Chapter 2
The Rationale for Project Financing
Several studies have explored the rationale for project financing.1 These studies have generally analyzed the issue from the following perspective. When a firm is contemplating a capital investment project, three interrelated questions arise:
Prior Studies' Explanations
The finance literature on the subject of project financing is still developing. Careful analyses of the true benefits and costs of project financing continue to appear in the literature and enhance our understanding of this very useful financing technique. Shah and Thakor (1987) were among the first to provide a carefully thought-out analysis of the rationale for project financing. They explained why project financing seems most appropriate for very large, high-risk projects. Unfortunately, their analysis was based on only two projects.3 Chen, Kensinger, and Martin (1989) observed that project financing is widely used for medium-size, low-risk projects, such as cogeneration facilities. They documented that project financing had become the dominant method of financing independent electric power generating facilities, including cogeneration projects developed for several Fortune 500 companies. At best, then, Shah and Thakor's theory appears incomplete. Esty (2004) explains the rationale for project financing and provides a variety of statistics that describe this form of financing and distinguish it from conventional corporate financing.
Mao (1982) noted that in order for a project to secure financing as a separate economic entity, the relationships among the participants must be spelled out in detailed contracts.4 Worenklein (1981) addressed the project's requirement for “sources of credit support” in the form of contracts to purchase output from the project and/or to supply the necessary inputs at controlled cost. The project's sponsors typically do not guarantee repayment of the project's debt, so creditworthy parties must provide credit support through such contractual undertakings. Esty (2004, 2007) provides an interesting overview of project financing and furnishes a set of more than two dozen case studies, which highlight the use of project finance to develop a rich variety of projects in different parts of the world. More recently, several studies have examined public-private partnership financing (Blanc-Brude and Strange, 2007), the emerging market for project bonds (Dailami and Hauswald, 2007), syndicated project bank loans (Kleimeier and Megginson, 2000, and Sufi, 2007), and the pricing of project bank loans (Sorge and Gadanecz, 2008).
The Need for Contracts
One theme is clear. Project financing arrangements invariably involve strong contractual relationships among multiple parties. Project financing can only work for those projects that can establish such relationships and maintain them at a tolerable cost. To arrange a project financing, there must be a genuine “community of interest” among the parties involved in the project. Only if it is in each party's best interest for the project financing to succeed will all parties do everything they can to make sure that it does. For experienced practitioners, the acid test of soundness for a proposed project financing is whether all parties can reasonably expect to benefit under the proposed financing arrangement. To achieve a successful project financing arrangement, therefore, the financial engineer must design a financing structure—and embody that structure in a set of contracts—that will enable each of the parties to gain from the arrangement.
It seems unlikely that a single theory is capable of fully explaining the rationale for every project financing. Nevertheless, a brief review of the various explanations of the rationale for project financing can provide valuable insights. This review will also serve as a useful backdrop for our discussion of project financing in the remainder of the book.
The Advantages of Separate Incorporation
Chemmanur and John (1996) have developed a rationale for project financing based on the benefits of corporate control. In their analysis, a firm's manager/owners derive, from being in control, benefits that they cannot contract away to other security holders. When the firm undertakes multiple projects its organizational structure and its financial structure both affect the owners' ability to remain in control. Control benefits include the owners' discretion to reinvest free cash flow in projects of their own choosing, their ability to pay themselves high salaries and perquisites, and their freedom to make other corporate decisions that might benefit their self-interest at the expense of lenders or shareholders. Chemmanur and John's model of the interrelationships among corporate ownership structure, organizational structure, and financial structure leads to interesting implications concerning (1) conditions under which it is optimal to incorporate a project as a separate legal entity; (2) the optimal amount of debt financing for a project, how to structure the debt contract (i.e., straight debt or limited-recourse debt), and how to allocate debt across a portfolio of projects; and (3) conditions under which limited-recourse project financing is the optimal financing technique for a project.
