Principles of Project Finance

Prof.b.p.mishra
XIMB

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“Project Finance “
Vs
“financing a project”

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 Project Finance

Project Finance is a lending Technique that involves

Lending against the “Cash Flow” of a Particular Project.

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 Project Finance

A method of raising long-term debt financing

for major projects Through “ Financial Reengineering”,
Based on the cash flow generated by the project alone.

It depends on a detailed evaluation of a Project’s

Construction ,Operating & Revenue Risks
And their allocation between
Investors, lenders and Other parties
Through contractual & other arrangements.

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 Project Finance

Since Project Finance Lenders lend against a Cash Flow,

a project suitable for a project finance has to be able to
“ Stand alone” with a separately identifiable cash Flow.

This also means that the project should be undertaken by a

Company whose sole business is the project,
“the Project Company”
Often called a ”Special Purpose Vehicle” (SPV).

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 Financing a project
Projects may be financed in different ways
Corporate Loan
Public Sector Debt
Both Domestic, International ,Multilateral etc.

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 The Change
LPG have changed the approach
to financing investments of major projects,
Transferring a major portion of Financing Burden to
the private sector, through PPP.

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 Public Private Partnership

“A long-term contract between

a private Party and a Government Entity,
For providing a public service,
in which the private party bears significant risk
And management responsibility , and
Remuneration is linked to performance.”

PPP reference Guide , Version-III– World Bank, 2017

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 The Current trend

Worldwide deregulation of Public sector utilities &

Privatization of Public Sector Capital Investment
Are promoted by internationalization of major
projects.

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Private finance for public infrastructure.

The English Road System renewal = 18th/ 19th century (Toll)

Natural Resource Projects-1930s=Minnig, Oil, Gas- Texas
North sea Oil Fields- 1970
Independent Power Projects – ELECTRICITY, IPPs -1990
Public Infrastructure- Road, Rail, Bridges, Public Buildings- PPPs
Mobile Telephone Networks-Under Sea Cables- 2000

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 Features Of Project Finance

PF structures differ between various Industry sectors

From Deal to Deal
No such thing as standard Project Finance
Each Deal has its Unique characteristics.
But there are common principles

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 Common Characteristics
It is provided for a “Ring-fenced “Project
(One which is legally and economically self contained)
Through a special purpose legal Entity( Usually a Company)
Whose only business is the Project( The Project Company).

It is usually raised for a new project rather than

an established business,
(Although Project Finance loan may be refinanced).

There is a high Ratio of Debt to Equity( Leverage or Gearing)

Roughly Speaking, PF debt may cover 70-90%
of the cost of a project.

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 Common Characteristics
There are no guarantees from the Investors
in the project company ( Non-Recourse Financing),
or only limited Guarantees (Limited Recourse Financing)
for the PF Debt.

Lenders rely on the future cash flow projected to be generated

by the project for interest and Debt repayment( Debt service)
rather than the Value of it’s assets or analysis of
Historical financial Results.

The main security for lenders is the Project Company's

Contracts, licenses or ownership of rights to use natural resources:
The Project company’s Physical assets are likely to be worth
much less than the debt if they are sold off after a default on
the financing. 13
 Common Characteristics

 The Project has a finite life,

based on such factors
as the length of the contracts or
Licenses or Right to use natural resources,
And therefore PF Debt must be
fully repaid by the end of this life.

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 PF- Building Blocks

PF is made up of a number of building blocks,

although all of these are not found in every PF transaction.
There may be ancillary contracts or agreements not shown
In the figure in next slide.

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Simplified project finance structure 16
PF has two elements:

Equity provided by investors in the project(Concentrated Ownership)

PF based debt, provided by one or more group of lenders
PF debt has first call on the project’s net operating cash flow.

The equity investor’s return is more dependent on the

Success of the project.

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 The Contract

The contract entered in to by project company

Provide support for the PF, particularly
by transferring Risk from the project company
to the other parties to the Project Contracts
And forms the lenders’ security package.

