EPJ3760 Construction Investments Lecture 12: December 2013

12.1 Project Finance 12.1 Project Finance

Definitions:
‘Project finance involves the creation of a legally
independent project company financed by nonrecourse
debt for the purpose of investing in a capital asset, usually
with a single purpose and a limited life.’
(Esty, 2004)
“the raising of finance on a Limited Recourse basis, for the
purposes of developing a large capital- intensive
infrastructure project, where the borrower is a special
purpose vehicle and repayment of the financing by the
borrower will be dependent on the internally generated
cashflows of the project”
Key features:
• Special purpose vehicle (SPV) or special purpose entity
(SPE)
• Nonrecourse / limited recourse financing = debt is
backed only by project cash flows
• Contract-based:
– All parties are united through numerous contractual agreements
(large projects can have thousands of contracts).
– Risk is allocated through contracts
– ‘Cash flow waterfall’ contract prioritizes claims on cash flows
– Very high transaction costs:
• including fees for financial, legal and technical advice
• 5–10% of project value

(Gardner & Wright, 2011)

1 • High leverage (high debt:equity ratio, typically 70:30) 2

12.1 Project Finance 12.1 Project Finance

Many of the projects financed in this way are Project Finance Corporate Finance
public infrastructure projects that are privately Higher leverage debt:equity ratio Lower leverage debt:equity ratio
financed and variously referred to as: = 70:30 = 30:70

Equity and debt ownership is Equity and debt ownership is

• Public Private Partnerships (PPP) concentrated (small number of dispersed for companies with
shareholders and lenders) publicly traded stocks
• the Private Finance Initiative (PFI)
Lenders have recourse to project Lenders have recourse to
• Privately Financed Projects (PFP) assets only company assets
• Private Participation in Infrastructure (PPI) Higher interest rates Lower interest rates
Sponsors’ reputation less Company’s reputation very
The contractual arrangements for these include: important important
• Concessions High transaction costs Low transaction costs
(associated with many contracts)
• DBFO, BOO, BOOT, BOT, BLOT, BROT, LOT,
Long time to arrange (typically Much quicker to arrange
LOTS, ROT, etc. 12-18 months)
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12.2 Significance of Project Finance 12.2 Significance of Project Finance

Source: Thompson Reuters (2012) Project Finance Review Source: Thompson Reuters (2012) Project Finance Review
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EPJ3760 Construction Investments Lecture 12: December 2013

12.2 Significance of Project Finance 12.3 Project Finance Arrangements

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Source: Esty (2003)

12.3 Project Finance Arrangements 12.4 Sources of Finance

Public sector
Debt:
procuring authority
Users • Commercial banks – syndicated loans or clubs of banks
Concession Concession
User charges
• Export credit agencies – e.g. EIB, Kredex
Shareholders
(Consortium typically includes:
Agreement payments
• Multilateral agencies – e.g. EBRD, EIB, IBRD (World
Construction
contractors
Equity
Special Purpose Vehicle
Debt
Financial
Bank)
Designers (SPV) Institutions
Facilities managers Dividends Debt repayments
Operators
Other investors)
Equity:
Design and Build Operation and maintenance
• typically from the project sponsors
Payment for design and
Contract Service
Contract
payments
• also from some multilateral agencies – e.g. EBRD
construction

Asset providers Service providers Guarantees:

• Governments
Legend:
Contractual relationships Financial flows
• Multilateral agencies

Generic PPP Scheme (adapted from Palmer, 2000 and Raisbeck, 2009) 9 10

12.4 Potential Benefits 12.4 Potential Benefits

For Project Sponsors
• Sponsors can separate large projects from their
corporate balance sheet => enables larger, higher risk For Lenders and Investors
projects to be carried out provided they have a positive
NPV. Project debt doesn’t count against corporate • Project finance loans / infrastructure investments
balance sheet. provide a different and sort-after asset class for
• High leverage => lower initial equity required; higher investors seeking diversity
returns on equity investment • Lenders earn additional fees associated with the
numerous transactions associated with project
For Procuring Authorities / Governments finance
• By transferring more risk (particularly the risk relating to
the design, construction operation and maintenance of
the capital asset) to the private sector, the private sector
has greater incentives to deliver the asset efficiently (as
opposed to designing and constructing it for a public
sector client who would then operate and maintain it or
separately contract out for these services.)
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EPJ3760 Construction Investments Lecture 12: December 2013

12.4 Potential Benefits 12.5 Potential disbenefits /issues

Esty (2003) argues that 3 economic motivations for
using Project Finance rather than corporate finance for
large projects:
1. Agency cost motivation - The asset-specific governance
system of a SPV reduces agency conflicts because
managers are not able to misallocate free cash flows.
2. Leverage induced underinvestment – by raising project
debt (NOT corporate debt) a corporation can preserve
their debt capacity (which lets it borrow more cheaply).
3. Risk management motivation – by isolating the project,
the possibility of risk contamination (where a failing
project drags the sponsoring corporation into distress) is
reduced
• High transaction costs
• Long time to arrange (12 – 18 months)
• Very little management discretion possible
• With project finance, assets are financed
separately, corporate finance involves assets
being jointly financed - what about
diversification?
• We have assumed that corporate financial
structure is irrelevant and the project investment
and project finance decisions are therefore
separable – if this were true, there would be no
benefit in project finance.
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12.6 References to Economic Theory

Transaction Cost Theory
Coase (1937)
Coase, R.H. (1937) The Nature of the Firm, Economica, New Series,
Vol. 4, No. 16 (Nov., 1937), pp. 386-405

Agency Theory (Principal - Agent Problem)

Alchian and Demsetz (1972)
Michael Jensen (1986) Agency costs of free cash flow, corporate
finance and takeovers

Modigliani-Miller (M&M) Theory (irrelevance

proposition)
Modigliani and Miller (1958)
Modigliani, F. and Miller, M. H. (1958). The Cost of Capital, Corporate
Finance and the Theory of Investment. American Economic Review,
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48, 261-97

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