Special Form of Organization
Choosing project financing over conventional direct financing involves choosing an organizational form that differs from the traditional corporation in two fundamental respects:
Main Results
Chemmanur and John's main results can be summarized as follows. First, if management can maintain control of all the projects it has under consideration when they are entirely equity financed, it will not issue any debt. This enables managers to avoid having lenders who will monitor (and restrict) their activities. If management has comparable abilities (relative to potential rivals) in managing all the projects, then forming a single corporation to own all the projects will be the predominating tactic. If, on the other hand, management's relative abilities differ significantly across the projects, then it will be better to incorporate at least some of the projects separately and hire separate management to run them.
Second, if management cannot retain control of all the projects that are entirely equity-financed (i.e., due to limited internal cash), then it will finance the projects by issuing a combination of debt and equity. If management's relative abilities are comparable across the projects, and the structure of the control benefits is also similar, the projects will be owned by a single corporation and partly financed with corporate debt. If, on the other hand, management's control benefits differ significantly from one project to another (while its relative abilities to manage the projects remain similar), limited-recourse project financing will be optimal. Management will operate all the projects but use limited-recourse financing to limit its liability.
Third, when a firm must issue debt to maintain control, and management's relative abilities differ significantly across the various projects, it will be optimal to spin off one or more of the separate firms.5 Shareholders will benefit if better managers take over a spun-off firm that was poorly managed.
Fourth, the optimal allocation of limited-recourse project debt across different projects depends on the structure of management's control benefits. In general, a project with smaller control benefits per dollar of total project value will have a higher proportion of debt financing. Managers have less to lose if the higher proportion of debt leads to tighter restrictions on their activities.
Fifth, when some of the projects are spun off, the optimal debt allocation is also affected by management's relative abilities across projects. Less well-managed firms are less able to support leverage.
Countering the Underinvestment Problem
The underinvestment problem arises when a firm has a highly leveraged capital structure. A firm with risky debt outstanding may have an incentive to forgo a capital investment project that would increase its total market value. If the business risk does not change, the firm's shareholders would have to share any increase in total market value with the firm's debtholders. The underinvestment problem involves a bias against low-risk projects. (See Emery, Finnerty, and Stowe, 2011, page 410.)
The Underinvestment Incentive
John and John (1991) have developed a model in which outstanding debt gives rise to an underinvestment incentive. They analyze how project financing arrangements can reduce this incentive, and they identify circumstances in which project financing is the optimal financing structure for a project. Their model builds on the prior work of Myers (1977), who argued that outstanding debt tends to distort a firm's capital investment choices. Risky (i.e., not free of default risk) debt can cause corporate managers to pass up positive-net-present-value projects in situations where the projects would operate to the benefit of debtholders but to the detriment of shareholders. For example, suppose that, without the project, the firm could not fully repay its debt under all possible scenarios. However, the project is sufficiently profitable that if the firm undertakes it, the debtholders are assured of being repaid in full. The debtholders would clearly benefit. But the firm's managers will only undertake the project if the firm's shareholders can expect to realize a positive net present value on their equity investment in the project—excluding whatever benefit the debtholders realize. Thus, a project might involve a positive net present value from the standpoint of the firm as a whole (i.e., debtholders and shareholders taken together) but a negative net present value from the narrower perspective of its shareholders. In that case, the firm's managers, who presumably operate the firm for the benefit of its shareholders, would decide not to invest in the project.
Passing up positive-net-present-value projects is not costless to the shareholders, however. Prospective lenders will demand a higher rate of return for their loans if they find the firm engaging in such behavior. The higher rate of return represents an agency cost. Agency costs arise out of the competing claims of shareholders and debtholders to corporate assets and cash flow. They occur because security holdings in large corporations are widely dispersed, and monitoring tends to be costly and therefore incomplete. For example, lenders can observe the firm's overall investment level but they generally do not have access to full information regarding specific capital investment projects. Project financing can alter that situation by enabling lenders to make their lending decisions on a project-by-project basis.
