Although project finance is used to refer to a wide range of possible financing structures that have been used in different industries for many years, the authors suggest that they all have five common fea- tures, which distinguish project finance from other financing methods:
1. SPV
2. contractual agreements of various third parties 3. non-/limited recourse
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4. off-balance sheet financing 5. robust income stream
Special project/purpose vehicle
An SPV is an independent legal entity, which will be committed and responsible to a contractual agreement with the parties involved in the project finance transaction (Ellafi 2005). SPVs are used in a variety of transactions, including securitisations, project finance and leasing. All those transactions are grouped as structured finance by Davis (2005).
In this guide, the definition of an SPV is limited to:
A legally and economically independent project company financed with non-/limited recourse debt for the purpose of financing a single purpose, capital asset usually with a limited life.
Contractual arrangement
Projects procured using project finance have to be structured through a series of contracts. Those contracts represent substantial components of credit support for a project (Orgeldinger 2006). The authors also sug- gest that the contractual arrangement in project finance transactions determines how the risks are structured among the parties, which provides a security to the project’s cash flow.
Project finance is often regarded as ‘contract finance’ because a typical transaction can involve as many as 15 parties united in a ver- tical chain from input suppliers to output buyers through 40 or more contractual agreements (Esty and Christoy 2002). To arrange project finance, there must be a genuine ‘community of interest’ among the stakeholders involved in the project. Finnerty (1996) suggests that project financing arrangements invariably involve strong contractual relationships among multiple parties. Lenders will require that such contractual security arrangements must be put in place to protect them from various risks.
The major contracts in typical project finance transactions are the construction contract, the product offtake contracts, the raw material
Concession agreement
Borrower (SPV) Principal
Off-take contracts Operation
contract Construction
contract
Loan agreement Shareholders
agreement Suppliers
Constructor
Investors
Users Operator
Lenders Supply
contacts
Bond agreement
Bond holder
Figure 2.1 A typical BOOT corporate structure (Merna and Smith 1994).
supply contracts, the operations and maintenance contracts, and a large number of financial agreements, including loan agreement, bond agreement, shareholders agreement and agreements which address support from the host country (Merna and Njiru 2002). These contracts transfer many of the individual risk elements to appropriate parties.
A typical structure of build-own-operate-transfer (BOOT) indicating the number of organisations and contractual arrangements that may be required to realise a particular project is shown in Figure 2.1.
Project finance can work only for those projects that can establish such relationships and maintain them at a tolerable cost. The project’s cash flow is guaranteed by these contractual arrangements. These contracts form an interwoven web that determines the project’s value and risk.
The key organisations and contracts involved in a BOOT project strategy have been identified and defined by Merna and Smith (1994) as follows:
Principal: The organisation responsible for granting a concession and often the ultimate owner of the project when the concession period is completed. Principals are often governments, govern- ment agencies or regulated monopolies.
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Borrowers/SPV: It is the organisation, sometimes referred to as spon- sor, which is granted the concession to build and operate a project for a specified period. Organisations involved are usually con- struction companies, operators or joint venture organisations in- corporating constructors, operators, suppliers, vendors, lenders and shareholders/equity providers who set up an SPV to un- dertake the project. During the operating period of a project, the SPV is often referred to as the concessionaire.
Concession agreement: This is the contract between the principal and the borrower/SPV in which the concession is defined and granted and essential risks associated with it are addressed, de- scribed and allocated. The agreement will describe any facility vehicle which the parties have agreed should be put in place to give effect to the concession, setting out its technical and finan- cial requirements and specifying the parties’ relative obligations in relation to its design, construction, implementation, opera- tion and maintenance over the lifetime of the concession. The concession agreement identifies and allocates the rights, respon- sibilities and risks associated with the project. It identifies and allocates the risks associated with the construction, operation, maintenance, finance and revenue packages and the terms of the concession relating to a facility. The preparation and evaluation of a project tender are based on the structure of the terms and project conditions contained within the concession agreement.
Merna and Smith (1994) suggest that the concession contract is the primary contract in project financings with all other contracts, as described below, being considered as secondary contracts.
Supply contract: This is the contract between the supplier and the SPV. The supplier may be a state-owned agency, a private com- pany or a regulated monopoly which supplies raw materials to the facility during the operation period.
Offtake contract: This is the contract agreed between the SPV and the user. It is applicable in contract-led projects such as power generation plants or water treatment plants. Users are the organ- isations or individuals purchasing the offtake or using the facility itself. In market-led projects such as toll roads where revenues
are generated on the basis of directly payable tolls or tariffs for the use of the facility, an offtake contract is not applicable since the users deal with the SPV directly.
Loan agreement: It is the basis of the contract between the lender and the SPV. Lenders are often commercial banks, niche banks, pension funds or export credit agencies. In some cases, several lenders will underwrite the debt and syndicate a percentage to other market participants.
Operations contract: This is the contract between the operator and the SPV. Operators are often specialist operating companies or com- panies created specifically for the operation and maintenance of the particular facility.
