What is Project Finance

At its core, project finance is a method of financing where the lender accepts future revenues from a project as a guarantee on a loan. In contrast, traditional method of financing is where the borrower promises to transfer to the lender a physical or economic entity (collateral) in the case of default. In practice, most projects are financed by a combination of both traditional methods as well as by guarantee-backed loans. While the name suggests that project finance refers to raising capital by any means to pay for any project, the term refers to a narrow but increasingly more prevalent method of financing capital- and risk-intensive projects across a broad array of industries.

What is the difference between Project Finance and Traditional Finance?

In traditional or corporate financing, the sponsoring company (the company building the project) typically procures capital by demonstrating to lenders that it has sufficient assets on its balance sheets. That is, in the case of default, the lender will be able to foreclose on the sponsor company’s assets, sell them, and use the proceeds to recover its investment. In project finance, the repayment of debt is not based on the assets reflected on the sponsoring company’s balance sheet, but on the revenues that the project will generate once it is completed.

The sponsoring company must consider several factors when determining whether to use a corporate or project finance structure. Such considerations include the amount of capital needed, the risks involved (political risks, currency risks, access to materials, environmental risks, etc.) and the identity of the participants (whether a government, multilateral institution, regional Lender, bilateral institution, etc. will be involved). As the graph below demonstrates, corporate finance most often involves private investors who provide financing in return for ownership (equity) in a project company. The focus in project finance, however, is mostly on loans to the project company, with project revenues as the source of the return on the investment to lenders.

Project finance greatly minimizes risk to the sponsoring company, as compared to traditional corporate finance, because the lender relies only on the project revenue to repay the loan and cannot pursue the sponsoring company’s assets in the case of a default. However, a sponsoring company can only use project finance where it can demonstrate that revenue streams from the completed project will be sufficient to repay the loan. In fact, lenders will often require that the sponsoring company demonstrate that it has agreements in place that will generate the required revenue (called “off-take agreements”). For example, in the case of power projects, the sponsoring company often signs contracts with distributors where the distributors agree to purchase electricity generated by the project. Therefore, project finance is most suitable for a project where there is a predictable revenue stream to support debt repayment.