Godfred Kwame Abledu
Project financing is largely an exercise in the equitable allocation of a project’s risks between the various stakeholders of the project. Indeed, the genesis of the financing technique can be traced back to this principle. Roman and Greek merchants used project financing techniques in order to share the risks inherent to maritime trading. A loan would be advanced to a shipping merchant on the agreement that such loan would be repaid only through the sale of cargo brought back by the voyage (i.e. the financing would be repaid by the ‘internally generated cash flows of the project’, to use modern project financing terminology). The ...view middle of the document...
The unique feature of project finance is its non-recourse to financing (Hoffman, 2001; Kwakkenbos, 2012). Non-recourse finance is an arrangement that limits lenders restitution to the project’s collateral but not the other properties of the lenders (Esty, 2006). In case of a default, the non-recourse borrower(s) are not personally held liable for the default. Apart from this unique non-recourse feature, Project Finance structures have bulk of it’s arrangements in tangible assets where all of the projects are pledged to the lenders (Yescombe, 2001; Esty, 2006; Fight, 2006). In view of this, project finance arrangements are usually used in long term investments ranging between 5 -20 years (Fight, 2006; UNDP, 2013).
B. Why is project financing being increasingly relied on to fund investments?
The first motivation to use project finance is the agency cost motivation, which recognizes that certain assets, namely large, tangible assets with high free cash flows, are susceptible to costly agency conflicts. The creation of a project company provides an opportunity to create a new, asset-specific governance system to address the conflicts between ownership and control. In many ways, the observed governance structures in project companies resemble leveraged-buyouts (LBOs) and achieve many of the same results described by Jensen (1989) and Kaplan (1989 and 1991).
In contrast to the agency cost motivation, which relates to the asset being financed, the two underinvestment motivations relate to the firms making the capital investments. These firms are known as “sponsoring firms” or “sponsors.” Although underinvestment in positive net present value (NPV) projects can occur for many reasons, this paper focuses on the effects of leverage and incremental distress costs as two important reasons, and show how project finance mitigates both effects. Project finance solves leverage-induced underinvestment by allocating project returns to new capital providers in a way that cannot be replicated using corporate debt. This debt overhang motivation is similar to the motivation described by Stulz and Johnson (1985) for using secured debt, but it is even more effective because it eliminates all recourse to the sponsor’s balance sheet and it eliminates the possibility that new capital will subsidize pre-existing claims with higher seniority or reduce the value of junior claims (Myers, 1977). While it is true that the origin of the debt overhang problem is also an agency conflict, this paper distinguishes the debt overhang motivation from the agency cost motivation because the conflict occurs at the sponsor rather than the project level.
The third motivation, risk management, recognizes that investing in risky assets can generate incremental distress costs for sponsoring firms. When these indirect or collateral distress costs are sufficiently large, at least in expectation, they can exceed the asset’s net present value (NPV), thereby turning a positive NPV project into...