Project Finance

By Jamie Johnson

What is project finance?

As you might guess, project finance refers to finance for long-term projects. These projects include infrastructure projects, mining projects and industrial plants.

Who is involved?

There usually are five actors involved.

Firstly, there are project sponsors. These are the actors who have some sort of stake in the success of the project, and they will borrow most of the funds needed for development.

Secondly, there is a project company to carry out the project itself. Often, there is a Special Purpose Vehicle (SPV) set up for the project. This project company will typically employ contractors and subcontractors to carry out the project itself.

Thirdly, there is often some government involvement in the project. Governments may have pushed for the project in the first instance and involved private actors through the use of Public-Private Partnerships (PPPs) or Private Finance Initiatives (PFIs).

Fourthly, there is an operator for when the project facility is completed. They will ensure that the maintenance is undertaken in line with the initial agreements surrounding the project at hand.

Fifthly, there can be an offtaker involved in the project. This is an actor who agrees to buy the end outputs of the project. There is not always an offtaker involved, as the outputs may just be sold on the open market.

There are also lenders and insurers, which are discussed below.

What are the stages of a project finance transaction?

In the case of a PPP, there are four stages.

Firstly, there could be a launching of tender. The government will announce the project and request proposals from companies who could carry out the specific project.

Secondly, there is the preparation of the bid. This is where there are bid agreements for the project funding.

Thirdly, the preferred bidder is chosen by the government. This stage may take months or years, depending on what the government thinks about the offer that the firm has made.

Finally, there is a financial close. This is where the deal is agreed, and any money is taken for the costs and fees as they are required. After this point, the project will hopefully run.

If the project is not a PPP, the process will normally avoid the tendering. Instead, the third and fourth stages will generally be replaced by negotiations over the financing of the project and over the rights of the project company to carry out the project.

Issues for lenders

As with any loan, lenders are concerned that the borrower will default on their loan obligations. This could happen for four reasons.

Firstly, any of the subcontractors involved in the deal could default or fail to fulfil their obligations. This would mean that the project might make a loss and so the firm would be unable to pay back their debt.

Secondly, particularly in the context of the developing world, there is the risk of the project being nationalised. If this happens, it is unclear what will be paid back to the project sponsors, and so they may not have the funds to pay lenders.

Thirdly, there are issues of currency convertibility. If the contract is denoted in a particular country’s currency and that currency suddenly drops in value, the project sponsors might not have enough to pay back their lender.

Finally, in some cases, there is the possibility of terrorist action. If terrorists destroy a project, then that project will not provide as much revenue. This is mainly a problem in politically unstable areas.

How is the finance structured?

Lending can come from commercial banks, development banks or non-bank actors (such as institutional investors). Most loans have syndicated facilities. This means that several banks or institutions provide a pool of money for the project company to drawdown.

Typically speaking, the debt will be secured against assets that the company has. This means that individual assets back the debt that the project company has. So, in the case of default, the lender can seize the asset and sell it off to make back their losses.

Sometimes, projects are funded through capital market offerings. So, a project company might issue bonds or shares to raise money for its project. This would allow the project company to access a broader investor pool than they otherwise might.

There is also sometimes an unconventional finance structure for the project. The primary example of this is a mezzanine facility. This is a form of debt that can be converted into a share in the company if the company goes bust. Higher interest rates generally accompany this form of finance.

How does insurance factor in?

There usually are credit risks for a project. Due to all of the risks that are involved, a bank could take out credit risk insurance. This is where insurance is taken out to protect against the risk that the project company cannot repay their obligations.

There can also be political risk insurance that a project company takes out. Here, the firm will take out insurance to avoid the risk of any extreme political events such as expropriation, discrimination or war.

Case studies

An ongoing case study of project finance is Nord Stream 2. Germany granted Nord Stream 2 a permit on the 31st of January 2018. This is a project to create a pipeline between Russia and Germany via the Baltic Sea. It was hoped that it would be finished by the end of 2019, but it has been pushed back due to issues with permits. This week, Denmark provided approval to put down the line in Danish waters using ships with anchors.

In terms of an example of syndicated financing, in June 2020 a syndicate of commercial banks led by BNP Paribas agreed to finance a Cellulose Pulp Mill in Brazil. When this is completed, the plant will be one of the most efficient dissolving wood pulp mills in Brazil.

Finally, in May 2020, the financing for Israel’s Sorek B desalination plant was agreed upon. This is a 25-year contract for designing, financing, constructing and operating the plant. IDE Technologies got the contract.