Wednesday 2 February 2022

What is project financing?

With the development of the project method of doing business all over the world, there was a need to introduce a fundamentally new mechanism for raising funds, which allows you to carry out work without the presence of any cash collateral property. Next, we will consider what project financing is, and how it differs from other types of raising money in the public and corporate sector.

The concept of project financing

Project financing is a way of raising funds to ensure a long-term investment project. It is also called an investment loan. The peculiarity of the method is that the money is issued not under a state or corporate guarantee and not on the security of property, but under the cash flow that the project will generate after its completion. From the point of view of traditional lending, a current loan looks low-income and risky.Project financing is displayed against the background of documentation.

Not everyone can get state guarantees, and obtaining collateral for cash assets can be complicated by their high degree of wear and tear and, accordingly, low cost. In an investment loan, the main guarantees for lenders can be a license, development and use of especially valuable assets, the right to use, and the production of products.

In the world, the practice of investment lending is already quite developed, however, for USA it is still unusual. To lend funds to a promising, but risky startup, most banking organizations will not risk. However, when a team of well-known professionals is formed, and the initiative itself promises a good profit, the chances of getting the necessary capital increase significantly.

In the form of financing instruments for an investment loan, share capital (direct investments), letters of credit, bank loans, leasing, and sometimes commodity loans can act. Projects with potential high profitability are in demand, such as the construction of housing, industrial and commercial facilities, the establishment of the production of a new type of product in demand on the market, re-profiling or modernization of the enterprise.

In order to obtain this kind of financing for the implementation of the idea, a project company is necessarily created in the form of a separate legal entity. Money is allocated for the implementation of certain goals, cost items are clearly defined, and the borrower cannot change them at will. If in corporate financing all the risks fall on the organizing company, then with an investment loan the risks are divided between the initiator, the creditor bank and the borrower.

In USA, it is very rare to allocate the full amount for the entire initiative, most often bankers require that the borrower invest part of his own funds, usually in the amount of 25-40% of the total.
At the same time, the initial work (FEED, feasibility study, project documentation) is paid by the initiator of the plan, and the credit day is connected at the construction stage. After the end of the investment phase, the newly created assets are pledged to the bank under the received loan.

To reduce the likelihood of losses with such risky lending, banks conduct a detailed examination, draw up business plans, feasibility studies, financial models, marketing research. This forces all parties to delve deeper into the specifics of the business, to understand the processes that occur in it. If we are talking about construction "from scratch" or modernization of an existing facility, then attention is drawn to the presence in the property or on the terms of a long-term lease of a land plot. In addition, the organization that will carry out construction and installation work is of great importance.Financial Analysis

There are two main forms of disbursement of funds in this type of initiative support:

  • Co-financing. With it, all lenders are united in a single pool (syndicate, consortium), and a single loan agreement is concluded with the borrower.
  • Parallel independent financing. In this case, each banking organization provides money for its subproject (part of the general undertaking), concluding a separate loan agreement with the borrower.

An investment loan is sometimes referred to as "recourse financing," that is, with a demand for repayment of the loan. There are three main forms of allocation of funds:

  1. With complete regression. Money is allocated in the presence of some guarantees, the risks are assumed by the borrower, so the cost of such a loan is quite low, and the funds are issued quickly. Most often, this form is used to issue export credits, as well as to ensure the construction of unprofitable or low-profit facilities of social importance.
  2. No right of recourse. This is a more dangerous scheme for the bank, there are no guarantees from the borrower, the financial institution assumes all the risks. Accordingly, the price of such money is high. This type of security is used quite rarely and only in relation to projects aimed at manufacturing competitive products using the most modern technologies with the possibility of a quick refund. There should also be contracts with suppliers of resources and markets for products.
  3. With a limited right of recourse. In this case, the risks are distributed among the participants. The borrower is responsible for the construction, and the bank is responsible for the operation of the facility. All parties are interested in the success of the undertaking and its profitability, so such projects are often promoted very actively.
  4. Unlike conventional lending, before making a decision on investment lending, the period of consideration of the submitted application is longer and can range from several months to one and a half years.
  5. Specifics of working with an investment loan
  6. Project financing is based on certain principles applicable to all such cases. The specificity is due to the high degree of risks for the parties, so much attention is paid not only to the recipient firm, but also to the idea proposed for implementation.

The project is separated from the main activity of the company, a legal entity is created through which all payments are made. This has its advantages and is necessary for a number of reasons:

The activity of introducing the idea begins "with a clean face". Bringing all manipulations into a separate structure avoids problems that may be associated with the activities of the main company in the past, for example, with inspections of fiscal services for previous periods, invalidation of individual contracts or lawsuits in other areas.

The project becomes more open and transparent. The conduct of all payments and the planning of financial flows are well tracked, there is no overlap with other financial flows of the firm. Transparency increases the estimated value of the idea and promotes trust between numerous partners.
All possible risks are carefully investigated and measures are taken to minimize them in order to attract an investor. This work is carried out at the pre-investment stage. After considering the potential hazards, each party assumes a portion of the risks that it is able to manage as effectively as possible, as well as control them. For example, risks can be distributed as follows:

  • political to give to the involved state body;
  • technological to entrust to equipment suppliers;
  • market transfer to buyers of products and their partners through the mechanism of specialized contracts.