How Project Financing Can Counter This Bias
In John and John's model, each project can be financed separately. All debt is nonrecourse (although the conclusions would be equally valid if the debt were only limited-recourse). The economic interests of debtholders and shareholders become better aligned when financing is accomplished on a project basis. Debt is allocated between the project sponsor and the project entity in a value-maximizing manner. John and John compare project financing to straight debt financing entirely on the sponsor's balance sheet. Project financing increases value (1) by reducing agency costs (the underinvestment incentive is countered) and (2) by increasing the value of interest tax shields. Because more projects are financed, more debt is issued, and therefore more interest tax shields are created. Both factors enhance shareholder value.
Reallocating Free Cash Flow
In the traditional corporate form of organization, the board of directors determines how the free cash flow is allocated between distributions to investors and reinvestment. Free cash flow is what is left over after a company has paid all its costs of production, has paid its lenders, and has made any capital expenditures required to keep its production facilities in good working order. Generally, when a corporation decides to invest in a new project, cash flow from the existing portfolio of projects will fund the investment in the new one. Management has the option to roll over the existing portfolio's free cash flow into still newer ventures within the company later on—without necessarily exposing its decisions to the discipline of the capital market.6 This discretion gives corporate management considerable power in determining the direction of the corporation. Whether this discretion is misapplied has become an important issue in the debate over shareholder rights.7
Free Cash Flow and Project Financing
Project financing can give investors control over free cash flow from the project. Typically, all free cash flow is distributed to the project's equity investors. As noted, because a project financing is specific to a particular pool of assets, the entity created to own and operate it has a finite life. Moreover, the project financing documents that govern the terms of the equity investments in the project typically spell out in writing the project entity's “dividend policy” over the life of the project.
Why Project Financing Can Be Beneficial
Jensen (1986) developed the concept of the agency cost of free cash flow. Managers, when left to their own devices, may not be sufficiently demanding when comparing projects that can be financed internally with other projects that must be financed externally. Giving managers (or boards of directors, which are often dominated or controlled by the managers of the corporation) the discretion to reinvest free cash flow can result in a loss of shareholder value. Forcing the free cash flow to be dispersed exposes the managers of the corporation to the discipline of the capital market because investors control the uses to which the free cash flow will be put. Such a shift in control should enhance shareholder value.8
Project financing can be beneficial because direct ownership of assets places investors in control when the time comes to make reinvestment decisions. Giving investors control resolves potential conflicts of interest that can arise when management has discretion over reinvestment. With project financing, funding for the new project is negotiated with outside investors. As the project evolves, the capital is returned to the investors, who decide for themselves how to reinvest it.
Reducing Asymmetric Information and Signaling Costs
The form of security a firm chooses to issue when it decides to raise capital externally can have important signaling effects (Smith, 1986). Consider, for example, a decision to issue debt rather than equity. Debt requires fixed charges in the form of interest and principal payments. These payments are contractual obligations. In contrast, dividends are not contractual obligations. Issuing debt, rather than common stock, signals that the firm expects to generate sufficient cash flow to service the additional debt in a timely manner.
Shah and Thakor (1987) have argued that project financing reduces the signaling costs associated with raising capital under asymmetric information, particularly in the case of large-scale, high-risk projects. Asymmetric information occurs when managers have valuable information about a new project that they cannot communicate unambiguously to the capital market. When a company announces a new project and how it intends to finance it, the best investors can do is try to interpret what the announcement really signifies (e.g., whether the method of financing indicates how profitable the firm expects the project to be). If the information is technical and complex in nature, communicating it to the market would be costly. Processing this information would also be costly to prospective investors.9
There is a second potential barrier to communication. Valuable information about what makes an opportunity potentially profitable must be kept from competitors in order to maintain a competitive advantage. When managers have information that is not publicly available, raising funds for new investment opportunities may be difficult unless this information is revealed to the public.10
How Project Financing Can Solve the Communication Problem
Project financing provides a potential solution. Managers can reveal sufficient information about the project to a small group of investors and negotiate a fair price for the project entity's securities. In this way, the managers can obtain financing at a fair price without having to reveal proprietary information to the public. The danger of an information leak is small because the investors have a financial stake in maintaining confidentiality.
