The topic of private sector financing of infrastructure cannot run away from the concept of Project Finance, which is really a financial structure that enables a projects to be financed solely based upon the cashflow expected from itself. In its purest form, it is non-recourse to the equity owners of the project; so the lenders cannot go after the owners of the project should the project itself fail to make payments on the loan. Often, project finance also provide higher leverage for the project sponsors than they could do at corporate level, which might be attractive even if the cost of debt is higher.
Maybe this already sounds like it is too much to take in. So bear with me a little while and allow me to take you from my credit-card application analogy to something closer, say, a mortgage loan. When you buy a house, you’d have no money to pay for it, and the bank would lend out the money to you, and for security/collateral, the bank gets your house. And the amount they would lend to you is based on the income that you make. Consider for a moment if the house is not yet built. So you commit to a loan, and the funds you are going to pay to the developers of the house, will be paid for by the bank, and the bank will be repaid by you, the customer, as the monthly payments are made. So did the developer actually borrow the money or was it you?
The bank must have a degree of trust in the developer, the project itself, and all the other things surrounding it, including the homebuyers’ ability to repay the loans for financing their homes eventually. And with all that in place, the home-building project itself actually can be financed largely by the lender rather than the developer themselves. An infrastructure project behaves very much the same way where the pre-commitments of the customer to that piece of infrastructure – very often the government – allows the lenders to take comfort that the project will be able to pay for itself over time.
This creates a very attractive structure for financing projects because it is self-contained, and parcels out various different risk factors to specific parties involved. For example, the developer takes care of the process to put together the parties and documentation required, the builders/contractors focus on bringing in execution capabilities, while the lenders bring in the much-needed capital and the users get their goods/services at a pre-arranged pricing schedule. Infrastructure is generally built for the long-term and last long. The demand for its services and payments to it are likewise long-term and repetitive; often also backed by the government as infrastructure often serves as public goods or at least club/common goods that are covered all or in-part by taxpayers. Project finance takes these advantages and enables benefits such as long-tenure financing (usually 15-20 years long repayment tenure, depending on the length of the concession contract), fixed interest rates over the long term (in some sense similar to a long-term sovereign bond), sometimes with repayment schedule sized according to the expected cashflow of the project (often part of ‘financial structuring’ of the loan).
This is last point is vital as infrastructure projects may be designed to accommodate growth over the next decade and therefore may be ‘overcapacity’ relative to the demand at time of commissioning. By sizing the repayments and managing the terms of the loan such that the lenders can tolerate lower payments in the beginning in exchange for higher payments at the end, the debt doesn’t become too overwhelming for the project to handle.
One final point I want to make is that project finance deals are often so large that a single bank would not want to take all the risks of lending to the project and would ‘syndicate’ with other banks or at least sell down part of their loan to another bank who would take the stream of payments down the line. This is another important feature of project finance as it allows multiple banks to partake in the risks of financing a single large project and be somehow acting as though they are a single lender as opposed to having multiple lenders facing off a single project and doing their own evaluations separately.
There are more nuanced technicalities involved and I didn’t set out to write something that would just copy-and-paste textbooks or content from other sites so there’s some recommended possible readings to get deeper. Though they can indeed go quite in-depth into those nuances:
- Energy Finance 101: Project Finance by Thirdway
- Investopedia Article on Project Finance
- Denton’s Guide to Project Finance
The last link contains an article that is very involved; and the geeky me kind of like how they even talked about fenus nauticum (sea loan) during the Roman empire as a sort of ‘pre-cursor’ to project finance today (which really started in 1970s and took off 1980s). Dentons do update this guide every now and then so the link may not be the latest. Googling ‘Dentons Guide to Project Finance’ should help to point you to something more updated.
This article is part of a series I’m working on to make topics in infrastructure a little more accessible to students and people from outside the industry who might want to get involved.
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