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Project Finance Chapter 12 Project Finance David Gardner and James Wright HSBC Introduction The purpose of this chapter is to provide an overview of Project Finance. This chapter will outline what Project Finance is, the key features which distinguish it from other methods of financing, the motivations and circumstances for utilising it and the typical structuring considerations therein. Moreover, it will be shown to be a method of infrastructure finance1 which has become increasingly relevant in the wake of the Global Financial Crisis2. What is Project Finance? Project Finance can be characterised in a variety of ways and there is no universally adopted definition but as a financing technique, the author’s definition is: “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” This definition in itself raises a number of interesting questions, including: What do we mean by ‘Limited Recourse’ financing – recourse to whom or what? Why is Project Finance typically used to finance large capital intensive infrastructure projects? Why is the borrower a special purpose vehicle (SPV) under a project financing? What happens if the internally generated cashflows of the project are not sufficient to repay the financiers of the project? These points will be addressed throughout the course of this chapter. The terms ‘Project Finance’ and ‘Limited Recourse Finance’ are typically used interchangeably and should be viewed as one in the same. Indeed, it is debatable the extent to which a financing where the Lenders have significant collateral with (or other form of contractual remedy against) the project shareholders of the borrower can be truly regarded as a project financing. The ‘limited’ recourse that financiers have to a project’s shareholders in a true project financing is a major motivation for corporates adopting this approach to infrastructure investment. Project financing is largely an exercise in the equitable allocation of a project’s risks between the various stakeholders of the project. Indeed, the genesis of the financing technique can be traced back to this principle. Roman and Greek merchants used project financing techniques in order to share the risks inherent to maritime trading. A loan would be advanced to a shipping merchant on the agreement that such loan would be repaid only through the sale of cargo brought back by the voyage (i.e. the financing would be repaid by the ‘internally generated cashflows of the project’, to use modern project financing terminology). As a more discernable financing technique, it was adopted widely during the 1970s in the development of the North Sea oilfields and also in the U.S. power market following the 1978 Public Utility 1 For simplicity, the term ‘infrastructure’ has been generically used to refer to any capital intensive asset or group of assets which provide essential goods or services (e.g. utilities, petrochemicals, transportation services, housing etc) and can be contractually structured to provide internally generated cashflows. 2 The capitalised term ‘Global Financial Crisis’ has been used to refer to the global period of economic stagnation and instability in the banking markets, which started in 2008 and has continued into 2011. 1 Regulatory Policy Act (PURPA), which provided the regulatory impetus for independent power producers (IPP) through the requirement of long term offtake contracts for the power they produced. Arguably the most prolific use of project financing has been the U.K. ‘Private Finance Initiative’ (PFI) which began in 1992 and has been actively promoted and managed by the successive British governments since then. PFI is the commoditisation of public-private partnerships (PPP) into a systematic programme. PPP is a specific form of Project Finance where a public service is funded and operated through a partnership of government and the private sector, typically structued under a long term concession arrangement. In return, the Project Company receives a defined revenue stream over the life of the concession from which the private sector investors extract returns. In the UK, the PFI framework has been used to procure a variety of essential infrastructure including street lighting, schools, military accommodation/equipment, roads, hospitals and prisons. In 1999, the UK government adopted the ‘Standardisation of PFI Contracts (SoPC) which has continued to evolve as a framework for PPP projects in the UK. SoPC effectively commoditised PPP in the UK, thereby enabling the Project Finance market (its contractors, advisors and lending community) to support a tremendously high volume of PPP contracts, some with transaction values as low as USD 40m which would otherwise be regarded as economically unviable due to the transaction costs and long lead times associated with