Project finance

What it means

Project finance is a way of funding a large project, such as a power plant, logistics park or residential development, where the loan is repaid solely from the project's own cash flows. The project is carried out through a special purpose company, known as an SPV.

Lenders rely on the project rather than the sponsor's balance sheet. If the project does not generate the expected cash flow, the lender can usually claim only the SPV's assets and income, not all of the parent company's assets. This is known as non-recourse or limited-recourse financing.

Typical features are high leverage, long maturities and a complex web of contracts covering construction, operation, supply, offtake and insurance. In renewables, for example, the key contract is often a power purchase agreement that secures sales of electricity and thus loan repayment.

How it works in practice

Before lending, the bank conducts detailed technical, legal, financial and environmental due diligence. The financial model projects cash flows over the whole project life and ratios such as debt service coverage, which must stay above an agreed level.

Security consists of liens over the SPV's assets, accounts, contract receivables and the shares in the SPV. The bank usually reserves the right to step into key contracts if the project runs into trouble, so it can rescue it.

Smaller projects, such as rooftop solar or an apartment block, use a simplified form in which the bank partly relies on the sponsor after all. For accounting, the SPV is usually consolidated with the sponsor if the sponsor controls it.

What to watch out for

Project finance is expensive to set up: legal, technical and advisory costs pay off only for larger projects. For an ordinary company investment, a conventional investment loan secured on company assets is usually simpler and cheaper.

Risks should be allocated to the parties best able to manage them. If the sponsor gives completion or cost overrun guarantees, recourse effectively widens and its balance sheet is less protected than it first appears.