Project Finance is a financing formula or technique that is usually used for very high investments and that will last over time. They are based on the ability of the project itself to generate positive cash flows . This means that the sponsors do not have to provide guarantees to guarantee the financing of the project. If not, the project itself has the necessary capacity to generate funds that remunerate the invested capital after repaying the debt contracted.
What is the objective of Project Finance?
The most common structure to carry out Project Finance operations is by creating a Special Purpose Entity or Special Purpose Vehicle (SPV ). Its sole objective is to carry out the investment project and structure its financing. This company is the one that issues the debt and uses the cash flows to recover the investment.
In addition, in this company, the only guarantee that exists for the external resources contributed are the cash flows and the assets of the project.
Therefore, in order to achieve better management and control of project risks, these will be assigned equally among the parties participating in the operation.
Before carrying out the project, it must be ensured that the cash flows generated are sufficient to cover operating expenses and repay the principal and interest on the debt. Until these are not covered, dividends will not begin to be paid to the sponsors.
What types of sponsors are there?
In a Project Finance we can find several types of sponsors such as Industrial Sponsors for which the initiative is usually related to their main business.
The Central, Regional or Local Government, whose objectives are focused on social welfare, would be part of the Public Sponsors .
Those who develop, build or operate the project are known as Contractors, Promoters, Sponsors or Sponsors.
Finally we have the financial Investors , who seek to invest in projects that give them high profitability.
What are the phases of a Project Finance?
Few participants usually collaborate in a Project Finance, which is why some perform different roles. This makes the costs are lower and therefore the return flows are higher.
The cornerstone of this type of project is the risk factor. as it is responsible for unexpected changes in the project’s ability to pay operating expenses, debt, and dividends to shareholders.
Depending on the phase of the life cycle in which the Project Finance is, the risks will be different.
For example, in the construction phase the risks are more associated with the planning of the activity as well as with the construction and technological aspects. However, in the operational phase, the risks that we may encounter are those related to the supply of materials or market risks for the sale of products or services. Although there are also macroeconomic and financial variables that pose a risk regardless of the phase in which the project is at that time.
Risk management strategies
The role of risk is so important that several strategies must be taken into account to try to mitigate its impact.
The company will try by all means to use all its tools to apply its own internal prevention and control procedures before resorting to the third party option which is always more expensive.
Another strategy is to transfer the risk to each of the entities participating in the project. Thus, if each one has to bear the cost of risk, it will be able to control and manage it better.
But some associated risks are so complicated to address that there is no choice but to resort to insurance companies to cover certain possibilities that are difficult to foresee and manage.
Advantages of Project Finance
Since the Special Purpose Vehicle is the one that assumes the debt, the financing is left out of the balance sheet, thus limiting the risks assumed by the promoters. They do not see their debt ratio change and they can maintain their credit rating or rating.
This financing formula can achieve much larger financing amounts and terms than if the promoters independently carried out the procedures.
Financial entities usually participate in these companies because the margins and commissions are usually higher as it is a leveraged structure. In addition to benefiting from advantageous conditions and being able to sell their participation in the project.
What is the difference between Project Finance and Corporate Finance?
Corporate Finance or Corporate Finance is the area that focuses on the monetary decisions made by companies in their financial field and whose main objective is to maximize shareholder value.
Corporate Finance is constantly working to find strategies that improve the profitability of companies.
Therefore, Project Finance is a financing mechanism with which Corporate Finance works to finance large-scale and stable projects. Its main characteristic is, as we have previously indicated, that the main guarantee is the ability to generate income from the asset itself that is being financed.
As we have been able to verify, financial engineering does not stop creating figures that lead and help carry out any imaginable project.