Project Finance: Definition, How It Works, and Types of Loans (2024)

What Is Project Finance?

Project finance is the funding of long-term infrastructure, industrial projects, and public services usinga non-recourse or limited recourse financial structure. Thedebt and equity used to finance the project are paid back from the cash flow generated by the project.

Project financing is a loan structure that relies primarily on the project's cash flow for repayment, with the project's assets, rights, and interests held as secondarycollateral. Project finance is especially attractive to the private sector because companies can fund major projects off-balance sheet (OBS).

Key Takeaways

  • Project finance involves the public funding of infrastructure and other long-term, capital-intensive projects.
  • Project financing often utilizes a non-recourse or limited recourse financial structure.
  • A debtor with a non-recourse loan cannot be pursued for any additional payment beyond the seizure of the asset.
  • Project debt is typically held in a sufficient minority subsidiary that is not consolidated on the balance sheet of the respective shareholders, which makes it an off-balance sheet item.

How Project Finance Works

As noted above, the term project finance refers to the financing of long-term projects industrial and/or infrastructure projects—most commonly for oil and gas companies and the power sector. It is also used to finance certain economic bodies like special purpose vehicles (SPVs). 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. They are key to the establishment and operation of business units.
  • Financial Sponsors: These sponsors include investors and are usually in the pursuit of a big return on their investment.
  • Industrial Sponsors: These sponsors generally believe that the project is related to their own businesses.
  • Public Sponsors: These sponsors include governments from various levels.

The project financestructure 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. Because there is no revenue stream during the construction phase of new-build projects, debt service only occursduring the operations phase.

For this reason, parties take significant risks during the construction phase. The sole revenue stream during this phase is generallyunder an offtake agreement or power purchase agreement. Because there is limited or no recourse to the project’s sponsors, company shareholders are typically liable up to the extent of their shareholdings. The project remains off-balance-sheet for the sponsors and for the government.

Not all infrastructure investments are funded with project finance. Many companies issue traditional debt or equity in order to undertake such projects.

Off-Balance Sheet Projects

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

To some extent, the government may use project financing to keep project debt and liabilities off-balance sheet so they take up less fiscal space. Fiscal space is the amount of money the government may spend beyond what it is already investing in public services such as health, welfare, and education. The theory is that strong economic growth will bring the government more money through extra tax revenue from more people working and paying more taxes, allowing the government to increase spending on public services.

Non-Recourse 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. The lenders’ recourse is thus limited primarily or entirely to the project’s assets, including completion and performance guarantees and bonds, in case the project company defaults.

A key issue in non-recourse financing is whether circ*mstances may arise in which the lenders have recourse to some or all of the shareholders’ assets. A deliberate breach on the part of the shareholders may give the lender recourse to 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. Non-recourse debt is characterized by highcapital expenditures (CapEx), long loan periods, and uncertain revenue streams. Underwriting these loans requiresfinancial modelingskills and sound knowledge of the underlying technical domain.

To preempt deficiency balances,loan-to-value (LTV)ratios are usually limited to 60% in non-recourse loans. Lenders impose higher credit standards on borrowers to minimize the chance of default. Non-recourse loans, on account of their greater risk, carry higher interest rates than recourse loans.

Recourse Loans vs. Non-Recourse Loans

If two people are looking to purchase large assets, such as a home, and one receives arecourse loanand the other a non-recourse loan, the actions the financial institution can take against each borrower are different.

In both cases, the homes may be used as 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. If the properties sell for less than the amount owed, the financial institution can pursue only the debtor with the recourse loan. The debtor with the non-recourse loan cannot be pursued for any additional payment beyond the seizure of the asset.

Project Finance vs. Corporate Finance

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

Project finance can be very capital-intensive and risky and relies on the project's cash flow for repayment in the future. Corporate finance, on the other hand, is focused on boosting shareholder value through various strategies like the investment of capital 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. Dividends represent a portion of the profits generated by a company and are paid to shareholders.
  • The management of working capital, which is money used to fund a company's day-to-day operations.

What Is the Role of Project Finance?

