What is project finance and why its needed

Project finance is defined as funding of a single purpose long term infrastructure facility such as pipelines, power plants, highways, ports, metro systems, airports, hospital, chemical facilities, refineries and industrial plant that generates the cash flow to repay the debt as an independent economic unit.

It can be formed as a separate legal entity to operate, construct and own the independent economic unit.

While funding, the loan structure primarily depends on the future expected cash flow to be generated by the project. For instance, in case of a power plant, the sale of electricity to grid will repay the loan.

After funding the project, banks or financial institutions may find the project not generating enough revenue to recover the debt. In case of default in repaying debts, bank will recover the entire outstanding from the project’s assets kept as primary and collateral security (if any) or else, they will come with a workaround plan instead of foreclosure if expected future cash flow is high.

In case assets are not sufficient to recover the debt, then the outstanding amount will be restricted up to the extent of company’s promoters shareholding.

Small projects like rice mill, drinking water facilities and other industrial units can be fully funded by banks. If such units are run by a proprietorship and partnership business, then loan outstanding amount can be recovered from personal assets of the proprietor and partners if dues are not recovered from business assets.

Please note, it’s not necessary that banks should only fund these units or it will be called project finance only when bank or financial institutions have funded it. Public and private sector corporations can also participate. Various government agencies have also started financing in public-private partnerships to finance infrastructure, highways and metro systems.

Project financing takes place when following important conditions are satisfied:

  • Business is capable of functioning as a independent economic unit.
  • Completion is certain.
  • Expected profitability is in line with the expectation of lenders.
  • It satisfy all legal or regulatory requirements.

Due to the risk associated to bigger projects, it’s not prudent for a single party to bear them alone. Risk can be assessed due to economic viability, environmental, political, regulatory or technical feasibility. Depending on the risk taking capabilities, more than one party can come forward with multiple ownership and risk sharing to fund the project.

Here is a list of world famous projects funded by lenders:

  • The euro disneyland
  • The eurotunnel
  • The tribasa toll road
  • Devon silver mines
  • Trans Alaska Pipeline system
  • Hibernia oil field

Why use project financing

The most important reason for choosing project finance is to isolate the risk associated to the project. To avoid sponsor’s or owner’s financial conditions, projects are taken off-balance-sheet by allocating risks to all the project participants including the lender.

By taking the project off-balance-sheet, owner’s existing financial ratios and credit rating will not change. You can take project off balance sheet by forming a joint venture or partnership or by creating a separate legal entity for the economic unit.

Another important reason is non-recourse or limited recourse financing. In this type of situations, collateral has limited value in case of liquidation due to which in case of difficulties, the lender will always try to find out a work-out scenario rather than foreclosing.