Project Finance: Definition, Structure, and Alternatives
Getting the most out of every dollar your enterprise invests is a critical component of project and business success. From identifying how best to spend available funds with capital budgeting to centralizing and organizing financial information, there are many key considerations when it comes to project finance. One of the most basic, and most important, is where to obtain the funds required by a project.
If your organization doesn’t have the cash flow necessary to finance a project directly, and typical financing methods aren’t a great fit, relying on a project’s own projected revenue streams to secure financing may be the answer. This article explains how project financing works, how it compares to other financing methods — like corporate finance — and how to decide whether project finance is the right fit for a particular business initiative.
What is project finance?
Project finance is an approach to funding major projects through a group of investment partners, who are repaid based on the cash flow generated by the project. The investors in a project finance arrangement are known as sponsors, and often include financial institutions with a high tolerance for risk. Sponsors may also include organizations in the same industry, a contractor interested in the project, and government or other public entities.
Project finance is most often used to fund large-scale industrial or infrastructure projects that involve a construction phase, such as building a transportation system addition or a power generation facility. Projects like these require significant upfront capital, and they do not generate a return until the construction phase is complete. They are also relatively high risk, as unforeseen problems during the construction phase can lead to project failure. Project finance is a good fit for initiatives like these because it provides access to a significant amount of cash to cover initial expenses.
The structure of project finance
Project financing directs funds to an entity called a special project vehicle, or SPV, that oversees the project until it is completed. This structure gives project financing two characteristics — off-balance sheet recording of liabilities and non-recourse financing — that differentiate it from other financing methods. An SPV differs from a joint venture, which doesn’t always involve establishing a new legal entity and, consequently, these two advantages.
Off-balance sheet liabilities
Debts and obligations associated with project finance arrangements are not recorded directly on the balance sheets of the businesses that sponsor the project. Instead, they are held by the subsidiary SPV. The debts may be mentioned in balance sheet notes or discussed by business executives, but they do not impact standard balance sheet calculations, such as a business’s total assets or liabilities.
The ability to keep debts off formal balance sheets is an attractive benefit of project finance. It means that organizations can undertake major projects without directly overloading themselves with debt. Neither do they run the risk that a sudden increase in balance sheet liabilities will harm their credit ratings or ability to obtain loans.
Non-recourse financing
Project finance is classified as a non-recourse type of financial structure. This means that in the event of default on the loans secured to fund the project, sponsors generally have recourse only to assets held by the SPV, rather than the parent company. The interest rates for non-recourse financing are typically higher to reflect the greater risk assumed by lenders.
Project finance vs. corporate finance
Corporate finance involves loans that businesses obtain directly and count as liabilities on their balance sheets. It’s one of the major alternatives to project finance and comes with its own advantages and drawbacks. As a recourse form of financing, creditors can demand repayment based on any asset or revenue source of the organization, even if it’s unrelated to the initiative that the business sought to fund via corporate finance.
For example, say your company chose to use corporate financing to pay for a fleet of new trucks by obtaining a loan from a corporate bank to fund the purchase. If your organization failed to meet its repayment obligations on the loan, the bank could seize both the trucks and any other assets you own. This means that project finance carries lower risks for businesses seeking to fund a project. However, as noted above, costs associated with lending are typically greater due to the proportionately high risk sponsors take on.
Who can benefit from project financing?
As noted above, project financing is a good fit for initiatives that require a significant upfront investment but won’t generate an immediate revenue stream and, by extension, ROI. Large-scale projects in the energy, infrastructure, and real estate development industries — among others — are all potential fits for project financing.
To decide whether an initiative can benefit from project financing, consider these factors:
- How much risk does the project pose? If the project’s failure could place your entire business at risk, funding it through project finance is a smart way to limit your risk.
- How much capital does the project require? If the project requires more capital than you could reasonably expect to obtain through other financing methods, project finance could be a solution.
- How long will the project take? For projects that won’t produce revenue for years while they’re underway, project finance allows your company to obtain the necessary financing without loading its balance sheet with liabilities.
Project financing isn’t the right fit for every initiative. But it offers a solution when project risk or the amount of capital required would otherwise prevent a project from moving forward.
Other project funding sources
Project and corporate finance aren’t the only funding sources available, of course, and your company should carefully evaluate every potential avenue for financing a project. Here are some of the most common:
- Cashflow. If your company has sufficient net revenue from its business operations, it may be able to fund a new project using that revenue, without relying on any type of financing.
- Savings. Your business can also leverage positive cash flows by saving the money, then using it to fund a project once it has sufficient funds on hand. The downside to this approach is that it can take years to save up enough cash, and the project opportunity may no longer be available.
- Partnerships. Partnering with other businesses that share the costs and liabilities necessary to complete a project is another potential option. This may be particularly appealing if it offers vertical or horizontal integrations that will boost project efficiency.
- Selling equity. You can obtain capital by selling equity in your company to investors. As ownership shares are not loans, they don’t expose you to the liability risks of project finance. This method does give external parties a significant say in your company’s affairs, although it will dilute ownership to a lesser extent for large enterprises.
- Issuing Bonds. Also referred to “debt financing,” a project can be funded by selling bonds to investors. These can be corporate bonds or those issued by municipalities in the public sector. These organizations will receive a credit rating that determines how much interest they need to pay the investors and is a measure of how risky the investment is perceived to be.
- Crowd-funding. Seeking financing from a large number of small-time investors — an approach known as crowd-funding — may provide enough money to fund projects in certain cases, although you’re unlikely to obtain the large sums needed for capital projects this way.
- Public-private partnerships. Private organizations often partner with government entities to complete large-scale endeavors like public infrastructure projects. The private entity provides much or all of the initial investment and makes it back by operating the investment after construction is complete. This isn’t the only way public entities help fund projects, of course — tax initiatives and federal, state, and local grants are just a couple additional avenues companies can explore to obtain public financing.
In general, employing these approaches makes the most sense when project funding needs are smaller-scale or for businesses that have very healthy cash flow and low liabilities. Organizations can also use a mix of these financing methods to fully fund projects when one is insufficient.
How to maximize the impact of project financing
Managing funds is just as important as securing them when it comes to completing projects successfully. Your company must develop accurate budgets, establish contingency funds to account for potential risks, and control costs, all while tracking how funds are allocated and actually utilized.
EcoSys™ is an enterprise project performance (EPP) solution that offers all the features your organization needs for fund management and beyond. You can use EcoSys to organize and manage hundreds of different fund sources, produce cash flow forecasts, and align funds with resource plans and project schedules. It also integrates with all your organization’s key project management and project portfolio management (PPM) processes, so team members can use the same platform for everything from project planning to change management.
Contact Hexagon today to learn how EcoSys can help your organization make the most of its financial resources.
