CHAPTER 1
Introduction
Why Project Finance for Business Development?

The treatment of project finance has primarily been for the infrastructure industry, but the processes and techniques used are also applicable to other off‐balance‐sheet financings of separate entities, joint ventures, and projects in other industries. Project finance has traditionally been treated from a financial engineering or from a contract finance perspective with applications in infrastructure projects in underdeveloped or developing countries lacking sufficient public and private resources to fund needed projects. Projects of such characteristics are the most challenging and once experience is obtained from such projects, it is easily transferable to projects in other industries and developed countries.

The globalization of business has intensified competition among project sponsors/developers, construction contractors, technology and equipment providers, and some funding sources. The result is coopetition in project development and financing that has increased the need for effective project finance solutions and better‐structured partnerships and joint ventures. In this environment, to win large project bids, sponsors need an overall competitive advantage. To create profitable investment projects, they need a disciplined, new business development approach to project finance.

Project finance is not a stand‐alone function based on contract finance or legal engineering as it is being treated in the current paradigm. It has been developed to advanced levels for the primary purpose of facilitating new project and business development activities with the nonrecourse aspect as an ancillary factor. It should be treated as part of new business development with its focus on striving to maintain or obtain competitive advantage. Hence, our approach to project finance is different than the one in the current literature and its novelty lies with the value created through addressing it from a broad, new business‐development perspective. Why? Because project finance is part of new business development and has to be viewed in that context and not as a stand‐alone discipline, and because its key objective is to get competitive advantage through new investments. Other reasons for and benefits of using this approach are explained later in the chapter.

Infrastructure projects are large investments by the public and/or private sectors that require major financial and human resource commitments to build physical assets and facilities needed for economic development and social functioning of a country. Infrastructure projects include power plants, pipelines, railroads, roads and bridges; ports, terminals, and airports; telecommunication networks, and water and sewage treatment plants. They also include social and healthcare facilities such as public housing, elder care facilities, prisons, hospitals, schools, and sports stadiums.

Due to their large and special financing requirements and challenges, infrastructure projects are usually placed in four categories:

1. Greenfield projects, where new facilities are built requiring larger capital investments than investments in existing project companies in operation
2. Brownfield projects, where investment is made to upgrade and refurbish existing facilities and equipment in order to increase productivity or extend their economic life
3. Stock or extraction projects, where natural resources are extracted and sold until depletion, such as coal and mineral mining, and gas and oil extraction
4. Flow‐type projects, where the project assets are used to generate income by selling their output or the use of their services. They include pipelines, toll roads and bridges, ports and airports, and so on

There are several definitions of project finance for different types of projects, all valid but each stressing some more than other parts of the discipline. However, we prefer the broader definition shown in the box. To understand what project finance is all about, the definition needs to be expanded to include the structuring of the project company, known as a special purpose company (SPC) or a special vehicle company (SPV); the characteristics of projects, what project finance involves, and the risks associated with a project. That is, it includes:

Project finance is the art and skill of piecing together new business development elements, financial engineering techniques, and a web of contractual agreements to develop competitive projects and make the right decisions to raise funding for industrial or infrastructure projects on a limited/nonrecourse basis where lenders look to the cash flow for loan repayment and the project assets for collateral.

1. Structure of the company: Common SPC structures are corporations, joint ventures, partnerships, limited partnerships, and limited liability companies
2. Properties of projects: Infrastructure projects require large capital expenditure, entail massive negotiations and contracts, and require long operating periods
3. What project finance involves: It requires the creation of a legally separate, single purpose entity that is a shell company to build the project assets and capture revenues. Financing is of a limited/nonrecourse basis and it is based on cash flows and the assets owned by the SPC that is responsible for loan repayment
4. Risks associated with a project: Financing is provided to the SPC and not to the sponsors and this gives rise to risks usually mitigated through contracts, insurance, and credit enhancements. A common set of risks in project finance includes primarily political, demand, price, supply, currency, interest rate, and inflation risks
5. Project development complexities: Addressing them entails the undertakings of project screening and the feasibility study, project development, financial model development, and economic evaluation. It also requires project risk management, due diligence, a financing plan, financial structuring, creation of a project company business plan, and project implementation

A key objective of project finance is to minimize or avoid uncertainty. Unlike asset‐based finance, where the asset value determines financing, the adequacy of project cash flow is the foundation of funding. Since infrastructure projects have different types of assets and objectives, capital requirements, and risks; they get different benefits from project financing. However, infrastructure projects have a number of common characteristic due to the common project financing technique. Gatti (2012) names the common elements of project financings as: long economic life assets with low technological risk, provision of essential public services with inelastic demands, regulated monopolies or quasimonopolies with high barriers to entry, and stable and predictable operating cash flow.

The components of project finance are outlined in Section 1.6 and discussed in subsequent chapters, but the basic and common components across projects are the presence of a host government ceding agency, sponsor or developer equity, commercial bank loans, and institutional debt and equity investors. Usually, there is some subordinated debt from sponsors and other project participants, collateral security and revenue assignment, and enhancements provided by sponsors and unilateral and multilateral institutions. Also, there is a common set of project finance prerequisites such as a stable political and regulatory environment, reasonably adequate industry structure, sound project development and planning, thorough risk assessment and mitigation to allocate risks effectively, and contractual agreements to ensure project viability.

The historical origins of project finance and its evolution are traced in Section 1.1 and its advantages and disadvantages are briefly discussed in Section 1.2. The differences between project finance and corporate and structured finance are explained in Section 1.3. To get a sense of the importance of project finance, its size, and the industries it impacts, some of its characteristics are shown in Section 1.4.

Because project finance is part of business development, Section 1.5 provides the rationale for using a new business development approach to evaluate, structure, and fund project finance transactions aiming to create a competitive advantage for the company. The structure of the book and chapter contents is presented in Section 1.6 and how to maximize its benefits to the reader is explained in Section 1.7.

1.1 ORIGINS OF PROJECT FINANCE

The basic idea of project finance is not new, but it has evolved and refined through time and has now become a highly skilled discipline and an art. According to Miller (1991), elements of project finance present in Mesopotamian societies were expanded by ancient Greeks to foster maritime trade and to finance wars. Maritime loans were given to ship owners and merchants to buy goods for sale abroad with the understanding that if the ship returned, the loan would be repaid in full plus a return (often as high as 25% because of risks involved) out of the proceeds of goods sold abroad and out of the proceeds from the sale of cargo brought back. If the ship was lost at sea or did not return with cargo from abroad, in the first instance the loan was not repaid and in the second case was partially paid through proceeds of sales of cargo sold abroad.

The Athenians used project finance concepts to finance war in the following manner: They created an...