What is Project Finance?
Project finance is defined as a method of financing large investment projects that require significant capital expenditures.
In global literature, you can find other definitions, as authors debate whether project finance is a method, formula, approach, concept, or form of financing.
This method was known as far back as Ancient Greece, where it was used to finance long-distance trade expeditions. Project finance was popular in the 19th and 20th centuries. In the United States, it supported the extraction of natural resources, starting with crude oil extraction and later other valuable energy resources.
Through this method, among other things, the construction of the largest railroads in the United States, the construction of the Suez and Panama Canals, the construction of the London Underground, Athens Airport, and prisons in the United Kingdom were accomplished.
The term “project finance” has not yet found an equivalent in most European languages. This is due to low awareness of project financing through this innovative instrument.
Therefore, in the literature, you can encounter translations such as “investment project financing” and “structured financing.”
The latter best describes the essence of project finance.
Table: Key Characteristics of Project Finance
| Characteristics | Brief Description |
|---|---|
| Creation of SPV | Financing is provided by a Special Purpose Vehicle (SPV), which is an independent legal entity created specifically for the implementation of a specific project with a defined life cycle. |
| Project Participants | The SPV consists of reputable and mature participants who have authority in the industry and can ensure guarantees for the successful implementation of the project. |
| Financial Leverage | A high level of financial leverage and allocation of funds for a legal entity without sufficient assets is most suitable for capital-intensive long-term projects. |
| Non-recourse Financing | Project finance implies limited recourse to the borrower, as the SPV will bear full responsibility for the financial obligations within the project. The sponsoring companies do not risk their assets in the event of failure. |
| Self-financing | Self-financing of the project means repaying obligations solely from the funds generated by the project. The project is planned in such a way that its operation will allow for the repayment of debt obligations. |
| Risk Allocation | The investment project must meet market requirements. The risk allocation, established by contractual relationships, optimally aligns with the needs of the participants. |
| Life Cycle | A defined (limited) project term means that obligations must be repaid within this term. |
| New Projects | Project finance is used to finance new projects rather than existing investments, although projects may be refinanced through project finance. Often, these are international projects. |
The growing popularity of investment project financing through project finance is explained by its numerous advantages.
First and foremost, strict risk diversification among all project participants. A characteristic feature of project finance is that financial institutions (such as banks) assume a significant portion of the project’s risk.
It is important to identify risks as accurately as possible and select participants who can control them to the greatest extent possible.
Negotiations with creditors can result in more flexible terms for project financing. Repayment terms, interest rates, or schedules for subsequent tranche payments, loan security, and the procedure for repaying obligations are also discussed in detail with creditors.
Another advantage of project finance is off-balance-sheet debt.
Sponsors initiating the project separate a special project company (SPV) from their assets, whose task is to attract external capital and implement the project.
This does not oblige the project initiators to reflect the project debt in their reports.
Off-balance-sheet financing allows the SPV to obtain higher loans than the project initiator could by avoiding many legal restrictions arising from the nature of loan agreements. Due to the off-balance-sheet nature of the debt, the bankruptcy of the project company does not mean the bankruptcy of the project initiators.
Project finance also has its drawbacks.
It is the most labor-intensive way to finance investment projects.
This is due to the organizational structure, which includes many entities interconnected by numerous agreements and contracts, which increases the time and duration of negotiations.
The cost of project finance is relatively high.
Often, commercial banks view SPVs with skepticism, which results from a lack of adequate risk assessment methodologies based on project finance.
Additionally, it is necessary to attract a large number of participants, including experienced management personnel, financial advisors, and experts, as well as to analyze the feasibility of the project, which is associated with high costs. Creditors assume greater risk and therefore expect a higher rate of return.
Despite the above drawbacks, project finance represents almost the only way to implement large-scale projects with limited assets.