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von Holger Langer, LL.M.

Project Finance

A. Definition of project finance

  • “project finance” is generally used to refer to a non-recourse or limited recourse financing structure for the construction and operation of a particular facility, in which lenders rely on the assets of the facility, including any revenue-producing contracts and other cash flow generated by the facility, rather than the general assets and credit of the sponsors or the borrower, as collateral for the debt
  • covers a wider range of financing structures, which have in common that they rely in the first place on the performance of the project (and the revenues generated by it) rather than the physical assets of the borrower
  • as a result the lenders concern will primarily involve the technical feasibility and economic viability of the prospective project
  • no strict definition of project finance, but will usually involve the following elements
    • some element of reliance on project assets and cash flows without full recourse to the sponsors or, as the case may be, the borrower
    • technical and economic evaluations of the project and the customer’s business, on-going monitoring by the lender
    • lengthy and complex loan documentation
    • higher margins and fees to reflect the lender’s exposure to the project risks

I. Non-recourse project finance

  • relying completely on the merits of a project (project assets and underlying cashflow from the revenue-producing project contracts)
  • independent of the non-project assets of the project sponsor
  • sponsor has no direct legal obligation to repay the project debt or make interest payments if the project cash flows prove inadequate to service debt
  • would result in no potential liability of the project sponsor for the debts or liabilities of the project, and is therefore rarely used in practice

II. Limited-recourse project finance

  • limited obligations and responsibilities of the project sponsor
  • the extent of the necessary recourse is depending on the unique risks that are involved in each individual project
  • often mixture, e.g. a limited recourse to the sponsor’s assets for substantial risks during the construction phase of the project until the risk subsides (e.g. minimum performance tests) or construction is complete and, thereafter, loan would be non-recourse

B. Contrast with other financing types

I. Balance sheet finance

  • Structure
    • retained earnings or short-term debt to develop and construct the project
    • upon completion, long-term debt, equity sales or other corporate finance techniques to obtain the needed funds for the permanent financing of the project
  • focus of the credit decision is not the stand alone project, but the entire company of the borrower, including the cash flow and assets and the effect of the new project on the company’s continued viability
  • relevant criteria for decision
    • access to the needed capital at reasonable costs
    • acceptable return on investment under the project feasibility study
    • satisfactory project risks

II. Asset-based finance

  • founded on the value of the assets financed
  • in the context of projects, the hard assets would probably not produce sufficient cash in a foreclosure sale to justify the value of an asset-based loan

C. Advantages of project finance to the sponsor

I. Elimination of, or limitation on, recourse to the sponsor

  • non-recourse project financing provides financial independence to other projects owned by the sponsor
  • protects the sponsor’s general assets from difficulties in a particular project

II. Avoidance of restrictive covenants in other arrangements that would preclude project development

  • structure permits to avoid e.g. cross-default, since the project financed is separate and distinct from other operations and would not be influenced by other defaults (as long as this default does not occur on the parent company level)

III. Favourable financing terms

  • project finance may permit for arrangement of attractive debt financing which is available to the project (depending on the risk profile and the prospective profitability), but which is unavailable to the project sponsor as a direct loan (because of its financial condition)
    • more attractive interest rates
    • more attractive credit enhancement

IV. Political risk diversification

  • the separation of the project finance from other projects in a non-recourse structure with the establishment of project-specific entities serves the diversification of political risks
    • the economic effect of a political risk in one country does not affect other projects of the same sponsor in other countries

V. Risk sharing

  • project finance structure permits the sponsor to spread risks over all project participants, including the lender
  • can improve the possibility of a project success since each participant accepts risks and is interested economically in the project success
  • however, the allocation of risks to other participants will invariably increase the costs for the sponsor, but will be accepted as a necessary element of non-recourse or limited-recourse project financing

VI. Limiting collateral to the project assets

  • non-recourse project finance loans are generally based on the premise that the only collateral that the project must pledge to the lenders as security for the loan is the project assets

VII. Facilitation of workouts

  • in the case of financial difficulties of the borrower, there is usually little that the lenders can do apart from a workout
  • since in a non-recourse finance the loan is primarily secured by the future revenues, the lenders have a stronger interest in a project success, since the debt can only be repaid if the operation of the project generates some revenues
    • the project assets alone are of little value and have value only with the project contracts
    • the project contracts have value only if the facility operates