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Elements of Project Contract
A project agreement which may be- either

A concession agreement
A turn-key Engineering
An input Supply contract
An off-take contract
An Operating & Maintenance contract( O & M)
A Govt. support agreement

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 Off-Take Contract
Under which the product produced by the project
Will be sold on a long term pricing formula.

Example: Power Purchase agreement

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 Concession Agreement

CA with the Government or another Public authority,

Which gives the Project Company
the Right to construct the project and earn Revenues from it
By providing a service to the public sector ( Public Building)
Or directly to the general public( a Toll Road)

Alternatively, the Project Company may have a license to operate

Under the term of General Legislation for the industry Sector
( A mobile phone Network)

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 Project Contracts- Others
A Turn-key Engineering, procurement & Construction( EPC)
Contract, under which project will be designed and built
For a fixed price and completed by a fixed date.
An input Supply Contract, under which fuel and other RM for
The project will be provided on a long term pricing formula
In agreed quantities.
An Operating & maintenance(OM) contract, under which a
Third party will be responsible for the running of the project.
After it has been built.
A Government support agreement which may provide
various kind of support, such as guarantee for the off-take
Or tax incentive for the project.

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Of course none of these structures or
contractual relationships are unique to PF:
Any company may have investors, sign contracts,
Get license from Government, and so on,
However the relative importance of these matters
and the way they are linked together
Is a key factor in PF.

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 Characteristics 0f PPP
• Efficient way to finance large tangible Assets.
• The Risk is transferred through Project company to Debt Holders.
• The Long Term Contracts is to check opportunistic
Behavior of Debtors.
• The allocation of Cash Flow works as a deterrent.
• The project comes through with Lower Equity Commitments.
• The Debtors in exchange for bearing RISK impose
tight discipline on the Management through contracts,
Oversight and forced Cash distribution schedule.
• It generates a low cost financing vehicle for
sponsoring Firms and creates an effective Governance structure.
• A separate entity can reduce “ Net Cost of Funding”
of Large & Tangible assets.
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Primary Motivation for Using Project Finance

(I) Agency Cost Motivation:

Reduce costly Agency (Incentive) conflicts inside project company and

among Capital Providers.

(II) Debt Over- Hang Motivation:

Reduce leverage-induced Under-Investment in sponsoring companies

a phenomena known as “Debt Overhang”.

(III) Risk Management Motivation:

Reduce underinvestment in positive NPV projects due to

distress cost and / or Managerial risk aversion.
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 PF Vs Corporate Loan

Corporate loan is primarily lent against a company’s BS

And projections extrapolating from its past cash flow
And profit record.
It also assumes that the company will remain in business
For an indefinite period and
so keeping renewing (Rolling Over) it’s loan.

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 Key Aspects of PPP
The Project structure:
 CAPITAL
 OWNERSHIP
 CONTRACTS
 ORGANIZATION STRUCTURE

Affects Managerial Incentives to create Value and Manage Risk,

By Combining Investment & Financing decisions.

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 PF and Privatization
Privatization
Either conveys the ownership of Public-sector assets
to Private Sector
Or Provides for services by a private company that have
previously been supplied by a public entity
Ex- Street Cleaning, Health Services, Education.

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 Project Finance - Forms
Build- Own- Operate -Transfer (BOOT) projects
Build-Operate – Transfer ( BOT) projects
[1.Also known as design-build-finance-operate or
DBFO projects. 0r
2.It may also be granted a Lease of the project site
and the associated buildings and equipments
during the term of the project- build- transfer- lease-(BLT)
or
3.Build –lease-operate- Transfer (BLOT) ]
Build- Transfer- Operate ( BTO) projects
Build -Own –Operate ( BOO) projects

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The real Value in a project financed in the above way
is not the ownership of its assets, but the right to receive
the cash flow from the project.

Though the different ownership structures are of limited importance

to lenders, any long term residual value in a project may be of
relevance to the investors in assessing their likely return.

