There is a large variety of private funding sources and instruments, but we concentrate on the most commonly used sources and instruments. This section also draws from OECD (2015) and Dewar (2010); Figure 12.2 is a pictorial summary of the private sources and instruments used in project finance. However, not all funding channels and facilities are open to all projects and host countries.
Figure 12.2 Private Financing Channels and Facilities
All project finance deals involve some sponsor or developer group equity in order to
attract private debt investments and the debt/equity ratio is commonly viewed as a proxy for sponsor commitment to a project. Sponsors want high debt/equity ratios which mean high return on equity investments while lenders prefer lower debt/equity ratios to
confirm sponsor commitment and provide some protection in the event of poor project company performance.
12.2.1 Project Equity
Equity in the form of ordinary share capital in project finance deals comes primarily from project sponsors or developers but, also, from construction and operation contractors, equipment providers, and financial institutions. Usually, project sponsor equity ranges between 20% and 30% of project value, but the higher the project risk, the larger the share of the sponsor or developer equity required to get lenders willing to lend to the project.
I. Sponsor equity. By their nature, project finance deals require some sponsor equity contribution for ownership of project company shares. Sponsor project equity takes the form of ordinary capital, which is long term capital, and debt that is temporary equity or quasi equity, which is a shareholder subordinated debt. Sometimes, equity is provided by the host government and, in some PPP projects, may take the form of in kind contributions. In other cases, project construction contractors or O&M
contractors make equity investments in the project company. Shareholder
subordinated debt or junior debt ranks below commercial bank debt that is senior debt.
II. Other investor equity. The broadening of the project finance market has increased equity investments by other investors who have long term horizons and are interested in stable cash flows. This group of equity investors is made up of participants who have the skills and experience to evaluate the potential of infrastructure project investments and includes the following funding channels:
1. Listed infrastructure funds. These are funds that invest in companies that generate stable cash flows from infrastructure assets usually diversified by infrastructure sector and geographic region.
2. Master Limited Partnerships (MLPs). These are entities structured as partnerships whose shares are traded in equity markets and yield income taxed only at the shareholder level. They invest in infrastructure projects and give investors dividends and liquidity similar to those of corporations.
3. Real Estate Investment Trusts (REITs). Infrastructure REITs are companies that own mostly, but not exclusively, the real estate assets of projects and
distribute at least 90% of their income to their equity holders.
4. Infrastructure Investment Trusts (IITs). IITs are similar to mutual funds that invest in infrastructure projects to earn stable income and in some cases they are a modified version of REITs.
5. Index Funds. They are a type of mutual fund whose portfolio consists of stocks of companies owning or investing in infrastructure assets weighted by their
capitalizations and are designed to track the performance of the project infrastructure market.
6. Exchange Traded Funds (ETFs). ETFs are passive management funds that trade in stock exchanges like ordinary shares and they are similar to index funds in that they track a group of infrastructure companies' assets they own.
7. Unlisted direct equity. These are investments in shares of new infrastructure projects not traded in open public markets and because of the nature of their structures they are considered risky investments. For that reason, they are the purview of large, sophisticated investors who avoid the costs of funds and fund managers.
8. Life insurance companies. Life insurance companies are subject to some strict equity investment restrictions and corporate bond investments and limits.
However, life insurance companies with large reserves that have long payout horizons, as do some property and casualty insurance companies, are looking for higher than Treasury bond returns and invest in sound infrastructure projects. In general, insurance companies hold a significant part of all outstanding credit market instruments in the United States and invest the majority of their assets in stable and liquid instruments.
9. Sovereign funds. There are several types of sovereign wealth funds which are national government funds coming from taxation and trade surpluses and which due to differences in their objectives they invest in different proportions and asset classes. Because of currently low interest rates globally, they have begun investing in promising infrastructure projects that have predictable cash flows and
instruments and consistently pay dividends.
