Project Finance is a non-recourse financing method for the sponsor or promoter of a project, under which the project promoter has no direct legal obligation to repay the debt contracted to finance the project if the project cash flows are insufficient to pay the debt. Accordingly, in view that it is a non-resource financing method, the debt is not reflected on the balance sheet or financial standing of the project promoter as it intends not to encumber it assets, which are rather given as collateral, and to have liabilities covered by the project cash flows. For this reason, it is also called “non-resource finance” or “off-balance sheet financing”.
To achieve this purpose, a third party is usually included to provide credit enhancement (Such as governmental entities which promote exports or multilateral credit institutions like the World Bank, to guarantee development loans).
The truth is that very few projects manage to achieve the required leverage by directly generating cash flows. Most of the time they need third parties interested in the project to provide collateral because there is practically: (i) no project capable of being self-funded and, on the other hand, financial institutions offering financing; and, (ii) are not interested in assuming the project risks, waiving their recourse against the debtor. The enhancement is intended to protect creditors from the most serious risks which may affect the project. Depending on the risk factors affecting a project, the enhancement may take many forms like letters of credit, capital contributions, collateral (like guarantees directly furnished by the promoter or other project participants, guarantees granted by third parties and, in some cases, contingent guarantees), and insurance.
The recourse level is determined after assessing the risks faced by the project and the credit markets’ willingness to accept said risks. For instance, if a creditor notices that substantial risks exist during the project construction stage, then it may require the promoter to agree to inject additional capital if said risk actually occurs. The creditor may have recourse against the project promoter’s assets until the risk disappears or the construction stage is completed. The project will then become a non-recourse project.