09 Dec

Author : Pınar Püdün

Primarily, the attractions of project finance lie in its features. Project finance packages risks associated with the project into discrete “bundles”. The distinguished risks can be parceled out in order to diverse willing parties. It therefore allows for parties best able to control or insure against the risks to assume them and alsoit enables efficient risk allocation. Splitting up the assumption of project risks in this manner has in addition to risk spreading,the effect of reducing the associated risks. As a consequence, a project, which is unacceptably risky to one party, becomes feasible through first, risk spreadingand second, risk reduction.

For the project sponsor, project finance enables the party to insulate project risks from his portfolio of investments. He avoids the risk of bankruptcy from the failure of one project. Although he may be required to provide guarantees as credit support, the guarantee amount may be limited to a level he is comfortable with. Moreover the impact of a guarantee on his balance sheet is less damaging compared to a direct loan even though the extent of liability is the same. Due probably to market inefficiency, the guarantee which is reflected as a footnote to the balance sheet tends to be viewed less unfavorably than a loan reflected directly on the balance sheet. Indeed other credit enhancement devices like take-or-pay contracts may not even be reflected on the balance sheet. Such off balance sheet financing can be extremely attractive to project sponsors as it enables them to avoid the restrictions on borrowing and creation of security interests found in their constitutional documents or existing credit facilities.

Currently, Project financing assumes increasing importance asdeveloping economies seek to develop their infrastructure. Infrastructural projects are invariably capital-intensive ventures. Financial constraints may hinder a country’s ability to commit its financial resources for the development of its infrastructure. Project financing offers the prospect of private investment in its infrastructural development. Private funding preserves the public coffers. Corollary to this, the participation of private enterprises offers the benefits of commercial discipline. Project feasibility is assessed and un- retaken on a commercial basis. If run as public sector project, considerations like obtaining a reasonable return may not be politically acceptable as the public may view the service to be integral to the functions of a government.

Moreover, Private sector participation also permits the employment of efficiency- oriented management techniques which may not be politically acceptable if the project were run as a purely public sector project; for instance, a commercial enterprise is able to hire and fire with far fewer constraints than the civil service or statutory body. Permitting the project to be run by commercial enterprises allows certain insulation from the political factors that inhibit the efficiency of public sector projects. The government continues to exercise its role as the custodian of public interest by settingthe terms of the concession and giving the appropriate regulatory responses to unanticipated and deleterious effects of a project. The attractions of project finance, therefore, account for the increasing use of BOT and its variantsin developing countries. 
The importance of project finance to States is not confined to infrastructuralprojects. Project finance concepts and structures are also integral to structuring the projects involving concessions granted by governments to exploit its natural resources.

The touchstones of project finance are cash flow and risk analysis. Cash flow is the life-blood of the project. Risk analysis looks at the events, which determine whether or not the actual cash-flow falls short of the projected cash flow. An appreciation of the risk factors is essential to a realistic assessment of the chances of realizing the projected cash flow.

From the perspective of the lender, risk-spreading or risk-minimization is credit support since any lowering of lending risk acts as credit support for the project and increases the bankability of the loan proposition. In order to ensure that their lending risk does not deteriorate into an equity risk, lenders require credit support from project participants to secure a minimum level of recovery. There are four classes of credit support devices, namely: legal guarantees, indirect guarantees (instruments which are not strictly legal guarantees but which perform similar functions), insurance, and “soft” credit support (commitments or actions which though not legally binding have the effect of assuring the lender). The means of credit support because its legal issues – especially in the cross-border context – tend to be more complex. Therefore it has to be paid attention to each context very carefully.

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