10. Pension funds. These are government and private company funded, benefit defined, retirement plans for employees that make payments out of the returns on invested pools of funds. Much like sovereign wealth funds, most pension funds make conservative investments although their asset allocations and appetite in infrastructure projects vary widely across countries.
12.2.2 Project Debt
Project debt is a crucial component of project finance and it takes the form of loans, bonds, and subordinated shareholder debt. Project debt is the largest share of funding, usually in the neighborhood of 70–80% of the project's value, with a good part of it coming from commercial banks.
I. Commercial bank debt. Commercial bank loans for project finance deals are
facilities that take the form of revolving credit for construction financing, term loans drawn during construction, standby letters of credit to support issue of commercial paper, and bridge loans up to four years. They also provide comprehensive credit facilities covering a project's entire loan requirements and, for large projects, they involve different lenders providing different portions of a loan. Syndicated loans and senior debt instruments are secured by project company asset collateral and cash flow.
II. Mezzanine debt. This is a subordinated debt or preferred equity instrument that is often a desired channel to raise project funding that is senior only to common shares.
These loans are unsecured bank loans that, in the event of project company asset
liquidation, can only be repaid after all claims of secured creditors have been met.
Mezzanine debt is a hybrid instrument that gives a lender the right to convert debt into equity in the event of a default and because of higher risk, mezzanine debt carries higher interest rates than commercial bank loans. The most important lender
requirement for mezzanine financing is the project company's ability to generate sufficient cash flow.
III. Equity bridge loans. These are short term loans—also known as capital call facilities—that are often offered as revolving credit while permanent financing is secured, at which point bridge loans are repaid. This type of loan is backed by project company asset collateral and carries higher interest rates and origination fees.
IV. Project bonds. These are privately placed or issued in public markets and are used to finance specific infrastructure projects. They are a source of long term funding,
particularly for brownfield projects. Institutional investors are the majority buyers of project bonds, which carry superior risk adjusted returns. A specific type of tax exempt bond, called green bonds, are issued by government agencies and are used to develop brownfield sites that are abandoned or underdeveloped.
12.2.3 Other Funding Sources and Instruments
There are private and public channels and facilities available to finance profitable projects in addition to the sources of funding and instruments mentioned earlier. The most
important channels are the Rule 144A market, asset backed securities, and Islamic financing. The latter is a large player in project financings in Moslem countries.
I. Asset backed securities. These project finance instruments are bonds sold to
investors in public markets and are backed by infrastructure loans pooled together and issued in tranches.
II. Rule 144A market. This is a Securities and Exchange Commission regulated market that specifies the rules for privately placed securities and was planned to facilitate trading among institutional investors. Internal Revenue Service Rule 144A is the basis on which project finance bonds are issued. These are restricted securities in private sales from an issuing infrastructure project company and may not be sold to the public.
III. Supplier credit. It is also known as supplier financing and it is an extension of credit, with repayment over a 7 to 10 years, to project companies buying equipment, goods, and technology and other services. It is credit extended from a bank in the supplier's country that takes the form of letter of credit. Supplier credit is usually supplemented with export credit for equipment, goods, and services produced in the supplier's country.
IV. Public sector assistance. A significant part of public sector assistance comes from local currency loans to infrastructure projects for purchase of local resources and to fill gaps in the financing of a project. Often, public sector assistance comes in the form
of in kind contributions, tax incentives, export support, subsidies, and other assistance programs.
V. Capital grants. These are contributions from public sector entities or from bilateral and multilateral institutions supporting economic development, often with
concessionary terms or not repayable. They are used to fund development for badly needed infrastructure projects or to establish the viability of commercializing new technologies. Capital grants, however, require strict compliance to requirements of grading agencies assigned to rate the project.
VI. Islamic financing. Project finance facilities from Islamic institutions are instruments compliant with Sharia law that are structured instruments for
infrastructure project investors to obtain income. One of the most common debt finance instruments is the sukuk, whose structure resembles a conventional bond, and the other being the equity like instrument modaraba, which is very similar to a western limited partnership arrangement.