Transcription
Hello and welcome to Project Finance Modeling Course. In this lesson, we will be talking about what project finance is.
Suppose that an investor has an idea, such as building a power plant, or airport, or a highway. These projects are called infrastructure projects, and infrastructure projects are expensive to build. They are capital-intensive projects that require a lot of money. It is rare that a single company can finance such large projects with its own money. The solution is project finance.
Project finance is basically raising necessary capital to finance such capital-intensive infrastructure projects. Project finance has several distinctive features. First, it is a long-term debt financing of a specific project. The project's assets and cash flows are isolated, as the project is incorporated as a special purpose vehicle. The project has to generate sufficient cash flows to cover debt repayments and dividends after covering operating expenses and capital expenditures. The debt financing raised is secured by the assets of the project company, and finally, the project has a finite life.
So, what is a special purpose vehicle? A special purpose vehicle is a legal entity, a limited liability company, created to fulfill a narrow and specific objective.
So, what are the steps involved in project finance? First, the investor, also called a project sponsor, sets up a special purpose vehicle with the sole purpose of designing, building, and managing a specific project. Then, the project sponsors develop the project. They carry out necessary technical and economic studies, obtain necessary permits, and acquire the land where the project will be built. Next, they conclude the necessary contracts, such as offtake agreements and construction contracts. When all the studies, permits, and contracts have been concluded, the project reaches a financing stage. At the financing stage, project sponsors negotiate with lenders on the debt financing for that specific project. When project sponsors and lenders reach the agreement, they inject the equity and debt financing into the SPV to finance the construction costs of the project. This stage is known as financial close. In project finance, typically the construction costs are financed with 70% debt and 30% equity.
So, project finance is a highly leveraged transaction. As we pointed out, the assets and cash flows of the project are isolated, and therefore lenders rely on the project's cash flows only. In case something goes wrong and project cash flows decrease, resulting in the SPV not being able to service the debt, the lenders cannot go after the project sponsors' other assets. Therefore, project finance is called a non-recourse financing. Lenders have no recourse to project sponsors' other assets.
So, how is this different from corporate finance? In corporate finance, investors and lenders inject capital into a holding company, which then initiates multiple different projects. These different projects serve as collateral for the debt. In case there's a problem with debt repayment or interest payments, the lenders can go after all the assets of the holding company and recover the debt through sale of those assets that the holding company owns. To remind ourselves, in project finance, the project sponsor can have multiple SPVs with a specific project in each SPV, and the project sponsor can be a holding company too. And when there is a problem with the specific project, the lenders cannot go after the project sponsors' other assets. They must rely on the assets and cash flows from that specific SPV.
To summarize, project finance is the financing of a long-term infrastructure project using a non-recourse financial structure, which relies only on the project's cash flows for debt repayment, with the project's assets held as collateral.
So, why does project finance make sense for investors? First, project finance enhances investors' equity return because of the high leverage. Infrastructure industry is typically a regulated industry, and project returns are usually low and are not sufficient to attract equity financing. So, high leverage is necessary to enhance the equity investment returns. Second, due to the high leverage, the required equity commitment is significantly lower than the project's cost, which reduces the risk for the investor. Third, because the project is carried out by the special purpose vehicle, the investor only risks losing the equity investment made into that special purpose vehicle. High leverage also generates significant tax savings, as interest expense is a tax-deductible item. Finally, the risk allocation in project finance is highly structured, meaning that risk is allocated to the party which is most capable of managing it. Thus, the overall risk of the project decreases, which we shall see in future lessons.