FNCE90048 Project Finance Lec1 2021s1

FNCE90048 Project Finance
Lecture 1
Introduction to Project Finance
Lecturer – Tony Cusack

March 2021
Lecture 1 topics
• Part 1 – introductory concepts

– what types of project?
– what is project finance?
– project finance v. corporate finance
• Part 2 – parties to projects
• Part 3 – the rationale
– why use project finance?
– pros and cons of project finance
March 2021 FNCE90048 Lecture 1 2

Lecture 1 – Part 1

• however, before we address these concepts, we need to address the

appropriate ‘mindset’ to enable successful completion of FNCE90048 Project
Finance

Thinking commercially
• this subject has a highly commercial focus, which means that you must quickly
develop the ability to think commercially (practically), like a consultant

Thinking commercially
• this subject has a highly commercial focus, which means that you must quickly
develop the ability to think commercially (practically), like a consultant
• it is inappropriate and ineffective to attempt to study for this subject by
memorising what is written in the notes without understanding it
– after all, it’s an open book exam …
• example: in week 11, we will examine the Eurotunnel case in some detail
– if you were an investor, what risks would you perceive?
– what would you do about them?
– how would you decide on whether or not to invest equity?
– how would you ensure that lenders will provide debt financing?
April 2018 FNCE90048 Lecture 6 8
What types of project?
• a project that is appropriate for project financing is typically a long-term

infrastructure, industrial or public services scheme, development or
undertaking, having:
– large size
– intensive capital requirement
– finite and (relatively) long life
– few diversification opportunities, i.e. asset specific
– high operating margins
– significant free cash flows
– unique risks

What types of project?
• a long-term infrastructure, industrial or public services development is a large

scale capital investment in an ‘asset’ that will produce future returns (ROI)
– capital budgeting / NPV principles apply
– will be either greenfield or brownfield (we focus on the former)
• a greenfield investment usually requires extensive, long-term construction of
asset facilities and equipment (the core costs of the investment / project)
• following completion of all construction, there will be an operational ‘asset’
that will generate (net) revenue
• this is common economic activity all over the world, whether or not project
financing is used
Examples of projects
• Mines and natural resource developments

• Power plants and other charged utilities
• Motorways and expressways (toll roads)
• Railway network and service – both passenger and cargo
• Metro, subway and other mass transit systems
• Ports and port terminals; airports and air terminals
• Hospitals, schools, jails
• Dams, etc.

Australian projects that used project finance
• Brisbane Airport Link

• Australia Pacific LNG
• The Gorgon Gas Project Western Australia
• BHP Ravensthorp Nickel Project
• INPEX Gas Project (NT)
• Badgery Creek 2nd Sydney International Airport
• RiverCity Motorway Brisbane
• Mundaring Water Treatment Project

SE Asian projects that used project finance
• Thailand:
– Bangkok’s Sky Train, and subway
– Toll roads
• Indonesia:
– Power plants
– Toll roads
• Hong Kong
– Hong Kong Disneyland
– Western Harbour Tunnel
What is Project Finance?
• there is no universally accepted definition of the term Project Finance (or

Project Financing)
– different users have different perceptions, but there are common elements
/ factors that all definitions contain
• Vintner (2006) provides the following (legal) textbook definition:
– “… financing the development or exploration of a right, natural resource or
other asset where the bulk of the financing is not to be provided by any
form of share capital and is to be repaid principally out of revenues
produced by the project in question”

Fabozzi and de Nahlik (2012) define Project Financing as:

• “a financing of a particular project in which the lender is satisfied to look initially to
the cash flows and earnings of that project as the source of funds from which a loan
is to be repaid and to the assets of the project as collateral for the loan”
Tinsley (2001) suggests:

• “project financing is an option granted by the financier exercisable when an entity
demonstrates that it can generate cash flows in accordance with long-term
forecasts. Upon exercising the option, a sponsor’s balance sheet is no longer
available for debt service. The financier then relies on the project’s cash flow for
debt service and repayment”

