Project Finance Structuring and Essentials
As an illustrative example, we are going to look at project financing a power plant. After mapping out a project that is to deliver electricity to the grid, the operational components must be structured to be satisfactory to the lenders.
So first off there needs to be demand for the electricity. If the population is growing and power consumption is rising this is a supportive data point. If the State power grid is willing to guarantee payments for provision of electricity in terms of certain volumes this is an even more supportive data point. If an electric utility is willing to be an offtake for this electricity, this is even better.
If the potential power plant signs on to provide electric utility 400 MW of electricity for 20 years via a Power Purchase Agreement (PPA), the project becomes more bankable because the revenue component is secured. Depending on whether there are renewal options at the end of the PPA life or if the contract simply rolls off and becomes merchant exposure, the term of the project finance may change.
Now from a cost perspective, the “fuel” for the power plant has to be secured as well. As a simple example, assume that the power plant runs on natural gas. If there is an abundance of natural gas reserves nearby, this adds to the bankability of the project. If the power plant is able to secure a long term natural gas supply contract from a nearby producer, this locks in a cost that generates power lower than what they sell it for via the PPA and ensures that an acceptable return is baked in for the stakeholders of this potential project (debt and equity).
This is simple enough, but both the creditworthiness of the supplier and the offtake are important. It makes a big difference whether the offtake is ExxonMobil (rated Aa1 and AA+) and it requires the power for a local petrochemical plant versus a small utility with a lot of debt and declining population growth in the area that it services. Likewise, if the gas producer goes bankrupt, legal remedies may be limited.
This can be enhanced with letters of credit. Project financiers may require that should the counterparty risk be sub-investment grade, letters of credit must be posted to ensure that payments are met.
Project Finance – Insurance, Permitting and Closing
The land lease also has to be secured for the project to be constructed. Deposits must be made and approvals must be sought from the appropriate regulatory bodies. While the land is getting secured and the land acquisition to be closed, permitting and regulatory applications are submitted.
Construction costs should be well known and bake in contingency reserves – this is a big reason why the equity cheque component exists. Without having “skin” in the game via an equity cushion, project finance cannot be completed. If there are cost overruns, equity is hit first. This ensures equityholders and bondholders and the banks are all aligned in terms of getting the EPC contractors (engineering, procurement and construction) to finish on time and on budget.
The right EPC contractor is required to give the banks comfort. A marquee name such as Bechtel, Hatch or Fluor will be preferred over a startup that does not have the same experience with projects of the same scale and without a track record of completing ahead of schedule and within budget.
Once the construction is completed, the question of operatorship arises. The operator must be experienced in the field and able to mitigate unforeseen site turnarounds and unscheduled maintenance. For many projects, the equity partners may be a joint venture between financial partners (private equity firms or infrastructure funds looking for a return) and a reputable operator.
Banks will also expect insurance with adequate coverage for the project if things go wrong. The larger the potential liability, the more expensive the insurance, eating into project returns.
Once all of these requirements are satisfied, the ideal capital structure and debt/equity mix as well as the terms of the debt – for example the interest rate, tenor, allowed debt service coverage can be sculpted. Plenty of financial advisors (investment bankers) and technical advisors are drafted in.
Once all of the planning and steps made to secure financing are complete, a project finance starts in earnest and the construction, operation and eventual decommissioning of the project are straightforward.
So PF ends up looking very different from a project that comes from the company’s normal capex. The project finance will be a standalone with non-recourse debt (bankers will have recourse to the project and nothing else – obviously the project will be structured where they expect to get a full recovery).
Dividends to shareholders will be a function of distributable cash flow – which will in turn be structured to ensure that banks will always be well covered in terms of interest and principal repayments via a debt service coverage ratio. A special purpose vehicle is set up with equity from the developer, which reiterates the standalone nature of the project.
Why Project Finance?
These are some key reasons for why a project developer would choose project finance:
Non-Recourse Debt – The larger corporate is will not be affected by spillover effects of the project going wrong and can only lose what it commits
Alternative Funding Option – For certain projects, the larger corporate may be tapped out in terms of debt capacity to fund the project – Project finance allows for the developer to get the deal done without a large capital commitment and can take on a lot more debt
Derisking of the Project – For major projects that have a high risk element associated with it, the developer is able to shift risk to other stakeholders such as creditors. The project is structured to meet the return needs and principal protection of all stakeholders. This makes the project possible. Project finance debt accordingly tends to be priced higher than normal corporate debt – this ends up working out for the small pool of lenders because they have good asset coverage (the project itself) while the interest rate return profile is attractive
Government Incentives for Project Finance and Infrastructure – For projects that have a larger societal benefit, such as infrastructure or clean power generation, there may be regulatory incentives by way of tax breaks or cheap debt
As evidenced by recent populist elections, governments love infrastructure because of job creation and pumping money into small businesses as well as the networking effects that will come upon project completion