VIII. Matching of specific assets with specific liabilities

  • project finance allows to match specific assets with specific liabilities by segregation of the assets of the project from other projects and from other assets of the sponsor and assign them to a specific liability
  • thus the evaluation of individual project profitability is facilitated

D. Disadvantages of project finance

I. Complexity of risk allocation

  • risk identification and risk allocation is at the core of the project
  • project financings are complex transactions involving many participants with diverse interests
  • if a project is to be successful, risks must be allocated among the participants in an economically-efficient way
  • however, there are necessary tensions between the participants, e.g. between the lender and the sponsor regarding the degree of recourse, between the sponsor and the contractor regarding the nature of guarantees etc., which may slow down the realisation of the project

II. Increased lender risk

  • the degree of risk for the lender in a project financing is not insignificant
  • although the bank is not an equity risk-taker, many risks cannot be effectively allocated or enhanced
  • this results in higher transaction costs compared to other types of transactions, because it requires an expensive and time-consuming due diligence conducted by the lender’s lawyer, the independent engineer etc., since the documentation is usually complex and lengthy

III. Higher interest rates and fees

  • similarly, the interest rates and fees charged in a project financing may be higher than on direct loans made to the project sponsor

IV. Lender supervision

  • in accordance with the higher risks taken in a project financing, the lender will impose a greater supervision on the management and operation of the project to make sure that the project success is not impaired
  • the obligations of the borrower / sponsor in regard to this supervision (satisfaction of certain test, restrictions imposed on the borrower etc.) will be incorporated into the project loan agreement
  • the degree of lender supervision will usually result in higher costs, which will typically have to be borne by the sponsor

E. Types of project finance

  • Loan
    • most conventional structure is a limited or non-recourse loan, repayable out of project cash flows
    • basic structure may be adapted by credit enhancements e.g. export credits given by export credit agencies
    • the borrowing entity will often be a limited liability vehicle established by the project sponsors, in which case the documentation might not provide for any overt restriction on recourse, the lenders accepting that the repayment obligation is that of the vehicle (the project company with its assets), not of the shareholders
    • however, if the borrowing entity is not a vehicle with limited liability, then the limitation on recourse has to be dealt with in the documentation in clear terms
    • loan agreement will recognise at least two distinct stages
      • Construction or development phase
        • loan funds will be disbursed
        • debt service will be postponed by rolling-up interest pending the generation of revenues (cash flows) in the operation phase
        • period of highest risk for the lenders, therefore not uncommon to have either full recourse financing at this stage, e.g. through legally binding guarantees of the project sponsors or, alternatively, higher margins than in other phases of the project
        • full recourse or higher margins may then fall away upon the satisfactory completion of the project by previously agreed and documented standard, which are usually verified by independent experts in various tests
      • Operation phase
        • the completion of such tests will mark the beginning of the operating phase when cash flows can be expected
        • the debt will then start to be serviced and/or amortised
        • the rate of debt service and repayment will be related to the anticipated level of output and receivables of the project (part of which will usually go to the lenders automatically, e.g. by assignment)
  • Production payments
    • technique involves the lenders establishing a special purpose vehicle to purchase an undivided interest in the product of the project company
    • the financing being the purchase price, the exclusive source of repayment and debt service is the production of the project
    • the project company will usually be obliged to repurchase the product or to sell it in the market as agent of the lenders to realise cash (as repayment and debt service)
    • method of achieving non- or limited recourse financing with complete security, i.e. through ownership rather than through assignment or mortgage
  • Forward purchase (Similar to production payment, but more flexible)
  • BOT

F. Project risk identification and allocation

  • risk has been defined as an uncertainty in regard to cost, loss, or damage (uncertainty being the crucial point)
  • the process of coping with risks consists usually of the following
    • risk structuring
      • by phases, i.e. development risks, construction risks, start-up risks, operating risks
      • by participants, identifying the risk most important to each
      • mixture of different criteria
    • risk analysis and allocation
    • risk management
      • transfer to another participant by contract
      • mitigation of risk by sharing equity ownership with an entity that can reduce the risk
      • risk minimisation
      • credit enhancement
  • common tool in risk management is a risk matrix in form of a table, stating
    • the risk which could be identified
    • the party to which it is (or should be) allocated
    • ways of mitigating this risk
    • the effects that this constellation has on the lender
    • the effects that this constellation has on the sponsor

