Table of Contents
- 1 What is Project Finance?
- 2 Parties Involved and Transaction Flow in Project Finance
- 3 Advantages of Project Finance
- 4 Disadvantages of Project Finance
What is Project Finance?
Project finance is a means of funding projects that are typically infrastructure heavy, capital-intensive or related to public utilities. During its lifetime, these projects are treated as distinct entities from its parent. A project finance venture undertaken is completely an off-balance sheet item for the parent. Therefore, all financing this entity avails, must be repaid exclusively out of its own cash flow and subject to its own assets. The assets of the parent cannot encroach for payback of its subordinate’s liabilities even if the venture fails. Popular sectors where project finance finds its applications include real estate, mining, telecommunication and power to name a few.
Parties Involved and Transaction Flow in Project Finance
Sponsors are usually the equity share capital holders of the parent company who wish to seek project finance. Two or more entities may also join hands to float an SPV. Instances of this phenomenon occur when two organizations create synergy for one another or are likely to mutually benefit from the underlying SPV. They are the equity providers of the SPV. Before floating an SPV, they must obtain authorization from the shareholders of the parent company via a shareholder’s agreement (SHA).
It may be a single lender or a consortium of financial institutions. They are the providers of senior debt and hold precedence over debt extended (if any) by the sponsors. The loan is secured strictly against the cash flows and assets of the SPV only. Therefore, sufficient due diligence is performed before the grant of any credit.
Special Purpose Vehicle (SPV)
It is a separate legal entity floated by the sponsors of the project. The project finance obtained is directed exclusively only towards this SPV. The SPV acts as a corporate veil between the lenders and the parent company preventing seepage of credit and attachment of property between the two parties.
Refers to the government of the home country where the SPV is located. The SPV must be incorporated in accordance with the government’s rules and regulations. It also often acts as a guardian angel in providing various tax concessions, subsidies, and rebates.
Off-takers are bound via an off-take agreement to mandatorily purchase a certain minimum quantity of produce from the selling party. An off-take agreement is a frequently resorted to in mining, construction and other industries of mass significance. The vendor (SPV) incurs a huge amount of capital expenditure. An off-take agreement ensures the seller of the existence of a market upon completion.
Suppliers & Contractors
As in any construction job, suppliers and contractors are necessary for the execution of a contract. They are the key suppliers of raw material. They also perform crucial functions such as design and build (D&B), operations and maintenance (O&M), etc.1,2
Advantages of Project Finance
Effective Debt Allocation
Project finance enables the sponsors to raise debt over and above the capacity of the parent. This borrowing can be viewed in an individual capacity and is not impacted by the credit reputation of its sponsors. Therefore, more beneficial and flexible terms of credit can be negotiated depending solely on the merit and potential of the project under review.
As already discussed, what makes project finance truly special is the separation of the legal identity of the parents and SPV. This provides enormous diversification and dilution of the risk element. The shareholders of the parent company are immune against the fluctuations in the fate of the project. The liability is limited to the amount of equity contributed by the sponsors. Additionally, the risk is also reduced upon involve of multiple entities. More than one companies may often form a joint venture to form a single SPV. Thus, the same amount of risk when distributed among a larger number of participants reduces each party’s exposure.
Economies of Scale
An SPV, when floated by more than one parent, is very likely to demonstrate economies of scale. Two contemporary organizations will only agree to come together for a common goal when they see a significant benefit flowing from the association. Especially in the case of manufacturing and construction industries, one entity can hugely benefit at the expense of another and vice-a-versa. For example, an extraction company and a mine owner may agree to combine for the sale of extracted material. Vertical synergies will come into play. Both entities will be able to achieve the scale and profits they could not have achieved in their individual capacity. Also, they will also hold better bargaining power with vendors as well as buyers.
Disadvantages of Project Finance
Project finance is a notch above a simple transaction of credit. It is based upon several contracts between multiple parties, each of them involving complex negotiations. It may be difficult to maintain a record of the flow of funds among the parties involved if proper discretion is not exercised. Also, an imaginary entity(SPV) is used to route all transactions. Therefore, it becomes important to have dedicated resources that monitor the flow of exchanges at all times.
Compliance and Documentation
At all stops, setting up an SPV faces resistance. Banks and financial institutions perform extreme due diligence and checks before extending even a penny of credit. This is mainly for the reason that an SPV holds separate legal status. The bank can make recoveries only against the asset and cash flows of the SPV. Therefore, they must be doubly sure of the future prospects and soundness of the operating plans. All these checks are time-consuming and expensive. Obviously, the SPV and its sponsors have to bear the brunt of this excruciating process.
Also, a project finance venture sets off the radars of the government. The government is extremely vigilant when it comes to sanctioning the creation of an SPV. This is because several parallel organizations that come into being have been known to evade taxes, circumvent money and indulgence is gross negligence of regulations. A potential SPV must, therefore, be patient and comply with all conditions imposed to win over its trust.
Constant Expert Assistance
Project finance involves complex transactions and multiple parties. Therefore, availing the services of professionals and experts is inevitable. Setting up a dynamic model for availing credit and conducting business involves huge cost. Think of this cost as the fancy and outrageous fees paid to investment bankers and other professionals who make the project finance happen.