What is Project Financing?

What Is Project Financing?

What does a Company do if it wants to execute a large project with ticket sizes of over US$100 million and up to and more than US$1 billion? If the Project succeeds, then all is well; but what if the project fails? It can jeopardize the existence of the parent company.

What about a non-recourse financing facility for executing such a Project? If the Project fails, no liability attaches to the Promoter. To enable this the promoters set up a Project Company in the form of a Special Purposes Vehicle (SPV) which is bankruptcy-remote from the promoters. The Project Assets are owned by the Project Company and the Project activities and Project cash flows are clearly segregated from the promoters. Welcome to Project Financing. The promoters are usually called the Sponsors of the Project.

Normal corporate loans are bilateral loans with recourse to promoters.

Sponsors like the arrangement because it prevents risk contamination; in case the project goes belly-up. Heads, they get to own a successful business (the project); tails, they only get to lose the equity.

Project risks are substantial and not bankable risks. Lenders usually do not take on unbankable risks. So why do lenders finance such projects? The answer lies in a unique financing technique, where the Lender parcels away most project risks to other stakeholders, who can best, manage such risks. Ultimately lenders only take on bankable risk.

So, if Project Financing is non-recourse, isn’t it extremely risky? Not really.

The major principle on which Project Financing works is this-" Transfer all risks, away from ProjectCo to those who can manage the risks best".

This means that Construction Risk, Operating Risk. Supplier Risks and Offtake Risks, the four major risks that bedevil Projects, are transferred away from the ProjectCo to the EPC Contractor, Operations and Maintenance Contactor(O&M), Supplier and Off taker. These are independent entities that provide Bank Guarantees/assurances to the Project Company. Other Project risks like Force Majeure risks are covered through Insurance Companies, while Political Risks are covered with MIGA (a World Bank affiliate). This makes Project Financing risk-free and perhaps one of the safest forms of finance. (See Figure below)