Project Financing, page 1 of 2
PROJECT FINANCING
WHAT IS PROJECT FINANCING?
- Project financing is for a distinct, readily identifiable investment or “project.”
- Project financing can be for a simple investment or a complex investment. The financing could be for a single ship or airplane. The financing could also be for a large complex investment such as a gas field for export overseas, complete with collection system, liquefaction plant, ships for transport and facilities at the consuming end to convert the liquid into gas.
- Projects are generally income producing. Pure project financing is non-recourse and payment to financing sources is entirely from the project. That is, only the project itself guarantees the financing. Non-recourse means that a group of utilities that owns a gas field and project finances it will not be responsible for any of the financing in the event of default.
- Project financing has existed for a long time.
- Project financing was very popular in the U.S. in the 19th century in financing railroads (bondholders only security was the railway and its revenues).
- Since 1945, the World Bank extended project financing for dams, power plants, ports and roads. However, these are not pure project financings because they loans are backed by the government of the country in with the project is based.
- There are various kinds of project financing arrangements. The common provisions include the following.
- Limited Recourse: Owners must contribute additional capital under certain circumstances (in this case, the loans are not completely non-recourse).
- Buy-Down: Accelerated principal payments to project creditors that are required because of project performance shortfall. The accelerated principal payments are to restore debt service coverage ratios to levels that would have been achieved if it were not for the performance shortfall.
- Fall-Away: Termination of a guarantor’s obligation to guarantee project debts because of a specified decline in project creditworthiness.
- Project financing has typically been provided in recent years by insurance companies and commercial banks. Insurance company loans generally provide fixed rate and long loan maturities (up to 20 years). Commercial bank loans are typically floating rate and of intermediate term (12 to 15 years). The floating rates may have collars, which limit the range of the float.
- Commercial banks sometimes also provide guarantees on project loans. These guarantees (known as “credit supports”) to projects, allow the projects to obtain lower cost financing in the commercial paper or public bond markets.
IMPLICATIONS FOR INVESTMENT ANALYSIS
If the owners are not subject to recourse, the NPV of the owners’ investment in the project is computed by discounting the cash flow that will be extracted by the owners from the project over its life (where those flows are discounted at the appropriate risk-adjusted discount rate) minus the amount invested. The cash flow that will be extracted from the project over its life need never be negative (due to non-recourse). However, the owners may have the option to invest more under certain circumstances, in which case the future cash flows can be negative.
If the owners are subject to recourse, the NPV of the owners’ investment in the project is computed by discounting the cash flow that will be extracted from the project over its life (where those flows are discounted at the appropriate risk-adjusted discount rate) minus the amount invested. The cash flow that will be extracted from the project over its life may be negative under certain conditions due to the recourse possibility. Furthermore, the owners may have the option to invest more under certain circumstances, in which case the future cash flows can be negative.