According to Shah and Thakor (1987), project financing is useful for projects that entail high informational asymmetry costs (e.g., large mineral exploration projects are often project financed). As Chen, Kensinger, and Martin (1989) note, Shah and Thakor's argument does not explain the use of project financing for low-risk projects that do not require the sponsor to hold back proprietary information.
Preserving Financial Flexibility
Chen, Kensinger, and Martin (1989) point out that corporate managers choose project financing for projects that entail low informational asymmetry costs (so-called transparent projects). By doing so, they preserve their flexibility to use internally generated funds to finance projects that are available to the firm but cannot be fully disclosed to the public without disclosing valuable proprietary information to competitors.11
Chen, Kensinger, and Martin's hypothesis is developed along the following lines. Suppose that a firm has (1) an opportunity to invest in a transparent project and (2) other investment opportunities about which management has important information that it is unwilling to make available to competitors or the general public. It would be advisable for the firm to reserve its internally generated cash flow to fund these opportunities (see Myers and Majluf, 1984). All forms of external financing are subject to informational asymmetry costs, which has led to the “pecking order” theory of capital structure choice (see Myers and Majluf, 1984). According to this theory, internally generated cash flow is preferable for financing information-sensitive projects. Internally generated cash flow is followed, in descending order of preference, by secured debt, unsecured debt, hybrid securities, and external common equity (least desirable).
The firm's internal cash flows, together with its unused borrowing capacity (as determined principally by the senior debt rating it would like to maintain), represent a limited financial resource. This resource can be used to take advantage of opportunities that would otherwise impose significant informational asymmetry costs. The firm can avoid incurring these costs by taking advantage of opportunities to sell transparent projects when it can obtain a fair price for the project securities. Choosing project financing in situations that entail low informational asymmetry costs thus preserves the firm's financial flexibility by conserving the firm's internal financing capacity to fund future projects that have potentially high informational asymmetry costs. The implication for the firm is: Sell projects that entail low informational asymmetry costs in order to preserve internal capital for those projects that have high informational asymmetry costs.
Why Project Financing Can Enhance Shareholder Value
The added financial flexibility that project financing affords enhances shareholder value by giving the firm the opportunity to pursue, in the near future, growth opportunities about which management will want to withhold proprietary information in order to maximize project value. Thus, firms with the most attractive information-sensitive investment projects will be most likely to utilize project financing for their transparent projects. Management's decision to resort to project financing can thus be interpreted as a positive signal regarding the attractiveness of the firm's proprietary investment projects.
More Efficient Structuring of Debt Contracts
The inherent conflicts of interest between shareholders and lenders give rise to a variety of agency costs (see Jensen and Meckling, 1976). Lenders deal with these agency costs by negotiating covenant structures that are contained in loan agreements. Covenants facilitate monitoring the borrower's financial performance. In addition, there are debt repayment provisions, such as sinking funds, that are designed to limit management's discretion to use cash flow that might otherwise be used to repay debt for other purposes.
Project financing can reduce these agency costs. A project has a finite life. Even the equity investors demand the distribution of free cash flow to the providers of capital. Management's discretion to reinvest cash flow net of operating expenses—to the possible detriment of outside equity investors as well as lenders—is thus restricted contractually. Lenders have the senior claim on cash flow net of operating expenses. It is therefore generally easier to design a debt contract for a specific project rather than for the entire firm. This factor protects lenders against the asset substitution problem.12 For example, debt covenants can be tailored to suit the project's expected profitability and cash flow. If the targets are not met, violation of the covenants will trigger some form of contract renegotiation. Also, the sinking fund can be contingent on project cash flow. If the project performs better than anticipated, lenders will be repaid sooner, rather than having the cash flow invested by management in other projects, possibly to their detriment.
