Construction Funding in Project Finance

By: Greg Ahuy

Date: August 2021

In this article, we will review the construction funding concepts necessary to model the construction funding.

Construction funding has to cover the construction and equipment costs, and construction funding sources are debt and equity in project finance. However, in addition to the construction and equipment costs, the project will have to pay interest during construction (IDC) on the construction loan and financing fees.

These IDC and financing fees will also be a part of project costs, and since the project does not generate any revenue yet, the IDC and financing fees have to be financed by equity.

The construction, equipment, and financing costs will be the uses of funds of the project, and these are the items that the project will spend the money on.

And, the construction debt and equity are called the sources of funds.

Note that the project’s construction debt size is based on the project cash flows, and it does not depend on the project costs.

If project costs increase, this increase will be mostly covered by additional equity funding.

Construction Loan

The construction loan's typical tenor comes to an end when the project's construction works are completed, and the loan is typically refinanced by the term loan at the construction completion.

Let’s now review the construction debt interest and fees that the project has to pay during the construction period.

First, there will be interest during construction.

Then, we have to pay the upfront fee to the lead arranger for loan origination efforts. It is sometimes called arranging fee or origination fee, and it is typically 0.5 percent to 1.5 percent of the loan amount. The upfront fee is payable at the financial close.

Since lenders will be committing a construction loan to the project from the start of the project, they will want to receive compensation for that commitment, and this compensation is called a commitment fee.

The commitment fee is typically in the range of 40 to 80 basis points per annum and it is based on the undrawn debt balance. The commitment fee is paid during the construction period.

Sometimes, the project company will also have to pay an agent bank fee, which is a fee that goes to the bank, which performs the role of the agent bank. Agent bank is responsible for administering the loan, including maintaining loan documents, keeping up-to-date information about the project, and maintaining financial model among other tasks.

Equity Financing During Construction

Equity usually comes in the form of the ordinary equity or sometimes preferred equity, and it may also come in the form of the loan from project sponsors to the project company.

Shareholder loans are used to reduce the taxes paid because interest on the shareholder loan is tax-deductible. Also, in countries where dividends payout is restricted by retained earnings, shareholder loans are used to release the trapped cash on the balance sheet.

In the United States, you also have another source of equity, which is called tax equity. We will introduce the tax equity financing in another article where we will discuss renewable projects fudning in the United States.

In renewable energy projects based on the PPA, debt is usually drawn on a pro-rata basis with equity investments.

While, in riskier projects such as projects in the mining industry, equity investment is made first, before debt drawdowns.

In this article, we learnt about the construction funding in project finance. To learn about financial modelling for project finance please enroll in our courses.