I. Construction and development risks

  • on the basis of technical feasibility study
    • use of independent experts (e.g. engineers, construction consultants, geologists etc.)
    • depending on the type of project, e.g.
      • Transport (design, construction schedules, traffic flow forecasts etc.)
      • Power / Plants (design, operating proposals, test procedures, completion criteria, raw material / feedstock supply (coal, oil, gas, wind) etc.)
      • Oil / Gas (reservoir assessment, extraction etc.)
      • Environmental
  • shortfalls
    • in the expected reserves (Oil, Gas, Mining etc.)
    • in the expected capacity, output or efficiency
  • cost overruns
    • supply and transportation of energy, raw material, equipment, machinery etc.
    • cost of contractors and labour
  • delays in completion
    • additional interest expense
    • lengthening of repayment profile
  • availability
    • energy
    • raw material / feedstock
    • transportation
    • equipment and machinery
    • work force, management, contractors
  • force majeure
    • factors outside the control of the parties, such as fire, flood, earthquake, war, rebellion, strike etc.
    • affecting the project itself or contractors, suppliers or markets for the products
  • technical failures and difficulties
  • accidents


  • ensuring that the project has binding and enforceable long-term fixed price contracts for supplies, energy, transportation and the like
  • the project establishing its own sources and infrastructure (e.g. project specific power generating plants)
  • performance bonds and completion guarantees given on behalf of contractors in favour of the project sponsors and assigned to the lenders
  • commercial insurances and export credit guarantee support
  • strict provisions in the underlying documentation with contractors and suppliers to penalise delay, fix costs and secure performance (benefit of which is passed on to the lenders by assignment of such contracts)

II. Market and operating risk

  • existence of local and international markets for the product
  • likely strength of competition, projections for prices, tariffs and existence of trade barriers
  • access to markets
    •  physical access (transportation, communication)
    • commercial access (freedom to sell the product, governmental control of the market)
  • obsolescence
    • will the product still be wanted by the time of operation?
    •   technology risk (technology still up to date?)
  • new technology
    • risk of delays, cost overruns and outright failures if technology is untried
    • risk of lagging behind more innovative competitors


  • Long-term take-or-pay contracts, throughput agreements (pipelines) or tolling agreements can guarantee a market for the product at a price that can be tailored to cover operating expenses, debt service and repayment
  • In electricity generating projects there will often be only one possible consumer, a national or local grid
    • negotiation of minimum off-take amount and minimum prices
    • alternatively, fee arrangements with further fees payable for the amount of power produced

III. Financial risks

  • fluctuation in exchange rates
  • increases in interest rates
  • increases in commodity prices on world markets, especially for energy and raw material
  • falls in the price of the product on world markets
  • inflation
  • protectionism


  • hedging facilities against exchange rate and interest rate risks by way of currency or interest rate swaps, caps, collars, floors and other techniques
  • debt service and repayment profile can be formulated by reference to a number of factors including market prices, inflation rates etc.
  • protection against a fall in the price of the product through hedging facilities such as forward sales, futures and options contracts etc.

IV. Political risks

  • external hostilities (war), civil war, revolution
  • government action (external or internal) through sanctions or freezing orders
  • expropriation / nationalisation (without compensation)
  • revocation of licences, concessions or permits (especially power generation, transport, infrastructure, exploitation of resources)
  • Changes in law having the same effect (“creeping political risk”), i.e. rendering the project increasingly uneconomic and unprofitable
    • concession variations
    • tax increases
    • reduction of import / export permissions
    • production controls
    • increase in social security costs
    • increase in environmental protection