• perhaps the final word on definition should go to the International Project

Finance Association (IPFA), which has defined project financing as:
– “the financing of long-term infrastructure, industrial projects and public
services based upon a non-recourse or limited recourse financial structure
where project debt and equity used to finance the project are paid back
from the cash flows generated by the project”
• accordingly, we can conclude that project financing refers to a (debt) financing
of a project in which lenders to a project look to the cash flow and assets of
that project as the source of repayment of their loans
• you might be thinking: so what? – all loans have to be repaid …
The mechanics of project financing
• in project finance, the distinction is that a project is treated as separate from

its owners in terms of debt financing
– i.e. cash flows from the project, not the owners, will repay the borrowings
• to achieve this, projects that are subject to project financing are carried out in
separate legal / economic entities
– these separate legal entities are typically referred to as Special Purpose
Vehicles (SPVs), often (usually) taking the form of a company
• the project owners (“sponsors”) set up the SPV with an initial injection of
equity, and the SPV borrows in its own name to raise funds (project debt)
– so, project finance is ‘off balance sheet financing’ for the sponsors
Limited or no recourse financing
• accordingly, in project finance there is limited or no recourse to project

sponsors, meaning that they are not the party obliged to repay the loan(s)
and interest thereon
– what is meant by recourse / non-recourse?
• this means that in a project finance transaction, the loan is structured such
that debt is repaid using cash flows generated from the operations of the
project (and it is typically secured by the project’s assets)
• however, it’s not immediate, as there will be a period when there is effective
recourse to the sponsors; this is until a ‘milestone’ or ‘Completion Test’ is met
– this is why we see the term “limited recourse”
Characteristics of projects
• provide high operating margins and high free cash flows

• relatively low to medium return on capital
– are these two characteristics contradictory?
• typically have a limited life (but not necessarily short term)
• capable of functioning as an independent economic unit
• can be completed without undue uncertainty
• when completed, will be worth demonstrably more than the cost to complete
• it provides few diversification opportunities due to asset specificity (but
projects can be part of a diversified portfolio of investments of a large MNC)

Corporate Finance v. Project Finance
Sponsor
Borrower Lenders
Loan Cash Flow
Cash Flow Borrower
SPV Project Loan Lenders
All Assets Capex
Project Lenders Security

CORPORATE FINANCE
 Lenders provide loan directly to the PROJECT FINANCE

Borrower/Company  Project vehicle (SPV) set up by Sponsor(s)
 Lenders have full recourse to the balance
 Lenders provide loan to SPV (the Borrower)
sheet of the Borrower/Company
 Lenders are typically unsecured  Lenders have full recourse to the cash flows of the SPV but
not to the balance sheet of the Sponsor(s)
 Lenders will typically have security over the SPV assets

‘Corporate’ Finance v. Project Finance
Corporate Project
Parameter Finance Finance
Pricing (debt) Low High
Tenor Short Long
Complexity Low High
Security Sometimes Always
Recourse Full Limited/Non

Project stages
• in broad terms, there are typically three phases (stages) in a project finance
transaction
– pre-construction, construction, and operations phase
• the initial part of operations, start-up, is sometimes recognised separately
• it will become clear that the unique risk in project financing is mainly present
in the construction phase
– i.e. if construction doesn’t complete, there is no project!
• for this reason, we will see that two-phase project financing is common
(construction phase and operations phase)
– this is because the risk profile changes when construction is completed
Activities in project stages
Project stage Project Activity Financing Activity
Pre- Project identification Project identification
construction Cash flow predictions Cash flow predictions
Risk identification and minimising Risk identification and minimising
Technical and financial feasibility Technical and financial feasibility
Construction Design operating facility / equipment Equity arrangement
Engage EPC contractor(s) to construct Debt negotiation and syndication
Sign offtake contract Commitments, security,
Meet completion tests documentation, disbursement
Operations Commence operations Financial closure

Continuous operations monitoring Monitoring operations and covenants
Project reporting / compliance Debt repayments

