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Understanding the Intricacies of Project Financing

Introduction:

Project Financing is a form of non-traditional lending whereby funds are provided for the development and/or exploitation of a particular asset-based project or natural resource (pursuant to a government issued concession or license). In a traditional lending scenario, a lender (typically a commercial bank) would provide financing for a particular individual or entity, on the basis of the underlying value of the asset being financed (“Asset Based Financing”) alternatively on the basis of the individual credit history (“Balance Sheet Financing”) of the Borrower.

In a non-traditional financing scenario, the financing sought by the Borrower is intended to be utilized to commence the Development, Construction, and/or Operation of a particular project. Consequently, the asset in question is often unbuilt or incomplete at the time the financing in question is sought.

Accordingly, an asset based financing decision would be of limited value to the Lender insofar as the underlying value of the Asset is often well below the total credit facility or total loan value afforded to the Borrower. Additionally, the Borrower in such a scenario often comprises a consortia of companies or their subsidiaries who form a single Special Purpose Vehicle (“Project Company”), thus an accurate Balance Sheet financing decision would be of limited value.

What is the basis for the non-traditional financing decision?

Naturally, much of the financing decision is dependent on the nature of the individual Lender (i.e. equity investors, commercial bank(s), or governmental loan(s), or even a combination thereto in the form of a Syndicated Loan/Facility), together with the Lender’s internal policies read with any prevailing national legislation or regulations.

As a general departure point, much of a financing decision would be based on the merits and projected revenue of the project, should the Project Company ultimately be taken to the operation and management phase. Given that the Project Company’s ability to service the debt is contingent on the viability and ‘bankability’ of the Project itself, it is of paramount importance that the fundamentals of the project are Technically, Financially, and Commercially sound.

By way of example, a Hydro Electric Power Generating Plant would need to demonstrate, in addition to the Drawdown Schedules and budgets for construction, sufficient credit enhancement (i.e. risk insurance, or subordinated debt) that can be called upon in the event of Construction or Operational budgetary overrun, as well as sufficient offtake/output agreements which are either in force, or enforceable by a pre-determined and agreed to date.

Furthermore, the Project Company would need to demonstrate that projected output is not only sufficient to service the underlying debt (together with interest and costs), but also to ensure revenue is sufficient to meet operating costs and contingencies, as well as provide a sufficient return to equity investors.

It should be manifest at this stage, that the Risks of Project Failure is incredibly high. It is a trite principle that Project Financing abhors uncertainty. Accordingly, the vast majority of a financing decision would turn on the initial Due Diligence undertaken by the Lender, which seeks to Identify, Assess, Allocate, and Manage the Commercial Risks involved.

Naturally, each individual Project would have an individual Risk Matrix, and certain Risks cannot be prevented, re-allocated or mitigated against. In such a circumstance the risk assessment would necessarily make a commercial decision to determine the reasonability of shouldering said risks, and would ordinarily entail a significant Risk Premium being allocated to the total cost of financing.

Naturally, the Lender would often insist on procedural safeguards (whereby the total credit afforded to the Borrower is drawn down in accordance with certain procedural milestones), together with significant restrictions to the transfer of equity within the Project Company, oversight and approval of all contractors, as well as significant reporting and monitoring requirements.

Admittedly, the costs of project financing are high. However, the key benefit of a project financing endeavour, centers on the flexibility of the lending terms (as compared to traditional financing arrangements). Both the Borrower and the Lender have a mutually vested interest in project completion. This in turn often means that the Lender would, up to a point, be more amenable to facilitating completion as oppose to stopping and recovering loss.

The legal intricacies of a Project Finance Management, cannot be overstated. This practice area is very document heavy, and would necessarily require extensive developmental work from incorporating a Special Purpose Vehicle, to contractual vetting, due diligence processes, regulatory and industry review, permit or licensing applications, and contractual harmonization.

Nevertheless, by fully understanding the source and nature of the financing arrangement, as well as the various Risks involved, the specific needs of a Project Company can be maximized (with the Risks therefor being mitigated or re-allocated), and the Company can make reasoned and commercially sound decisions to ensure a successful endeavour.

Prepared by:  

Kshethra Naidoo | Associate | Dispute Resolution

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice. Errors and omissions excepted (E&O