What is 'Project Finance'

Project finance is the financing of long-term infrastructure, industrial projects and public services using a non-recourse or limited recourse financial structure. The debt and equity used to finance the project are paid back from the cash flow generated by the project. Project financing is a loan structure that relies primarily on the project's cash flow for repayment, with the project's assets, rights and interests held as secondary collateral. Project finance is especially attractive to the private sector because companies can fund major projects off-balance-sheet.

BREAKING DOWN 'Project Finance'

The project finance structure for a build, operate and transfer (BOT) project includes multiple key elements.

Key Elements of BOT Project Finance

Project finance for BOT projects generally include a special purpose vehicle (SPV). The company’s sole activity is carrying out the project by subcontracting most aspects through construction and operations contracts. Because there is no revenue stream during the construction phase of new-build projects, debt service only occurs during the operations phase.

For this reason, parties take significant risks during the construction phase. The sole revenue stream during this phase is generally under an off-take or power purchase agreement. Because there is limited or no recourse to the project’s sponsors, company shareholders are typically liable up to the extent of their shareholdings. The project remains off-balance-sheet for the sponsors and for the government.

Off-Balance-Sheet

Project debt is typically held in a sufficiently minority subsidiary not consolidated on the balance sheet of the respective shareholders. This reduces the project’s impact on the cost of the shareholders’ existing debt and debt capacity. The shareholders are free to use their debt capacity for other investments.

To some extent, the government may use project financing to keep project debt and liabilities off-balance-sheet so they take up less fiscal space. Fiscal space is the amount of money the government may spend beyond what it is already investing in public services such as health, welfare and education. The theory is that strong economic growth will bring the government more money through extra tax revenue from more people working and paying more taxes, allowing the government to increase spending on public services.

Non-Recourse Financing

When defaulting on a loan, recourse financing gives lenders full claim to shareholders’ assets or cash flow. In contrast, project financing provides the project company as a limited-liability SPV. Therefore, the lenders’ recourse is limited primarily or entirely to the project’s assets, including completion and performance guarantees and bonds, in case the project company defaults.

A key issue in non-recourse financing is whether circumstances may arise in which the lenders have recourse to some or all of the shareholders’ assets. A deliberate breach on the part of the shareholders may give the lender recourse to assets. Applicable law may restrict the extent to which shareholder liability may be limited. For example, liability for personal injury or death is typically not subject to elimination.

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