All project financings have almost indistinguishable fundamental elements. Primarily, debt, generally which can be found in the form of traditional term notes, bonds, or subordinated notes from the project sponsor or other project participants, is the most common element.
Collateral security can be similarly presented in the form of assignments of the project revenues in order to support the underlying debt obligations. Diverse types of credit enhancement from the project sponsor or third parties include supportingthe risk allocation as well. Precisely selected structure is dependent upon a range of variables, influenced in large part by project viability and the goals of the project sponsor.
ADVANTAGES OF PROJECT FINANCE
Project financing is used by companies, which desire any or all of several objectives. Established and also well-capitalized corporations generally select project-financing method in order to assist in undertaking large debt commitments with a minimum of risk. Innovativedevelopers rely on project financing to permit development of several projects in different geographic areas, each based on the merits of the project, independent of the financial obligations of the other projects, and with minimal equity requirements.The advantages, which result from a project financing, differ according to the unique nature of each project, its characteristic risks, capital needs, capital access, and motives.
Nonrecourse Debt Financing
Classic Nonrecourse project financing provides a structure that does not impose upon the project sponsor any obligation to guarantee the repayment of the project debt if the project revenues are insufficient to cover principal and interest payments. The nonrecourse nature of a project financing provides financial independence to each project owned and protection of the sponsor’s general assets from most difficulties in any particular project. A typical non-recourse project finance loan provision provides that no recourse is available against the sponsor or any affiliate for liability to the lender in connection with any breach or default, except to reach project collateral. Thus, the lender relies solely on the project collateral in enforcing rights and obligations inconnection with the project finance loan.
The nonrecourse nature of the debt in a project financing need not extend throughout the term of the financing. For example, a project financing may be structured to provide recourse liability to the project sponsor during a limited period of the project development. Under that structure, if a new technology is used in a project, the project sponsor’s full recourse liability for the debt could be limited to the construction period. Thereafter, if the technology satisfies minimum performance tests, the lender could release the project sponsor from recourse liability and shift the risk from the assets of the project sponsor to the project assets.
Off-balance-Sheet Debt Treatment
A second objective of some project financings is the potential for using off- balance-sheet accounting techniques for project commitments.From the perspective of the project sponsor, accounting rules generally require the consolidation of financial statements of a company and certain of its subsidiaries and other entities over which it can exercise control. A subsidiary that is controlled more than fifty percent by the parent company is consolidated on a line by line basis with the parent. Otherwise, the equity method of accounting is used, whereby the investment in the subsidiary is shown as a one-line entry. Debt in such circumstances is not reported on the parent company’s financial statements.
Highly Leveraged Debt
A third objective of project finance sponsors is the ability to finance a project using highly leveraged debt without a dilution of existing equity. The amount of leverage acceptable to a lender varies from project to project. Often the leverage percentage is between seventy-five and eighty percent, but transactions are sometimes structured with ratios between ninety and one hundred percent. The amount of the equity contribution required of the project sponsor is influenced by many factors, including the project economics and whether any other project participants, such as the contractor or equipment supplier, invest equity in the project.
Avoidance of Restrictive Covenants in Other Transactions
A fourth reason for selecting a project financing is that the structure permits a project sponsor to avoid restrictive covenants, such as debt coverage ratios, in existing loan agreements and indentures. Since the project financed is separate and distinct from other operations and projects of the sponsor, existing restrictive covenants do not typically reach to the project financing. Similarly, the distinct nature of the project financed permits the sponsor to leverage debt to an extent that may be prohibited under existing agreements.
Favorable Financing Terms
A project financing is selected in many circumstances because more attractive interest rates and credit enhancement are available to the project than are otherwise available to the project sponsor. A credit appraisal of an individual project is sometimes more favorable than a credit appraisal of the project sponsor. Thus, a more attractive risk profile can result in more favorable interest rates and lower credit enhancement costs.
Internal Capital Commitment Policies
The rate of return goals of the project sponsor for new capital investments can also make project financing attractive. Companies that typically establish goals for rates of return generated from a proposed capital investment often determine that the return on a project investment is improved with a project-financing, which permits highly leveraged debt financing with aminimum of equity commitment.
DISADVANTAGES TO A PROJECT FINANCING
Project financings are complex transactions involving many participants with diverse interests. Risk allocation tensions exist between the lender and sponsor regarding the degree of recourse for the loan, between the contractor and sponsor concerning the nature of guarantees, and so on, resulting in protracted negotiations and increased costs to compensate third parties for accepting risks.
In addition to third party project participants, the degree of risk for the lender in a project financing is not insignificant. Although by definition and law a bank is not an equity risk-taker, many project financing risks cannot be effectively allocated, nor can the resultant credit risk be enhanced. This high risk scenario results in higher fees charged by lenders for the transaction than are charged in other types of transactions;it also results in an expensive process of due diligence that is conducted by the lender’s counsel.
Similarly, Interest rates charged in project financings are typically higher than on direct loans made to the project sponsor.Also, although some economies are achieved because only one lender, acting as the agent bank, and onelender’s counsel are involved, the documentation is complex and lengthy. The complexity results in higher transaction costs than is typical of traditional asset-based lending. Another disadvantage of a project financing is the degree of supervision that alender will impose on the management and operation of the project. This obligation is incorporated into the project loan agreements, which require the sponsor to satisfy certain tests, such as debt service and operating budget, and comply with various covenants, such as restrictions on transfer of ownership and management continuity.