The vast majority of projects around the world are financed through loans. Sponsors can choose to finance the project abroad directly or indirectly. If they choose the direct path of financing, then funds can be raised either on normal terms or on a limited recourse basis.
There are several sources of funding for projects, which will be discussed in detail in this article. If, after reading the material, you need advice from a Project Finance Europe deal regulation specialist, you can contact us by filling out the feedback form below.
Project Finance in the US and the UK: Bonds
The bond market is a potential source of project financing. For example, there is a demand for financing projects in the United States through bonds. However, the vast majority of projects are financed through loans because they are considered more flexible.
The main advantage of the bond market is the availability of long-term financing with a fixed interest rate, which is not only cheaper than bank borrowing, but also provides an opportunity to increase the debt repayment time, which can significantly improve the economics of the project.
There are several disadvantages to using bonds to fund projects in the UK and the US, including the following:
- Consent and refusal from creditors are often requested when financing projects; it is much more difficult to get them from bondholders. The trustees of such securities will have certain powers.
- Upon completion of the transaction, the bondholders pay one large amount. This does not fit well with most project structures where the company periodically uses funds, for example, based on an engineer or architect certificate confirming the completion of the corresponding stage of the project. The solution to this problem is to deposit the proceeds from the bonds into an escrow account with a trustee and allow the project company to withdraw these funds using the credit structure. This can lead to significant additional project costs that need to be accounted for.
- In many cases, bondholders are anonymous, making it much more difficult to organize bondholders' meetings to determine what action should be taken as a result of any defaults.
Lease financing of UK projects
This is often used to finance large scale infrastructure projects in the UK. Small projects use this model very rarely, because, firstly, the tax opportunities available in this jurisdiction for investing in such projects are rather limited. Secondly, there is an obligation to rent the main equipment. Third, the introduction of the lessor into the project structure will significantly complicate the documentation. The aforementioned factors can lead to tax and, accordingly, credit risk of the project company and the project itself.
US project finance: Borrowing
The basic borrowing model was developed in the United States, in particular with regard to the financing of oil and gas assets. Using this approach, borrowers will be eligible to use the funds to finance one or more designated projects, provided the overall borrowing base coverage ratios are met. To protect its loans, the lender accepts as collateral all assets included in the borrowing base structures.
This approach is popular among those wishing to start a project deal in the USA that is not large-scale, since excess capital from one project can be used to cover cost overruns on another project.
Project finance abroad: Direct Buy Model
Under this structure, sometimes known as the “advance payment mechanism”, the project company will use the proceeds from the advance payment to finance the construction and development of the project. Alternatively, the project company can sell products to lenders as a sales agent.
Sometimes a more complex structure is used, where another company, owned by the lenders, acts as the mechanism through which the financing flows. This type of structure has often been used to evade borrowing restrictions. Another reason for using this model may be related to circumstances where lenders cannot obtain a security interest in the assets financed. This type of agreement, if legally binding, gives creditors ownership of the products produced by the project.
The “production payment” model is often used in the United States to achieve tax advantages. Under this structure, lenders can acquire ownership of the US project. It usually obliges the project company to buy back products supplied to the lender or sell them as an agent of the lenders. The share acquired by the lenders can be either a percentage in the project itself or a share in the proceeds from the sale of products.
The essential difference between these two structures is that in the first case there is simply a contract for the supply and receipt of the product as it is produced, whereas in the production payment transaction there is the transfer or sale of the product.
Risks of project finance abroad and ways to minimize them
Of course, project financing is more risky than current financing. Unlike, for example, mortgage lending, there is not always the possibility of obtaining adequate collateral at the investment phase of the project.
- Economic risk - the risk that the project's products will not be able to sell at a price that covers all project costs and debt service costs;
- Political risk;
- Legal risks - licenses and permits for construction and registration of a land plot are often obtained after the start of construction;
- Additional risks in project finance abroad may be delay in commissioning the facility, increase in prices for raw materials and materials, excess of construction estimates.
To minimize risks in project finance abroad, lenders use a scheme of equity participation, the organizer of the project or the attraction of other banks for financing (forming a syndicate) to distribute risks evenly among all project participants.
Another type of risk minimization is insurance: professional liability, buildings, business and financial risks.
Project finance is a transaction that focuses on creating a reliable source of income for the project in question to cover operating costs, service debt, and provide a return on investment to sponsors.
To understand in detail the issues of raising funds for new projects, you can request advice on structuring project finance transactions abroad from IQ Decision UK specialists.