Project Finance: The off-balance sheet financing method

Nigeria is a nation that offers a wealth of options. A population that is expanding and possessing countless opportunities in a variety of sectors, including commerce, communication, energy, infrastructure, aviation, technology and manufacturing. Because of this, business plans are created daily by people sharing a common interest and joining forces to form corporations allowing them to conduct business and make considerable profits in Nigeria.

The business plans created by these organizations are capital-intensive and long-term projects that require being carried out, and for these projects to be carried out effectively, there must be substantial investment to support them. This is where project finance is relevant. Businesses depend on project finance to fund their capital-intensive projects.

This article takes a look at the project financing method and how it seeks to support business practices.

How does Project Finance work?

Project financing is a way of funding infrastructure projects where the project itself serves as the means of payment. It refers to a variety of financing models where a project’s funding is based on its productiveness rather than the project sponsors’ or lenders’ reliability.

Long-term infrastructure, energy and industrial projects are financed using a complex financing structure that relies on debt and equity rather than the balance sheets of the sponsors.

Project finance offers a clear funding alternative for capital-intensive projects. For instance, the Lekki toll gate, which was funded by project finance, requires larges capital to construct.

The government of Lagos as the sponsor can approach businesses and investors for funding the project with a promise that the project would be a success and offer millions from toll fees. 

Usually, project finance is structured as a non-recourse loan. The non-recourse loan is one that the borrower is not personally liable. In project finance, the borrower’s project and the proceeds only ought to be pledged as collateral for a non-recourse loan. The only assets of the borrower from which the lender may receive repayment as collateral are the proceeds of the project that the loan is funding. 

However, the lender’s right to recover damages is only as much as the collateral if the borrower defaults. A project serving as collateral must be able to repay the loan. The difference between the value of the collateral and the loan becomes a loss for the lender rather than the borrower’s responsibility if this collateral is insufficient to cover the outstanding debt, for instance, in cases where the value of the collateral declines or where it is initially overestimated.

This is because the financing is based on the project’s merits rather than the project sponsor’s credit. Therefore, lenders would typically prudently cap the loan amount at a certain proportion of the project’s cost so that the collateral would rather be overpaid than prove insufficient.

In practice, it’s common to find limited recourse project financing than fully non-recourse financing. A portion of the project’s funding is required from the sponsor, with the lender contributing the majority. The lender would also avoid taking the project alone, usually, a syndicated loan structure is attractive to a project finance transaction, which mitigates and shares the risks. 

Additionally, though to a lesser extent, the sponsor is obligated to assume certain risks. Each project has unique risks that are assigned to the sponsor, and the extent to which this is done varies. It ensures greater involvement by the sponsor and provides a further guarantee to the lenders to increase the sponsor’s equity contribution and liability.

In some situations, the agreement becomes a structured project where the project sponsor takes on some project risks in exchange for a reduction in the risk premium that would otherwise be due.

The sponsor retains any risks that are not allocated to the various contracting parties. This could imply that, if necessary, the sponsor has the option of injecting additional capital or debt into the project company.

Players in a Project Finance transaction

The project finance transaction is a highly complex one with several parties playing crucial roles in its success. Here are some significant parties to a project finance transaction.

1. Sponsor or Developer

The sponsor is primarily responsible for the project’s procurement and development. He is sometimes referred to as the developer. Most of the time, the sponsor is the party interested in seeing the project through. 

Although it is important to him that the project be undertaken, he initiates project finance because he faces several financial and other constraints that necessitate the use of this financing option. He also manages and guides the project’s development in general. The sponsor could be the government, an energy company, or any other corporation in need of the project financing method.

2. Special Purpose Vehicle (SPV)

The SPV is the party that is registered for the sole purpose of managing, organizing, acquiring, and supervising the project on behalf of the project sponsor. The SPV is usually registered with a single object, to see to the success of the project.

Because the SPV is a new company interfacing with intended investors, it technically possesses no balance sheet or asset at the time, unlike the sponsor who is an already established enterprise. The absence of a balance sheet by the SPV allows the investors to concentrate on the project’s expected success rather than the SPV’s creditworthiness.

3. Investors

Investors are the project’s main financier. They often provide a significant portion of the money required to finance the project. In project finance transactions, there are frequently numerous investors. 

A syndicate of commercial banks and financial institutions may act as investors. These might not always be the local institutional investors. Depending on the project, it is frequently preferable to involve both domestic and international institutions. Due to the non-recourse nature of project finance, this feature allows investors to diversify their risk exposure.

Conclusion

The non-recourse financing option is a significant part of today’s business innovative processes. With governments and energy corporations across the world demanding the funding of capital-intensive projects by exploring project finance styles, the rise of the off-balance sheet financing option has accessed its relevance in the world of investment.