Project finance is a long-term method of financing large infrastructure and industrial projects based on the projected cash flow of the finished project rather than the investors' own finances. Project finance structures usually involve a number of equity investors as well as a syndicate of banks who will provide loans to the project.
The types of project for which project finance is commonly used include the following:
- infrastructure projects, such as government buildings and transport systems;
- oil and gas exploration projects;
- sports stadia; and
- liquefied natural gas development projects.
In the UK, most project financings have been carried out under the Government's private finance initiative (PFI) and are known as Public Private Partnerships (PPPs). PFI was introduced in the early 1990s and aimed to introduce private sector skills and finance into the provision of public sector services. PFI is structured so that the private sector obtains finance - usually from a bank - to design, build and operate a facility for the benefit of the public. In return, the public sector grants this private sector partner a long-term contract to run the facility - usually for 25-30 years. Once the facility has been built, the public sector pays the private sector a monthly fee over the life of the project which is used to service the bank loan which financed the project which is used to service the bank loan which financed the project.
PFI has traditionally been used because:
- it is argued that the public sector gets better value for money in the long term by transferring the risks of building and running the facility over the life of the project to the private sector. This means that the private sector, which is generally perceived as more efficient, manages the risks of the project; and
- since the public sector is essentially purchasing a service rather than outlaying the significant capital cost of building, for example, a school or a hospital, it does not need to account for this cost as a liability on its balance sheet. This means that the public sector does not have to borrow to finance the capital cost.
Key parties to a project financing
Private sector partner/owner: Usually a corporation or a limited partnership created for the sole purpose of the particular project. This party is at the centre of all contracts, borrowings and the construction and operation of the project. For simplicity, we refer to this party as 'Projectco'.
Project sponsor: The person who takes on the active role in managing the project. The project sponsor owns Projectco and will receive profit, either as a result of the ownership of Projectco or via management contracts, if the project succeeds. The project sponsor often has to cover certain liabilities or risks of the project by providing guarantees or by entering into management or service agreements.
Lenders: Commercial banks, investment banks or other institutional investors who provide the debt portion of the project financing. The sheer scale of a typical project financing means that most lending cannot be undertaken by a single lender. Instead, group of lenders form a syndicate.
Agent: one of the lenders will be appointed as the agent and will act on behalf of the other lenders to administer the loan.
Account bank: a single lender will hold the accounts through which all the cash generated by the project will pass.
Equity investors: lenders or project sponsors who do not expect to have an active role in the project. In the case of lenders, they will have a shareholding in addition to lending by way of debt, as a way of receiving an enhanced return if the project is successful. In most cases any investment by way of shares is coupled with an agreement to allow the equity investor to sell its shares to the project sponsor if the equity investor wishes to exit the project. Similarly, the project sponsor may have the option to repurchase the shares.
Suppliers, contractors and customers: these include the suppliers of materials for the project, the contractors responsible for designing and building the project and the customers of the project.
Construction company: the construction contractor is one of the key project parties during the construction phase of the project. Typically, a construction contractor's remit will be based on one of two models:
- turnkey model: where the construction company designs, engineers, procures and constructs the project output, assuming all responsibility for timely completion; or
- EPC model: where the construction contractor engineers, procures and constructs the project output but does not design it.
Consortia of contractors may be involved in larger projects. As far as liability is concerned those contractors can be either severally or jointly and severally liable. Several liability means that each contractor is only liable for its own contribution to the project, while under joint and several liability any contractor can be pursued for the whole of the obligation and it will then be the responsibility of the consortium to sort out the extent of each contractor's obligations. Lenders prefer the joint and several liability, since the risk of failure of performance is then the total responsibility of each member of the consortium.
Multilateral credit agencies: some projects - particularly in developing countries - are co-financed by the World Bank or its investment bank division, the International Finance Corporation, or regional development banks such as the European Bank for Reconstruction and Development or the Asian Development Banks. Multilateral agencies such as these are able to ensure the bankability of a project by providing commercial banks with a degree of protection against political risks, such as the failure of a government to make agreed payments or provide the necessary regulatory approvals.
Host governments/awarding authorities: the government of the country where the project is based is likely to be involved in issuing consents and permits both at the start and throughout the life of a project. The awarding authority is the contracting local authority which enters into the project agreement with Projectco.