More Effective Corporate Organization and Management Compensation
Project financing can enhance the effectiveness with which assets are managed. Schipper and Smith (1986) have explored the link between the ownership structure of the firm and firm value. They note the benefits that can result from giving managers a direct ownership stake in the firm. The purpose of such compensation programs is to align more closely the objectives of the firm's professional managers and its equity investors.
Project financing lends itself nicely to management incentive schemes. Management compensation can be tied directly to the performance of the project. Profit-sharing programs are but one example. When managers have a direct share in the profits of the project, they can be strongly motivated to make decisions that enhance its profitability.
Project Financing versus Direct Financing
Project financing should be compared to direct financing on the sponsor's general credit, when deciding how best to finance a project whose characteristics would make it suitable for project financing. Figure 2.1 compares direct financing by the sponsor and project financing, on the basis of several criteria. It is important to appreciate that just because project financing might be arranged does not mean that the project should be financed in this manner. The relative advantages and disadvantages of these alternative means of financing (discussed in the next sections) should be carefully weighed to determine which technique will be more advantageous to the project sponsor's shareholders.
| Criterion | Direct Financing | Project Financing |
| Organization |
 Large businesses are usually organized in corporate form. Cash flows from different assets and businesses are commingled. |
The project can be organized as a partnership or limited liability company to utilize more efficiently the tax benefits of ownership. Project-related assets and cash flows are segregated from the sponsor's other activities. |
| Control and monitoring |
Control is vested primarily in management. Board of directors monitors corporate performance on behalf of the shareholders. Limited direct monitoring is done by investors. |
Management remains in control but is subject to closer monitoring than in a typical corporation. Segregation of assets and cash flows facilitates greater accountability to investors. Contractual arrangements governing the debt and equity investments contain covenants and other provisions that facilitate monitoring. |
| Allocation of risk |
Creditors have full recourse to the project sponsor. Risks are diversified across the sponsor's portfolio of assets. Certain risks can be transferred to others by purchasing insurance, engaging in hedging activities, and so on. |
Creditors typically have limited recourse—and in some cases, no recourse—to the project sponsors. Creditors' financial exposure is project-specific, although supplemental credit support arrangements can at least partially offset this risk exposure. Contractual arrangements redistribute project-related risks. Project risks can be allocated among the parties who are best able to bear them. |
| Financial flexibility |
Financing can typically be arranged quickly. Internally generated funds can be used to finance other projects, bypassing the discipline of the capital market. |
Higher information, contracting, and transaction costs are involved. Financing arrangements are highly structured and very time-consuming. Internally generated cash flow can be reserved for proprietary projects. |
| Free cash flow |
Managers have broad discretion regarding the allocation of free cash flow between dividends and reinvestment. Cash flows are commingled and then allocated in accordance with corporate policy. |
Managers have limited discretion. By contract, free cash flow must be distributed to equity investors. |
| Agency costs |
Equity investors are exposed to the agency costs of free cash flow. Making management incentives project-specific is more difficult. Agency costs are greater than for project financing. |
The agency costs of free cash flow are reduced. Management incentives can be tied to project performance. Closer monitoring by investors is facilitated. The underinvestment problem can be mitigated. Agency costs are lower than for internal financing. |
| Structure of debt contracts |
Creditors look to the sponsor's entire asset portfolio for their debt service. Typically, debt is unsecured (when the borrower is a large corporation). |
Creditors look to a specific asset or pool of assets for their debt service. Typically, debt is secured. Debt contracts are tailored to the specific characteristics of the project. |
| Debt capacity |
Debt financing uses part of the sponsor's debt capacity. |
Credit support from other sources, such as purchasers of project output, can be channeled to support project borrowings. The sponsor's debt capacity can be effectively expanded. Higher leverage (which provides valuable interest tax shields) than the sponsor would feel comfortable with if it financed the project directly can be achieved. |
| Bankruptcy |
Costly and time-consuming financial distress can be avoided. Lenders have the benefit of the sponsor's entire asset portfolio. Difficulties in one key line of business could drain cash from “good” projects. |
The cost of resolving financial distress is lower. The project can be insulated from the sponsor's possible bankruptcy. Lenders' chances of recovering principal are more limited; the debt is generally not repayable from the proceeds of other unrelated projects. |
Advantages of Project Financing
Project financing should be pursued when it will achieve a lower after-tax risk-adjusted cost of capital than conventional financing. In an extreme case, the sponsors' credit may be so weak that it is unable to obtain sufficient funds to finance a project at a reasonable cost on its own. Project financing may then offer the only practical means available for financing the project.
