project finance what it is and what it is not

7/31/2019 Project Finance What It is and What It is Not

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PROJECT FINANCE: WHAT IT IS AND WHAT IT IS NOT- Review of Literature

Iwora G Agara

Finance and Accounts Dept

Geometric Power Ltd

and

Raphael Etim

Department of Accounting

University of Uyo, Nigeria

Abstract

This paper reviews literature on project finance, explains the conceptual framework of project

finance and discusses the attractions associated with the new financing strategy. Project finance is

becoming inevitable in funding large projects and infrastructure by private investors in contemporary

time. We posit that Nigeria would benefit immensely from project finance in her quest to develop

infrastructure, especial in the areas of power, rail and road construction amidst budgetary

constraints and revenue crunch of the various strata of governments. Therefore, Nigerian investors

should embrace project finance arrangements to stimulate investment and create employment.

Keywords: Project finance, expropriation, corporate governance, agency theory, non-recourse and

limited recourse projects.


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1.1 Introduction

From the nineteen nineties, the economic fortunes of, especially, developing nations dwindled and it

became increasingly difficult to fund infrastructural projects through the yearly direct budgetary

allocations by governments. This condition was exacerbated by the change in lending policy of the

World Bank that required borrowing countries to deregulate their economies and allow private

participation in the provision of infrastructure that can provide economic goods and services to be

paid for. In this way the government would reduce spending (Ham's and Knfhy, 1999). Second, key

changes in lending policies from major multilateral banks shaped governments emphasis on private

investment by restricting access to concessionary loans unless coupled with complementary moves

to reform and privatize infrastructure. Furthermore, specifically between 1990 until 1996, the World

Bank Group had a no-lend policy for specifically the power sector unless such requests, by

countries, are accompanied by substantial reforms intended to commercialize and corporatize the

electricity sector and to introduce independent regulation (Erik, 2006). These developments

popularised the use of project finance, a hybrid project funding alternative, in the development of

infrastructure which require huge capital outlay. Project finance emphasises the involvement of the

private sector in infrastructural development.

Historically, project finance dates back to at least 1299 A.D, about 723 years ago, when the

English Crown financed the exploration and the development of the Devon silver mines by

repaying the Florentine Merchant Bank, Frescobaldi, with output from the mines. The Italian

bankers held a one-year lease and mining concession, i.e., they were entitled to as much silver as

they could mine during the year. The more recent prominent example of project finance is the

construction of the Trans-Alaskan pipeline and exploration of the North Sea oil fields in the 1970s

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(Kensinger and Martin, 1988). From the late 1990s, after a temporary stagnation of project finance

due to the economic recession in Asia and America in the mid 1990s, the technique has become

rather prevalent in the financing of independent power plants and other infrastructure projects

around the world as governments face budgetary constraints (Comer, 1996). Project Financing has

continued to grow in prominence as a tool for financing infrastructure and capital assets with huge

cost at terms which would reduce risk to both the originators( project sponsors) and investors and

help to stimulate economic development, especially in developing countries((Ahmed and

Fang,1999; Ghersi and Sabal, 2006). In Africa, project finance is still at its infancy level with

South Africa leading the pack. In Sub-Saharan Africa, the earliest example of project finance is the

financing deal of Ashanti Goldfields in 1992 with the World Bank (Mitchell, 2002). Mitchell

(2010) adds that the Chad-Cameroon Pipeline Project, at a total cost of around $4 billion,

represented the largest foreign direct investment in sub-Saharan Africa to date. Three main reasons

have been adduced for the difficulty in practicing project finance in Africa. These include poor

credit rating of African countries by international investors, lack of depth and breadth in the

capacity of domestic capital market to support project finance arrangements, and high regulatory

risks such as regular government intervention and direct or indirect expropriation (Sheppard et al,

2006).

1.2 What is Project Finance?

Esty(2004) observes that there is no single generally acceptable definition of Project Finance but

defines project finance as the creation of a legally independent project company financed with

equity from one or more sponsoring firms and non-recourse debt for the purpose of investing in a

capital asset. The US Financial Standard FAS47 (1981) clarifies project finance concept further as:

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The financing of major capital projects in which the lender looks principally to the cash

flows and earnings of the project as the source of funds for repayment and to the assets of

the project as collateral for the loan(p.11).

