Project Finance: An Introduction into Off-Balance Sheet Financing
The global business space has grown incredibly in the last three decades. With economies reaching more soaring heights than had ever been seen before and increasing investments that are sure to attract billions, if not trillions, of dollars on a single run. Today, there has, more than ever, been a demand for a sufficiently accepted scheme of financing that would aid large projects that require huge investments in most economies.
This is where the concept of project finance comes in. a concept that became popular during the post-World War II era when nations sought investments to build back their already fallen infrastructure. In this post, we take a closer look at project finance and how it generally works to support large-scale investments.
What is Project Finance?
Project finance is an off-balance sheet financing method that is used to finance large projects that would require large-scale investments. The financing technique is a non-recourse or limited recourse financing mechanism.
How does project finance work?
The concept of project finance is adopted for the financing of capital-intensive projects that ordinarily take longer to be completed. The general rule is that upon the completion of the project, the gains derived from the project itself shall be used towards the settlement of the large investment made in the construction of the project.
For this reason, there is huge scrutiny of the actual success of the project before funds are channelled towards its construction. The project and all that accompanies it are held as security for the investments made and are similar to a loan structure.
For instance, AAA Ltd. intends to construct a two-billion-dollar oil refinery. AAA Ltd. approaches banks and other high-net-worth investors for the investment sum. The project (the oil refinery) is anticipated because Nigeria, being a large importer of fuel, spends over twenty billion dollars annually. For this reason, the project itself would be taken as collateral upon completion, and the proceeds of the crude oil being refined would be used to settle the debt.
Off-Balance Sheet Financing
The balance sheet is particularly important to all businesses and shows whether a company is profitable or not. Every company has a balance sheet.
The balance sheet of a company is not a topic of project finance. This is because the parties are mostly concerned with the viability of the project and not whether or not the company makes a profit. This works for most businesses by keeping the debt of the project away from the balance sheet of the company. The company undertakes this by creating a Special Purpose Vehicle (SPV), which is technically a new company created to execute and manage the project until the investment has been fully paid.
This method is particularly of interest to businesses because it reduces the consequences of the project’s debt on their overall standing. Project finance is a technique employed by most businesses to place projects that attract high costs away from their balance sheet.
Securities under Project Finance
The security under project finance is the project itself. But there exists a crucial question asked by many in the world of finance: “What if the project cannot pay the investment amount?” This is where the concept of recourse comes in.
Recourse is the general right of the lender to access the assets of a debtor in case of a default on the loan. In project finance, the owner and manager of the project is the SPV; hence, there is no claim by the lenders on the assets of the company that owns the project and created the SPV. There are two types of recourse known to project finance: non-recourse and limited recourse.
Non-recourse technique
This is the most popular way of structuring project finance transactions. Here, the project and its proceeds are given as security collateral to the lenders. Therefore, the lender has no business going after the assets of the actual company that formed the project where the project’s proceeds cannot afford the investment sum.
Hence, where the project proceeds cannot pay the loan sum borrowed for the project, recourse cannot be made to the project sponsor company’s assets.
Limited recourse technique
Generally, the practice of non-recourse is ideal, but it’s not practical. Many project financing styles adopt limited recourse. The limited recourse provides the pledging of some assets of the sponsor company just in case the project fails and cannot cater for the investment sum. This style allows for shared risks and lowers the chances of a loss.
Parties in a Project Finance Transaction
Below are a list of parties you will find under a Project Finance Transaction:
Project Sponsor Company
This is the actual owner of the project. The sponsor company creates the project and calls on investors to invest. The project is off-balanced by the sponsoring company.
Special Purpose Vehicle (SPV)
An SPV is created by the sponsoring company to carry out the project. The SPV is a newly incorporated company with only one object, which is to create, manage, and pay up the debt of the project. The project is the only asset of the SPV.
Investors
These are corporations, banks, or high-net-worth individuals who invest in the project. They are also called lenders.
Construction Company
These are the companies that are in charge of bringing the project to completion. They are vital to the actual specifics of the project and ensuring that it meets standards.
Off takers
Off-takers are individuals or corporations that would act as eventual users of the project when it is completed.
Conclusion
Project finance has become a standard in the world of large-scale financing. In Nigeria, some notable projects that the project finance was used on are the Lekki-Epe Express Way, the Lekki Deep Sea Port, the Murtala Muhammed Airport 2, the Geometric Power Plant Aba, and a host of other projects.
Frequently asked questions
What is a balance sheet?
Can the government be a project sponsor?