Project finance is a mechanism to finance large-scale investment projects. It is supported by both (i) the project’s capacity to generate cash flows to repay the loan, and (ii) agreements signed between several parties to guarantee the profitability of the project, instead of having the project backed by assets or by the developer’s credit rating.
In this kind of financing structure, the creditor or lender will obtain repayment of its loan via the cash flows and other income to be generated by the project, and can also receive project assets or the project’s economic unit as collateral. It is usually said that under the project finance mechanism, banks fund a unique project and assume great part of its success or failure.
The project finance method is used in large-scale infrastructure projects, particularly in the public sector, for which traditional financing systems are insufficient or at least inappropriate to contribute to project success. Capital intensive industries or projects, like those related to the electricity and mining sectors (gas, oil, etc.), telephone projects, bridge and road construction projects, refineries, oil pipelines and any other project requiring a significant construction or engineering component usually resort to project financing as a lending mechanism.
Project finance has contributed substantially to financial economics; to the extent many of the projects carried out during the last few years would have not been implemented without the support of entities that are willing to cooperate with each other to share the risk. Not only because of the large financing required, but also because of the need to diversify risk in large financial transactions.
As stated above, in view that we are speaking of large-scale projects, a consortium of banks is required in order for each bank to provide a portion of the required financing. In this way, the risk is proportionally shared, based on the risk each bank assumes in the transaction. The bank in charge of dealing with administrative and management matters with the consortium and the special purpose vehicle (SPV) is usually the one that assumes the highest risk in the deal (as in syndicated loans).
Besides, this type of projects are playing an increasingly important social role to the extent the State is entrusting private companies with the construction of some infrastructure projects, for which reason, in practice, it has become a mechanism to let private capital participate in large State investment projects.
The main difference between project finance and other financing methods (like syndicated loans) is that project finance is a project based financing mechanism and the cash flow generated by the project covers the required financing. In an SPV, a high ratio of debt to equity exists, for which reason transactions involve a very high risk because it is unlikely that participating financial institutions will be able to recover the financing they have granted in case of payment default. That’s why, in practice, payment default in project finance structures is almost inexistent because appropriate debt refinancing formulas are chosen.