Capturing an Economic Rent
A natural resource deposit has scarcity value when the content is in short supply (for example, a deposit of low-sulphur coal at a time of heightened demand because of tighter environmental regulation) or can be mined at a relatively low cost (for example, an ore body in which the ore is highly concentrated). The legal entity that controls such a natural resource deposit may be able to arrange long-term purchase contracts that are capable of supporting project financing and offer supernormal rates of return on investment. Economists refer to the portion of the total return that represents excess return as an economic rent. The project sponsors can monetize the economic rent by entering into long-term purchase contracts. These contracts, provided they are properly drafted, can be used to secure project borrowings to finance the development of the ore body. They will also generate the cash flow to service project debt and provide equity investors the return of and a return on their investment.
Achieving Economies of Scale
Two or more producers can benefit from joining together to build a single facility when there are economies of scale in production. For example, two aluminum producers might decide to build a single aluminum processing plant near a location where each has a large supply of bauxite. Or, the firms in a densely industrialized area might decide to cooperate in a single cogeneration facility, with each firm agreeing to buy steam to meet its own needs for heat and the group selling all the excess electricity to the local electric utility.
Risk Sharing
A joint venture permits the sponsors to share a project's risks. If a project's capital cost is large in relation to the sponsor's capitalization, a decision to undertake the project alone might jeopardize the sponsor's future. Similarly, a project may be too large for the host country to finance prudently from its treasury. To reduce its own risk exposure, the sponsor or host country can enlist one or more joint-venture partners.
Expanded Debt Capacity
Project financing enables a project sponsor to finance the project on someone else's credit. Often, that someone else is the purchaser(s) of the project's output. A project can raise funds on the basis of contractual commitments when (1) the purchasers enter into long-term contracts to buy the project output and (2) the contract provisions are tight enough to ensure adequate cash flow to the project, enabling it to service its debt fully under all reasonably foreseeable circumstances. If there are contingencies in which cash flow might be inadequate, supplemental credit support arrangements will be required to cover these contingencies. For example, the contract might provide for a variable product price, which could result in lower cash flow when the selling price falls. Nevertheless, the contractual purchase commitments form the foundation that supports the project financing.
The project company may be able to finance with significantly greater leverage than would be normal in the sponsor's capitalization. Data provided in Chapter 3 show that a broad range of projects have been financed with capitalizations consisting of 70 percent or more debt. However, the degree of leverage that a project can achieve depends on the strength of the security arrangements, the risks borne by creditworthy participants, the type of project, and its profitability.
Lower Overall Cost of Funds
If the output purchaser's credit standing is higher than that of the project sponsors, or if the project financing is more effective at resolving the agency problems inherent in financing a particular project, the project will be able to borrow funds more cheaply than the project sponsors could on their own. Also, to the extent the project entity can achieve a higher degree of leverage than the sponsors can comfortably maintain on their own, the project's cost of capital will benefit from the substitution of lower-cost debt for equity.
Release of Free Cash Flow
The project entity typically has a finite life. Its “dividend policy” is usually specified contractually at the time any outside equity financing is arranged. Cash flow not needed to cover operating expenses, pay debt service, or make capital improvements—so-called free cash flow—must normally be distributed to the project's equity investors. Thus, the equity investors, rather than professional managers, get to decide how the project's free cash flow will be reinvested.