Project finance for short entails setting up a distinct legal entity, called the project company, to

execute an approved project, raises funds through equity contribution by the project initiators or

proponents and by loans using the project assets and estimated cash flows as the collateral (Huang

and Knoll, 2000). The loans can be either purely debentures (also referred to as senior debts) and/or

preference shares (convertible or none convertible and also referred to as sub-ordinate or junior

debts)

The most common applications of project finance according to Esty (2004) are in the natural

resource (mines, pipelines, and oil fields) and infrastructure (toll roads, bridges,

telecommunications systems, and power plants). The practice of project finance entails the

assemblage of a consortium of investors, lenders and other participants (i.e. contractors and human

capital) to undertake infrastructure projects that would be too large for individual investors to

underwrite and, such investments require the construction and management of greenfield(i.e.

completely new) infrastructure or expanding of existing capacity. At least this is what theory

depicts. However in practice, we note the difficulty in assembling investors to participate in the

project concept, especially in the case of greenfield projects. Also, especially in the case of Nigeria

and using the independent power projects as a reference, most project proponents see the projects as

their family businesses and allocate significant proportion of the equity of the project company to

themselves and to their acquaintances leaving out the participation of other international and viable

local institutional investors who would have supported the project to completion within the

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deadline. Also, there are indications of no effective sponsoring entities that ought to sponsor the

projects separate from their internal operations, but rather the supposed proponents lean heavily on

the funding provided for the projects by external lenders to fund programmes unrelated to the

projects. These practices coupled with lack of adequate local human capacity to handle and properly

manage power projects contribute to delay in project completion.

1.3 Types of Project Finance

There are two basic types of project finance: non-recourse project finance and limited recourse

project finance. Non-recourse project finance simply means that there is no recourse to the project

sponsors assets for settlement of the debts or liabilities of an individual project. The limited

recourse project finance, on the other hand, permits the loan providers and creditors some recourse

to the project sponsors for some sort of support, usually in the form of guarantees and confirmations

to support the project to completion (Ahmed and Fang, 1999 and Fight, 2006).

1.4 Project Finance and Corporate Finance Compared

Corporate finance is the traditional project financing medium adopted by most companies using the

in corporate balance sheets as collaterals for the project or investment fund raising. There are

marked differences between corporate finance and project finance. Comer (1996) identifies the

following differences between project and corporate finance:

DIMENSION CORPORATE FINANCE PROJECT FINANCE

Financing vehicle Multi purpose organization Single purpose entity

Type of capital Permanent - an indefinite time

horizon for equity

Finite - time horizon matches life of

projectDividend policy and

reinvestment

decisions

Corporate management makes

decisions autonomous from

investors and creditors

Fixed dividend policy -immediate

payout; no reinvestment allowed

Capital investment Opaque to creditors Highly transparent to creditors

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decisions

Financial structures Easily duplicated; common

forms

Highly-tailored structures which

cannot generally be re-used

Transaction costs for

financing

Low costs due to competition from

providers, routinized mechanisms

and short turnaround time

Relatively higher costs due to

documentation and longer gestation

period

Size of financings Flexible Might require critical mass to cover

high transaction costs

Basis for credit

evaluation

Overall financial health of

corporate entity; focus on balance

sheet and cash flow

Technical and economic feasibility;

focus on projects assets, cash flow

and contractual arrangementsCost of capital Relatively lower Relatively higher

Investor/lender base Typically broader participation;

deep secondary markets

Typically smaller group; limited

secondary markets

Another striking difference between corporate and project finance is that in project finance the loan

taken does not show in the books of the owner of the project and therefore is an off balance sheet

transaction.

2.1 Evidences on the imperatives of Project Finance

The use of project finance has grown dramatically over the years from $ 12.5 billion (bn) per

annum in 1991 to $113.4 in 2005(Kleimeier and Versteeg, 2010). The increase in the use of

project finance does not appear to have a clear explanation (Esty, 2003). Kleimeier and

Versteeg(2010), however, hint that project finance is designed to reduce transaction costs of

raising large financing to execute projects in particular those arising from a lack of information on

possible investments and capital allocation, insufficient monitoring and exertion of corporate

governance, risk management, and the inability to mobilize and pool savings. They add that project

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finance should have a clear impact on economic growth; especially where the capital and financial

market development is shallow. These variables aptly describe the Nigeria environment with low

corporate governance, high risk, low savings, and shallow capital and financial development

market. Would this suggest, therefore, that project finance would be popular in Nigeria?

