Principles of Project Finance

E. R. Yescombe

• Publisher: Academic Press
• Year: 2013
• ISBN:
  9780124157552
• Edition: 2
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

The Second Edition of this best-sellingintroduction for practitioners uses new material and updates to describethe changing environment for project finance. Integrating recent developments in credit markets with revised insights into making project finance deals, the second edition offers a balanced view of project financing by combininglegal, contractual, scheduling, and other subjects.Itsemphasis onconcepts and techniques makes it critical for those who want to succeed infinancing large projects. Withextensive cross-references and a comprehensive glossary, the Second Edition presents anew a guide to the principles and practical issues that can commonly causedifficulties in commercial and financial negotiations.

• Provides a basic introduction to project finance and its relationship with other financing techniques
• Describes and explains: sources of project finance; typical commercial contracts ( e.g., for construction of the project and sale of its product or services) and their effects on project-finance structures; project-finance risk assessment from the points of view of lenders, investors, and other project parties; how lenders and investors evaluate the risks and returns on a project; the rôle of the public sector in public-private partnerships and other privately-financed infrastructure projects; how all these issues are dealt with in the financing agreements

Chapter 1

Introduction

Project finance is a method of raising long-term debt financing for major projects through ‘financial engineering,’ based on lending against the cash flow generated by the project alone; it depends on a detailed evaluation of a project’s construction, operating and revenue risks, and their allocation between investors, lenders, and other parties through contractual and other arrangements. In 2012, at least $375 billion of investments in projects around the world were financed or refinanced using project-finance techniques. This book is intended to provide a guide to the principles of project finance and to the practical issues that can cause the most difficulty in commercial and financial negotiations, based on the author’s own experience both as a banker and as an independent advisor in project finance. The book can serve as a structured introduction for those who are new to the subject, and as an aide mémoire for those developing and negotiating project-finance transactions. No prior knowledge of the financial markets or financial terms is assumed or required.

Keywords

project finance; financial engineering; debt financing; lending; market developments

Project finance is a method of raising long-term debt financing for major projects through ‘financial engineering,’ based on lending against the cash flow generated by the project alone; it depends on a detailed evaluation of a project’s construction, operating and revenue risks, and their allocation between investors, lenders, and other parties through contractual and other arrangements. In 2012, at least $375 billion of investments in projects around the world were financed or refinanced using project-finance techniques.

‘Project finance’ is not the same thing as ‘financing projects,’ because projects may be financed in many different ways. Traditionally, large scale public-sector projects in developed countries were financed by public-sector debt; private-sector projects were financed by large companies raising corporate loans. In developing countries, projects were financed by the government borrowing from the international banking market, development-finance institutions such as the World Bank, or through export credits. These approaches have changed, however, as privatization, deregulation, and the introduction of private finance through public-private partnerships have changed the approach to financing investment in major infrastructure projects, transferring a significant share of the financing burden to the private sector.

Unlike other methods of financing projects, project finance is a seamless web that affects all aspects of a project’s development and contractual arrangements, and thus the finance cannot be dealt with in isolation. If a project uses project finance, not only the finance director and the lenders but also all those involved in the project (e.g. project developers, engineers, contractors, equipment suppliers, fuel suppliers, product offtakers, and—where project finance is used for public infrastructure—the public sector) need to have a basic understanding of how project finance works, and how their part of the project is linked to and affected by the project-finance structure. The nexus of contracts which make up a project cannot only be considered from a commercial perspective: a financial perspective is essential if much time and money is not to be wasted in creating projects which appear to work but cannot.

This book is therefore intended to provide a guide to the principles of project finance and to the practical issues that can cause the most difficulty in commercial and financial negotiations, based on the author’s own experience both as a banker and as an independent advisor in project finance. The book can serve as a structured introduction for those who are new to the subject, and as an aide mémoire for those developing and negotiating project-finance transactions. No prior knowledge of the financial markets or financial terms is assumed or required.

