Nonrecourse project finance is an arrangement under which investors and creditors financing the project do not have any direct recourse to the sponsors, as might traditionally be expected (for example, through loan guarantees)
Before it can attract financing, then, the project must be carefully structured and provide comfort to its financiers that it is economically, technically, and environmentally feasible, and that it is capable of servicing debt and generating financial returns commensurate with its risk profile.
This frequently takes the form of a precompletion guarantee during a project’s construction period, or other assurances of some form of support for the project. Creditors and investors, however, still look to the success of the project as their primary source of repayment. In most developing market projects and in other projects with significant construction risk, project finance is generally of the limited-recourse type.
Difference from corporate lending. Traditional finance is corporate finance, where the primary source of repayment for investors and my site creditors is the sponsoring company, backed by its entire balance sheet, not the project alone. Although creditors will usually still seek to assure themselves of the economic viability of the project being financed, so that it is not a drain on the corporate sponsor’s existing pool of assets, an important influence on their credit decision is the overall strength of the sponsor’s balance sheet, as well as their business reputation. Depending on this strength, creditors will still retain a significant level of comfort in being repaid even if the individual project fails. In corporate finance, if a project fails its lenders do not necessarily suffer, as long as the company owning the project remains financially viable. In project finance, if the project fails investors and creditors can expect significant losses.
Project finance benefits primarily sectors or industries in which projects can be structured as a separate entity, apart from their sponsors. A case in point would be a stand-alone production plant, which can be assessed in accounting and financial terms separately from the sponsor’s other activities. Generally, such projects tend to be relatively large because of the time and other transaction costs involved in structuring and to include considerable capital equipment that needs long-term financing. In the financial sector, by contrast, the large volume of finance that flows directly to developing countries’ financial institutions has continued to be of the corporate lending kind.
Traditionally, in developing countries at least, project finance techniques have shown up mainly in the mining and oil and gas sectors. Projects there depend on large-scale foreign currency financing and are particularly suited to project finance because their output has a global market and is priced in hard currency. Since market risk greatly affects the potential outcome of most projects, project finance tends to be more applicable in industries where the revenue streams can be defined and fairly easily secured. In recent years, private sector infrastructure projects under long-term government concession agreements with power purchase agreements (PPAs) that assure a purchaser for the project’s output have been able to attract major project finance flows. Regulatory reform and a growing body of project finance experience continue to expand the situations in which project finance structuring makes sense, for example, as in the case of merchant power plants, which have no PPA but sell into a national power grid at prevailing market prices.
Although creditors’ security will include the assets being financed, lenders rely on the operating cash flow generated from those assets for repayment
In IFC’s experience, project finance is applicable over a fairly broad range of nonfinancial sectors, including manufacturing and service projects such as privately financed hospitals (wherever projects can stand on their own and where the risks can be clearly identified up front). Although the risk-sharing attributes of a project finance arrangement make it particularly suitable for large projects requiring hundreds of millions of dollars in financing, IFC’s experience-including textile, shrimp farming, and hotel projects- also shows that the approach can be employed successfully in smaller projects in a variety of industries. Indeed, that experience suggests project finance could help attract private funding to a wider range of activities in many developing markets.