In an ever changing and evolving world infrastructure has become more critical than ever before. Apart from the traditional port, transport (rail, pipe and road), civil and mechanical infrastructure sets that has been in existence for many years, society has adopted a transformed approach to development, implementation and management of these assets.
Table of Contents
1 Infrastructure and Projects
Infrastructure project finance, a trained engineer or developer would spot a critical piece of infrastructure around every corner. A well-versed banker would spot an infrastructure funding opportunity in every article on his/her news feed. For laypeople, however, identifying with these critical pieces of “kit” or “assets” or “the things that help us all” are not always as easy.
Think about the following questions:
Where does my fibre come from;
Where is the cloud that hosts my data;
Why do I have a cellphone signal wherever I go;
What produces my biodiesel;
How do wind, water and the sun to power my hybrid;
Who owns my children’s school/university?
The answers to the above can always, in some way or form, be related to infrastructure. To ensure that we have enough of “the things that help us all”, the world has adopted a specific way of developing them – through planning and implementing Projects.
A Project can be defined as “an individual or collaborative enterprise that is carefully planned to achieve a particular aim”.
In its simplest form, the development and implementation of an infrastructure set relate directly back to the definition of a Project: People, Organisations and Regulatory Bodies (such as Governments) collaborate to plan and implement a project to achieve a specific outcome; establishing the piece of infrastructure.
Not only has our society adopted a specific way to ensure the rollout of critical infrastructure, but we also have a unique way of funding these. It’s called Project Finance.
Project Finance focuses on individual Projects. It is differentiated from traditional Corporate Finance in the sense that it aims to fund the Project, instead of a business, in a way that suits the risks and circumstances that accompany a Project.
2 Infrastructure Project Finance Elements
Project Finance follows a specific set of underlying rules or “elements” which needs to be put in place for it to work or effectively. This piece aims to educate the reader on these elements and to better understand and apply this on future projects.
2.1 SPV’s and Ring Fencing
Infrastructure Project Finance is predominantly ring-fenced in a separate legal entity, commonly referred to as a Special Purpose Vehicle (SPV), established for the implementation of the Project.
This enables separation between the Project (its finance) and external variables which may affect it further down the line. In other words – Project Finance is raised and intended for a specific Project, and ring-fencing it ensures specific allocation and usage of funds for implementation of the Project only.
2.2 Project Participants
These parties consist of a mix of the following players, all of which end up having vested interests (through the way of shareholding or contract holding) in the Project:
2.2.1 Infrastructure Project Finance: Sponsors
Individuals, organisations or a combination of the two that originate and drive Project Development. The Sponsors often start the process of development for a Project and is mainly the “jockeys” backed to make a success of it.
2.2.2 Implementation Contractors
Consists of a combination of Engineers, Built Environment Professionals, EPC and/or Construction Contractors. These parties are engaged throughout the development process of the Project to identify capital expenditure and implementation costs. All contractors are tied in based on contracts that are developed to incorporate the various areas of implementation and construction. These contracts can often be a deal killer in the Project Finance world, as detail as to what funder requirements are may be overlooked.
2.2.3 Equipment Suppliers
Equipment suppliers also play a big role during the development and “construction” phases of a Project. They contribute their equipment in exchange for an economic benefit which adds up the capital expenditure of the Project. Solid contracts, which fall in line with funder requirements, should always be put into place for the supply of equipment, with specific attention given to items such as lead times on orders placed, bonds and guarantees required and possibilities of the vendor.
2.2.4 O&M Contractors
These contractors usually start delivering their services once the construction or implementation of a Project has been finalised. They participate in ensuring the operations of the Project is performed and may include services such as maintenance, the supply of operational capability and resources, logistical management and maintenance etc. Again, funders usually focus on the contracts for these guys to evaluate the overall bankability of the Project.
2.2.5 Infrastructure Project Finance: Others
Although the main players in a Project Finance environment have been listed above, often SPV’s incurs expenses on the services of various consultants for successful development. These may include environmental-, legal-, financial- and other advisors, insurance brokers and companies, logistical partners, clearing agents etc. These are the essential service delivery agents required to stitch together the main elements required for Project Finance to succeed.
Stability and security of supply contribute to the effectiveness of a Project and obtaining supply at the right price and terms will almost certainly boost the Project’s bottom line. Supply can take various forms: It can be the fuel which is stored and transported through a tank farm, grain which takes up capacity in a silo, electricity and fibre optic connectivity to a data centre or water, yeast, grain and hops into a brewery.
As supply is a key element in the optimal functioning of a Project, financiers place a huge emphasis on the terms, practicalities and circumstances surrounding supply (in the form of supply agreements) into the Project. Supply is a key element, not only for the implementation and operation of a successful project but also to obtain Project Finance.
