Why Choose Project Finance?

Why Choose Project Finance?

Having answered the question of what is project finance, we turn to the next most common question in the world of project finance, why choose project finance. To answer this question, we’ll draw on the features of project finance and many of the elements of project finance. Much like the definitions of project financing, the question of why choose project finance is nebulous and different for everyone.

Identifying the common elements of project finance is a worthy exercise to determine if project finance is really the best type of financing for your deal. If you cannot envision all of these elements of project financing being part of your deal, project finance is not the right financing. In the alternative, you should consider trade finance, contract finance, monetization or traditional corporate finance.

Why Choose Project Finance?

One of the most asked questions in project finance is why choose project finance? For those who are not familiar with the project finance structure, it is the most asked question. So, why do sponsors choose project finance as the preferred method of funding their projects, even though it is considerably more expensive than corporate financing?

In addition to being significantly more expensive, project finance takes a great deal more time to organize and involves a significant commitment of time and management expertise to implement, monitor and administer the loan during the life of the project. Therefore, what compels sponsors to choose this route to finance a particular project. The following are some of the more obvious reasons why project finance might be chosen:

• The sponsors may want to insulate themselves from both the project debt and the risk of any failure of the project.
• A desire on the part of sponsors not to have to consolidate the project’s debt on to their own balance sheets. This will, of course, depend on the particular accounting and/or legal requirements applicable to each sponsor. However, with the trend these days in many countries for a company’s balance sheet to reflect substance over form, this is likely to become less of a reason for sponsors to select project finance (the implementation in the UK of the recent accounting standard on “Reporting the Substance of Transactions” (FRS 5) is an example of this trend).
• There may be a genuine desire on the part of the sponsors to share some of the risk in a large project with others. It may be that in the case of some smaller companies their balance sheets are simply not strong enough to raise the necessary finance to invest in a project on their own and the only way in which they can raise the necessary finance is on a project financing basis.
• A sponsor may be constrained in its ability to borrow the necessary funds for the project, either through financial covenants in its corporate loan documentation or borrowing restrictions in its statutes.
• Where a sponsor is investing in a project with others on a joint venture basis, it can be extremely difficult to agree a risk-sharing basis for investment acceptable to all the co-sponsors. In such a case, investing through a special purpose vehicle on a limited recourse basis can have significant attractions.
• There may be tax advantages (e.g. in the form of tax holidays or other tax concessions) in a particular jurisdiction that make financing a project in a particular way very attractive to the sponsors.
• Legislation in particular jurisdictions may indirectly force the sponsors to follow the project finance route (e.g. where a locally incorporated vehicle must be set up to own the project’s assets). This is not an exhaustive list, but it is likely that one or more of these reasons will feature in the minds of sponsors which have elected to finance a project on limited recourse terms.

Project finance, therefore, has many attractions for sponsors. It also has attractions for the host government. These might include the following:

• Attraction of foreign investment,
• Acquisition of foreign skills and know-how,
• Reduction of public sector borrowing requirement by relying on foreign or private funding of projects,
• Possibility of developing what might otherwise be non-priority projects,
• Education and training for local workforce.

Why Choose Project Finance?

The most common answer to the why choose project finance question is, in a word, liability. Project financing is non-recourse or, at a minimum, limited recourse. Project sponsors can choose project finance with impunity. They will face no liability if they default on the project loan or if the project undertaking fails.

? For those who are not familiar with the project finance structure, it is the most asked question. So, why do sponsors choose project finance as the preferred method of funding their projects, even though it is considerably more expensive than corporate financing?

In addition to being significantly more expensive, project finance takes a great deal more time to organize and involves a significant commitment of time and management expertise to implement, monitor and administer the loan during the life of the project. Therefore, what compels sponsors to choose this route to finance a particular project. The following are some of the more obvious reasons why project finance might be chosen:

• The sponsors may want to insulate themselves from both the project debt and the risk of any failure of the project.
• A desire on the part of sponsors not to have to consolidate the project’s debt on to their own balance sheets. This will, of course, depend on the particular accounting and/or legal requirements applicable to each sponsor. However, with the trend these days in many countries for a company’s balance sheet to reflect substance over form, this is likely to become less of a reason for sponsors to select project finance (the implementation in the UK of the recent accounting standard on “Reporting the Substance of Transactions” (FRS 5) is an example of this trend).
• There may be a genuine desire on the part of the sponsors to share some of the risk in a large project with others. It may be that in the case of some smaller companies their balance sheets are simply not strong enough to raise the necessary finance to invest in a project on their own and the only way in which they can raise the necessary finance is on a project financing basis.
• A sponsor may be constrained in its ability to borrow the necessary funds for the project, either through financial covenants in its corporate loan documentation or borrowing restrictions in its statutes.
• Where a sponsor is investing in a project with others on a joint venture basis, it can be extremely difficult to agree a risk-sharing basis for investment acceptable to all the co-sponsors. In such a case, investing through a special purpose vehicle on a limited recourse basis can have significant attractions.
• There may be tax advantages (e.g. in the form of tax holidays or other tax concessions) in a particular jurisdiction that make financing a project in a particular way very attractive to the sponsors.
• Legislation in particular jurisdictions may indirectly force the sponsors to follow the project finance route (e.g. where a locally incorporated vehicle must be set up to own the project’s assets). This is not an exhaustive list, but it is likely that one or more of these reasons will feature in the minds of sponsors which have elected to finance a project on limited recourse terms.

Project finance, therefore, has many attractions for sponsors. It also has attractions for the host government. These might include the following:

• Attraction of foreign investment,
• Acquisition of foreign skills and know-how,
• Reduction of public sector borrowing requirement by relying on foreign or private funding of projects,
• Possibility of developing what might otherwise be non-priority projects,
• Education and training for local workforce.