Project finance has witnessed explosive growth in the past few years. Its emergence has resulted in number of favourable trends like privatisation, deregulation of industries and new attitudes towards the role of private sector. Despite this success, certain underlying challenges remain about project finance as the financing vehicle of choice, says R. Balaji – Vice President, Finance and Treasury Head, Technip India Ltd.
The past decade has not been easy for due to erratic markets and a complex web of new regulations and compliance issues. This has forced the finance function to redefine its role in the organisation to face rapidly changing market and economic conditions. From providing more insightful business intelligence and forecasting, anticipating and responding to sudden market disruptions, today’s finance professional is expected to be a business strategist and a financial expert by transforming their functions to deliver efficient as well as effective services. While the global financial crisis and economic downturn have made these tasks even more complex and challenging, they have also underlined the fundamental importance of the role.
Against this backdrop, let us look at the project financing scenario and its challenges:
Although portrayed as a new financing technique, project finance is actually a centuries-old financing method. With the explosive growth in privately financed projects in the developing world, the technique is enjoying renewed attention. The purpose of this note is to highlight the advantages and disadvantages of project finance and explain the myriad of risks involved in these transactions and to raise questions for future research.
The basic characteristic of project financing is the use of the project’s output or assets to secure financing. The essential aspect of project financing is the finite life of the enterprise. In corporate finance terms, this amounts to mandatory liquidation as a fixed dividend policy rather than reinvestment. Project financing has evolved through the centuries into primarily a vehicle for assembling a consortium of investors, lenders and other participants to undertake large and long gestation projects that would be too large for individual investors to underwrite. Prominent examples are construction of infrastructure like roads, telecom and power plants around the world as the governments face budgetary constraints.
The common features of project finance transactions are:
* Capital-intensive: Project financing tend to be for large-scale projects that require significant debt and equity capital. A World Bank study in 1993 found that the average size of such infrastructure projects in developing countries was $440 million.
* Highly leveraged: These transactions tend to be highly leveraged with debt accounting for 65 per cent to 80 per cent of project cost.
* Long term: The tenor is generally for 15 to 20 years.
* Independent entity with a finite life: Similar to the ancient voyage financing, project financing rely on a newly established legal entity (project company) whose sole purpose is for executing the project with a finite life. For e.g., in a BOT project, the company ceases to exist after the project assets are transferred to the transferee company.
* Non-recourse or limited recourse financing: As new entities do not have credit or operating histories, lenders focus on the project’s cash flows. Thus, it takes an entirely different credit evaluation or investment decision process to determine the potential risks and rewards of a project financing. Lenders work with engineers to determine the technical and economic feasibility of the project.