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WHAT IS PROJECT FINANCE?

Project Finance is a method of funding in which the lender looks primarily to the revenues
generated by a single project, both as the source of repayment and as security for the
exposure. Project Finance transactions play an important role in financing development
throughout the world. This type of financing is usually for large, complex and expensive
installations that might include, for example, power plants, chemical processing plants,
mines, transportation infrastructure, environment, and telecommunications infrastructure.
See below the definition of project finance from the Basel Committee on Banking
Supervision, International Convergence of Capital Measurement and Capital Standards
("Basel II"), November 2005.
Project finance may take the form of financing of the construction of a new capital
installation, or refinancing of an existing installation, with or without improvements. In such
transactions, the lender is usually paid solely or almost exclusively out of the money
generated by the contracts for the facilitys output, such as the electricity sold by a power
plant. The borrower is usually an SPE (Special Purpose Entity) that is not permitted to
perform any function other than developing, owning, and operating the installation. The
consequence is that repayment depends primarily on the projects cash flow and on the
collateral value of the projects assets.
Project finance is a long-term method of financing large infrastructure and industrial projects
based on the projected cash flow of the finished project rather than the investors' own
finances. Project finance structures usually involve a number of equity investors as well as a
syndicate of banks who will provide loans to the project.
The types of project for which project finance is commonly used include the following:
infrastructure projects, such as government buildings and transport systems;
oil and gas exploration projects;
sports stadia; and
liquefied natural gas development projects.
In the UK, most project financings have been carried out under the Government's private
finance initiative (PFI) and are known as Public Private Partnerships (PPPs). PFI was
introduced in the early 1990s and aimed to introduce private sector skills and finance into the
provision of public sector services. PFI is structured so that the private sector obtains finance
- usually from a bank - to design, build and operate a facility for the benefit of the public. In
return, the public sector grants this private sector partner a long-term contract to run the
facility - usually for 25-30 years. Once the facility has been built, the public sector pays the
private sector a monthly fee over the life of the project which is used to service the bank loan
which financed the project which is used to service the bank loan which financed the project.
PFI has traditionally been used because:
it is argued that the public sector gets better value for money in the long term by
transferring the risks of building and running the facility over the life of the project to
the private sector. This means that the private sector, which is generally perceived as
more efficient, manages the risks of the project; and
since the public sector is essentially purchasing a service rather than outlaying the
significant capital cost of building, for example, a school or a hospital, it does not
need to account for this cost as a liability on its balance sheet. This means that the
public sector does not have to borrow to finance the capital cost.
Key parties to a project financing
Private sector partner/owner: Usually a corporation or a limited partnership created for the
sole purpose of the particular project. This party is at the centre of all contracts, borrowings
and the construction and operation of the project. For simplicity, we refer to this party as
'Projectco'.
Project sponsor: The person who takes on the active role in managing the project. The
project sponsor owns Projectco and will receive profit, either as a result of the ownership of
Projectco or via management contracts, if the project succeeds. The project sponsor often has
to cover certain liabilities or risks of the project by providing guarantees or by entering into
management or service agreements.
Lenders: Commercial banks, investment banks or other institutional investors who provide
the debt portion of the project financing. The sheer scale of a typical project financing means
that most lending cannot be undertaken by a single lender. Instead, group of lenders form a
syndicate.
Agent: one of the lenders will be appointed as the agent and will act on behalf of the other
lenders to administer the loan.
Account bank: a single lender will hold the accounts through which all the cash generated
by the project will pass.
Equity investors: lenders or project sponsors who do not expect to have an active role in the
project. In the case of lenders, they will have a shareholding in addition to lending by way of
debt, as a way of receiving an enhanced return if the project is successful. In most cases any
investment by way of shares is coupled with an agreement to allow the equity investor to sell
its shares to the project sponsor if the equity investor wishes to exit the project. Similarly, the
project sponsor may have the option to repurchase the shares.
Suppliers, contractors and customers: these include the suppliers of materials for the
project, the contractors responsible for designing and building the project and the customers
of the project.
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