most project financings. The Project Finance Market (2010) The EMEA region (Europe, Middle East and Africa) and North America has traditionally been the focus of the global project financing market, particularly as a result of western governments’ prolific utilisation of PPP as a method of funding essential national infrastructure. However, since the Global Financial Crisis, Asia Pacific transaction volumes made up nearly half of the total global Project Finance market, representing a significant shift in the balance of trade flows in the infrastructure market: Exhibit 1: Project Finance transactions by region 2010 2007 US $ m % US $ m % Asia Pacific 98,708.30 47.42% 44,842.30 20.38% EMEA 83,931.20 40.32% 130,667.30 59.40% Americas 25,534.50 12.27% 44,476.30 20.22% Global Total 208,173.90 100.00% 219,985.90 100.00% Source: Thomson Reuters Project Finance International As shown in Exhibit 2, India’s huge demands for domestic infrastructure development have provided more than a quarter of the total global volume of project financing in 2010: Exhibit 2: Project Finance transactions by country (2010) Country US$m % 1 India 54,801.70 26.32% 2 Spain 17,376.10 8.35% 3 Australia 14,592.10 7.01% 4 United States of America 13,423.80 6.45% 5 United Kingdom 13,020.80 6.25% 6 Taiwan 12,064.40 5.80% 7 Saudi Arabia 10,000.20 4.80% 8 Switzerland 5,371.20 2.58% 9 France 5,350.70 2.57% 10 Italy 5,014.50 2.41% Top 10 Total 151,015.50 72.54% Global Total 208,173.90 100.00% Source: Thomson Reuters Project Finance International Exhibit 3 confirms that the Project Finance market continues to be dominated by the power and transportation projects. These sectors are highly capital intensive, form essential pieces of national 2 infrastructure, have long asset lives and typically have predictable revenue streams, making them ideal assets for project financing: Exhibit 3: Project Finance transactions by sector (2010) Sector US$m % Power 73,300.40 35.21% Transportation 52,315.40 25.13% Oil & Gas 25,950.80 12.47% Leisure & Property 13,824.20 6.64% Telecommunications 13,382.70 6.43% Petrochemicals 11,306.40 5.43% Mining 8,857.70 4.25% Industry 6,306.00 3.03% Water & Sewerage 1,577.50 0.76% Waste & Recylcing 1,266.60 0.61% Agriculture & Forestry 86.30 0.04% Global Total 208,173.90 100.00% Source: Thomson Reuters Project Finance International The volume, geographic spread and cross-sector penetration of project financing in 2010 was impressive and confirms that the infrastructure market remains resilient, although there have been notable implications for the product as a result of the Global Financial Crisis which are revisited later in this chapter. Similarities to other forms of financing The extent to which Project Finance should be regarded as a distinct wholesale banking product, or as a financing technique which incorporates a number of disciplines, is debatable. As a method of debt finance, project financing shares a number of the techniques and approaches found in other areas of wholesale banking: Table 1: Comparison of Project Finance versus other wholesale financing techniques Form of financing Parallels/commonalities Key differences Corporate Lending Dependent on available cash Under an (unsecured) corporate flows to service debt loan, the lenders have recourse to Term loan structures used all the assets of the company itself (regardless of whether the proceeds of the loan are used to finance a specific asset or not) or in the case of a secured loan, a specific asset of the company In Project Finance, the borrower (the Project Company) is an SPV and the principle Lender security is are the future cashflows of the project itself – it is ‘cashflow lending’ Securitisation (Asset The borrower is an SPV A securitisation can only occur for Backed Securities) A form of ‘off balance sheet’ cash generative assets (e.g. a loan financing for the originator portfolio which is generating interest payments). Project The SPV issues bonds to fund 3 3 projects In a securitisation, there are typically a large volume of assets being financed via a single SPV (e.g. a portfolio of mortgages). The pool of assets may therefore be of a variable credit quality and hence the financing instruments (bonds) are usually tranched accordingly. In a project financing, a single (or very small number) of assets are funded via a single borrower, presenting a uniform credit profile for all Lenders Leveraged Buy-Out Highly leveraged transactions In a project financing, the (LBO) shareholders to the transaction are not contractually at risk if the project vehicle (borrower) defaults on its loans Venture Capital Discrete number of equity Venture Capital investments are investors speculative assessments of a High focus on equity return of company’s potential to generate an investment returns.
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