What are the Sources of Project Finance?

Author: Greg Ahuy

Date: May 12, 2021

In this article, we will look at the typical sources of financing in project finance transactions.

Typical sources of financing in project finance are equity, provided by project sponsors, and, debt provided by lenders.

The project sponsors can further be classified as industrial and financial sponsors, and sometimes, especially in emerging markets, the government can also provide funding to the project in the form of equity.

The industrial sponsors undertake the project because they have industrial expertise. They can be large companies such as Duke Energy or then can be smaller developers.

sources of equity financing

Financial sponsors, on the other hand, look for the yield on their investments. Also, renewable projects and infrastructure projects in general, provide the additional benefit of diversification. The financial sponsors are represented by private equity funds, pension funds, and insurance companies.

You also have a number of companies that invest equity in renewable projects to take advantage of the tax benefits that the project presents. This source of financing is referred to as tax equity, and it is relevant only for the US market.

Typical tax equity investors are large companies that usually have nothing to do with infrastructure or power industries. These are such large companies such as Google and Microsoft, that have large tax payables and investing in renewable projects provide a means to reduce those tax payables for those companies.

When it comes to the government, the primary motivation for providing equity to the project is to ensure that the project will be built. The government often pursues the welfare benefits that the project will provide such as employment.

Usually, the project company raises equity by issuing common shares to the project sponsors.

However, equity can also be provided to the project company in other forms.

The loan from project sponsors to the project company is also counted as an equity investment. This loan is subordinated to the senior loan provided by the lenders. The primary motivation why shareholders provide loans instead of investing through shares is to reduce income tax payable because interest paid on the loan is a tax-deductible expense.

The main source of debt financing comes from commercial banks. Commercial banks are the largest and most experienced debt finance provider in project finance transactions.

Bonds can also be used to finance project finance transactions, however, since bonds are sold to bond investors, they are subject to market sentiment. Also, bonds have to be rated by rating agencies which adds to the cost of financing.

Source of project finance debt

Export-import agencies or ECA also play an important role in project finance, especially when it comes to investing in emerging markets. ECA provides financing to support the export of the equipment or service. Additionally, ECAs provide political insurance against, for example, asset expropriation, and that insurance covers debt financing.

Multilateral financial institutions such as International Finance Corporation (IFC), which is a member of the World Bank, or European Bank for Reconstruction and Development (EBRD), also provide debt financing. Multilateral financial institutions are government-backed organizations that promote economic development in emerging markets.

The added benefit of having multilateral as a creditor to the project company is the preferred creditor status.

Preferred creditor status provides implicit and explicit insurance against asset expropriations, defaults by the countries, local currency convertibility issues, and other issues related to political risks.

For example, On August 17, 1998, the Russian Federation announced that it would force a restructuring of domestic government debt and impose a 90-day moratorium on external debt repayments by private and public companies.

Then, the Russian Federation issued a statement confirming debt due to multilateral development agencies, including IFC, was not included in the moratorium.

Accordingly, payments for debt continued to be made to IFC.

The typical loans that are made in project finance transactions is a construction loan, which is a loan with a specific purpose of covering construction costs of the project.

A term loan is a loan that takes out or refinances the construction loan and it is made upon project construction completion.

The construction period is the riskiest period in project finance, and therefore construction loan typically carries high interest rate and includes restrictive covenants. Therefore, the project company tends to renegotiate with existing lenders the terms of the loan once the project is completed, or it may raise a new loan on better terms to take out the construction loan.

The revolving credit facility is a subordinated loan with the purpose of covering short term cash-flow problems that the project company may have.

Typically, commercial bank loans are made either through syndication or loan sales.

When syndication is undertaken, one bank, known as the lead bank, acts as a syndicate manager, recruiting a sufficient number of other banks to make the loan, negotiating details of the agreement, and preparing documentation. Each syndicate member will have a direct agreement with the borrower under loan syndication.

syndication in project finance

The manager/lead bank handles disbursements and repayments and is responsible for disseminating the borrower’s financial statements to the syndicate members. The manager/lead bank is paid a fee by the borrower for these services.

In the loan sales, the lead bank is the sole contractual lender for the borrower, and the borrower signs a single Loan Agreement with the lead bank.

loan sales in project finance

The lead bank retains a portion of the loan for its own account and sells participations in the remaining portion to the participating banks under the Participation Agreement.

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

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