Definition, How It Works, and Types of Loans

What Is Project Finance?

Project finance funds long-term infrastructure, industrial projects, and public services using a nonrecourse or limited-recourse financial structure. The debt and equity used to finance the project are repaid solely from the cash flow generated by the project itself.

In project finance, the loan structure relies primarily on the project’s cash flow for repayment, with the project’s assets, rights, and interests serving as secondary collateral. This approach is especially attractive to the private sector because companies can fund major projects off-balance sheet (OBS), meaning the debt used to fund the project does not appear on the company’s balance sheet and has no impact on its credit rating or borrowing capacity.

In the U.S., project financing offers businesses a way to secure funding for large-scale projects like infrastructure, telecommunications, and energy.

How Project Finance Works

“Project finance” refers to financing long-term industrial and infrastructure projects, particularly in sectors like oil and gas, power generation, and transportation. It’s also used to finance certain economic bodies like special purpose vehicles (SPVs), which are created to manage a single project. The funding required for these projects is based entirely on the projected cash flows.

Some of the common sponsors of project finance include the following entities:

• Contractor sponsors: These sponsors provide subordinated or unsecured debt and/or equity and are crucial to the project’s establishment and operation. 
• Financial sponsors: These include investors who are mainly focused on achieving a big return on their investment.
• Industrial sponsors: These are companies with a strategic interest in the project, as the project may align with their core business.
• Public sponsors: These sponsors include governments from various levels.

The project finance structure for a build, operate, and transfer (BOT) project includes multiple key elements. Project finance for BOT projects generally includes an SPV. The company’s sole activity is carrying out the project by subcontracting most aspects through construction and operations contracts. Since new-build projects don’t generate revenue during the construction phase, debt service begins only in the operations phase.

This creates significant risks during the construction phase, as the only revenue stream might come from an offtake agreement or power purchase agreement. Because there’s limited or no recourse to the project’s sponsors, company shareholders are typically liable up to the extent of their investment. This structure keeps the project off the balance sheets of both the sponsors and the government, minimizing financial risk.

Off-Balance Sheet Projects

Project debt is typically held in a sufficient minority subsidiary and not consolidated on the respective shareholders’ balance sheets. This reduces the project’s impact on the shareholders’ existing debt and debt capacity cost, and the shareholders are free to use their debt capacity for other investments.

Governments may also use project financing to keep project debt and liabilities off their balance sheets, so they take up less fiscal space. Fiscal space is the amount of money the government may spend beyond what it already invests in public services such as health, welfare, and education. Governments can create fiscal space by raising taxes, cutting lower-priority spending, or securing external grants, but they must do so carefully to ensure long-term economic sustainability. The theory is that strong economic growth will boost tax revenues, allowing the government to increase spending on public services.

Nonrecourse Project Financing

When a company defaults on a loan, recourse financing gives lenders full claim to shareholders’ assets or cash flow. In contrast, project financing designates the project company as a limited liability SPV. If the project company defaults, the lenders’ recourse is thus limited primarily or entirely to the project’s assets, including completion and performance guarantees and bonds.

A key consideration in nonrecourse financing is whether there are circumstances under which lenders could access shareholders’ assets. For example, if shareholders deliberately breach the terms of the agreement, the lender may have recourse to their assets.

Applicable law may restrict the extent to which shareholder liability may be limited. For example, liability for personal injury or death is typically not subject to elimination. Nonrecourse debt is characterized by high capital expenditures (CapEx), long loan periods, and uncertain revenue streams. Underwriting these loans requires financial modeling skills and sound knowledge of the underlying technical domain.

To reduce the risk of deficiency balances, lenders typically limit loan-to-value (LTV) ratios to 60% in nonrecourse loans. As a result, borrowers face stricter credit standards, and the loans carry higher interest rates than recourse loans, reflecting their greater risk.

Recourse Loans vs. Nonrecourse Loans

If two people purchase large assets, such as homes, and one has a recourse loan while the other has a nonrecourse loan, the financial institution’s actions against each borrower will differ.

In both cases, the homes may be collateral, meaning they can be seized should either borrower default. To recoup costs when the borrowers default, the financial institutions can attempt to sell the homes and use the sale price to pay down the associated debt. However, if the homes are sold for less than the amount owed, the lender can pursue the borrower with a recourse loan for the remaining debt. In contrast, the borrower with the nonrecourse loan can’t be held liable for any additional payment beyond the seizure of the property.

Project Finance vs. Corporate Finance

Project and corporate finance are important concepts in the world of financing. Both of these funding methods rely on debt and equity to help businesses reach their financing goals, but they are very distinct.

Project finance can be very capital-intensive and risky, and it relies on the project’s cash flow for repayment in the future. On the other hand, corporate finance focuses on boosting shareholder value through various strategies, such as capital investment and taxation. Unlike project financing, shareholders receive an ownership stake in the company with corporate financing.

Some of the key features of corporate financing include:

• A company’s capital structure, which is a company’s funding of its operations and growth.
• The distribution of dividends, which represent a portion of the profits generated by a company and paid to shareholders.
• The management of working capital, or money used to fund a company’s day-to-day operations.

The Bottom Line

Project finance is a form of funding best suited for large, long-term projects like major infrastructure improvements or industrial developments. It relies on the project’s estimated future cash flow for repayment with minimal recourse. This allows companies to take on bigger projects without negatively impacting their balance sheets.

Project finance may carry higher risks due to its reliance on future income streams. However, it also offers a way to fund businesses in sectors where traditional corporate finance may not work or even be an option.