Before we even start to get into what project finance is, let me make clear that this is only a very short intro to the fundamental concept of what project finance represents. It is not a detailed description nor can it be unless this website became a 10+ book series. Yes! that is how complex and far reaching project and infrastructure finance and investing can be.
So What is it Than – In essence, project finance is the planning, financing, designing, constructing and post construction, operating an infrastructure focussed asset. This can be Social Infrastructure – ie schools, hospitals, cultural centres amongst others. Transport – ports, railways and toll-roads. Commodities/utilities – electricity grids, oil and gas and mining etc. The structure of the project company will in most cases be an SPV or special purpose vehicle/entity. This means that the only assets of the SPV will be those relating to the project and there is no linkage to the balance sheet of the companies who are sponsoring the SPV. This provides assurance to the companies who are the sponsors that if the project goes bad – ie bankrupt, than the lenders will only have recourse to the project or SPV asset/s and cannot seek assets on the balance sheet of the individual sponsor companies. This isn’t always clear cut however, and banks may seek guarantee’s from the sponsors (especially during the construction phase) due to the greater level of risk involved.
The Parties Involved & Their Roles – There are generally a number of parties to a project finance transaction, including equity investors/sponsors, debt/finance providers, government, EPC companies (engineering, procurement and construction), operation companies (will be the company operating the infrastructure asset post completion of construction) and insurance companies, just to name the main players. The role of each player and the risk they take on really depends on the structure of the project and whether its traditional government procurement (simply the construction of a government/public asset) being financed and eventually operated by the government and financed via tax or sovereign/semi sovereign debt. Public Private Partnership (PPP) which as the name suggests is a partnership between the government and private sector. Although this comes in many shapes and sizes, it generally involves design and construction (D&C) risk taken on by the sponsors (which may be transferred to the EPC company), debt financing risk taken on by the private sector as well and post construction, the private sector sponsors taking on operational risk of the asset. The operational side is generally a concession awarded by the government for a certain period of time. Depending on the jurisdiction and nature of the asset, concessions are usually between 30-99 years. In a PPP, the government owns the overall asset but pays the sponsors for the construction and allows the private consortium to own commercial revenue by operating the asset for the concession period. Ie charging users a fee for the use of a toll road. Alternatively, the private entity may not take on any commercial revenue risk but rather get paid an availability or performance fee by the government during the operations concession period, which is essentially the government paying the consortium a fee for making the services of the infrastructure asset available to users. In this structure, the government takes on the commercial usage risk. In a privatisation model, it usually entails the bidding process by a consortium of sponsors to bid for the right to operate and earn revenue from the state asset being privatised/sold. As noted above, this usually entails an initial concession period for which the consortium provides an acquisition like fee. Most of the financing will be from debt relative to equity, with the debt component accounting for about 60% – 80% of the purchase price. Apart from traditional government financing, most project finance structures that involve the private sector are highly geared. It should be noted that PPP and privatisation structures, due to their generally monopoly like position are heavily regulated and much of the revenue for the private partners is pre-agreed with the state as per the financial model. Ie concession agreement that involves commercial revenue generally entails an agreed cost of equity for the sponsors or agreed availability or performance fee’s if not taking on commercial risk. The other main structure is purely a private project development where government involvement usually does not extend beyond regulation and at times can also involve government assurances and support if the project in question is in line with government policy of promoting a certain sector or social service. The final point to note is that just as the sponsors are usually a consortium of partners (which are usually also responsible for the D&C and operating component) due to the very nature of high costs related to infrastructure projects, the debt financing is also provided by a group of banks called a syndicate. The participating banks all take on a portion of the construction and operation related debt costs. However, there is usually a financial advisor or investment bank who arranges the financial model, negotiates terms and invites participating banks to form a syndication on behalf of the sponsors.
Greenfield vs Brownfield – This is simply establishing whether an infrastructure asset is already in place and operating – Brownfield or its yet to be designed and constructed – Greenfield. Naturally project finance as the name suggests generally relates to greenfield projects which are to be constructed and eventually operated. However, there may also be projects related to brownfield assets; ie revamping of an existing infrastructure asset, expanding or modifying. Privatisations of state assets will be brownfield.
One last Point – As noted at the beginning of this article, the above is a very simplified summary of the main concepts related to project finance. There are many more less often used structures or attributes of alternative structures. Modifications of contracts where the transfer of risks is distributed or shared among different parties and the significant influence of government policy, regulations, laws and even populist social perceptions of new infrastructure or perceptions of the private sectors involvement, which in turn can have a great weighing on the government decision process. We will be providing other educational articles going forward that require a greater focus on their own, such as PPP’s, debt and bank syndications, greater risk phases (D&C) and operational and maintenance phase (O&M) among others.