Project financing timeline

Project financing key activities
• after as suitable project has been identified, these key activities follow:
1. Cash flow predictions derived from technical and financial studies
2. Risk allocation through application of risk mitigation techniques (e.g.
project design, project contracts and financing agreements)
3. Funding and repayment mechanisms
4. Legal security and provision to handle defaults and/or ‘workouts’
5. Project reporting / Compliance
• in terms of achieving the project (debt) finance, we will see that 1. and 2. are
the most important so they are our main areas of focus

Project financing key activities
• cash flow predictions are required in two separate categories

– first, the cost of constructing the project assets must be estimated (CAPEX)
– next, the projected net cash flows from operating the project assets (i.e.
after completion of CAPEX stage) must be forecast
• broadly speaking, the latter will comprise estimated revenue from operations,
and the expenses related to producing revenue (OPEX)
• PV(net cash flows) must be > PV(CAPEX) for a project to proceed
• since the future is uncertain, the estimates of both CAPEX and operations
cash flows are subject to risk, hence the importance of risk allocation

Risk identification and minimising
• accordingly, project finance essentially becomes an exercise in the allocation

of project risks between the various project stakeholders
• we will see that projects have unique risks, with differing characteristics:
– symmetric risks (e.g. demand, price, input/supply, currency, interest rate,
inflation, reserve (stock) or throughput (flow)
– asymmetric downside risks (e.g. environmental, creeping expropriation)
– binary risks (e.g. technology failure, direct expropriation, counterparty failure,
force majeure, regulatory risk)
• we will cover project risk and mitigation in detail over 3 lectures

Documentation / contracts
• it will become clear that project finance arrangements require strong

contractual relationships among multiple parties
• accordingly, the role of contracts is central to the risk allocation process that is
the essence of project finance
• projects typically commence with initial (pre-contract) documentation such as
commitment letters (e.g. from sponsors and investors) and MOUs (e.g. with
governments and/or financiers)
• contracts for a project are sometimes divided into categories, such as:
financing contracts (equity documents, lending agreements, security
documents) and project contracts (design, construction, operations, etc.)
Technical and Financial feasibility
• as a project is being developed, the SPV will prepare a project plan, the key
contents of which will comprise substantial detail relating to both technical
and financial elements of the project
• technical feasibility relates to items such as project structure and process
design, specialised equipment, operations facilities, even project location
• financial feasibility relates to the economics of the project plan, requiring
construction of a detailed and robust financial model, which will incorporate
project capital and operational cash flows, financing structure, NPV,
sensitivity analysis, etc.



Parties to a project financing
• primary participants:
– Sponsors
– Lenders
– Offtaker(s) / purchasers
– Contractors, especially design and construction
– Materials provider(s) and/or suppliers
– Governments
– Arranger / procurers
• other participants include financial advisers, lawyers and technical consultants
Simple project finance structure
Sponsor
2
Sponsor Sponsor
1 3
Project
Loans entity
Lenders (SPV) Government
Concession
contract
Repayments
$ Services
User /
Offtaker
Primary parties to a project financing
• Sponsors
– the equity investors and owners of the Project Company – can be a single party,
but will usually be a consortium of Sponsors
– in some projects, a Government may also retain an equity stake in the project
and therefore also be a Sponsor (but it is not common)
– we will see that is common for Sponsors or their subsidiaries to also act in
substantive roles (e.g. as contractors) in the project
• Lenders: typically include one or more commercial banks and/or multilateral
agencies and/or export credit agencies and/or bondholders
• Offtaker(s): one or more parties contractually obligated to ‘offtake’ (purchase) some
or all of the product / service produced by the project
Sponsors example: Gladstone LNG project

Offtake example: Gladstone LNG project
https://www.ogj.com/articles
/2016/05/gladstone-lng-s-
second-train-starts-up.html