Purchasers: in infrastructure projects, Projectco will normally contract in advance with a purchaser who will purchase the project's output on a long-term basis.
Insurers: insurers are vital to a project. If there is a catastrophe affecting the project, then the sponsors and the lenders will look to the insurers to cover the losses.
Key documents in a project financing
Project agreement: the principal agreement for any PFI project, the project agreement governs the relationship, rights and obligations between the public authority and Projectco throughout the term of the project. It can also be called a concession agreement.
In early PFI projects, it was common to have separate agreements for different phases of the project, such as a development agreement for the design and construction phase and an operating or facilities management agreement for the operating phase. However, these days it is more common to have a single project agreement covering all aspects of the project.
Property documents: where the project involves land-based development, property documentation will be required to reflect the interests of the public authority and Projectco and the intended ownership position at the end of the term of the project. Some common structures are:
- the public authority grants a licence to Projectco – this would occur where no property interest could be granted or would be needed by Projectco;
- the public authority grants a lease to Projectco with a lease back to the authority – this has occurred in a number of hospital projects where the interest in land was acquired by Projectco to construct the project but the authority was to occupy the building throughout the term of the contract;
- the public authority retains the freehold interest and grants a lease to Projectco with no lease back for the term of the contract; or
- Projectco retains the freehold interest and grants a lease to the authority for the contract term.
The type of structure used will depend on the type of facility comprised in the project and who will be responsible for its operation once the construction phase is completed.
Construction contract: Projectco will enter into the construction contract with the building contractor, under which Projectco's construction obligations under the project agreement will be passed on to the building contractor.
The building contractor and design team provide warranties in favour of both the authority and the lenders. The lenders generally have the first right to step into the construction contract in place of Projectco. Any rights the Authority has are usually subject to the rights of the lenders.
Service contracts: Projectco enters into service contracts with the service providers and passes on its service obligations under the project agreement to those contractors. As above, the service providers provide warranties in favour of the authority and the authority has step-in rights in certain circumstances – again, subject to the rights of the lenders.
Funding agreements: the facilities agreement is the main document between the lenders and Projectco and contains the terms of the project funding. The lenders will also require a security package and guarantees to protect the funds lent. The loan agreement is discussed in more detail in our separate OUT-LAW Guide to Key issues for lenders in Project Finance Agreements.
The lenders' direct agreement: this is a three-way agreement between the authority, Projectco and the lenders under which the authority agrees to give the lenders a period of advance notice of the impending termination of the project arrangement. This agreement will also offer the lenders the opportunity to step in, either directly or through a nominee or representative, to remedy the termination event or to find another party acceptable to the authority to take over the rights and obligations of Projectco under the project agreement.
Authority collateral agreements: these have emerged as an extension of the concept underlying the lenders' direct agreement. Authority collateral agreements are entered into between the authority and the contractors which contract with Projectco. The intention is that, if Projectco defaults on its responsibilities under the contract during the construction phase, the authority can ensure that the project is completed by taking over the relevant contract from Projectco. In addition, the authority will be able to take over the operating contract from Projectco if the project is terminated.
Sub-contracts: various sub-contracts are put in place by Projectco to pass down the risks it undertakes under the project agreement. It is common for Projectco not to undertake any of the key activities itself but to instead be a vehicle for forming the suite of contracts associated with the project - hence the term 'special purpose vehicle'.
Performance bonds: there are two main scenarios Projectco will have to pay for where performance bonds may be used:
- where the authority requires a performance bond to be issued in its favour by an acceptable surety to cover claims which may arise against Projectco during the construction phase when, if a default were to occur, it is likely that Projectco would not be able to meet a claim. The bond and the cost will ultimately be met by the authority. As a result their use is not common;
- where the lenders require performance bonds to be issued on behalf of a key contractor because they are not satisfied with the financial strength of that contractor.
Collateral warranties: the lenders and the authority typically seek contractual warranties from key contractors and consultants appointed by Projectco. The value of collateral warranties, to the authority in particular, is that they protect the position of the authority following termination of the project where the losses of the authority exceed the value of the built (or partly-built) project.