Origination Risk In Project Finance

Origination Risk Overview

Origination risk in project finance is the first risk to which a project financing is exposed.  Project financings are exposed to origination risk from the moment the project is conceived until the commencement of construction. Origination risk is the most extensive project finance risk because everything is still unknown. The origination phase of project financing is also the most speculative because the tasks that must be performed in the origination phase have no defined timeline.

The origination phase of project financing focuses on the due diligence that must be performed, the project funding that must be arranged and structured, the development and construction plans that must be created, and the entitlements that must be negotiated and approved.

The primary origination risks to which the project is exposed include sponsor risk, funding risk, and entitlement risk. Unlike most project finance risks that occur in the later phases of a project financing, it is virtually impossible to allocate origination risks to anyone except the project sponsor.

Sponsor Risk

The Project Sponsor is the individual or entity who provides the motivating force behind the creation and development of the project. More often than not, the project sponsor is a corporation or a related or subsidiary entity of a larger parent company that is structuring the deal to take advantage of the off-balance sheet deal structure and non-recourse financing structure of project finance. Alternatively, the project sponsor may be an individual entrepreneur or group of entrepreneurs who are putting the deal together as an investment.

There is inherent sponsor risk with entrepreneurial project sponsors because they often lack sufficient capital to successfully complete the project. They may have a world-class idea for a project, but without the capital to see the deal through it is almost always ill-fated. Entrepreneurial project sponsors often seek very highly leveraged project loans, often attempting to secure project loans equal to 80%, 90%, or even 100% of project costs.

Corporate sponsors who are organizing a project financing on behalf of a parent company typically do so specifically to avoid liability. They may well have ample capital to complete the project but may be reluctant to part with the cash. They typically follow the pattern of repeatedly discussing how much money they have while avoiding parting with it. In either of these cases, an undercapitalized project sponsor or a sponsor unwilling to use their cash to sufficiently capitalize the project represent a meaningful Sponsor Risk to the project.

In addition to capital limitations, project sponsors who lack sufficient experience, adequate management skills, or relationships in the region and industry also pose real project finance risks.

Managing Sponsor Risk

It is impossible to eliminate or mitigate sponsor risk. While some sponsor risks may end up allocated to stakeholders and early-stage investors, most sponsor risks remain allocated where they belong; to project sponsors. When Global Trade Funding provides project finance services we work closely with project participants to identify and assess sponsor risks to ensure project participants aren’t blindsided later. By identifying sponsor risk early in the origination phase, sponsors and stakeholders are always prepared for what may come.

Entitlement Risk

Entitlement Risk is the risk that the project sponsor is unable to secure entitlement approvals for the project. Entitlement Risk is the most significant origination risk because projects that are unable to secure the entitlement approvals are unfinanceable and are, for all intents and purposes, dead deals.

Project companies that cannot secure the necessary entitlements are well-advised to employ experts who specialize in securing entitlement approvals in the subject jurisdiction.

There are two primary types of entitlement approvals that must be secured before the project can proceed, land use approval and building approval. Each of those must secure both ministerial and political approvals.

Land use approval is a governing jurisdiction’s approval of the project on a conceptual level. It may be called zoning approval, planning approval, or planned development approval, but it is the approval to do what you want with the land. Land use entitlements can take months or even years to secure. The land use entitlement, while not the final approval needed for construction, is often the greatest hurdle to achieve project financing. It is also the single step in a project that adds the most value.

Depending on the local governing jurisdiction, there are likely numerous secondary and tertiary entitlements that must be secured. These can include environmental impact studies or gaining the cooperation of an organized opposition group of NIMBY citizens. Regardless of jurisdiction, project companies must have tremendous expertise in securing entitlement approvals.

Mitigating Entitlement Risk

When Global Trade Funding is your project finance provider, we deploy a team of experts who are specially trained to assist project sponsors mitigate origination risk by securing the entitlements they need. Project sponsors worldwide rely on Global Trade Funding to manage project finance risk and arrange the financing they need. Apply for project finance today and put our team to work for your project.

Allocating Origination Risk

Origination risk in project finance is unlike other project finance risk exposures because it cannot reasonably be allocated to any project participant except the project sponsor. The overarching philosophy on project finance risk at Global Trade Funding is to allocate those risks to the project participants or stakeholders who are best suited to manage them. While the most significant characteristic of project finance is the art of minimizing and apportioning risk among the various participants and stakeholders, origination risk belongs to the project sponsor.

Origination risks can only be born by the project sponsor. Until a project proceeds beyond the origination phase, there are no other participants or stakeholders to whom you can allocate origination risk. While early-stage equity investments by anyone other than the project sponsor are rare, equity invested during the origination phase must receive very high returns, unlike the lower-risk, pari passu structure found in later-stage investments.

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