Other key parties to a project financing
• Contractors: the substantive performance obligations of the SPV to (1) construct and
(2) operate the project will usually be done through engineering, procurement and
construction (EPC) and operations and management (O&M) contracts, respectively
• Equipment or Feedstock provider(s): one or more parties contracted to provide
operations equipment or feedstock (raw materials or fuel) to the project
• Governments will always be involved, either as the initiator of the project (discussed
later), an equity participant (not common) or simply by providing permission for the
project to proceed, which will involve execution of a concession agreement
• Arranger / procurer is the typically the council or department of state responsible
for running a competitive tender in a government initiated project, evaluating the
proposals and selecting the preferred Sponsor consortium to implement the project
Other key parties to a project financing
• in addition to the core project stakeholders listed above, there are typically a
host of other advisors, experts and professionals whom are either directly or
indirectly involved in a project financing, including:
– advisors to the Lenders which, at a minimum, will include technical and legal
professionals and potentially also financial, insurance, auditing, tax, accounting,
market and/or environmental advisors (depending on the specifics of the project)
• one key task of these advisers is formal due diligence
– advisors to the Sponsors – typically financial, legal and technical advisors at a
minimum; and
– in a government initiated project, advisors to the government / procuring
authority (again, will typically be financial, legal and technical advisors)
Crowded: project finance participants


• Part 3 – the rationale
– why use project finance?
– pros and cons of project finance

Rationale for project financing – sponsors
• clearly, the decision to undertake an investment funded via project finance is

based on the benefits that are expected to be obtained
• first, because the project entity will be an SPV, the liabilities and obligations
associated with the project debt are a step removed from the sponsors
– this limited / no recourse status of debt is often a key driver
– the associated off-balance sheet treatment of project debt is attractive, as
it means no adverse impact on net assets and other ratios, enables
preservation of borrowing capacity for other projects, and can also ensure
no negative impact on the sponsor’s credit rating (where relevant)
• project financing enables effective risk minimisation / transfer
Rationale for project financing – sponsors
• project financing is attractive when the size and cost of projects is very large,
as it enables participation in larger projects than corporate assets / credit
standing would otherwise allow
– i.e. it may be only way that enough funds can be raised to do the project
• it is also effective for participation in non-core activities
– this highlights a common consideration for large MNC sponsors, as they
are compelled to be forward looking and must maintain a ‘pipeline’ of
available opportunities, often in related (but not core) activities
• additional benefits arise from providing goods / services to the project –
these are sometimes quite substantial and might influence the decision
(Tenuously related) practical example
• Linc Energy (Mkt. Cap $1.2b), whose shares jumped 20¢ to $2.17 this morning, has
appointed Barclays Bank to find a partner with shale oil expertise to fund the development
of Arckaringa. Peter Bond told BusinessDay on Tuesday that Linc was looking for a joint
venture partner in the Arckaringa Basin to “put two or three hundred million dollars into the
ground and take it to the next level”
• “I don’t want to put the cost of development on my balance sheet. Shale’s very hot at the
moment. We’ve already drilled a lot of this and seismic’d a lot of this. It’s a very, very good
prospect.”
• “We’ll probably hold hands with a major operator who knows what they’re doing and let
them, over the next 2-3 years, develop it. “We’ll still hold a significant stake – we’ll probably
hold at least half of it. I don’t want to just flog it off because it’s too good for that, just at the
moment. We’ll wait and see in a couple of years how it drills and develops.”
The Age 23rd January, 2013

Rationale for project financing – Lenders
• as with any form of financing, lenders (financiers) to a project financing seek to

extract a return commensurate with the level of risk – in itself, this is a motivation
for any form of lending (a straight application of the corporate objective)
• lenders to a project financing also typically extract additional returns through the
provision of the associated products and services required by the project company
(e.g. project accounts, trustee roles, hedging and advisory services)
• the HSBC article reports that studies of project finance loans confirm that as a class
of asset, they are generally robust
• they quote a Moody’s survey of 2,639 projects from 1983-2008 showing that 213 of
the projects had a senior loan default (~8%) of which the average ultimate recovery
rate was 76.4%
Rationale for project financing – Government
• when you think about it, it’s not difficult to perceive why governments are
attracted to project financing
• it relates to the fact that the role of governments includes provision of
appropriate infrastructure to their community
• growing populations and increasing infrastructure requirements means that
most governments no longer have the financial resources to meet their
obligations
– the alternative is to raise more revenue – how can they do this?
• technically, the advantages to governments fall into three categories

