Project Finance

Explained:

Project finance is a form of off-balance sheet financing used to fund large-scale projects. These techniques have origins in financing arrangements for oil exploration and extraction projects in the United States during the 1930s. By the 1970s, similar arrangements were financing the development of the North Sea oil fields. Today, project finance is widely used to fund power plants, mines, transit infrastructure, telecommunications, water and sewage projects and real estate.

Each project has at least one sponsoring firm. Rather than carry the project and its considerable financing on its own balance sheet, a sponsor establishes a special purpose vehicle (SPV) that carries all the assets and liabilities associated with the project on its balance sheet. This has two advantages:

As a stand-alone venture, the project does not draw on the sponsor's own financing channels. If it did, its considerable needs could stress those channels, impacting the sponsor's ability to fund its other operations.

The project's ability to attract capital is unaffected by the credit quality of the sponsoring firm. Funding for the project depends on its viability as a stand-alone project—will it generate sufficient ongoing income to pay down debt on schedule?

In theory, the sponsor might provide no financing for the project whatsoever. In practice, it will typically provide equity capital, and it may provide additional guarantees. Other financing is mostly in the form of bank loans or bond issues, so the goal is to present a project that offers predictable cash flows. Risky projects based on untried technology or that target uncertain markets are not good candidates for project finance. Captive markets, as occur with water and sewage or transit projects, ensure predictable cash flows. In energy projects, long-term forward sales of the output energy will often be in place prior to financing the project. Public works projects can also be good candidates for project finance. These may not generate sufficient income to pay down debt, so a government will commit resources. In a typical arrangement, all the financing might be private, but debt is then paid down partly with public funds.

Each project is unique, and considerable expertise must be applied to structure a project that will appeal to investors. Generally, one lead bank will organize a syndicate of investors. That same bank may provide advice on structuring the project, but there are also consultants who specialize in advising on project finance.