PROJECT FINANCE

Article by Arijit Sanyal and Nickolaus Ng

A viable option for financing large projects.

Introduction

With impediments arising before corporate financing of long-term projects in the post-COVID world, the focus is likely to shift towards Project Finance. But what is Project Finance? It may be defined as a method of non-recourse financing where the lender's sole recourse to repayment is the cash flow generated by the project upon its completion.[1] It is primarily used for complex and long-term projects such as oil refineries, mines, telecommunications[2] and recently for green projects etc. The Special Purpose Entity (SPE), which is the most important legal entity in such projects[3], is vested with the powers of subcontracting parties necessary for the completion of the project.[4] As the assets of the SPE are unlikely to make up for the investments, the lenders have to depend on the cash flow generated once the project is complete.[5] Project finance differs from other methods of financing as the debt is usually suspended until the project enters into operation, even before the completion of the project sale-purchase agreements are finalised which in turn boosts the confidence of the lenders. The finance structure is usually decided considering the needs of that project and is a share of debt and equity, the former having a larger share. This article aims to throw light on the utility of the SPV and other general features of project finance along with a comparative analysis of corporate and project financing of infrastructure projects. Further, the article attempts to give an overview of recent trends vis-à-vis project finance and the potential risks involved.

Features of Project Finance

Source: Dentons ‘A Guide to Project Finance’ (2018) pg 14

1) Special Purpose Vehicle (SPV)

Project finance generally includes an SPV. This is usually a subsidiary created by a parent company to legally isolate financial risk and share risks amongst investors.[6]

Because of its legal status as a separate company, this makes the SPV’s obligations secure even if the parent company goes bankrupt. The SPV’s sole activity is carrying out the project by subcontracting most aspects through construction and operations contracts. As there is no revenue stream during the construction phase of projects, debt service will only occur during the operations phase.

Furthermore, SPVs may help to save on tax, particularly so where the SPV is incorporated in tax-lenient countries or tax havens like the Cayman Islands.[7]

Very often, SPVs subcontract to other firms such as ‘Engineering, Procurement, Construction’ (EPC) contractors to manage tasks related to project procurement and supply of construction materials. For tasks related to operation and maintenance of tools and construction sites, the SPVs subcontract out to O&M contractors.

Inevitably, long-term projects require a huge sum of financing. SPVs often get financing from two potential sources:

1. Equity providers through a shareholder’s agreement

For this option, capital is invested by sponsors such as project developers, construction firms, and/or institutional investors. The sponsors will adopt a “First in Last Out” approach, where they will invest right at the beginning of the project and eventually pay for any losses if any. Hence, it could be said that any project losses are first borne by equity investors. Project finance lenders are entitled to financial recourse before equity contributors can claim any returns or repayments. Because of this high risk, equity contributors correspondingly stand to receive the highest potential return if things go as planned.

1. Debt providers through a loan agreement

For this option, SPVs usually take out loans from commercial banks, international financial institutions like the World Bank, and/or Export Credit Agencies. Notably, the interest rate of banks depends on the risk profile. An issue arising from the taking out of loans is that banks can rarely grant loans for a 20-year span, which is the type of loan an SPV takes out for long-term PPP projects. Furthermore, bank loans usually reach maturity before the end of concession and therefore refinancing is needed. Therefore, refinancing usually occurs after the construction phase where the risk of project failure is lesser and resulting in decreased costs of borrowing.

