feasibility of a project and its funding requirements on the basis of the cash flows that the project is expected to generate, if undertaken, over the years.
- Large projects, especially related to infrastructure, oil, and gas, or public utility, are highly capital intensive and require funding. Project finance acts as a means to fund these projects. It involves considering a project on a standalone basis. The project themselves are treated as financial entities (Special Purpose Vehicles or SPVSPVA Special Purpose Vehicle (SPV) is a separate legal entity created by a company for a single, well-defined, and specific lawful purpose. It also serves as the main parent company's bankruptcy-remote and has its own assets and liabilities.s).
- It is so because the financing of these projects usually remains off-balance-sheetOff-balance-sheetOff-balance sheet items are those assets that are not directly owned by the business and therefore do not appear in the basic format of the balance sheet. However, they tend to impact the financials of the company indirectly. of the company that is undertaking the project. It is done in order to reduce the risks involved and their possible impact on the company’s existing balance sheets.
- Thus, all the liabilities of the project are paid off only from the cash flows generated by the project. Assets owned by the parent companyThe Parent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. can’t be used to pay off these debts.
Key Features of Project Finance
The following are key features –
- Risk Sharing: The company shares the risks associated with the project failure with the other participating entities by keeping the project off the balance sheet.
- Involvement of Multiple Parties: As the projects are large and capital extensive, multiple parties often provide capital in the form of debt or equity.
- Better Management: As the whole project is a different entity in itself, often, a dedicated team is assigned to look after the completion of the project, which results in better efficiency and output.
Sponsors in Project Finance
Sponsors associated with a special purpose vehicle can be of following types:
- Industrial: These are mainly those whose business gets impacted in some way (positive impact) with the project been executed.
- Public: These include the sponsors that have the public interest in mind. These can be associated with government or other cooperative societies.
- Contractual: These sponsors are mainly involved in the development, operations, and maintenance of the project.
- Financial: These include the sponsors that participate in project financing, looking for high returns.
Different Stages of Project Financing
The following are different stages –
#1 – Pre Finance
- Identification of the project to undertake to depend upon business requirements and industry trends;
- Identifying the risks involved if the project is undertaken (both internal and external);
- Investigating the feasibility of the project, both technical and financial, on the basis of resource requirements;
#2 – Finance
- Identification and reach out to possible stakeholders to meet financial needs.
- Negotiate the terms and conditions associated with the debt or equity from stakeholders.
- Receiving the funds from the stakeholders;
#3 – Post Finance
- Monitoring the project cycle and milestones associated with the execution;
- Completing the project before the deadline;
- Repayment of the loans through the cash flows generated from the project;
The following are risks involved –
- Costs of Project: During the financial and technical analysis of a project, a certain cost of raw materials would have been assumed. If the costs exceed the assumptions, it will get difficult to repay the capital.
- Timeliness: Missing the deadlines associated with the project can result in penalties.
- Performance: Even if the project gets completed on time, it is necessary that it meets the expectations so that it can generate expected cash flows.
- Political Risks: Government related projects always have huge political risksPolitical RisksPolitical risk is defined as a risk that emerges as a result of a change in a country's governing body, posing a risk to investors in financial instruments such as debt funds, mutual funds, and equities. involved as a change in political policies can impact funding, feasibility, requirements of the project.
- Currency Exchange: If the lenders are not local, the capital will involve exchange rate risksExchange Rate RisksExchange Rate Risk is the risk of loss the company bears when the transaction is denominated in a currency other than the company operates. It is a risk that occurs due to a change in the relative values of currencies. as interest payableInterest PayableInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company's balance sheet. can go up.
Why is SPV Necessary for Project Finance?
SPVs are beneficial from the perspective of both the lenders as well as sponsors:
- Sponsors: As the project is off the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. of the sponsors, it mitigates the risks associated with project failure; that is, if the project fails, creditors will not have any right on the assets of the sponsors.
- Lenders: It is beneficial for the lenders, too, because risks that are associated with the sponsors’ main business do not get transferred to the project.
- As the SPV is a different entity altogether, it can raise as much debt as the project needs, depending upon expected cash flows, irrespective of the credit rating of the sponsors.
- Project Financing helps to reduce the risks associated with the project as well, for both lenders and sponsors, as discussed in the benefits of SPV.
- Project Financing provides the companies with an opportunity to come together for a common objective. For example, an upstream oil and gas company can form an SPV with a company having oil storage tanks to form a pipeline that connects both.
Some of the disadvantages are as follows.
- A simple loan facility is easier to avail as well as to manage in accounts books than project financing because an SPV often involves multiple entities, and they all have to agree on multiple decisions related to financing, operating, execution, etc. which makes the project financing complex.
- Incorporating an SPV can be a tedious process in terms of compliances, regulations, documentation, etc. because its functions and business requirements differ from other corporate entities.
- Considering the complexities involve with the funding and business conduct of the SPVs, there might be the requirements of experts and professionals like investment bankers, which can be costly.
The major limitation of project financing is associated with its usage for small projects. Considering the disadvantages of project financing discussed above, such as the costs, complexities, documentations, it may not be feasible to opt for project financing for small scale projects.
Project Financing is a very useful capital infusing scheme for huge projects in which cash flows generated from the project itself can be used to repay the loans availed for its execution. It helps in risk mitigation, collaboration, and project management as well. On the other hand, it involves higher costs, is more complex, and more compliance-oriented. Thus, a cost-benefit analysisCost-benefit AnalysisCost-benefit analysis is the technique used by the companies to arrive at a critical decision after working out the potential returns of a particular action and considering its overall costs. Some of these models include Net Present Value, Benefit-Cost Ratio etc. should be conducted before opting for project finance.
This article has been a guide to what is project finance and its meaning. Here we discuss the features and risks of project finance along with its sponsors, advantages, and disadvantages. You can more about finance from the following articles –