When a project is financed on a company's general credit, the project's assets become part of the company's asset portfolio. Free cash flow from the project augments the company's internal cash resources. This free cash flow is retained or distributed to the company's shareholders at the discretion of the company's board of directors.
Project financing eliminates this element of discretion. Investors may prefer to have the project company distribute the free cash flow, allowing them to invest it as they choose. Reducing the risk that the free cash flow might be retained and invested without the project's equity investors' approval should reduce the cost of equity capital to the project.13
Note that the sponsor is not necessarily placed at a disadvantage under this arrangement. If the sponsor is considering additional projects that it believes are profitable, it can negotiate funding for these projects with outside equity investors. If they agree to fund any of these additional investments within the project entity, the dividend requirement can be waived by mutual agreement and the funds invested accordingly.
Reduced Cost of Resolving Financial Distress
The structure of a project's liabilities will normally be less complex than the structure of each sponsor's liabilities. A project entity's capital structure typically has just one class of debt, and the number of other potential claimants is likely to be small.
As a general rule, the time and cost required to resolve financial distress increase with the number of claimants and with the complexity of the debtor's capital structure. Over time, a corporation will tend to accumulate a large number of claims, including pension claims, which may be difficult to handle in the event of insolvency or debt default. An independent entity with one principal class of debt, particularly if the debt is held privately by a small number of sophisticated financial institutions, tends to emerge from financial distress more easily.
Project financing does, however, limit the lenders' opportunity for recovering principal in the event of financial distress. Loans directly to the sponsor would be backed by the sponsor's entire portfolio of assets; if one line of business failed, lenders could still be repaid using cash flow from the sponsor's other lines of business. In a project financing, the project assets are normally segregated from the sponsor's other assets. Access to those assets (and the related cash flows) is limited by the degree of recourse to the sponsor that is granted to lenders in the project loan agreement. On the other hand, segregating the project assets from the sponsor's other assets insulates lenders to a project from the risk that the sponsor might go bankrupt, provided that the sponsor's lenders do not have recourse to the project corporation.14
Reduced Legal or Regulatory Costs
Certain types of projects, such as cogeneration projects, involve legal or regulatory costs that an experienced project sponsor can bear more cheaply than an inexperienced operator can.15 For example, a chemical company or an oil company that undertakes a cogeneration project on its own would face significant costs because of an unfamiliar technology and legal and regulatory requirements. A general contracting firm that specializes in cogeneration projects understands the technology involved and is experienced in dealing with regulatory bodies (which must approve the terms on which the electric utility company purchases the cogeneration project's excess electricity). For this type of firm, a cogeneration project is a normal business undertaking to which it can apply the knowledge and experience it has gained in earlier cogeneration projects.
When managed expertly, project financing can lead to economies of scale for controlling legal and regulatory costs. The continued economic viability of the project might depend on continued cooperation with several outside organizations (such as the local utility that buys the electricity) over which the industrial firm has no direct control. At some point, it might be necessary to enforce one or more agreements, thereby incurring legal fees and running the risk of regulatory interference. Using an experienced developer who has successfully completed similar projects can also reduce operating costs. The project's independent status, coupled with the developer's willingness to make a long-term commitment to make the project profitable, can reduce the risks the industrial firm would face if it financed the cogeneration project internally.
A Questionable Advantage
Practitioners often argue that project financing is beneficial when it keeps project debt off each sponsor's balance sheet. It is important to recognize that financial risk does not disappear simply because project-related debt is not recorded on the face of the balance sheet. The accounting profession, in the United States at least, has tightened footnote disclosure requirements in recent years. In a reasonably efficient market—one in which investors and the rating agencies process all available financial information intelligently—the benefits of off-balance-sheet treatment are likely to prove illusory. The investors and the rating agencies in such a market environment can translate the footnote information into an assessment of the sponsor's credit-risk exposure related to the project financing. The rating agencies factor such assessments into their bond rating decisions, and investors can incorporate their assessments (and the debt rating) into the prices they are willing to pay for each sponsor's outstanding securities.
