The Project Finance Law Review: What is Project Finance?
I Definition of project finance
Project finance is a specialised form of financing, utilised in a very specific circumstance – the non-recourse or limited recourse funding of an individual asset or set of assets (a 'project'). Some of the more significant distinguishing characteristics are:
- with certain exceptions, described later in this volume, payment is entirely dependent upon the revenues earned from the relevant project, without recourse to the sponsors;
- as a result, the loan liability generally is 'off balance sheet' for the sponsors;
- a credit evaluation must be made of the project independently of the sponsors;
- dependable cash flow to the project is required – this is achieved both by an absolute requirement for payment, without excuse or set-off, and by the creditworthiness of the project's offtaker or offtakers;
- the project is typically walled off in a separate project company – a special purpose vehicle (SPV) – that is bankruptcy remote from the project sponsors and is tightly controlled by the lenders, because of the financing's dependence on project cash flow; and
- lenders hold security over all material project assets, as well as the sponsors' equity in the project company.
At a very high level, the project can be thought of as a box, walled off pursuant to the lender requirements, into which financing is advanced, from which a product is sold, back into which proceeds of those sales are received, and out of which loans, and interest, are repaid. The project debt is either non-recourse or limited recourse (for example, an obligation to fund construction cost overruns) to the project sponsors, so the sponsors' risk is limited to their equity investment in the project.
Because of its reliance on project cash flow for loan repayment, a project financing arrangement intrudes deeply into the operation of the project. Each material contract is reviewed and signed off on by the lenders, and changes require lender approval. The need to assure cash flow generally leads to requirements to hedge prices during the loan term, where a commodity is involved, and to hedge currency risk during the loan term, where proceeds received by the project are in a different currency from the loan. Project cash flow is controlled through a requirement that proceeds received by the project be deposited into a series of accounts controlled by the lenders, from which funds are disbursed in accordance with a pre-determined 'waterfall' (priority) scheme.
This type of financing differs significantly from general corporate financing, where the credit of the sponsor entity, not a particular set of its assets, is most important to the lenders, and where, even if the financing is secured, the lender is more concerned about the value of the assets as a whole rather than the detailed contractual arrangements for a given subset of them.
While project financing and structured financing share a number of the characteristics recited at the top of this page, project financing also differs from structured financing, where various assets of a particular class, or their cash flows, are pooled and securitised, and combined with derivative instruments, to spread risk and increase liquidity, rather than concentrating and controlling risk in a single or small set of assets.
II Challenges of project finance
As would be expected for a financing that is dependent upon a single asset or small set of assets, and the contracts that govern them, project financing is very paper intensive. In addition, risk is heightened by dependence upon the single asset or set of assets, and a single source of cash flow for repayment. These factors, along with regulatory developments discussed at the end of this chapter that decrease the attractiveness of project finance to commercial banks, often make project financing expensive, particularly when compared to general corporate financing. Although security is taken over all project assets, the real source of repayment is project cash flow, not potential sales of the project assets upon foreclosure (which may be difficult, or impossible in the case of public infrastructure), so lenders have a strong interest in assuring that cash flow will continue. Project financing is therefore restrictive, with noticeably more information requirements, specific covenants and lender consent rights than in a general corporate financing. For example, the relevant project company is typically not allowed to participate in any lines of business unrelated to the core business of the project, to reduce risks to the lenders. Defaults in the underlying project documents can be expected to trigger a default under the project financing as well.
III Reasons for utilising project finance
What, then, are the drivers for sponsors to utilise project financing? There are actually quite a number.
First, where a project has very high capital needs compared to the capitalisation of the sponsor or sponsors, general corporate finance is likely not an option. The same is true where a sponsor or sponsor's credit is not sufficient to attract reasonably priced, or any, general corporate finance. Mid-sized and smaller sponsors, and less creditworthy sponsors, are more likely to seek project finance than large, highly rated entities with ready access to the capital markets. Similarly, sponsors developing very large projects are more likely to seek project finance than those developing small projects.
Second, because of the non-recourse nature of project finance, the lenders bear a significant share of the project risk (though, as discussed throughout this volume, they take numerous steps to reduce that risk). A sponsor may prefer to share the risk of a risky project with others, particularly where the risk-sharing party is a lender who does not require a full equity rate of return. As noted above, the sponsor's financial exposure is generally limited to its equity investment.
Third, despite its cost, project finance may enhance the return on capital employed in a project, by increasing the debt levels that a project can bear. A classic example would be the early liquefied natural gas (LNG) financings in which lenders (including, indirectly, export credit agencies) funded 100 per cent of the basic cost of the liquefaction plant. Although those levels of funding would be challenging to achieve today, because of the bankruptcy remoteness of a project-financed project and the degree of lender control over contracts and cash flow, lenders may be willing to advance a larger share of the project's cost (for example, 70 per cent or 80 per cent) than they would through a traditional secured corporate loan, particularly where the sponsors do not have strong credit.
