Project Finance is the funding of a specific project or group of projects (like a PV Solar electricity generation project) on a non-recourse basis through a special purpose entity. What does that exactly mean?
- The lenders to the project do not have access to the assets of the corporation, but only the assets of the project if the project defaults (non-recourse).
- There is a special purpose entity (SPE) set up to construct, operate and maintain the project(s). This SPE is responsible to also distribute the funds from operations such as expenses, taxes, debt service and returns to equity through the life of the project.
Why do we use project finance?
- Lower financing costs.
Because debt is cheaper than equity and a project financed structure can use more debt the overall cost of capital is lower. This makes the project have a higher return. To convince yourself of the benefits of leverage go to this simplified model. Play around with the debt percentages in cells d2 and g2. This shows how higher debt levels can increase returns to equity shareholders. Also please note that above a certain level of debt, the model does not compute a return. This is because, at a certain level of debt, lenders become less willing to capitalize projects if developers do not have some “skin in the game” (bear some risk). You will also see that the interest rate increases on the debt as the leverage goes up. Why do you think the interest on the debt would increase as the leverage increases?
- Enforces discipline on how the project is developed and managed.
Because the debt is tied to a specific project, the project developers are required to spend the capital and manage the project subject to covenants agreed to by the lender and developer.
- Allows greater investment in worthy projects.
By providing for the financing off the balance sheet and therefore not breaching its corporate debt covenants or other constraints, the developer can raise most of the funds to capitalize the project based on the projected cash flows of the project.