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PPP Introduction and Overview - Appendix A - Project Finance

1a5. Project Finance — Benefits and Limitations

Financing infrastructure projects through the project finance route offers various benefits such as the opportunity for risk sharing, extending the debt capacity, the release of free cash flows, and maintaining a competitive advantage in a competitive market. Project finance is a useful tool for companies that wish to avoid the issuance of a corporate repayment guarantee, thus preferring to finance the project in an off-balance sheet manner. The project finance route permits the sponsor to extend their debt capacity by enabling the sponsor to finance the project on someone's credit, which could be the purchaser of the project’s outputs. Sponsors can raise funding for the project based simply on the contractual commitments.

Project finance also permits the sponsors to share the project risks with other stakeholders. The basic structure of project finance demands that the sponsors spread the risks through a network of security arrangements, contractual agreements, and other supplemental credit support to other financially capable parties willing to assume the risks. This helps in reducing the risk exposure of the project company.

The project finance route empowers the providers of funds to decide how to manage the free cash flow that is left over after paying the operational and maintenance expenses and other statutory payments. In traditional corporate forms of organization, corporate management decides on how to use the free cash flow — whether to invest in new projects or to pay dividends to the shareholders. Similarly, as the capital is returned to the funding agencies, particularly investors, they can decide for themselves how to reinvest it. As the project company has a finite life and its business is confined to the project only, there are no conflicts of interest between investors and the management of the company, as often happens in the case of traditional corporate forms of organization.

Financing projects through the project finance route may enable the sponsors to maintain the confidentiality of valuable information about the project and maintain a competitive advantage. This is a benefit of raising equity finance for the project (however, this advantage is quite limited when seeking capital market financing (project bonds). Where equity funds are to be raised (or sold at a later time so as to recycle capital) through market routes (for example, Initial Public Offerings [IPOs]), the project-related information needs to be shared with the capital market, which may include competitors of the project company/sponsors. In the project finance route, the sponsors can share the information with a small group of investors and negotiate the price without revealing proprietary information to the general public. And, since the investors will have a financial stake in the project, it is also in their interest to maintain confidentiality.

In spite of these advantages, project finance is quite complex and costly to assemble. The cost of capital arranged through this route is high in comparison with capital arranged through conventional routes. The complexity of project finance deals is due to the need to structure a set of contracts that must be negotiated by all of the parties to the project. This also leads to higher transaction costs on account of the legal expenses involved in designing the project structure, dealing with project-related tax and legal issues, and the preparation of necessary project ownership, loan documentation, and other contracts.


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