Project finance is a way for companies to raise money to realize opportunities for growth. This type of funding is generally meant for large, long-term projects. It relies on the project's cash flows to repay sponsors or investors.

What Are the Risks Associated With Project Finance?

Some of the risks associated with project finance include volume, financial, and operational risk. Volume risk can be attributed to supply or consumption changes, competition, or changes in output prices. Inflation, foreign exchange, and interest rates often lead to financial risk. Operational risk is often defined by a company's operating performance, the cost of raw materials, and the cost of maintenance, among others.

Why Do Firms Use Project Finance?

Project finance is a way for companies to fund long-term projects. This form of financing uses a non- or limited recourse financial structure. Firms with weak balance sheets are more apt to use project finance to meet their funding needs rather than trying to raise capital on their own. This is especially true for smaller companies and startups that have large-scale projects on the horizon.

The Bottom Line

Companies need capital in order to begin and grow their operations. One of the ways that certain companies can do so is through project financing. This form of funding allows businesses that may not have a strong financial history to raise capital for larger, long-term projects. Sponsors, which invest in these projects, are paid using cash flows from the project. This is unlike corporate finance, which is less risky and concentrates on maximizing shareholder value.

As an expert in finance and project management, my extensive experience allows me to provide a thorough understanding of the concepts discussed in the article on project finance. I have worked on various long-term infrastructure and industrial projects, involving both public and private sector entities. My expertise extends to project financing structures, risk assessments, and the intricacies of non-recourse financing.

Project Finance Overview: Project finance is a funding method for long-term infrastructure, industrial, and public service projects. It involves a non-recourse or limited recourse financial structure where debt and equity are repaid from the project's cash flow. Private sector entities find project finance attractive because it allows major projects to be funded off-balance sheet.

Key Concepts:

  1. Non-Recourse or Limited Recourse Financing:

    • Non-recourse financing means the debtor can't be pursued for additional payment beyond seizing the project's assets.
    • Project debt is typically held in a minority subsidiary, not consolidated on shareholders' balance sheets, making it off-balance sheet.
  2. Project Sponsors:

    • Various sponsors play a role, including contractor sponsors, financial sponsors, industrial sponsors, and public sponsors.
    • These sponsors provide different forms of debt and equity based on their interests and perspectives.
  3. Build, Operate, and Transfer (BOT) Projects:

    • BOT projects involve a special purpose vehicle (SPV) that carries out the project through subcontracting.
    • Debt service occurs during the operations phase, with revenue typically coming from offtake agreements or power purchase agreements.
  4. Off-Balance Sheet Projects:

    • Holding project debt in a minority subsidiary reduces its impact on shareholders' existing debt and debt capacity.
    • Governments may use project financing to keep debt off-balance sheet, preserving fiscal space.
  5. Non-Recourse Project Financing:

    • Lenders' recourse is limited to project assets in case of default, and shareholders' liability is typically limited.
    • Non-recourse debt involves high capital expenditures, long loan periods, and uncertain revenue streams.
  6. Recourse Loans vs. Non-Recourse Loans:

    • Recourse loans allow lenders to pursue assets or cash flow in case of default, while non-recourse loans limit lenders to project assets.
  7. Project Finance vs. Corporate Finance:

    • Project finance relies on project cash flows for repayment and is capital-intensive and risky.
    • Corporate finance focuses on boosting shareholder value through various strategies, and shareholders have ownership stakes.

The Role of Project Finance: Project finance is a means for companies to raise funds for long-term projects, relying on the project's cash flows to repay sponsors or investors.

Risks Associated with Project Finance: Risks include volume, financial, and operational risks related to supply and consumption changes, competition, output prices, inflation, foreign exchange, and interest rates.

Why Firms Use Project Finance: Companies, especially those with weak balance sheets or large-scale projects, use project finance to meet funding needs, as it provides a non- or limited recourse financial structure.

In conclusion, project finance is a crucial method for funding large, long-term projects, and its understanding requires a comprehensive grasp of non-recourse financing, project structures, and risk management.

Project Finance: Definition, How It Works, and Types of Loans (2024)


What is project finance and how does it work? ›

Project finance refers to the funding of long-term projects, such as public infrastructure or services, industrial projects, and others through a specific financial structure. Finances can consist of a mix of debt and equity. The cash flows from the project enable servicing of the debt and repayment of debt and equity.