2) Non-Recourse Financing

Recourse and non-recourse loans are types of commercial lending that allow lenders to lay claim to assets if borrowers default on their obligations and fail to repay their debts. Lenders are allowed to take possession of any assets used as collateral to secure these loans. Many loans are taken out with one or more assets of a certain value that the lender can take if the borrower does not fulfil their obligation as outlined in the loan agreement.[8]

Recourse loans are secured by collateral. If the borrower fails to live up to their obligation and default on the payment schedule, the lender can go after the borrower's other assets so that the loan can be made whole again. As there is usually a balance left on the loan, the lender can go after the borrower to recoup whatever is left owing on the loan. Most automobile loans are recourse loans. If the borrower defaults, the lender can repossess the car and sell it at full market value. This amount is much lower than the value of the loan because vehicles depreciate significantly after it's driven off the lot. [9]

Non-recourse finance entitles the lender to repayment only from the profits of the project the loan is funding and not from any other assets of the borrower. Such loans are generally secured by collateral. In the case of long-term infrastructure projects, the lenders’ recourse is limited entirely to the project’s assets, including completion and performance guarantees and bonds, in case the project company defaults.[10] The lender will take the loss and have no claim on the borrower's other funds, possessions, or funding sources.[11]

3) Off-Balance Sheet (OBS)

Project debt is typically held in a sufficient minority subsidiary not consolidated on the balance sheet of the respective shareholders. This reduces the project’s impact on the cost of the shareholders’ existing debt and debt capacity. The shareholders are free to use their debt capacity for other investments. The financials of an SPV may not appear on the parent company's balance sheet as equity or debt. Instead, its assets, liabilities, and equity will be recorded only on its balance sheet.[12]

This prevents shareholders from incurring liability on a balance sheet through operating leases or partnerships. Operating leases have been used for a long time, where a company leases a piece of equipment and then buys the equipment at the end of the lease period for a minimal amount of money, or it can buy the equipment outright.[13]

The company records only the rental expense for the equipment and does not include the asset on the balance sheet. If the company buys the equipment or building, the company records its purchase of the equipment and the purchase price. By using the operating lease, the company records only the rental expense, which is significantly less than the entire purchase price and results in a cleaner balance sheet.[14]

When a company engages in anR&D partnership, it does not need to show the partnership’s liabilities on its balance sheet. In the authors’ opinion, partnerships are attractive to companies who require R&D to further their projects. This is because R&D is very costly and may have a long time horizon before completion. Using such an accounting method as OBS for an R&D partnership allows the company to add minimal liability to its balance sheet while conducting the research.[15] This is beneficial because, during the research process, there is no high-value asset to help offset the large liability.[16] This is particularly true for PPP projects in the pharmaceutical industry where R&D for new medicines takes many years to complete.

4) Offtake Agreements

An offtake agreement is prearranging between the seller and the buyer(s) for sale and purchase of the commodity once the facility has begun operating. Such arrangements serve a dual purpose as, apart from finalising the sale of its future production and guaranteeing cash flow, they allow the parent company or the SPV, in this case, to attract more investments for the project.[17] Though these agreements are finalised way before the production begins, it provides for incentives for the buyers as their purchase price is shielded from future price fluctuations.[18] Moreover, it secures the interests of the project company by having clauses dealing with penalties to be activated on account of the buyer repudiating the agreement, however, the same does include Force Majeure clauses to protect the party from unforeseen circumstances such as the current pandemic.

Project Finance v. Corporate Finance

Lending

Project finance is marked by the facility of suspended debt which is to be paid out of the cash flow generated in future, once the company has begun operations. Lending in Project Finance is based on cash flow, viz, at the time of lending the primary consideration for the group of lenders is the future cash flow of the enterprise and not its physical assets per se.[19] This departs from the entire process from Corporate Finance, which is based on collateral lending, viz lending against the borrower’s balance sheet.[20]

Liability

The borrower has certain liabilities towards their lending however, the degree of liability differs greatly depending on the model of finance. Considering the lending has been done through Project Financing, the lender will have access to the limited cash flow and assets belonging to the SPV. As a result of which, if the limited cash flow and assets belonging to the SPV do not make up for the loan amount, the borrower’s assets independent of the SPV cannot be pursued. This is different in case of Corporate Financing as the lender usually has access to the entire cash flow and assets of the borrower and in case there is a default in payment and the primary assets do not make up for the loan amount, the lending institution has recourse to other assets, which might be independent of the business.[21] Hence Project Finance is often called Non-Recourse lending.