Rationale for project financing – Government
1. Fiscal optimisation: project finance transfers the financing responsibility to

the private sector, thereby allowing the government to afford infrastructure
by amortising the cost of the asset over the term of the concession
2. Process efficiency: using project finance can eliminate inefficiencies from
infrastructure construction, through tighter contracting and increased rigour
of execution (i.e. private sector profit motive increases efficiency)
3. Performance risk: the risks of constructing and operating the infrastructure
asset are passed to the private sector through project finance contracts
• again, the private sector (sponsors) are heavily incentivised financially to
ensure full asset performance

Public-Private Partnerships (PPP)
• for the above reasons, governments are now major users of project finance
• in recent years, the demand for infrastructure has been growing faster than
available government funding
– this is particularly the case in emerging / developing economies
• the trend has been to engage the private sector in the supply and provision of
these assets – these projects initiated by governments are known as Public-
Private Partnerships (PPP)
• for PPPs to be successful, there must be a clear benefit for both the public
and the private partners (based on the factors that we have seen)

Public-Private Partnerships (PPP)
• project-financed public sector activities can include:

– roads, rail links, schools, hospitals, prisons, etc.
• construction / operation risks are borne by private sector
– however, typically the government assumes market risk in a PPP arrangement
(e.g. hospital usage, schools, etc.)
• objectives:
– encourage better management
– promote more efficient risk-sharing
– expand pool of available funds

Advantages of project financing
• eliminate or reduce the lender’s recourse to the sponsors

• permit off-balance sheet treatment of the debt financing
• maximise the leverage of a project
• preserve sponsors’ borrowing capacity for other projects
• avoid negative impact on the credit standing of the sponsors
• obtain better financial conditions when the credit risk of the project is better
than the credit standing of the sponsors
• obtain a better tax treatment for the project, the sponsors, or both
• obtain additional benefits by providing goods or services to the project
Disadvantages of project financing
• it takes longer to structure than equivalent size corporate finance

• higher transaction costs due to tendering, commitments, technical and
feasibility studies, creation of operating entities, secondments, etc.
– can be in the $million
• project debt is substantially more expensive (50-400 basis points), essentially
due to its non-recourse nature
• the extensive contracting required restricts managerial decision making
• project finance requires greater disclosure of proprietary information and
strategic deals

Examples: Higher transaction costs
• Connect East Freeway

– each consortium (of two) estimated that they spent $30 million trying to win
– each provided the Victorian Government ~750,000 pages of documentation
• PNG Gas Pipeline
– Esso committed US$80 million for front end engineering prior to making a firm
commitment to proceed
• Woodside/BHP/etc. Browse gas fields in WA
– partners spent up to $100 million on studies before proceeding, and then project
was abandoned in the original form [the partners investigated an alternative
proposal (FLNG), before recently shelving it for a pipeline plan]

Summary – what is project finance?
• project finance is a method of financing the cost of investment in large scale

capital projects – so, it is simply a specialised method of financing commercial
activity, and nothing more
• due to the time and cost involved in setting up a project financing transaction,
it will only be a suitable choice if the intended project is on a large scale
• the technical distinction between project financing and other forms of finance
is that project financing is set up to provide for limited or no recourse to
project ‘sponsors’ (owners), meaning that they are not the party obliged to
repay the loan(s) and interest thereon

Summary – what is project finance?
• to achieve this, sponsors set up a special entity (SPV) to implement and

operate the project
• ‘limited recourse’ means there will usually be a period for which there is
recourse to the sponsors, i.e. until ‘completion tests’ are met
• once non-recourse, debt is repaid only from cash flows generated from the
operations of the project, and is typically secured by the project’s assets
(including revenue producing contracts)
• there is typically no recourse to cash flow from sponsors’ other assets after
construction phase (but subject to negotiations in each case)

