Theoretical Overview

1. Introduction 

Project finance is a mechanism of funding large, complex, and long-term infrastructure or industrial projects, hinging on the project’s predicted cash flow and assets as collateral instead of the sponsors’ balance sheet. It is more particularly as regards infrastructure, public and private venture capital requirements. Examples of largely financed projects are highways, metro systems, Eurotunnel, Energy investment, oil refineries, mining, telecommunications, or airports.

The debt associated with it are typically non-recourse or limited recourse, signifies that lenders fundamentally look to the project’s revenue and assets for repayment. More characteristics of project finance are: (1) Special Purpose Entity (SPE)- a separate legal entity usually created to undertake the project, isolating its assets and liabilities from the sponsors’ other businesses; (2) Complex Contractual Agreements- entails complex contracts between different parties, encompassing sponsors, investors (lenders), contractors, and off-takers, manage risks and secure project completion.

2.  Procedural Characteristics

2.1.  Project Identification and Feasibility

Project identification and feasibility studies are significant initial stages in project management. Project identification entails recognizing and interpreting a potential project (identifying  problems and feasible solutions, stakeholder analysis and potential intervention), while a feasibility study evaluates the project’s viability before important resources are committed. These studies assess technical feasibility, economic feasibility, financial feasibility, market feasibility, operational feasibility, social feasibility, social feasibility, and environmental feasibility, to ascertain if a project is worth undertaking.

2.2.  Project Structuring

Project structuring entails establishing a framework that describe the scope, tasks, and deliverables of a project, making sure that it is well-organized and effectively managed from initiation to completion. This structure encompasses defining project stages, work packages and specific tasks, usually using a hierarchical framework, such as a Work Breakdown Structure (WBS), roles and responsibilities, creating communication channels, identification of potential risks and challenges, allocation of resources (personnel, budget, and timeline), and so on.

 2.3.  Financing

Large-scale project can be financed by debt, often based on the project’s future cash flows and assets to secure financing instead of the balance sheet of the project sponsors. Also, it can also be financed by equity which represents an ownership stake of the project (i.e., funded by investors in exchange for a share the profits and assets).

Debt financing can be in the form of syndicated finance, lenders principally consider the project’s cash flow and assets for repayment, with non-recourse or restricted recourse loans, which means the debt is secured by the project’s assets and not the sponsor’s other assets. In the case of equity project financing, funds provided by investors must be adequate to cover all the costs associated with the development of the project.

2.4. Legal Perspective of Project Finance

From the legal viewpoint, lenders’ ability to recover their investment is restricted to the project’s assets and cash. In non-recourse financing, the lenders have no claim on the sponsors’ other assets in case of default.

The security package of project finance is legally well-established, including liens on project assets, awarding and assignment contracts, and legal terms that guarantee sponsors and other parties. Generally, the contractual framework defines the rights and obligations of all parties (lenders, sponsors, contractors, operators, and off-takers) involved. In addition, compliance with regulatory regulations (environmental regulations, etc.).

 2.5.  Risk Management

2.5.1.  Corporate Credit Ratings

Project finance credit ratings evaluate the likelihood of a project accomplishing its financial obligations, mainly hinging on the project’s cash and risk allocation (between sponsors, lenders, and contractors). Its expected loss for investors, which is computed using probability of default (PD) and loss given default (LGD).

These ratings are spurred by factors, such as project’s construction and operational phases, potential external factors (negative interventions and guarantees), and the creditworthiness of the project’s participants.

Ratings entail a combination of analyzing both qualitative factors (e.g., management quality, regulatory environment) and quantitative factors (e.g., financial projections, debt service coverage ratios).

2.5.2.  Economic Risk Profile

Project finance comprehensively involves a complex economic risk profile owing to its long-term nature, reliance on often a single asset, and dependence on future cash flow. Key assessments include demographic characteristics, structure of economy, recent economic trends, and economic policy.

 2.5.3.  Sovereign Rating Profile

A sovereign rating profile sheds light on the creditworthiness of a country, affecting project finance by influencing the availability and cost of financing for projects within that country. Factors, such as a country’s economic structure and growth, economic management, government finance, political environment, government policy, government finance, and external payments contribute to its sovereign rating which, in turn, impacts the willingness of lenders to provide funds for projects and the determination of interest rates.