  • licenses, concessions and permits should be checked and possible ambiguities should be clarified with the authorities
  • assurances against expropriation / nationalisation in connection with guarantees for proper compensation payments in that case
  • central bank undertakings to ensure the continuing availability of foreign exchange
  • collection of cash flows offshore, where the project is generating hard currency revenues
  • structuring and financing in a way to take advantage of double taxation treaties, bilateral or multilateral trade agreements etc.
  • insurance by export credit agency support against political risk
  • involvement of multilateral or regional funding agencies (e.g. IBRD, IFC, EBRD)


V. Legal risks

  • especially because in developing countries the legal systems are less sophisticated and judicial support is harder to obtain
  • lack of legislation
    • taking and enforcement of security
    •   preclusion of property
    • enforcement of security is of crucial importance in a facility with limited recourse
  • dispute resolution problematic
    • no equal access to the courts for foreign parties
    • foreign judgments not enforceable
    • ability to resort to arbitration restricted
    • accordingly, status and enforceability of arbitration awards uncertain or unsatisfactory
  • inadequate protection of intellectual property rights
  • inadequate regulation of fair trading and competition
  • whole legal system might be slower, more expensive, less predictable
  • limitation on appeal rights
  • environmental legislation (both existing and prospective)


  • thorough review of legal risks at an early stage by consultation of local lawyers and host governmental offices (department of justice, attorney general etc.)
  • legal opinions to ambiguous or unclear questions

G. Security

  • non- or limited recourse structure makes it necessary to secure the project finance (in contrast to a customary loan)
  • purpose of security
    • to prevent disposal of assets by the borrower or the granting of interests to third parties
    • to take possession of and realise assets ahead of other creditors
  • fundamental considerations
    • Does the borrower have sufficient ownership interests in the assets that allow him to effectively grant security?
    • Over which project assets can security be effectively created?
    • Which possibilities are given by the applicable law as to the nature of security instruments (can mortgages be given?, are floating charges possible?)?
    • Which creditors will – in case of insolvency – be preferred to secured creditors?
    • How can security be enforced by the lenders?
    • What formalities have to complied with to perfect security?
    • Can security be held by a trustee or by an agent for a group of creditors (with the possibility to change the beneficiaries, i.e. the members of such group), e.g. for the facilitation of transfer of loan participations?

I. Asset security

  • mortgages, hypothecation or fixed charges over immovable assets (land, buildings etc.)
  • fixed or floating charges over movable assets (book debts, equipment, production etc.)
  • pledge of shares of the project company + charge over dividend rights
  • however, “thin asset security” that is not of value before completion (half-built facility does not generate revenues and cannot easily be sold)

II. Non-asset security (revenue security)

  • assignment of rights under the underlying project documents / step-in-rights (direct agreements)
    • construction contracts and sub-contracts
    • performance bonds, completion guarantees, project insurances
    • joint venture agreement
    • management and consultancy agreements
    • off-take agreements, sales contracts, take-or-pay, throughput, tolling
    • supply contracts
  • escrow accounts to control and retain (if necessary) any revenues generated by the project

III. Credit support

  • no security in the legal sense, but fundamental financial and market support
  • Government undertakings (to cover political risks)
  • Sponsor support undertakings (supply, marketing etc.)
  • Export Credit Agency support (covering political risks)

H. Project Documentation

I. Financial Documents (Loan Documentation)

  • conditions precedent to lending (legal opinions, board resolutions, expert reports)
  • amount and purpose of the finance
  • interest rate, debt service and repayment profile
  • limitation on recourse to the borrower and/or sponsor
  • protective clauses (taxes, increased costs, market disruption)
  • project covenants (compliance with licenses, standard of workmanship)
  • restrictive covenants (negative pledge, pari passu)
  • events of default
  • project completion (specifications, tests)
  • financial and project information (reporting requirements, project supervision by lenders)
  • assignment and transfer provisions
  • choice of law, choice of forum
  • references to other underlying or supporting documents (security documents, support documents, underlying documents etc.)

