What is Project Finance?
Project finance is the financing of large, long term infrastructure projects. But theoretically, companies can still “corporate finance” an infrastructure project. So what really separates project finance from other types of finance? The answer is twofold:
#1: Project Finance is Non-Recourse
In corporate finance, lenders can generally lay claim to the the assets of the entire company. For example, when Hertz announced their bankruptcy in 2020, their lenders are generally entitled to collect on their debts from all the assets held by Hertz. By contrast, in project finance, the project is “ring-fenced” from the company (sponsoring entity) that is putting the transaction together via a special purpose vehicle (SPV) and lenders claims are solely limited to the cash flows the SPV generates.
The lenders to the SPV have no claim on the assets of the corporate entity that is sponsoring the project.
That difference changes everything.
That’s because in corporate finance, debt capacity and borrowing costs are determined based on the assets and risk (or more specifically, enterprise value) of the entire firm.
By contrast, the amount of debt that can be raised in project finance is based on the projects ability to repay debt through the cashflows generated of that project alone. This is the key point around which the structure of project finance hangs off.
Project Finance is Non-Recourse, meaning the amount and risk of debt financing is determined solely by the cash flows the project can generate.
#2 Project Finance has no Terminal Value
The second distinction is that there is very often no “terminal value” in project finance – no sale at the end of the project lifespan which results in an influx in cash to pay creditors (e.g. lenders). This is partly due to the long term nature of the assets, and the size of the assets – the market just isn’t that liquid for an operator of a $1B toll road.
Consider a toll-road concession, where the government grants the rights for 30 years to a private entity for operating the toll road. At the concession end, the government takes over the toll road. There are no further cashflows to the private entity beyond that. Therefore, it’s critical that the cashflows during that 30 year concession can repay the loan principal and interest, AND adequately compensate the entity.
Alternatively, consider a wind farm which a private entity develops and operates. It may be that the technology is rated for a 25-30 year lifespan. Or the lease of the land expires, and the entity needs to decommission the wind farm. There are really no assets to speak of at the end of the project life. Typically any scrap value is offset by the cost of removal and rehabilitation of the land.
And therefore, terminal value is not a factor.