Indications point positively in favour of project finance, at least with the wave of deregulation of

the critical sectors of the economy. But, we are yet to witness a marked participation of the private

investors, under the project finance arrangement, in the development of infrastructure in Nigeria.

2.2 Motivations for Project Finance

Esty(2003) adduced three reasons or motivations for the increasing use of project financing in spite

of the high cost of concluding project finance deals occasioned by the long negotiations and the

complexities required to establish a project company. The three motivators are:

Agency Cost Motivation: This motivation recognizes that there exist conflicts between the owners

(ownership) and managers (control) of economic entities according to Agency Theory of the firm.

Agency Theory posits that agency conflicts can undermine the performance of the firm (Jensen and

Mecklin(1976). However, the nature of project finance removes such conflicts and makes it

possible for projects to function without being hindered by the idiosyncrasies of the individual

project sponsors in their domains. According to Esty (2003) project companies utilize joint

ownership and high leverage to discourage costly agency conflicts among participants. Today,

these agency cost motivations remain the most important reasons why firms use project finance.

The debt overhang motivation: Project finance involves the use of debt without recourse to the

assets of the sponsors and so the balance sheets of the sponsors are not affected unlike corporate

finance that considers the quality of the balance sheets which are normally used as collaterals for

the debt facilities. The bad luck of one project does not transfer to another one. Project eliminates

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the possibility that new capital will subsidize pre-existing claims with higher seniority or reduce

the value of junior claims (Esty, 2003).

Risk Management:The nature of project finance is that project assets have significant risk and

investing in such assets drags the company into risks which could impact negatively on other

investments in a port folio if not segregated. Project finance enables assets to be segregated so as to

ensure that the risk of one project is not transferred directly or indirectly to another. By isolating

the asset in a standalone project company, Esty(2003) posits that project finance would reduce the

possibility of risk contamination, the phenomenon whereby a failing asset drags an otherwise

healthy sponsoring firm into distress. Therefore, with project finance the project company is

bankruptcy remote from all the stakeholders to the project as all the parties to the project agree in

advance that in the event of failure recourse will not be made to the assets of the sponsors but

rather to limit recourse only to the project assets (Vaaler, et al. 2008).

Investors Protection and low bankruptcy cost- With project finance, various contracts are

modelled and risks are allocated with the attendant penalties for default. This ensures that in the

event of default, the lenders would have recourse to the project assets , thus leading to low

bankruptcy cost (Subramanian, et all, 2007).

Reduction in the earnings capacity of Industrialized Economies: Another motivation of project

finance is the global economic integration that has provided the opportunity for capital to be

internationally mobile. This enables international investors to seek investment opportunities in

developing and emerging markets due to lower yields in industrialised countries and the

advantages that come with risk diversification (Ferreira and Kanran (1996). According to Hams

and Knreger(1999) Project Finance is like a chameleon; it always finds a way to take advantage of

changes in the business.

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Investable environment. The World Bank Group (2003) indicates that investors prefer to invest in

projects in countries where the environment is investment friendly. Also Vaaler, et all(2008)

indicate that environments with low overall project risk would attract project finance at very high

leverage ratio, and if creditor rights are stronger, they are more willing to lend to projects while if

time to enforce their rights increases, they are less willing to lend to projects. These may be the

explanations for the increase use of project finance in developed countries they have stable

economic policies, embrace the rule of law and obey investment covenants. Developing and

emerging economies, including Nigeria may only be able to attract project finance arrangements

by ensuring economic and political stability.

2.3 Evaluation of Project

The selection of projects under the project finance model involves complex project appraisal.

Several models of project appraisal models used in project finance have been identified to include

the discounted cash flow (Net Present Value, Internal Rate of Return), the payback period,

Weighted Average Cost of Capital, and some other variants or combination of these (Arnold, 1998;

Andra, et al, 2009; Finnerty, 1996; Savvakis, 1994; Brealey and Myers, 1996; NERC, 2008).