The appropriate accounting treatment for project debt and long-term purchase obligations is determined more by economic substance and less by form than it used to be. For example, until recently, if a project sponsor formed a special-purpose entity to build a power plant and the project company entered into a take-or-pay contract with a local utility that was designed to provide the main credit support for project debt, neither the take-or-pay obligation nor the project debt would have to be reported on the balance sheet of the sponsor or the utility if the project company had at least 3 percent equity. Under revised FASB Interpretation No. 46 (FIN 46(R)), “Consolidation of Variable Interest Entities,” originally published in December 2006 and amended by FASB Statement Nos. 166 and 167 in 2009, a purchaser of the project's output under a take-or-pay or similar contract that exposes the purchaser to the majority of the economic risks and rewards of the project may be required to consolidate the project entity (and thus its debt) on its balance sheet. Avoiding consolidation requires setting the equity percentage high enough that the equity investors (assuming they are different from the purchaser) have enough of the project's risks and rewards. Project sponsors may have to adjust the project capital structure (and tinker with its economics) to achieve the desired accounting treatment of project debt.
Disadvantages of Project Financing
Project financing will not necessarily lead to a lower after-tax risk-adjusted cost of capital in all circumstances. Project financings are costly to arrange, and these costs may outweigh the advantages enumerated earlier.
Complexity of Project Financings
Project financing is structured around a set of contracts that must be negotiated by all the parties to a project. They can be quite complex and therefore costly to arrange. They normally take more time to arrange than a conventional financing. Project financings typically also require a greater investment of management's time than a conventional financing.
Indirect Credit Support
For any particular (ultimate) obligor of the project's debt and any given degree of leverage in the capital structure, the cost of debt is typically higher in a project financing than in a comparable conventional financing because of the indirect nature of the credit support. The credit support for a project financing is provided through contractual commitments rather than through a direct promise to pay. Lenders to a project will naturally be concerned that the contractual commitments might somehow fail to provide an uninterrupted flow of debt service in some unforeseen contingency. As a result, they typically require a yield premium to compensate for this risk. This premium is generally between 50 and 100 basis points, depending on the type of purchase contract negotiated. The hell-or-high-water contract, described in Chapter 7, provides the greatest degree of credit support and therefore requires a yield premium that is at the low end of this range.
Higher Transaction Costs
Because of their greater complexity, project financings involve higher transaction costs than comparable conventional financings. These higher transaction costs reflect the legal expense involved in designing the project structure, researching and dealing with project-related tax and legal issues, and preparing the necessary project ownership, loan documentation, and other contracts.
Conclusion
Project financing represents an alternative to conventional direct financing. Choosing project financing over direct financing involves choosing an alternative organizational form that is different from the traditional corporation in two fundamental respects: (1) the project financing entity has a finite life, and (2) the cash flows from the project are paid directly to the project investors, rather than reinvested by the sponsor. Project financing can:
Reduce the agency costs of free cash flow by giving investors the right to control reinvestment of the project's free cash flow. Mitigate the underinvestment problem that arises when firms have risky debt outstanding. Enhance a company's financial flexibility by giving it the ability to husband internally generated cash flow for investment in projects that involve proprietary information that it does not wish to disclose to investors at large. Facilitate the design of less costly debt contracts, which can be tailored to the cash flow characteristics of the project.Because of the higher transaction costs and the yield premium that is required, when both financing alternatives are available, project financing will usually be more cost-effective than conventional direct financing when (1) project financing permits a higher degree of leverage than the sponsors could achieve on their own and (2) the increase in leverage produces tax shield benefits sufficient to offset the higher cost of debt funds, resulting in a lower overall after-tax risk-adjusted cost of capital for the project.