Project financing involves non-recourse financing of the development and construction of a particular project in which the lender looks principally to the revenues expected to be generated by the project for the repayment of its loan and to the assets of the project as collateral for its loan rather than to the general credit of the project sponsor.
Project financing is commonly used as a financing method in capital-intensive industries for projects requiring large investments of funds, such as the construction of power plants, pipelines, transportation systems, mining facilities, industrial facilities, and heavy manufacturing plants. The sponsors (the sponsor(s) or developer(s) of a project financing is the party that organizes all of the other parties and typically controls, and makes an equity investment in, the company or other entity that owns the project) of such projects frequently are not sufficiently creditworthy to obtain traditional financing or are unwilling to take the risks and assume the debt obligations associated with traditional financing methods. Project financing permits the risks associated with such projects to be allocated among a number of parties at levels acceptable to each party.
The important characteristics of Project financing are:
The typical project financing involves a loan to enable the sponsor to construct a project where the loan is completely “non-recourse” to the sponsor, i.e., the sponsor has no obligation to make payments on the project loan if revenues generated by the project are insufficient to cover the principal and interest payments on the loan. In order to minimize the risks associated with a non-recourse loan, a lender typically will require indirect credit supports in the form of guarantees, warranties and other covenants from the sponsor, its affiliates and other third parties involved with the project.
2. Off-Balance-Sheet Treatment
Depending upon the structure of a project financing, the project sponsor may not be required to report any of the project debt on its balance sheet because such debt is non-recourse or of limited recourse to the sponsor. Off-balance-sheet treatment can have the added practical benefit of helping the sponsor comply with covenants and restrictions relating to borrowing funds contained in other indentures and credit agreements to which the sponsor is a party.
3. Maximize Leverage
In a project financing, the sponsor typically seeks to finance the costs of development and construction of the project on a highly leveraged basis. Frequently, such costs are financed using 80 to 100 percent debt. High leverage in a non-recourse project financing permits a sponsor to put less in funds at risk, permits a sponsor to finance the project without diluting its equity investment in the project and, in certain circumstances, also may permit reductions in the cost of capital by substituting lower-cost, tax-deductible interest for higher-cost, taxable returns on equity.
4. Maximize Tax Benefits
Project financing should be structured to maximize tax benefits and to assure that all available tax benefits are used by the sponsor or transferred, to the extent permissible, to another party through a partnership, lease or other vehicle.