Project finance

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Project finance is the nonrecourse financing of long-term infrastructure, industrial projects and public services based upon a complex financial structure where project debt and equity used to finance the project are paid back from the cashflow generated by the project rather than the general assets or creditworthiness of the project owners. The financing is typically secured by the project itself, including the revenue-producing contracts. Typically, special purpose corporations (SPCs) are created for each project.

1 Explainer
2 Related Terms
3 History
4 Sources
5 See also

[edit] Explainer

The following is a hypothetical description of a basic project finance scheme. Image:Project finance.png

Acme Coal Co. imports coal. Energen Inc. supplies energy to consumers. The two companies agree to build a power plant to accomplish their respective goals. Typically, the first step would be to sign a memorandum of understanding to set out the intentions of the two parties. This would be followed by an agreement to form a joint venture.

Acme Coal and Energen form a SPC called Power Holdings Inc. and divide the shares between them according to their contributions. Acme Coal, being more established, contributes more capital and takes 70% of the shares. Energen is a smaller company and takes the remaining 30%. The new company has no assets.

Power Holdings then signs a construction contract with Acme Construction to build a power plant. Acme Construction is an affiliate of Acme Coal and the only company with the know-how to construct a power plant in accordance with Acme's delivery specification.

A power plant can cost hundreds of millions of dollars. To pay Acme Construction, Power Holdings receives financing from a development bank and a commercial bank. These banks provide a guarantee to Acme Construction's financier that the company can pay for the completion of construction. Payment for construction is generally paid as such: 10% up front, 10% midway through construction, 10% shortly before completion, and 70% upon transfer of title to Power Holdings, which becomes the owner of the power plant.

Acme Coal and Energen form Power Manage Inc., another SPC, to manage the facility. The ultimate purpose of the two SPCs (Power Holding and Power Manage) is primarily to protect Acme Coal and Energen. If a disaster happens at the plant, prospective plaintiffs cannot sue Acme Coal or Energen and target their assets because neither company owns or operates the plant.

A Sale and Purchase Agreement (SPA) between Power Manage and Acme Coal supplies raw materials to the power plant. Electricity is then delivered to Energen using a wholesale delivery contract. The cashflow of both Acme Coal and Energen from this transaction will be used to repay the financiers.

This is a simple explanation which does not cover the mining, shipping, and delivery contracts involved in importing the coal (which in itself could be more complex than this scheme), nor the contracts for delivering the power to consumers. However, this serves to explain how and why companies create SPCs and obtain financing for major projects.

[edit] Related Terms

Non-recourse financing: financing secured only by the project itself.

Non-recourse project financing : A loan where the lending bank is only entitled to repayment from the profits of the project the loan is funding, not from other assets of the borrower. These types of projects are characterized by high capital expenditures, long loan periods, and uncertain revenue streams. Analyzing them requires a sound knowledge of the underlying technical domain as well as financial modeling skills.

Limited recourse financing: financing secured primarily by the project and by additional reassurances from sponsors.

Off-Balance Sheet Financing: when a minority owner discloses its participation in the project as an investment and excludes the debt from its financial statements by disclosing the debt as a footnote related to the investment. In the United States, this eligibility is determined by the Financial Accounting Standards Board.

War risk insurance: Standard insurance does not cover war or civil unrest, but this can be covered by additional war risk insurance that covers acts of hostile attack, derelict mines and torpedoes, and civil unrest. Today, some altered policies that include terrorism are called Terrorism Insurance or Political Risk Insurance.

Sectors: Project finance typically covers the following sectors: Power; Mining; Oil & Gas; Transportation; Water/Utilities; Telecommunication; and Petrochemicals.

[edit] History

The origins of project finance can be traced to the construction of the Panama Canal, although the modern origins are the power projects of the 1970s and 1980s where newly created Special Purpose Corporations (SPCs) were created for each project, with multiple owners and complex schemes distributing insurance, loans, management, and project operations. Such projects were previously accomplished through utility or government bond issuances, or other traditional corporate finance structures.

The new project finance structures emerged primarily in response to the opportunity presented by long term power purchase contracts available from utilities and government entities. These long term revenue streams were required by rules implementing PURPA, the Public Utilities Regulatory Policies Act of 1978. Originally envisioned as an energy initiative designed to encourage domestic renewable resources and conservation, the Act and the industry it created lead to further deregulation of electric generation and, significantly, international privatization following amendments to the Public Utilities Holding Company Act in 1994.