Project Financing

The term project financing describes a variety of financing arrangements for large, individual investment projects. Often a separate legal entity is formed to own the project. Suppliers of capital then look at the earnings stream of the project for repayment of their loan or for the return on their equity investment. Often, the projects involve energy: not only large explorations of gas, oil, and coal but also tankers, port facilities, refineries, and pipelines. Other projects include aluminum plants, fertilizer plants, and power plants. These projects require huge amounts of capital, often beyond the reach of a single company. Many times a consortium of companies is formed to spread risk and to finance the project. Part of the capital comes from equity participations by the companies, and the rest comes from lenders or lessors.

If the loan or lease is on a nonrecourse basis, the lender or lessor pays exclusive attention to the size of the equity participation and to the economic feasibility of the project. In other words, the lender or lessor can look only to the project for payout, so the larger the equity cushion and the greater the confidence that can be placed in the projections, the better the project. Sometimes the project's sponsors will write "comfort" letters, giving general assurance that they will do their best to make the project a success. The letters are not legally binding, although they do represent a moral commitment.

One risk is that the project will be seriously delayed, pushing the completion date and the start of cash flows far into the future. For this reason, the project's sponsors sometimes are required to guarantee its timely completion with suitable remedies to the lender or lessor if such does not occur. After its completion, suppliers of capital are on their own. Repayment must come from the project's earnings, so the economic feasibility of the project continues to be of major concern. In still another type of arrangement, each sponsor may guarantee its share of the project's obligations. Under these circumstances, the lender or lessor places emphasis on the creditworthiness of the sponsors as well as on the economic feasibility of the project.

For the sponsors of the project, there are several types of sharing rules. In a "take or pay" arrangement, each sponsor agrees to purchase a specific percentage of the output of the project and to pay that percentage of the operating costs of the project plus debt servicing charges. When pipelines are involved, the type of sharing rule is frequently a "throughput" arrangement. Here each sponsor is required to ship through the facility a certain amount, or percentage, of product. if the total shipped is insufficient to cover the expenses of running the facility, sponsors are assessed additional amounts to cover the shortfall. The amount of assessment is proportional to their participation. The maturity of the loan or lease corresponds to the likely ability of the project to generate cash over time. Although the financing need not be long term, in most cases it extends over a period of 8 or more years. In this type of arrangement, the lender or lessor has limited recourse to the project's sponsors in the sense of being assured of minimum cash flows.

Actually, the term project financing conveys nothing more than the financing of a large project. The methods of financing are no different from those we have studied. They include debt and lease financing. What is different is the size and complexity of the financing. It is tailored to the needs of the sponsors as well as to the needs of potential suppliers of capital. Tax considerations rank very high in tailoring the financing to the best advantage of all parties. Certain environmental restrictions must be observed, and these influence the type of financing undertaken. When the project is located on foreign soil, political risks arise, but they may be reduced by guarantees from the Export Import Bank or from some other government agency. Nonetheless, foreign projects are complicated by laws and political risks different from those that prevail for domestic projects. We can expect project financing to continue in importance, but its use varies with the number of large energy and mineral exploration projects being undertaken.