Preface

Project finance has intrigued me ever since I was introduced to it as an associate at Morgan Stanley & Co. My experience in project finance, both as an investment banker and as a professor of finance at Fordham University, has firmly convinced me of its usefulness, especially in enabling the emerging economies to unlock the value of their natural resources and build the infrastructure they need to move forward.

Project financing is a well-established technique for large capital intensive projects. Its origins can be traced to the thirteenth century when the English Crown negotiated a loan from the Frescobaldi, one of the leading merchant bankers of the period, to develop the Devon silver mines. They crafted a loan arrangement much like what we would call a production payment loan today.

A great variety of investments have since been project financed, including pipelines, refineries, electric power generating facilities, hydroelectric projects, dock facilities, mines, mineral processing facilities, toll roads, and many others. Indeed project finance experienced a resurgence in the 1980s when it was used frequently to finance cogeneration and other forms of power production. It grew in the 1990s as a means of financing projects designed to help meet the enormous infrastructure needs that exist in the developed countries and especially in the emerging markets.

I wrote the first edition of this book with both practitioners and students of finance in mind. For practitioners, project financing can provide a cost-effective means of raising funds. Sponsors should carefully consider using it whenever a project is capable of standing on its own as a separate economic entity. In this book, I describe the types of capital investments for which project financing is suitable and explain how to engineer the financing arrangements that support it. Because of project financing's enormous practical value, students of finance would be wise to learn about it so they can include it in their financing skill set.

The audience for this book includes:

Financial managers who are responsible for arranging financing for their companies' projects.

Government officials who are wondering how to finance their wish lists of infrastructure projects.

Investment bankers and commercial bankers who assist companies in raising funds for large capital intensive projects.

Accountants, consultants, lawyers, and other professionals who work in the corporate finance area and wish to keep up-to-date.

Investors who are considering committing funds to limited-purpose companies or to mutual funds that have been set up to invest in infrastructure projects in the emerging markets.

MBA students and executive MBA students studying corporate finance.

Students of finance who wish to be fully knowledgeable concerning the techniques modern financiers are using to finance large-scale projects.

The first two chapters describe project financing and the circumstances in which it is most likely to be advantageous. Project financing involves financing projects on a stand-alone basis, so particular attention must be paid to who bears the risks and who reaps the rewards. Chapter 3 discusses what is special about large projects, and Chapter 4 describes the role that financial institutions play in getting large projects financed. Chapter 5 explains how to identify the various risks associated with a project. Chapter 6, which is new in this edition, discusses socially responsible project financing, and in particular, its application to renewable energy projects. Chapter 7 describes how to craft contractual arrangements to allocate project risks and the project's economic rewards among the interested parties. Chapter 8 discusses the legal, tax, and other issues that must be considered when selecting the legal structure for a project.

Chapters 9 through 12 deal with financial issues: preparing a financing plan, performing discounted cash flow analysis, using the techniques of discounted cash flow analysis to evaluate a project's profitability, and using real-options analysis to evaluate large projects. Chapter 12 provides analytical tools that are increasingly useful in capital budgeting. Chapter 13 describes the sources of the funds to invest in a project. Chapter 14 explains how to manage project risks and describes a variety of derivative instruments that are useful for managing interest rate, commodity price, exchange rate, and credit risks. Chapter 15, which is new in this edition, discusses Sharia-compliant project financing, which is an increasingly important application that holds great promise. The chapter explains how to design the project financing arrangements to comply with Islamic law. Chapter 16 reviews the issues a host government faces when private entities will finance the project. This material is particularly relevant to infrastructure projects in emerging markets because the capital requirements are often well beyond the capacity of the local government to meet them on its own.

Chapters 17 through 20 contain case studies that illustrate how the concepts discussed in the earlier chapters have been put into practice in four prominent projects. These examples richly illustrate the application of the concepts developed in the previous chapters. Finally, Chapter 21 provides some concluding thoughts on the direction in which project financing seems to be headed.

The two new chapters in this edition, Chapters 6 and 15, bear special mention. Renewable energy generates about 19 percent of the world's electricity. Its importance is increasing as world concern grows over the potentially high environmental cost of mining fossil fuels. As a result of the potential harm that can result from the misuse of project financing and also in recognition of the value of project finance as a mechanism for promoting responsible international economic development, the international project lending community has developed standards designed to ensure that projects are carried out in an environmentally and socially responsible manner. Chapter 6 describes the IFC Performance Standards and the Equator Principles, which are designed to promote only those projects that commit to follow acceptable environmental and social risk management practices. The chapter illustrates their application to a renewable energy project in Chile.

Muslims, or followers of Islam, comprise more than one quarter of the world's population, and Muslim countries produce more than 10 percent of the world's gross domestic product. Moreover, Islamic finance is especially well-suited to project financing because it is structured around physical assets. Chapter 15 explains how the basic Sharia principles affect Islamic financing transactions and financial instruments, describes the main Sharia-compliant debt and equity transaction structures, and discusses the application of Sharia-compliant Islamic financing to project finance. The chapter explains how Sharia-compliant financing can be tailored to finance large projects in Islamic regions of the world where this form of financing must conform to strict religious principles. Project finance engineers need to be aware of the special conventions and restrictions that apply in Islamic finance in order to be in a position to tap this source of funding for their projects because Islamic project finance will play an increasingly important role in furthering the economic development of these countries.

John D. Finnerty

New York, New York

March 2013