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 PF & Structured Finance
There is no precise boundary between the two.
However the bankers deal their lending operation
As “ structured Finance”, covering any kind of Finance
Where a SPV :

 Like a project company to be set up

 To raise the funding
 With an equity & debt structure to fit the cash flow

{No existing Business}

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 Types

Receivable Finance
Securitization
LBO
Acquisition Finance
Asset Finance
Leasing

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 Why use Project Finance

• A project company, unlike a corporate borrower has no

“track record” for a corporate loan..
• Lenders have to be confident that they will be repaid.
• They have to have high degree of confidence in the project
As regards-
 On-time completion & within budget
 Technically capable of operating as designed
 There will be enough cash flow
 to cover the debt service adequately

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 Why Investors use PF
oHigh Leverage improves the return for Investors
Low Leverage High Leverage
Project Cost 1000 1000
A Debt 300 800
B Equity 700 200
C Revenue From Project 100 100
D Interest rate on Debt( P.A.) 5% 7%
E Interest Payable [a x d] 15 56
f Profit [ c- e ] 85 44
Return on Equity { f /B } % 12% 22%

Loading with Debt is adding more risk. Due diligence process

ensures that the financial Structuring is prudent.
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 oTax Benefits encourages High leverage
Low Leverage High Leverage
Project Cost 1000 1000
A Debt 300 800
B Equity 700 200
C Revenue From Project 100 100
D Interest rate on Debt( P.A.) 5% 7%
E Interest Payable [a x d] 15 56
f Profit [ c- e ] 85 44
Return on Equity { f /B } % 12% 22%
Tax Rate 30%- ROE 8.5% 15.5%
60 (85x70%) 31[44x70%]

The tax deduction may not be significant due to initial high Capital cost.

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 oOff- Balance Sheet financing

The Debt raised is an off- balance sheet item as it is

Raised in the name of the project company.
This is seen beneficial in the financial market.

However this becomes an item as part of Disclosure in BS.

PF should not be undertaken purely to keep debt off the
Investor’s BS.

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 oBorrowing Capacity

Non- Recourse finance raised by the project company

Is not normally counted against corporate credit line.
It increases the overall borrowing capacity
And hence the ability to undertake several major projects
Simultaneously by the Investor Company.

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 oRisk Limitation

Risk is limited to the equity invested by the project

As part of non-recourse commitment

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 oRisk Spreading & JV
Limited partners to the Project by taking off-taker as investor.
Creating JV with specialized expertise spread the risk.

Input contract
Off take contract
EPC
O&M

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oLonger Term-
Credit with longer maturity & easy terms.

oEnhanced Credit-
If the off-taker has a better credit than the equity investor,
this may enable debt to be raised for the project on better
terms than the investor for corporate loan.

oUnequal Partnerships.
Projects are often put together by a Developer with an idea
but little money, who then has to find investors. A PF
structure, with less equity, make it easy for the weaker
developer to maintain an equal partnership.

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 Benefits of PF to third parties
Lower Product or Service Cost
Low Leverage High Leverage
Project Cost 1000 1000
A Debt 300 800
B Equity 700 200
C Return on Equity[ B x 15%] 105 30
D Interest rate on Debt( P.A.) 5% 7%
E Interest Payable [a x d] 15 56
f Revenue Required [C + D ] 120 86

If the off-taker or end-user wishes to fix the lowest long term purchase cost
For the product of the project and is able to influence how the project to be
Financed, the cost to the off-taker is reduced.
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Additional Investment in Public Infrastructure
to overcome funds constraint
Risk Transfer-
Risk transferred from Public to private sector as Payment contingent on
specific performances.
Lower Project Cost-
Cost Effective & Efficient which may be neutralized/ eroded in
“ Deal Creep”-cost changed in later negotiation, change in specifications
during construction period.
Third party due diligence
Transparency
If the Sponsor is in a regulated business, the unregulated business can be
shown to be financed separately & on arm’s length basis through PF.
Additional Inward Investment-
Successful PF for a major project opens up window of opportunities
Can act as a showcase to promote further investments.
Technology Transfer

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WHAT ARE THE 5 MOST COMMON CRITICAL SUCCESS
FACTORS (CSF’S) TO DEEM A PPP PROJECT
SUCCESSFUL?

1. Good governance;
2. Commitment and responsibility of
public and private sectors;
3. Favourable legal framework;
4. Sound economic policy; and
5. Available Financial market

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thanks

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