Past exam question
In order to ensure a project is completed, banks require loans to be ‘recourse’ to

the sponsors during construction phase. Only once the project has reached a
‘certain point’ does it become ‘non-recourse’ to the sponsors.
a) What is meant by ‘recourse’ and ‘non-recourse’ loans?
b) Why do banks initially require ‘recourse’ loans? Why do sponsors prefer
‘non-recourse’ loans?
c) What is the ‘certain point’ at which the financing of a project becomes non-
recourse? Provide and explain two examples in relation to reaching this point
in the case of a toll road project.
d) …
Lecture 1 questions
1. What are the key features of project finance that distinguishes it from other
forms of financing?
2. Why would businesses consider the use of project finance in a proposed
project? What are the alternatives?
3. Would a listed company’s share price go up, down, or stay the same if it
announces it will use project finance for a proposed new project?
4. Who are the main parties to a project financing?
5. What is the main rationale for using project finance, in the case of (i)
Sponsors, (ii) Lenders, and (iii) Governments?

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FNCE90048 Project Finance

Introduction to Project Finance

Lecturer – Tony Cusack

• Part 1 – introductory concepts

March 2021 FNCE90048 Lecture 1 2

• Part 1 – introductory concepts

• however, before we address these concepts, we need to address the

March 2021 FNCE90048 Lecture 1 3

March 2021 FNCE90048 Lecture 1 4

• a project that is appropriate for project financing is typically a long-term

March 2021 FNCE90048 Lecture 1 9

• a long-term infrastructure, industrial or public services development is a large

• Mines and natural resource developments

March 2021 FNCE90048 Lecture 1 11

• Brisbane Airport Link

March 2021 FNCE90048 Lecture 1 12

• there is no universally accepted definition of the term Project Finance (or

March 2021 FNCE90048 Lecture 1 14

Fabozzi and de Nahlik (2012) define Project Financing as:

Tinsley (2001) suggests:

March 2021 FNCE90048 Lecture 1 15

• perhaps the final word on definition should go to the International Project

• in project finance, the distinction is that a project is treated as separate from

• accordingly, in project finance there is limited or no recourse to project

• provide high operating margins and high free cash flows

March 2021 FNCE90048 Lecture 1 19

Project Lenders Security

 Lenders provide loan directly to the PROJECT FINANCE

March 2021 FNCE90048 Lecture 1 20

Tenor Short Long

Complexity Low High

Security Sometimes Always

Recourse Full Limited/Non

March 2021 FNCE90048 Lecture 1 21

Operations Commence operations Financial closure

March 2021 FNCE90048 Lecture 1 23

March 2021 FNCE90048 Lecture 1 24

March 2021 FNCE90048 Lecture 1 25

• cash flow predictions are required in two separate categories

March 2021 FNCE90048 Lecture 1 26

• accordingly, project finance essentially becomes an exercise in the allocation

• we will cover project risk and mitigation in detail over 3 lectures

March 2021 FNCE90048 Lecture 1 27

• it will become clear that project finance arrangements require strong

March 2021 FNCE90048 Lecture 1 29

• Part 1 – introductory concepts

March 2021 FNCE90048 Lecture 1 30

March 2021 FNCE90048 Lecture 1 34

March 2021 FNCE90048 Lecture 1 35

March 2021 FNCE90048 Lecture 1 39

• Part 1 – introductory concepts

March 2021 FNCE90048 Lecture 1 40

• clearly, the decision to undertake an investment funded via project finance is

March 2021 FNCE90048 Lecture 1 43

• as with any form of financing, lenders (financiers) to a project financing seek to

March 2021 FNCE90048 Lecture 1 45

1. Fiscal optimisation: project finance transfers the financing responsibility to

March 2021 FNCE90048 Lecture 1 46

March 2021 FNCE90048 Lecture 1 47

• project-financed public sector activities can include:

March 2021 FNCE90048 Lecture 1 48

• eliminate or reduce the lender’s recourse to the sponsors

• it takes longer to structure than equivalent size corporate finance