Should Companies Use Project Financing or Ordinary Credit Lending?

Since the banking crisis of 2008, most companies have noticed changes in the way that banks make commercial loans. Prior to the recent financial shakeout, it was common for businesses of all sizes to obtain working capital financing and many other forms of business funding without collateral — simply by agreeing to repay the loan on a timely basis.

Ordinary credit lending generally refers to a straightforward loan agreement between the lender and commercial borrower — usually based only on the creditworthiness of the business borrowing funds. In an increasing number of situations, this form of commercial borrowing has been replaced by project financing (also known as project finance).

This distinction is an important one because it directly impacts whether a company is likely to receive the business funding it needs to continue operations. Even the most successful and profitable companies routinely rely on large amounts of debt to build infrastructure. Although the price of oil and many other commodities has declined recently, the cost of energy-related projects such as building a wind park or power plant is sufficiently expensive that few companies can afford to proceed without external financing of some kind. For example, a 1,100 MW nuclear power plant is likely to cost $6 billion to $9 billion.

The energy sector is not alone in regularly confronting the need to finance high-ticket projects. The cost to build roads, airports and other massive construction projects are capital intensive for both private and public institutions. To meet this funding need while also keeping the lending risks under control, many banks now offer project financing for long-term projects. Because project finance considerations involve specialized financial research, experts such as Research Optimus often play an important role in helping commercial borrowers comply with the complicated requirements that must be met in order to successfully obtain needed business capital.

Project Finance: Off-Balance Sheet Financing

Accounting regulations and requirements typically play a deciding role in many financial decisions made by both public and private companies. For example, the need to maintain a delicate balance between debt and equity can cause many companies to postpone needed expenditures because an ill-timed new liability can effectively “blow up” the overall balance sheet.

One practical solution is to use a project finance mechanism instead of an ordinary bank loan because the project finance financial transaction can occur “off-balance sheet” by creating a “Special Purpose Vehicle” (SPV) for the specific project being funded. With this special legal and financial arrangement, both equity from the borrower (or sponsor) and debt from the commercial lenders (banks or other entities) flow into the SPV. This specialized structure provides the following advantages:

• Reducing Risks — By insulating the company’s balance sheet from the performance of the SPV, a business can reduce its internal financial risks. Even in the worst case of a project failure and bankruptcy of the Special Purpose Vehicle, the borrower will not need to sell corporate assets that are outside of the SPV.
• Providing Easier Access to Financing — Project finance considerations are the determining factor for project financing to the SPV rather than the credit standing of the commercial borrower. Even companies with a poor credit history or cash flow can obtain Special Purpose Vehicle funding if the SPV cash flow is sufficient.
• Changing the Underlying Accounting Metrics — Ordinary credit lending will change debt-equity and interest-coverage ratios and other accounting metrics. In turn, this can result in higher financing costs for other projects as well. With the notable exception of a company’s equity contribution, project finance arrangements will keep project costs off of the balance sheet. In most cases, the equity portion will not result in a material impact.

Project Financing Via Syndication

A commercial borrower is not the only party that can reduce risk with project finance — banks also manage their risk by the involvement of multiple lenders instead of just one. This is particularly important because a single bank is unlikely to be interested in assuming 100 percent of the risk in building projects such as a nuclear power plant. For example, Basel III regulations effectively force individual financial institutions to reduce risk-weighted assets. The practical solution is to arrange syndicated financing from a group of lenders to the Special Purpose Vehicle.

In a project finance syndicate, the sponsor/borrower selects one bank — often called the lead bank, lead underwriter or Mandated Lead Arranger (MLA). The lead underwriter then acts as the central lending party on behalf of other underwriters. The overall arrangement is often complex, with legal, financial, technical and government advisers each playing an important role.

With public infrastructure projects, governmental bodies assume a critical role — a public asset (such as a hydroelectric dam) is financed by a public and private party via financing structures such as a Public Private Partnership (PPP). Rules and regulations for such entities can vary widely from one country to another. Because of their financial experience on a global level, research experts such as Research Optimus typically provide specialized help to both borrowers/sponsors and lenders.

After syndication, banks have a reasonable amount of liquidity for their credit facilities. By selling their syndication interest to other parties, banks free up capital that then facilitates future syndicated loan participation. Because of the long-term cash flow originating from the SPV, insurance companies are frequently interested participants in the secondary market due to duration matching.

The Changing Future for Project Finance

According to the European Investment Bank (EIB), project finance has grown to about $400 billion per year on a global basis, with recent annual growth of about 15 percent. The EIB forecast is for continuing growth, especially in emerging economies due to outdated and overloaded infrastructure currently in place for a growing population.

However, the looming impact of the 2008 financial crisis is beginning to affect the ability of banks to meet all project finance needs. Banking regulators are continuing to impose new liquidity requirements on banking institutions, and this is likely to reduce some lending activity. In the United States, the Federal Reserve is using annual “stress tests” to measure how well banks could handle the unexpected “stress” of another banking crisis similar to what happened in 2008. Banking regulators in the European Union are making similar periodic adjustments to how much liquid capital banks must keep on hand.

The likely lesson to be learned from this is that project finance does not have an unlimited supply of funds — excessive demand will eventually occur, and banks are likely to react by being more selective in what projects get funded with lower-cost financing. In some cases, projects might not get funded at all and in other cases project financing costs might be more expensive. To increase the likelihood of receiving project finance approval at the lowest cost, borrowers/sponsors should be prepared to enlist the help of experienced research partners such as Research Optimus.

Some Concluding Thoughts from Research Optimus

When your business is thinking of how to fund projects, please keep these points in mind:

1. Traditional bank loans can still “work” for smaller projects, but large investments — for example, energy and infrastructure projects — often require a more specialized approach via project finance.
2. Off-balance sheet financing is facilitated by a syndicated project finance structure involving multiple banks.
3. The advantages of project finance include risk reduction, increased capital access, and minimal accounting impacts.
4. The increased demand for project finance makes it increasingly prudent to select an experienced global research partner such as Research Optimus to help with the entire process.

Please contact Research Optimus for more details about how we can help keep your project finance costs as low as possible.

– Research Optimus