Fourth, because of the off-balance sheet nature of project finance, sponsors may prefer to employ it, even if it has a higher cost, because it does not directly impact their general corporate credit, which they may prefer to have available for other purposes.
Fifth, where a number of sponsors need to finance the same project, project finance by the sponsor group may greatly simplify funding, and ensure that the entire group, including those entities that are smaller or less creditworthy, are able to provide the necessary funding.
Sixth, sponsors may find that project finance reduces political risk in high-risk countries, as the presence of bilateral and multilateral lenders and major international banks may make host governments or other local players more reluctant to interfere with the project and its cash flow, at least during the tenor of the loan.
Seventh, certain project finance may, in contrast to the usual situation, offer concessionary terms. For example, export credit agency financing to encourage the purchase of capital goods from a certain country may offer very attractive rates. In addition, some government-backed funding (for example, municipal bonds in the United States) may offer tax advantages to the funding parties and thereby lower the cost of capital for the project. In recent years, economic stimulus programmes by governments have also appeared as a source of low-cost funding for projects in favoured industries.
Eighth, and finally, project finance ensures a careful and detailed structuring of the project and management of its risks, reducing the odds of project failure for the sponsors as well as the lenders.
This is by no means an exhaustive list of the reasons sponsors may seek project financing, but it does recite the most common reasons why an often higher cost, and certainly more complicated, route to financing may in fact be the most attractive one.
IV Typical uses for project finance
As might be expected from the list of drivers for use of project financing recited above, certain types of projects are far more likely to see this sort of financing.
Energy projects (both electric power, and oil and gas) comprise the largest single share of worldwide project financing. They share the characteristics of having large capital needs, in many cases having higher than average risk, occupying a politically sensitive sector and, in the case of oil and gas, often having a number of sponsors.
If private real estate projects are excluded, public and quasi-public infrastructure projects (airports, roads, bridges, dams, stadiums and the like) then comprise the second-largest share of worldwide project financing, for different reasons. Governments may expand their outlays without seeking increases in general revenue funds by utilising project finance. This provides a convenient way to fill budgetary shortfalls in a politically acceptable manner. Governments have the ability to issue project bonds that bear relatively low rates, because of implicit government sponsorship and in some cases tax benefits attaching to the income earned (though, as many defaults have shown, the implicit government backing for the project will not in practice prevent a default on the bonds). Governments may also be able to raise funds and shift some of the burden to the private sector through public–private partnerships (PPPs).
One relatively recent development is the significant rise of project financing of telecoms projects and data centres, in line with the explosive growth in worldwide data requirements. These now comprise the third largest share of worldwide project financings.
V Sources of project finance
Project financing for all of these projects may be obtained from a variety of sources that are discussed in detail later in this volume. These include capital markets (through public bond issuance or private placement), commercial lenders, government funding (including government bonds), multilateral lenders and regional development banks, and national export credit agencies and insurers, among others. Some sources (e.g., bonds) tend to impose fewer constraints on the project, but those constraints may prove much harder to modify or waive. Others (e.g., commercial lenders) may be quite intrusive with regard to project operations but easier to work with as changes occur in the project. Still others (multilateral lenders and regional development banks, export credit agencies, etc.) may offer particularly attractive rates and perhaps political risk protection, but with strings attached, such as requirements to purchase goods of certain national origin, follow certain preferred environmental or labour standards, and the like. Project financing for larger projects may include tranches from several of these sources, with intercreditor agreements and common collateral arrangements used to manage the interrelationships between the various creditors.
VI Basic structure of a project and project financing
Although the set of agreements and interrelationships in a project are quite complex, they can be broken down into a handful of basic categories that make them more understandable.
i Equity agreements
The various project sponsors will have agreements among themselves, often centred in a shareholders' agreement, joint venture agreement or similar arrangement, that define their requirements for capital contributions, rights of governance and entitlement to distributions from the project.
ii Host government agreements
In much of the developing world, host government agreements for a project may consist of concessions or similar agreements spelling out in great detail the rights and obligations of the project company (and perhaps project sponsors as guarantors) with regard to the host government. These rights and obligations may include matters such as work commitments and schedules, tax payments and other fiscal obligations, tax holidays and other incentives, local contracting and hiring, domestic supply obligations, dispute resolution and stability of terms (if any). In the developed world, host government agreements are most likely to consist of permits obtained following various processes required by generally applicable laws, particularly in the areas of land use and environmental restrictions, though incentive agreements, particularly at the regional and local level, may be available in these countries as well.