However, the use of Discounted Cash Flow analysis and Net Present Value (NPV) in project

appraisal appears to be recommended in literature. Also, the estimation of cash flow is very critical

in project finance because it is the basis for financing the project (Jenkins, et al, 2002).

2.4 Characteristics of Project Finance

Literature is unanimous on the broad characteristics of project finance which are inherent in all

forms of project finance arrangements. The broad characteristics can be more distinctly identified

as : formation of an independent project company, funding of the project majorly with loans and

less of equity with an average debt equity ratio of 70%:30%, the repayment of the loan and

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associated interest is made from the cash flow of project, management transparency and effective

corporate governance permeate project transactions, high level of Investment Risk( both financial ,

construction and operation risks), parties to project finance often prepare risk allocation matrixes to

track the various risks and who would be responsible for what risk, project finance entails a series

of complex and interwoven contract scenarios involving several parties to the project- a typical

project may have as many as 15 parties united in a vertical chain from input( suppliers) to output

(buyers),bulk of investments relate to tangible assets, compared with corporate finance, the cost of

capital in project finance is very high because of the high risk associated with project finance

arrangements and the cost of putting in place the consortium of both financiers and contractors to

participate in the project(Jechoutek and Lamech, 1995; Subramanian and Tung, 2009; Esty, 2003;

Pernice, 2005; Fight, 2006; V aaler, et al, 2006; Andra, et al, 2009; Didkovskiy, 2003; Esty and

William, 2002; Erik, 2006; Esty, 2003 and Ghersi and Sabal, 2006)

2.5 Risk of expropriation

Of all the risks associated with project finance, the risk of expropriation has been identified to be

the worst distraction to investors. Commenting on expropriation, Erik (2006) states

... initially, the government needs private investors and thus offers attractive terms. Once

operational, the investors require a long amortization period to attain their expected return while

the host government has already secured what it needs; the original bargain has become obsolete.

Theory predicts that the host will force a change in termseither by outright nationalization or by

squeezing revenue streams as far as possible(p.127).

The overall risk profile of a project is however determined by several factors including the

economic environment of the host country, volatility in the exchange rates, unpredictable inflation

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rates, the probability of the host country expropriating or nationalising the project, project type and

its developmental stage, regulatory framework, political risk associated with stability of

government, control of corruption adherence to the rule of law and the ability of the host country to

mobilize and pool savings to facilitate access to long-term funds for the project (NEPAD-OECD

Africa, 2009, Alike, 2010, David and Mody, 1998, Hainz and Kleimeier,2006 and Kleimeier and

Versteeg, 2010 ).

2.6 Parties in Project Finance

Project finance involves a complex network of participants; each assigned specific responsibilities

in the project. The parties can be grouped into three main project stages: Pre-construction/ planning

stage; Construction Management Stage and Operations Management Stage. Figure 1 below shows

parties to a typical independent power project.

Participants

in the Project

planning stage

Participants in the Construction

Management Stage

Participant in the operations and Maintenance

Management Stage

Project Sponsors and

other equity

participants, government,

consultants, lenders.

Project Sponsors and other

equity participants,

government, consultants,

lenders, property right owners (

project site and right of way),

Engineering, Procurement and

Construction(EPC) Contractors

and other contractors(Foreign

and local), and other

materials(Gas/Fuel, machines

project Sponsors and other

equity participants,

government (Environmental Monitoring, and Ta

Authorities), consultants (Auditors and Tax, ICT

Trainers, lenders ,gas/fuel suppliers, managemen

consultants (in-house or outsourced),of

takers(bulk power purchase agents an

consumers), trade unions and other pressur

groups. Project finance negotiations are anchore

by the project owners and equity holders.

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and pipes)

(Ghersi and Sabal, 2006, Comer, 1996).

2.7 Importance of the Capital market

Infrastructural development requires huge capital outlay which most banks, especially in

developing economies, are unable to provide. To be able to obtain required funding, project

proponents seek for long term funds through issuance of bonds. The capital market would provide

the platform for this and therefore, the success of large projects, such as power, transport, ports etc.

requires the support of the capital market. However, the use of capital market in project finance is

generally low because of the low liquidity of the project related financial instruments since such

instruments are private, made to measure and impregnated with contractual relationships. To

access the required funding via the capital market at an economic cost of capital, project

proponents participate in the equity of the project company and provide, in some cases, limited

corporate guarantee in support of the project (Fletcher,2005; Corene and Banfield, 2006; Sorge,

2004; Sagar, 2006; Ghersi and Sabal, 2006; Okereke, 2010, National Treaury of South Africa,

2001)

3. Conclusion

Given the current situation of the Nigerian economy, vis a vis the imperative on the government to

proovide employment, the propagation of project finance arrangements cannot be overemphasized.