Duration

In the case of corporate financing, it is understood that the life of the business is infinite resulting in the viability of rolling-over loans. This enables the borrowers to renew the loans which result in the debt being carried over to a new term.[22]

Trends in project finance in recent years

Over the past decade, project finance has notably been on the rise, with numerous shareholders investing in such ventures in areas of renewables, power, oil and gas, infrastructure, and telecommunications to name a few.

Source: IEA analysis with calculations for project finance based on data from IJGlobal (2019), WindEurope (2019), and US DOE (2018)

As reflected in the diagram above, while project financing in Europe for onshore wind has been stable, that for offshore wind has grown as the maturity of the technology has increased and the risks have fallen, thanks to competitive bidding for long-term contracts and, in some markets, system operators assuming grid connection risks. Renewable project finance has also spread into Australia, Japan and Latin America, boosted by policies to help manage the risks. In 2018, around 45% of utility-scale renewables spending was in projects whose contractual remuneration is determined by competitive mechanisms. These are mostly delivered through government schemes - such as auctions, which play an increased role in Europe, India and have started in China, among others.

Furthermore, aviation infrastructure in many countries employ Public-Private Partnerships and use project finance for the building of airports, reflected in the diagram below.

Risks Involved in Project Finance

Projects, irrespective of the mode of financing, carry out due diligence to assess the potential risks which might affect the operation of a project. However, a process peculiar to project financing is the allocation of risks to parties who are better suited to handle them and absorb the risks if any. Though risks are diverse, they can be identified as one belonging to the fold of commercial, construction, environment, political, operational etc.

Commercial Risks

Every project company tries to assess the commercial risks which are reasonably foreseeable, as it has a direct nexus with the lending and repayment when the project enters into the operational stage. Commercial risks involve but are not limited to, marketability of the product, competitors in the market and the impact it might have on the sale of future products, an imminent change in technology which might make the operation too expensive, making it impossible for the parties to discharge their obligations etc...[23]

Construction Risks

Construction is the core of such projects because it controls funding as well as the operational capacity of a project. Hence, to make things run smoothly, the contractor needs to ensure things like the acquisition of land on time along with the suitability of the land for the project. Moreover, it needs to be ensured whether the construction contractors are qualified to handle large scale projects, in absence of which the entire credibility of the construction phase can be questioned, resulting in other repercussions such as delay in completion, cost overruns, repudiation of offtake agreements or operation of the project.[24]

Environmental Risks

Financial institutions investing in a particular project, need to be aware of the environmental risks surrounding the same. Project companies often end up getting fined, facing considerable delay or their permits getting cancelled by the regulators. Poor monitoring of environmental factors can result in excessive losses for the financial institutions, evident from recent events in developing economies.[25]

Political Risks

Acts of sedition, coups, civil wars, a transition of power, etc... can have a serious impact on the profitability, and even viability of the project. Though companies have an option to insure their projects from political risk, these insurances cover a few typical risks such as acts of terrorism, coups, civil unrests, etc..., completely ignoring government change or a change in regulations. These risks can go to the extent of making it a tedious task for the shareholders to liquidate their shares, let alone allow the banks to find a way to recover their loans. Hence, being one of the most unpredictable risks, formal international regulations should be in place to protect the interests of the parties involved.[26]

Concluding Opinions

Today, we stand at a juncture where we see companies trembling and financial institutions crippled, with negligible chances of a quick recovery. From the above discussion we have had it is evident that a lot of project companies will be looking for Project Financing, with this pandemic leaving their financial health in an abysmal state. However the changing times signify that even if they do proceed with unconventional modes of financing, a situation such as this would jeopardise that too which has called for reforms in this sector globally.