Shareholder agreement: This is the contract between the SPV and investors. Investors purchase equity or provide goods in kind and form part of the corporate structure. Investors may include suppliers, vendors, constructors, operators and major financial institutions as well as private individual shareholders. Investors provide equity to finance the facility, the amount of which is often determined by the debt/equity ratio required by the lenders or by a provision of the concession agreement.
Construction contract: This is the contract between the constructor and the SPV. Constructors may be individual construction com- panies or a joint venture of specialist construction companies.
Bond agreement: This is the agreement between the bondholders and the SPV. Bonds are issued for projects to suit a project’s revenue streams and because of the costs associated with raising a bond issue of projects of a high capital value.
Non-/limited recourse
Non-/limited recourse is one of the key distinguishing factors used in project financing. In corporate finance, the primary source of repay- ment for investors and lenders is backed by the entire balance sheet of the sponsors’ companies, and usually there is a diversity of sources of
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cash within the corporate structure (IFC 1999). Even if an individual project fails, lenders still retain a significant level of comfort in be- ing repaid depending on the overall strength of the sponsor’s balance sheet. By contrast, for projects procured by project finance there is no operating history. Lenders and investors do not have direct recourse to the sponsors (Merna and Njiru 2002). If the project fails, the project sponsors’ organisations have no direct legal obligation to repay the project debt and will lose only the equity invested in the project. Pay- ment of principal, interest, dividends and operating expenses should be derived only from the project’s future cash flow throughout the life of the project.
However, there are very few pure project financings. Maiward (2003) claims that it is very rare for projects to be purely non-recourse.
In other words, instead of being truly non-recourse, project financing often involves limited recourse to the sponsor companies. Willingham (2000) describes a banker as ‘a person who will lend you an umbrella when the sun is shining and will want it back the moment it starts to rain’. Limited-recourse debt has a repayment guarantee for a defined period for a fraction of the total principal until a certain milestone is achieved (Esty 2004). A typical example of a limited-recourse model is North Sea oil projects which were split into construction and operation stages in terms of project financing. The transactions were structured on the basis that full-recourse loans would be converted into limited- recourse loans, typically when the lenders were satisfied with mechan- ical completion of the platform and other facilities (Cuthbert 2004).
How much recourse is necessary to support a financing is determined by the unique characteristics of a project. Tinsley (2000) claims that the recourse is constrained in three main ways or any combination of these:
1. Time: Recourse stops after an agreed date.
2. Amount: Recourse has a ceiling or cap in money terms.
3. Event: Where satisfaction of some event or trigger is required.
Off-balance sheet transaction
One of main reasons for choosing project finance is to isolate the risks and take them off the balance sheet so that a project failure does not
damage the owner’s financial condition. An off-balance sheet transac- tion simply means that all financial matters relating to a project cannot affect the balance sheet of the sponsor’s organisation: the project stands on its own. Debt payment comes only from SPV rather than from any other entity, which becomes the essential feature of project finance. By comparison, on-balance sheet financing is any form of direct debt or equity funding of a company. If the funding is equity, it appears on the company’s balance sheet as owners’ equity. If it is debt, it appears on the balance sheet as a liability. Any asset the company acquires with the funding also appears on the balance sheet.
The authors suggest that there are two significant advantages as- sociated with the basic features of project finance. First of all, project finance structures the risk among the parties, which make it possible to undertake the projects that would have too large capital invest- ment with too high a risk to be taken by one party on its own. Since petroleum refinery projects are capital-intensive with high risks in- volved, project finance is a method to allocate risks and obtain funds.
Second, through non-/limited-recourse lending, the risks are sepa- rated from a sponsor’s existing business. In other words, project fi- nance enables a project sponsor to finance the project on someone else’s credit. Nevitt and Fabozzi (2000) state that by using project fi- nance, some credit sources that would not be available on a corporate basis may be available to the project.
Robust income stream of the project as the basis for financing
The future income stream of a project is the most important element in project finance. Repayment of the financing relies on the cash flow and assets of a project itself as the lenders have no recourse to other funds or assets owned by the SPV. Therefore, the SPV has to demonstrate strong evidence of future income through various means such as power sales contracts for a power plant or through tolls for a market-led bridge project.
In general, there are two types of revenues streams: contract led and market led (Merna and Njiru 2002). In a contract-led revenue stream project, the SPV enters into contracts with users of the facil- ity before the project is sanctioned. This guarantees revenues to the
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SPV provided the service or product is provided to specification. For example, in a power plant project, the SPV will enter into a contract with the offtaker, usually a transmission company, who guarantees to purchase a specified amount of electricity over a period. In effect, this mitigates the market risk. In many public–private partnerships, the SPV provides the availability of the facility and is paid irrespective of the demand for the facility.
In a market-led revenue stream project, there is no contract with the users, hence no revenue guarantee. An example of a market-led project is a toll road where revenues are expected to be generated from motorists using the toll road. If motorists find an alternative route or use other forms of transport not dependent on the toll road, no revenue will be generated; hence, the project is subjected to the market risk.
A contract-led revenue stream provides more security to the lenders as they look to the revenues to repay both principal and interest on loans. Lenders often provide more favourable terms of loans to projects having contract-led revenues since the risk of default is less than in market-led projects. This is often in the form of a lower interest rate.