With the deregulation of the power, petroleum, transport and other sectors, it is expected that

significant employment would be generated arising from the huge investment that would flow into

the deregulated sectors.

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The Central Bank should champion the concept and enlist the support of commercial banks and

other financial institutions under her control. The intervention funds of N500 billion allocated by

the Central Bank of Nigeria (CBN) in 2010 to support the power (N300 billion), aviation and the

real manufacturing sectors (N200 billion) is commendable as this would enable projects in these

sectors to access funds at more liberal terms and catalyze power generation and distribution and

improve the performance of the other two sectors (Sanusi, 2010). But given the enormity of the

capital investment required to support the sectors, the amount allocated by the CBN appears to be

grossly inadequate and therefore calls for the embrace of project finance framework in order to

encourage private participation in a more systematic and effective manner. Commercial banks that

are the main project bankers can issue development bonds of 10 years minimum term in respect of

the projects they support and have the CBN to co-guarantee such bonds. This way, cheaper funding

can be raised to support infrastructure development continually.

The Government should be prepared to provide the required support to encourage investors to

participate in the deregulated sectors. In this regard, sovereign guarantee that would be required by

investors to guide against expropriation (directly or indirectly), unwarranted government

interventions, and other contingencies should be provided by government. Investment in

infrastructure is long term; therefore, the legal system should be resilient enough to withstand

external influences. This will indicate reliance on the legal system and ensure effective

enforcement of the rights of parties associated with the contracts that bind parties involved in the

PF framework. There should also be clarity of investment regulations and incentives to avoid

double standards and provide an objective interpretation of actions and decisions by potential

investors.

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Esty(2004) advises that given the demand for investment and the growing importance of project

finance as a financing pool, corporate executives, bankers, lawyers, and governments need to

understand what project finance is and why it creates value. The starting point is to propagate the

practice of project finance arrangements in Nigeria through seminars and workshops on the subject

and to encourage the private sector investors (foreign and domestic) to participate in the new

project financing phenomenon.

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Figure 1: PARTIES TO A TYPICAL INDEPENDENT POWER PROJECT

15

Government

Consultants

Lawyersand

Engineers

Regulator

ybodies

Development andMultilateralsInstitutions

Land andproperty

owners,

Host

Communities

IFC,WorldBank,

ADB,

OthersTrade Unions,Capital Markets andInsurance companies

Source: Howrey's Construction Practice Group:http://www.constructionweblinks.com/Resources/Industry_Reports__Newsletters/June_3_2002/project_finance.htm, Accessed 25/10/10. Tdiagram has been amended to accommodate other parties not included in the original Howreys diagram


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Vaaler, et al. (2008) indicate that project finance mitigates the domestic risk of countries and makes

investment in risky but also potentially rewarding countries more attractive for sponsors. The time

has come when Nigeria should seek to introduce and maintain governance models that would ensure

stability and sincerity in policy in order to encourage the practice of project finance arrangements.

What is required is for proper enlightenment on the benefits associated with project finance

arrangements, which include financial, developmental and social benefits associated with project

success (Esty, 2004). To ensure this, efforts most be made to address some challenges such as

inadequate legislation and gaps in existing statutes, lack of depth in debt capital market, absence of

political will, weak local banks and government bureaucracy that have been identified to hinder

infrastructure funding in Nigeria(Ekwere, 2009). There is no gain saying that given the fiscal

position of many governments, including Nigeria, project finance is seen as an important mechanism

to deliver much of the infrastructure finance requirement (KPMG, 2010). Collaboration among the

government, the academia and the investing public to achieve the level of consciousness and

popularise project finance is desired now than ever before given the need to simulate economic

development through the public-private sector co-operation encapsulated in the adoption of project

finance framework as one of the economic development strategies.

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