II. Underlying Documents

  • concession agreements, governmental licenses and governmental consents
  • joint venture agreements between the project sponsors
  • constitutive documents of the project company
  •   construction contract and sub-contracts
  • project management agreement
  • technical consultancy agreements
  • contractor’s performance bonds and advance payment guarantees
  • project insurances
  • supply contracts
  • off-take agreements, take-or-pay- / take-and-pay agreements, throughput agreements
  • transportation contracts

III. Security documents

  • see above

IV. Support Documents

  • see above

V. Expert reports and legal opinions

  • Expert reports
    • Engineers                 - technical and economical feasibility of the project
    • Insurance experts           - adequacy of the project insurances
    • Accountants                        - Financial position of the project sponsors and capitalisation of the project company
  • Legal opinions
    • binding effect and enforceability of the lending and security documentation
    • legal status, power and authority of the parties to perform their respective obligations under the agreement
    • need to obtain and comply with licenses, concessions etc.
    • existence of exchange controls, taxes or other duties
    • validity of choice of law and forum


I. Comparison of project finance and customary syndicated loan facilities

  • in many cases, project finance will take the form of a syndicated loan, although other types of finance, which do not involve conventional borrowing, such as forward purchase agreements or production payments, are just as common (similarly, depending on the complexity of the project, innovative finance structures will frequently be tailored to the requirements of the particular project and its specific features)
  • however, project finance is characterised by some peculiarities which would normally not be covered by conventional syndicated loan facilities
    1. some element of reliance on project assets without full recourse to the borrower / sponsor
    2. technical and economical evaluations of the project and the customer’s business, which are continually monitored by the lenders
    3. lengthy and complex loan documentation
    4. higher margins and fees to reflect the lender’s exposure to the project risks
  • the realisation of projects involves a legion of risks that cannot be borne by one party alone
    • the idea behind project finance is therefore to distribute the risks of the project among all participants in an economically efficient way
    • risk structuring is therefore the crucial part of the finance structure
  • the lenders are merely taking particular risks themselves, since most of the risks will be allocated to the parties most closely connected with certain risks, such as the contractor, the sponsor, the host government etc. but they will most likely have effects on the lender’s position (e.g. the risk of cost overrun which has been allocated to the contractor may negatively affect his creditworthiness and financial constitution and might therefore impair the completion of the project construction, which will again threaten the debt service and repayment of the finance)
  • projects will frequently be regarded as stand-alone projects, and the finance structure will, thus, usually rely on the project assets and cash flows alone without full recourse to the borrower
  • accordingly, the lenders will try to protect their position by taking security of the projects assets and future revenues
    • this differs fundamentally from the position in conventional loans which are usually unsecured and which would therefore by other means try to ensure that the lenders will be in a favourable position on bankruptcy, e.g. pari passu ranking with other creditors or maximal assets for distribution between unsecured creditors by negative pledge clauses
  • likewise, repayment and debt service will usually be limited or postponed until the completion of the project and the commencement of the operation phase, since payments are based on the (future) generation of revenues
    • the lenders’ commercial interest is therefore depending on the success of the project
    • accordingly, the lenders will take a much more active role in monitoring and supervising the project, as they would normally do in conventional syndicated loan facilities
  • all these particularities will be reflected by the loan documentation, which will be lengthy and complex and will usually provide
    • for special clauses dealing with security (which would not be part of a conventional syndicated loan) and calling for particular security documents, such as mortgages on immovable property, fixed or floating charges on movable property, pledges on the project company’s shares (plus charges on the prospective dividend interests), assignments and step-in-right documents of all underlying and supporting contracts with third parties etc.
    • the supply of such documents will usually be made a condition precedent to the disbursement of funds
    • the loan agreement will, furthermore, call for legal opinions stating that the security granted by the borrower will be legally valid and enforceable under the applicable law; the supply of such legal opinions will likewise be made a condition precedent
    • the covenants will – in addition to the general and financial covenants, which also form part of the conventional loan – contain a part on operational covenants that cover the borrower’s obligations in regard of the construction, development and operation of the project
    • in this context, the loan agreement is likely to cover the contents of technical and economical feasibility studies, since debt service and the repayment profile will to a large extent depend on the projections of future cash flows therein
  • last, but not least, the higher exposure of lenders to risks, the complexity of the necessary preliminary work (risk management, feasibility studies, expert opinions, legal opinions), the resulting lengthy and complex loan documentation and the continuing involvement of the lenders in supervision and monitoring of the project progress will add to the transaction costs of the lenders and will normally result in significantly higher margins and fees, compared to conventional loan facilities