It is incumbent upon international bodies such as The World Bank, International Monetary Fund, Asian Development Bank etc. to enter the post-COVID phase of financing with regulations which though do not pressurise the states in similar situations but dilute the “Force Majeure” card which has dampened the prospects of recovery from a lot of PPP project. Moving forward, Project Finance might be something better at their disposal but dealing with a newer problem with the same old ways might do more harm than anticipated.

[1] Adam Hayes, ‘Project Finance’ (Investopedia, 22 April, 2019)<https://www.investopedia.com/terms/p/projectfinance.asp> accessed 24 September 2020. [2] E. R. Yescombe, Principles of Project Finance (2nd edn, Elsevier Science & Technology, 2013) 7. [3] Andrew Fight, Introduction to Project Finance (Elsevier Science & Technology, 2005) 16. [4] Such contracts include, but are not limited to, Engineering Procurement and Construction Contract; Offtake Agreements, Input Supply Contracts, Operation and Management Contracts etc. [5]Supra note 2, at 8. [6] Tristiano Sainati, et.al., ‘Types and functions of special purpose vehicles in infrastructure megaprojects’ (2020) International Journal of Project Management, Volume 38, Issue 5, 243-255 [7] Corporate Finance Institute, ‘Special Purpose Vehicle (SPV)’ (CFI, 2020) <https://corporatefinanceinstitute.com/resources/knowledge/strategy/special-purpose-vehicle-spv/> [8] Internal Revenue Service. "IRS Courseware: Recourse vs. Nonrecourse Debt” <https://apps.irs.gov/app/vita/content/36/36_02_020.jsp?level=advanced> [9] Julia Kagan, ‘Non-Recourse Finance’ (Investopedia, May 2020) [10] ibid [11] Ken Clark, ‘Recourse Loans vs. Non-Recourse Loan: Knowing the Difference’ (Investopedia, March 2020) [12] Adam Hayes, ‘Project Finance’ (Investopedia, April 2019) [13] U.S. Securities and Exchange Commission. "Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers," Pages 15-16. Accessed April 3, 2020 [14] U.S. Securities and Exchange Commission. "Final Rule: Disclosure in Management's Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations <https://www.sec.gov/rules/final/33-8182.htm> [15] Remco L.A. de Vrueh and Daan J.A. Crommelin, ‘Reflections on the Future of Pharmaceutical Public-Private Partnerships: From Input to Impact’ (2017) Pharm Res 34, 1985–1999 [16] ibid [17] Troy Segal, ‘Offtake Agreements’ (Investopedia, 5 August, 2019)<https://www.investopedia.com/terms/o/offtake-agreement.asp> accessed 24 September 2020. [18] Kerem Toklu, ‘INSIGHT: Transfer Pricing Analysis of Offtake Agreements’ (Bloomberg Tax, 22 May, 2020)<https://news.bloombergtax.com/transfer-pricing/insight-transfer-pricing-analysis-of-offtake-agreements> accessed 24 September 2020. [19] Anwar Talukder, ‘Collateral-based lending vs Cash-based lending’(The Financial Times, 20 October 2017)<https://thefinancialexpress.com.bd/views/collateral-based-lending-vs-cash-flow-based-lending-1503933680> accessed 25 September 2020. [20] Kyle Channing Pearce, ‘Project Finance v Corporate Finance’ (Wall Street Prep<)https://www.wallstreetprep.com/knowledge/corporate-finance-vs-project-finance/> accessed 25 September 2020. [21] E. R. Yescombe, Principles of Project Finance (2nd edn, Elsevier Science & Technology, 2013) 9. [22] Ibid at 198. [23] Steffano Gatti, ‘Project Finance in Theory and Practice: Designing, Structuring, and Financing Private and Public Projects’ (Elsevier Science & Technology, 2007) 290. [24] John E. Triantis, Project Finance for Business Development (John Wiley & Sons, Incorporated, 2018) 8e. [25] Barclays, ‘Environmental Risks in Lending’, <https://home.barclays/citizenship/the-way-we-do-business/environmental-risks-in-lending/> accessed 24 September 2020. [26] Supra note 12, at 318.