Any business functions on revenue generated. In a Project environment, revenue is derived from an off-taker. This can take the form of a tenant paying to utilise office space, a client paying to transport gas through a pipeline, or even a farmer that leases hydroponic planting space. Without an off-take/rs no revenue will be derived. Thus, without an offtake/rs, required returns, expected for funding provided, will not see the light of day.
Project Finance generally leverages on off-take (viewed in conjunction with the free cash flow generation capability that originates from it) as a pillar for serviceability of required returns. It is often the starting point of any evaluation for a Project, by a Project Financier, and the terms surrounding the off-take (and thus flow of cash) often drives the investment decision.
Any legitimate business is governed by legislation, rules and regulation. Whether it is enforced by the government, local or international agencies, -associations or other third parties, laws and regulation has a significant impact on the operations of a business. A Project is not different. Compliance with laws and regulation is a must for optimal functioning of any Project. Even more so, with Infrastructure Projects, compliance with environmental laws and regulations has nowadays become very topical.
Infrastructure often has an impact on the environment. Generally, governments and international associations have specific rules and regulations in place to help protect the environment, which is enforced continuously. In most instances, authorisation is required from specific bodies to implement infrastructure projects in specific areas. For this, Project owners or Sponsors, need to do Environmental Impact Assessments before the implementation of their projects, to satisfy the relevant bodies that their Projects will not detrimentally affect the Environment.
Furthermore, other laws and legislation may have a significant impact on Projects. Think anti-money laundering legislation, anti-competitive behaviour prohibitive legislation, tax legislation, trade legislation, stock exchange legislation, banking and credit regulatory legislation etc.
Very often Project Financiers commit to comply to relevant pieces of legislation, and if not done, may be at risk of fines, penalties and possible retraction of committed funds from underlying investors. Compliance with relevant laws and legislation is thus a crucial element in the successful implementation of Projects and raising of Project Finance.
Any business needs to be covered in the event of things going wrong. This principle applies throughout in a Project Finance environment. Essential mitigation against risks that can’t be hedged on a natural or operational basis can in most circumstances only be implemented through insuring against losses that arise from circumstances that are out of the control of Project owners. Similarly, Project Financiers often require security or insurance for the investments made into Projects. This protects them against unforeseen circumstances that may lead to the required returns on investment not being realised.
These types of loss inhibitors or protection can take various forms, depending on the nature of the Project. Physical security put down usually takes the front stage in a Project Financier’s books (as with any other funder). Thus, if you put up your assets owned (physical and non-physical) as security against non-settlement of required returns, your Project is more de-risked in a Project Funders eyes.
The aim of Project Finance, however, is to see whether the risks related to a Project, can’t be successfully mitigated through the use of alternative forms of security. Normal insurance practices often play a big role in contributing to mitigation – i.e. insurance against theft, bad debts etc. In more complicated circumstances, insurance for cross border transactions (export credit insurance), the cession of income and off-take agreements, performance and operational guarantees and hedges can be put into place to bring investment associated risks down to an acceptable level. These kinds of services and instruments usually require the need for inputs from specialised service providers that understand the intricacies that revolve around them.
An array of funders exist in the Project Finance world. Normally, Project Finance consists of a combination of efforts from these funders. In general, debt and equity funders join forces to make Project Finance dynamics work. This means that one would usually encounter two different main kinds of funders in a Project Finance environment: equity funders, who buy a stake in the shares of the Project (usually through acquiring an equity stake, or share in the SPV); and debt funders, who borrow funds into the Project and its operations in exchange for repayments.
2.7.1 Debt vs Equity Funders
The main difference between these two is that equity funders take on more risk. This is because they stand behind debt providers when it comes to waiting in line for required returns. I.e. – debt providers borrow funds into the Project (usually through the SPV), have specific rates of return (interest rates and cost of debt) and usually link these returns to specific events or timelines. They get preference above any other creditors of a Project and very often take up all security available from the Project.
Equity providers, on the other hand, invest in the share capital of the Project (or SPV) and share in the profits that the Project generates. Their returns are less guaranteed than that of debt providers, but often, if a Project works, more lucrative. The simple economic principle of risk and return is often clear when these two kinds of funders, the risk they take and the returns achieved are weighed up against each other.
Different funding instruments are used by these funders to structure and implement Project Finance, and very often these instruments are the tools that the funders utilise to make Project Finance fit specific Projects. Items like preference shares ratchets and mezzanine/hybrid instruments can affect the returns generated by Project Financiers and thus Project Finance dynamics are often very different for different Projects. This is performed to mitigate investment risks specifically for each Project and to effectively fund Projects of different kinds.
The key elements described above are generally the things to look out for when developing a Project to apply for Project Finance. A lot more can be said around each of these elements, and the effects and impact that these have on specific Projects would most probably differ between Projects. But, Project owners/sponsors who follow a strict approach of “satisfying” each of these elements would always stand a good chance of raising Project Finance for their Projects, should the Project make sense.