iii Supply agreements
Aside from public infrastructure projects, many projects involve the conversion of some type of raw material or fuel into a usable or transportable product (e.g., liquefied natural gas, refined products, metals and electricity). The agreements under which the raw material or fuel is supplied to the project are critical to its success and must assure a supply throughout the loan term.
iv Offtake agreements
At the back side of most projects, a product is produced that must be monetised in order to generate project cash flow. Again, these agreements (and the credit of the offtaker) are critical to the success of the project and (in general, where there is no large, recognised liquid market for the product) must assure cash flow throughout the loan term.
v Construction agreements
The principal purpose for most project financing is the construction of the project. During construction, lenders must advance most if not all of the project finance funding prior to having a finished project that can generate revenues to repay the loans. Certainty of project completion and construction price, and coverage for cost overruns, if any, will be major focuses of the project lenders. A single engineering, procurement and construction contractor may 'wrap' project risk under one agreement, or some services and goods may be separately supplied. In either case, the greater the risk to the project, the more likely it is that the lenders will insist on some level of recourse to project sponsors during the construction phase.
vi Operation and maintenance agreements
The quality of the operator and its effectiveness in operating the project are key concerns of lenders. A project that is operated poorly will suffer mechanical breakdowns, government fines and potentially mandated shutdowns, and low productivity. All of these threaten the cash flow upon which the lenders depend.
vii Financing agreements
Aside from a basic loan agreement or indenture, there are numerous other agreements used in a project financing, many of them having to do with security over collateral, the control and management of cash flows, and the relationship among multiple lenders. These are discussed in detail in other chapters of this volume.
Lenders will be concerned about all of these contractual arrangements, as all of them must work together as a seamless whole for the project to be successful. The project finance documentation will include security over all of the project agreements (except, of course, the financing agreements themselves).
VII Evolution of the project finance market
Recent years have seen some changes in the project finance market that may affect how deals are funded and structured.
These changes include the exit of some traditional commercial lenders from the project finance market as Basel III liquidity coverage ratio and net stable funding ratio requirements (and changes in treatment of project finance for risk-weighted asset purposes) phase in and other regulatory pressures reduce the ability of banks to make profitable project finance loans. Potential lenders' analysis of their risk adjusted return on capital will take into account the additional capital, and the nature of the capital, that they need to specifically set aside as a result of a project loan to a special purpose project company. For these and other reasons, the term of available project finance has trended downward, with more refinancing risk for project borrowers. Other institutional lenders, including export credit agencies, multilaterals, sovereign wealth funds and pension funds, have become more important sources of funding during this period, filling some of the void left by the banks.
The rise of alternate lenders has not helped all sectors, however, as environmental, social and governance (ESG) concerns relating to climate change are having a significant impact on institutional participation in project finance relating to hydrocarbons projects. This trend started with European banks announcing limits on funding for coal, oil sands, and other developments viewed as less environmentally friendly, but has since spread more broadly. The European Investment Bank is now in the process of discontinuing all fossil fuels funding, for example. Likewise, major US banks have now announced restrictions on lending for coal projects and projects based in the Arctic, and are subscribing to 'net zero' carbon emissions goals that will require gradual (or rapid) reduction in loans to the fossil fuels sector. The birth of 'green bonds', on the other hand, has opened up more financing channels for funding renewable energy, energy efficiency and similar projects.
Reverberations are still felt from the near-collapse of the monoline insurance market (which served among other things to enhance the credit of various government project bond offerings, particularly in the United States) during the 2008 financial crisis, which has increased the difficulties in marketing some government bonds to fund local infrastructure projects. These challenges, and budgetary pressures facing governments around the world, have helped in turn to fuel a rise in the PPP market, where direct private investment has stepped in to relieve government funding needs for infrastructure expansion.
New types of projects have also entered the mix, increasing technology risk for lenders. As just a few examples, carbon capture and storage projects are moving from the drawing board to the commercial realm, offshore wind projects are moving into ever-deeper and harsher environments, and natural gas liquefaction (LNG) is moving increasingly from an onshore business to a floating offshore one.
Finally, new competitors have arisen to traditional project finance, including structured finance used to bundle and fund multiple smaller projects (e.g., schools, rooftop solar) and private equity, which now frequently provides an alternate source of capital for projects at the lower risk end of the spectrum (e.g., pipeline or terminal projects in the developed world). Notwithstanding the changes, the project finance market remains a critical element of support for the development of energy, public infrastructure and telecoms projects around the world.
1 David F Asmus is a partner at Sidley Austin LLP.