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26-02-2018 | Brenda Rodríguez López
Highways, tunnels, airports, hospitals, wind farms, optic fiber networks, satellites, amusement parks, water treatment plants, bridges, universities, oil pipelines,... Many projects have moved forward thanks to a financing alternative called project finance. What does this financing model consist of? Why is this alternative so attractive to promoters? Why are entities interested in investing in high-risk or off-balance-sheet projects like these ones? What do "super projects" need to have to get funding?
Project finance is a funding mechanism used in projects that require a high capital investment. From roads to refineries, there are many large projects that can fit in this type of specialized financing, but mainly they have the goal of building civil works, developing new infrastructures or implementing energy projects.
Project finance is a external financing model which is key so their materialization is possible. These big initiatives need a high financial leverage and a long-term financing model and which is focused on them so they can stay afloat. As these "super projects" have such exorbitant dimensions, they are usually financed through a pool of banks or venture capital funds. The particular characteristics of this financial alternative are not few. They are very interesting and can attract the attention of anyone.
Projects out of balance!
In project finance, the projects themselves are able to generate enough resources to compensate the financing, in fact, it is precisely their estimated future flows which are offered as amortization guarantees. The reimbursement and backing of the financing is not based neither on the physical assets value, nor on the guarantee of the promoter partners, but on the cash flow generated by the project, which as a general rule is not materialized until the first two years of its implementation. Therefore, financing will depend on the project capacity to generate free cash flows, replenish the capital invested and the generated interests.
What makes this model of financing so attractive to its promoters is that it allows the debt contracted to be taken out of its accounting balance. In this way, the impact that this debt may have on the financial costs of the sponsors is minimized. They greatly reduce the risk they assume, they keep their borrowing capacity and can overcome obstacles when undertaking new projects with other loans. Project finance can be established under two types of financing:
- Non-recourses financing: if the project fails, the funders cannot demand the assets from the promoters (only the ones from the funds of the SPV)
- Limited recourses financing: it will depend on contractual commitments and additional guarantees
What do "super projects" need to obtain this financing?
In a financial project, many parties are involved (workers, engineers, managers, lawyers, auditors, ...), but there are only two fundamental agents. The sponsors or promoters who are the ones who propose the "super project" and who are also in charge of carrying it out since they are the ones who have the know-how. They function as partners and allies of the funders, the second indispensable actors in this equation, which usually appear as a "pool" of banks or venture capital funds. They are the ones that, as a general rule, assume a greater risk since they will only have cash flows and project assets as a guarantee, therefore, a good project design will be indispensable for those who decide to invest in it.
Project finance mandatorily requires the constitution of a project vehicle company, known as SPV, that will be financially and legally independent from the promoters, a society bounded to the project where a contractual network will be built in order to provide robustness to it. These contracts will be vital for the success of the "superprojects". Through a multitude of clauses adapted to the particular project cases, the conditions of the financing and its repayment will be fixed, the risks assumed by the parties will be distributed and the guarantees will be established. This design is complex, detailed and meticulous because it needs to minimize uncertainty and the risk and guarantee that the project is a success. The more solid the legal-economic framework is, the more viable and profitable the project will be.
The resources generated by the project must allow the return of the capital invested, of the interest generated and also cover operating expenses. Therefore, cash flows have to be foreseeable, steady and safe; and the risks assumed by the parties involved should be well defined and minimized. Reports, viability studies, contracts and audits are the key elements that substitute traditional guarantee methods. Offering a good base case with reasonable figures and ratios is essential so the funders bet on these projects.
Advantages and disadvantages of project finance
Apart from their essential characteristics like the off-balance accounting or the financing through the cash flows from the own project, project finance offer other advantages like the reduction of the risk faced by the promoters, the high leverage that is usually between 60 and 90% of the total or the coverage of the financing until the profitability is reached. These models represent an alternative that makes possible the private financing on the promotion of goods of public interest. They can also serve for the internationalization of companies and in the design of innovative and environmental projects.
Although financial projects are very useful models for financing projects that require high investment, their design is, on the other hand, laborious and very complex. It also implies a high cost, a lot of work and it is essential to count on professionals with a high level of specialization. In their development, they have to take into account the different risks assumed by the different parties and establish guarantees, due diligence and well-defined ratios so the "super-project" can be a success. The higher the risk they assume, the higher the profitability of the funders, hence their interest on them. In addition, this model transfers the risk of the promoters to the project itself and allows the funders an intensive monitoring of it. As long as the design and the base case are good, the project will be a profitable business.
If you want to go in depth on the knowledge of financing mechanisms such as "project finance" or acquire the necessary knowledge for the design, creation, modification and revision of financial models like this, consult our training programs on Corporate Finance and Financial Modelling.