Project Finance: Definition and Working


Susan Kelly

Oct 08, 2023

A limited recourse financial framework is used to finance long-term infrastructural, industrial, and public service projects. The cash flow created by the project is utilized to repay the loans and equity that you used to fund the project.

For projects, cash flow is the primary source of repayment, with rights, assets, and interests held as supplementary collateral in the event of default. The private sector finds project financing particularly alluring since it allows large projects to be funded outside of the balance sheet (OBS).

Understanding the Project Finance

To repay project financing, you must anticipate future cash flows. The project's assets or rights are collateral for the financing. Governments or corporations prefer project financing for long-term initiatives, joint ventures, or collaborations.

The BOT model's project financing model includes several critical features. A special purpose vehicle arranges the funding (SPV). Subcontracting a piece of a project can be done by a corporation itself or by a third-party contractor. The interest on loan capital is paid after the start of activities in the lack of income during the building period.

Project funding is used for large, high-risk endeavors. It's not until the start of operations that the participating firms start making money. Some offtake agreements may exist during the building period, but no income sources. The parties that provide the funds for the projects have no recourse.

Financing parties and the government often keep the project off their financial sheets. The project debt is often held in a subsidiary with a minority stake by companies. You can maintain debt ratios by doing this. The government may want to keep the project off its books to have more leeway in its budget.

What are the Challenges of Project Finance?

Project finance is particularly paper-heavy, as one might anticipate financing based on a single asset or a small group of assets and the contracts that regulate them. Furthermore, the risk is increased by the reliance on a single asset or collection of assets and a single source of cash flow for repayment.

After this chapter, a combination of these variables and legislative measures that reduce the appeal of project finance to commercial banks typically results in project financing being more expensive than ordinary corporate financing.

Because lenders have a vested interest in ensuring that cash flow does not stop if the project's assets are seized (which may be difficult or impossible in the case of public infrastructure), they must ensure that security is taken over all of the project's assets.

As a result, project financing is far more restricted than a normal corporate loan, requiring considerably more information, special covenants, and lender consent rights. For example, to minimize risks to lenders, the relevant project firm is often prohibited from participating in any lines of business unrelated to the project's primary activity. Defaults in the project's underlying documentation may also lead to a default in the project's funding.

What is a Non-Resource Finance?

When a corporation fails to repay a loan, recourse finance allows lenders to seize all of the assets and cash flow of the firm's stockholders. As an alternative, project funding establishes a limited-liability special purpose vehicle (SPV). If the project business defaults, the lenders' recourse is restricted to the project's resources, including complete and delivery guarantees and bonds.

Whether or not the lenders have access to the shareholders' assets is a critical consideration in non-recourse financing. The lender may be able to seize assets if the shareholders commit a willful violation.

The extent to which shareholder responsibility can be restricted may be restricted by applicable law. Examples include personal injury and death responsibility that you cannot eliminate.

High CapEx, extended loan terms, and unclear revenue sources are all characteristics of non-recourse debt. Financial modeling abilities and a thorough understanding of the underlying technical area are required for this type of loan underwriting.

Typically, non-recourse loans have a loan-to-value (LTV) ratio of 60% or less to prevent deficiency amounts. To reduce the risk of default, lenders place stricter requirements on their customers. Non-recourse loans carry higher interest rates than recourse loans because of their greater risk.

Difference Between Non-Resource and Resource Loan

Loans with recourse versus non-recourse terms have differing consequences for the financial institution. Two persons seek to acquire substantial assets, such as a home, and one obtains a recourse loan. At the same time, the other does not receive one.

When a borrower defaults on a loan, the property can be taken as collateral and sold to cover the debt. When debtors default on their loans, banking institutions can sell the properties and use the proceeds to pay off the debt.

The banking institution may only pursue the debtor with the recourse loan if the properties sell for less than the amount owing. There is no other way to collect money from a non-recourse loan borrower but to seize the asset.

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