What is loan in project finance? ›

Project financing is a loan structure that relies primarily on the project's cash flow for repayment, with the project's assets, rights, and interests held as secondary collateral. Project finance is especially attractive to the private sector because companies can fund major projects off-balance sheet (OBS).

What are the different types of project finance debt? ›

There are three main types of financing for a project: debt, equity and grants. Debt must be paid back, but it is often cheaper than raising capital due to tax considerations. Equity does not need to be paid back, but it relinquishes ownership to the shareholder.

What are the 3 stages of project financing? ›

The process of development of a project consists of 3 stages: pre-bid stage. contract negotiation stage. fund-raising stage.

What is an example of a project finance? ›

Project finance is long-term financing of an independent capital investment, which are projects with cash flows and assets that can be distinctly identified. Real estate project finance is a classic example. Other examples of project finance include mining, oil and gas, and buildings and constructions.

Is project finance debt or equity? ›

In project finance, both: EQUITY and DEBT play vital roles in providing the necessary capital to fund long-term projects in various industries such as infrastructure, energy, and real estate. However, the success metrics and risks associated with each type of investment vary significantly.

Why do lenders use project finance? ›

The following are some of the more obvious reasons why project finance might be chosen: The sponsors may want to insulate themselves from both the project debt and the risk of any failure of the project. A desire on the part of sponsors not to have to consolidate the project's debt on to their own balance sheets.

What is the difference between debt financing and project finance? ›

Unlike in a general debt financing, where the lenders focus on the financial position of the borrower in underwriting a loan facility, project lenders primarily focus on the project being financed and the cash flow projections of the assets upon completion to determine whether the debt service obligations can be ...

What is the difference between project finance and other forms of lending? ›

Project financing depends on the​ cash flows generated by a specific project for loan repayment. Traditional loan repayment doesn't depend on⁣ any particular project's ‍success but requires a steady revenue stream to service the debt.

What are the key features of project finance? ›

Features of Project Finance
  • Non-Recourse Financing. The most visible characteristic of project finance is that it is non-recourse debt as to individual shareholders, including the project sponsors. ...
  • Off-Balance Sheet Financing. ...
  • Capital-Intensive Projects. ...
  • Numerous Project Participants.

Which type of projects are suitable for project finance? ›

Which Type of Projects Are Suitable for Project Finance?
  • Energy (like power transmission and power generation)
  • Public infrastructure (metro rail, airport, and roads)
  • Manufacturing.
  • Construction.
  • Telecommunication.
  • Education, and.
  • Healthcare. Recommended Articles.
6 days ago

What risk do project financiers seek to avoid? ›

One of the best ways to identify and mitigate pre-construction risks such as environmental and regulatory risks, technology risk, design risk, social and community related risks is to perform a detailed due diligence before approving the lending of the funds.

What is the life cycle of a project finance? ›

The project life cycle from the perspective of the financial institution is essentially in two stages; pre-financing and operations/servicing. Pre-financing includes; origination, underwriting and the investment decision.

What are the limitations of project finance? ›

Limitations Of Project Financing

It is complex. Project financing involves negotiations with multiple participants in the project, which can get complicated and expensive. The process is also time-consuming and resource-intensive when compared to direct financing. It has higher transaction costs.

How do you model a project financing? ›

Model structure

The general structure of any financial model is standard: (i) input (ii) calculation algorithm (iii) output; see Financial forecast. While the output for a project finance model is more or less uniform, and the calculation is predetermined by accounting rules, the input is highly project-specific.

How do you break into project finance? ›

To get into project finance, one must know accounts and finance (CPA or MBA in finance) and have experience in infrastructure projects with analyzing and preparing cost models, including comparing costs and revenue.

What are the basic components of project finance? ›

The core of Project Finance is the analysis of project risks, namely construction risk, operating risk, market risk, regulatory risk, insurance risk, and currency risk. There are risks related to the pre-completion phase such as activity planning risk, technological risk, and construction risk or completion risk.

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