Participants in the undertaking give each other functional guarantees in the form of "comfort letters" or by concluding a memorandum of understanding, preliminary contracts with buyers. The ideal option is to obtain state guarantees on preferential taxation or special conditions for a certain period, this is possible with the social significance of the initiative being implemented.

Financial models used in investment credit are very important for the stability of the implementation of the idea. Modeling is carried out by creating structured proforma reporting, which are integrated into the calculations of the balance sheet state of the project, its cash flows and expected profit. International generally accepted financial reporting standards are a good help for this.

The construction of the financial model is made on the basis of assumptions regarding the key factors affecting the business produced during planning. For this purpose, specialists should carefully study the features of entrepreneurial processes in the right area and the relationship with key factors. The more accurately the expected activity of the object is modeled, there will be more reliable estimates of its cash flow, which is the basis of the loan.

High-quality management of the implemented initiative directly depends on the professionalism of their own or invited managers, their readiness and ability to properly organize communications between partners and participants in the undertaking, to coordinate their actions. Management should qualitatively adjust the issues of marketing, finance, logistics, information exchange.

It is often practiced to involve an experienced financial adviser who can provide support in the analytical, legal and information support of the idea. Most often, help is required in solving such problems:

  • selection of the best project structure;
  • preparation of a business plan, information and investment memorandums;
  • organization of the necessary examinations (technological and engineering);
  • search for investors and shareholders, organization of negotiations with them;
  • measures to reduce costs and maximize the expected price of the object;
  • development of ways of interaction between organizers and creditors, solving current monetary and legal issues;
  • regular preparation of progress reports;
  • Assistance in the development of control, management accounting and personnel management.

Project financing involves the allocation of funds for a long period, which is unusual for USA, where "short money" is more often used. Rarely, the implementation of a large-scale initiative fits into 2-3 years, as a rule, the invested money will begin to return to the lender in 5-10 years. In this period, a year and a half is occupied only by preparatory work, economic calculations and preparation of a plan.

All these activities require considerable investments, which can be 10% of the total cost and even more, and they fall on the initiator of the idea. At the same time, investors do not always take into account these costs when drawing up an agreement and demand to invest 25-30% of their money in the undertaking to confirm the seriousness of intentions.

Roles of participants in the process

As noted above, unlike in the case of obtaining a traditional loan, an investment loan is possible only with the involvement of a wide range of participants who distribute risks. These include such organizations.

  1. Financial institutions that allocate funds. Usually, large banking organizations that have the ability to allocate money or other assets with a deferred repayment period are ready for project loans. Banks are trying to minimize the dangers of losses by allocating funds not once, but in separate tranches according to the approved schedule. If something goes wrong, you can stop securing the project, avoiding large losses. There is also the possibility to introduce into the project your controller, who has the right to stop risky transactions.
  2. Initiator. He is required to have management experience in the relevant field, since his area of responsibility is the operational part and sales performance indicators (KPIs). A good name and authority among the buyers of products is desirable. It is easier to get a loan to already well-known companies that have decided to expand their business. To them, the requirements of bankers are more loyal than to individual clients who want to just start their own business.
  3. Landowner. It is often the practice when the owner of a land plot transfers it to a landless initiator for management, receiving a share in the project in return. The cost of the plot directly depends on the location, the availability of roads and railways, the availability of energy carriers, the availability of a building permit.
  4. Technical customer. Such specialized organizations are involved by banks in cases where it is required to perform complex construction work, to which standard options are not applicable.

The technical customer carries out the whole complex of works:

  • engineering (surveys, approvals, design);
  • supply of materials and equipment;
  • construction (selection of a contractor, smr, commissioning).
  • The risks of the technical customer are the implementation of work on schedule and the fulfillment of the budget. Overspending (price increases by subcontractors, unaccounted for work) he pays from his own pocket.

Investor. As a rule, banks do not cover all the needs of the initiators, so an investor is required who will fully or partially close all monetary issues for a share in the starting business. Investors are usually individuals who do not expect to actively participate in the development of production later. Their interests are most often limited to the desire to profitably resell their share to large players in the market after increasing its value or to receive dividends (passive income) from the use of the object for its intended purpose. If it comes to the extraction of natural resources, it is possible to use such a mechanism as an agreement on the division of extracted products.

Advantages and risks of investment lending

Project financing makes it possible to implement a new initiative without being tied to the previous long-term activities of the company or organization. At the same time, unlike many other undertakings, with such support, the applied management system is of great importance, which automatically makes the project much more qualitative and predictable.

In many business plans, marketing and financial justification is put in the first place, pushing to the background the issues of selection and training of personnel, establishing a system of interaction, information and organizational support. When considering an application for an investment loan, all sides of the issue without exception are carefully studied in order to avoid losses, which will have nothing to cover.

The main risks in project financing are as follows:

  • a change in the political situation that could affect the key parameters of the plan;
  • legal issues, in particular, obtaining the necessary permits and licenses;
  • errors in economic calculations regarding the level of demand for products and their profitability, which will not allow to cover all costs;
  • rising commodity prices;
  • failure to meet the deadlines for the construction and commissioning of the facility;
  • significant excess of the approved estimates.

USA conditions are not yet able to reliably protect business from external non-economic influence, so banking institutions are very reluctant to give long-term loans without reliable confirmation of highly liquid collateral or state guarantees.


No comments:

Post a Comment