‘The devil is in the detail’ is a favorite saying among project financiers, and a lot of detailed explanation is required for a book on project finance to be a practical guide rather than a generalized study or a vague summary of the subject. But with a systematic approach and an understanding of the principles that lie behind this detail, finding a way through the thickets becomes a less formidable task.

The subject of project finance is presented in this book in much the same way that a particular project is presented to the financing market (cf. §5.2.8), i.e.:

• A general background on the project finance market and the rôles of the main participants:

• Chapter 2 explains how project finance developed, its key characteristics and how these differ from other types of finance, and why project finance is used.

• Chapter 3 explains how investors develop projects, as well as the process for procuring public-sector projects using project finance.

• Chapter 4 provides information on the markets for raising private-sector project finance debt.

• Chapter 5 sets out the procedures for raising finance from private-sector lenders.

• A review of the commercial contracts that can form a framework for raising project finance:

• Chapter 6 reviews the different characteristics of the main types of Project Agreements, which play a central rôle in many project-finance structures.

• Chapter 7 looks at terms and conditions which are common to most Project Agreements.

• Chapter 8 deals with the Sub-Contracts, which form a key part of a typical project-finance structure—including those for construction, operation and maintenance of the project, provision of fuel, raw materials and other input supplies, and insurance.

• An explanation of project-finance risk analysis:

• Chapter 9 explains how lenders analyze and mitigate the commercial risks inherent in a project.

• Chapter 10 similarly examines the effect of macroeconomic risks (inflation, and interest rate and exchange—rate movements) on project financing and how these risks are mitigated.

• Chapter 11 analyzes regulatory and political risks and how these may affect a project.

• A description of a project’s financial structuring and documentation:

• Chapter 12 explains how the basic financial structure for a project is created.

• Chapter 13 summarizes the inputs used for a financial model of a project and how the model’s results are used by investors and lenders.

• Chapter 14 sets out what lenders usually require when negotiating a project-finance loan.

• Types of external support for projects:

• Chapter 15 explains how the public sector may provide financial support as part of the financing structure.

• Chapter 16 reviews the rôles of development-finance institutions and export-credit agencies.

Finally Chapter 17 reviews recent market developments, new financing models and the future prospects for project finance.

Technical terms used in this book that are mainly peculiar to project finance are capitalized, and briefly explained in the Glossary, with cross-references to the sections in the main text where fuller explanations can be found; other specialized financial terms are also explained and cross-referenced in the Glossary, as are the various abbreviations.

Spreadsheets with the detailed calculations on which various tables in this book are based can be downloaded from www.yescombe.com.

References to books and articles are intended to provide some further reading for those interested in a particular topic, rather than as authorities for statements in this book, so they do not purport to provide a full bibliography. The main focus in these references is on those which can—at the time of writing—be freely downloaded from the internet (marked with an *). Again links to these and other similar resources are maintained at www.yescombe.com.

Chapter 2

What is Project Finance?

This chapter reviews the basic features of project finance (§2.2), the factors behind its development (§2.3) and the ‘building blocks’ of a project-finance structure (§2.4), with examples (§2.5). The benefits of using project finance are then considered from the point of view of the various project participants (§2.6).

Keywords:

project finance; independent power projects; public-private partnership; concession; project company

§2.1 Introduction

This chapter reviews the basic features of project finance (§2.2), the factors behind its development (§2.3) and the ‘building blocks’ of a project-finance structure (§2.4), with examples (§2.5).

The benefits of using project finance are then considered from the point of view of the various project participants (§2.6).

§2.2 Definition and Basic Characteristics

Project-finance structures differ between various industry sectors and from deal to deal, since each project has its own unique characteristics. But there are common principles underlying the project-finance approach.

The Export-Import Bank of the United States (cf. §16.4.4) defines project finance as:

“…the financing of projects that are dependent on project cash flows for repayment, as defined by the contractual relationships within each project. By their very nature, these types of projects rely on a large number of integrated contractual a...