Project financing is a process of financing large capital-intensive projects having a long gestation period. The lenders providing such finance are dependent on the assets created for the project as a means of security, and the cash flow is produced by the project as a source of fund for refunding their dues.
Basically, project finance is fundamentally financing on the project security itself, with no recourse or limited against the project sponsors or other parties that are involved in the implementation and development of the project. Due to such features of project finance, the finances required by the borrowers are constantly accepted by the lender on the basis of strong-in house examination of the cost and feasibility of ventures in addition to credit standing of project promoters.
Note: In project finance, the mortgage is repaid from the earned cash flow of the subjected projected instead of from the creditworthiness of the project sponsors or from the general assets. This mortgage is secured by the assets of the project, comprising of revenue-producing contracts. The other point is that the lenders are specified a lien on project assets and can assume the control of subject if the project company has some difficulties in complying with the terms of the loan.
For What Types of Projects for Finance Can Be Used?
Project finance largely covers industrial projects, construction ventures or other infrastructure projects. Capital intensive business diversification and expansion in addition to the replacement of equipment is also covered under the project finance.
An understanding of the conceivable money streams into a specific project and the conceivable expenses streams out of the same is vital to the finance structure. Such understanding would be based on an examination of the legal framework leading the project, complete project documentation including approvals of the government with regard to implementation and financing of the project and the finance documents.
A detailed description regarding the importance of project finance is described as below:
The usual project financing constitutes of a loan to allow the sponsor to construct a project where the loan is entirely ‘non-recourse’ to the sponsor, which implies that the sponsor is not responsible for making payments on the project loan, in case revenues produced by the project is not sufficient to cover the principal and interest payments on loan. For minimizing the risks that are related with a non-recourse loan, the lender will need indirect credit support typically in the form of warranties, guarantees and other covenants from the sponsor, its associates and third parties involved in the project.
- Maximum Leverage
In project financing, typically the sponsor seeks to finance the development cost and construction of a project on a high leverage basis. Normally, such costs are financed by using 80% to 100% debt. High leverage in non-recourse project financing enables the sponsors to finance the project deprived of its equity investment in the project. In such situations, reductions are done in the cost of capital by substituting low-cost, tax deductible interest for high-cost, taxable returns on equity.
- Off-Balance Treatment
Reliant on the structure of Project Finance, the sponsor of the project might not be required for reporting any debt in the project on its balance sheet since such debt is non-recourse to the sponsor. Off-balance sheet treatment might possess the practical benefit to aid the sponsor complying with restrictions and covenants regarding borrowing funds contained in other credit agreements to which the sponsor is a party.
- Maximize Tax Benefit
Structuring project finance is essential for maximizing the tax benefits and to guarantee that all the possible tax benefits are utilized by the sponsor or transferred, to the permissible extent to another party through a partnership, lease or other project development vehicle.
Financing of a project is a very complicated procedure. It takes a period of time to structure document and negotiate project financing instead of traditional financing. Also, the fees and associated expenses related with project financing are very high. As the risk interpreted by the lenders is more in non-recourse project finance than traditional finance, the cost of capital is also greater than traditional finance.
The End Words
If you have a project, like creating an infrastructure for distributing electricity, gas or building a power plant, etc., then Project Financing is the ideal option. It is an effective method, but one must thoroughly asses the risks that are previously involved.
About the Author:
Alex Smith is an editor and works at Challis Capital Partners. He enjoys creating, uncovering and disseminating new and interesting perspectives on Finance, Investments and Mortgages. Challis Capital Partners provides Commercial Loans and Property Finance services throughout Australia.