Principles of Project Finance

Leveraged buyout (“LBO”) or management buyout (“MBO”) financing.

This highly leveraged financing provides for the acquisition of an existing

business by portfolio investors (LBO) or its own management (MBO). It

is usually based on a mixture of the cash flow of the business and the value

of its assets. It does not normally involve finance for construction of a new

project, nor does this type of financing use contracts as security as does proj-

ect finance.

Acquisition finance. Probably the largest sector in structured finance, acquisi-

tion finance enables company A to acquire company B using highly leveraged

debt. In that sense it is similar to LBO and MBO financing, but based on the

combined business of the two companies.

Asset finance. Asset finance is based on lending against the value of assets

easily saleable in the open market, e.g., aircraft or real estate (property) fi-

nancing, whereas project finance lending is against the cash flow produced

by the asset, which may have little open-market value.

Leasing. Leasing is a form of asset finance, in which ownership of the asset

financed remains with the lessor (i.e., lender) (cf. §3.4).

§2.5 WHY USE PROJECT FINANCE?

A project may be financed by a company as an addition to its existing business

rather than on a stand-alone project finance basis. In this case, the company uses

its available cash and credit lines to pay for the project, and if necessary raise new

credit lines or even new equity capital to do so (i.e., it makes use of corporate

finance). Provided it can be supported by the company’s balance sheet and earn-

ings record, a corporate loan to finance a project is normally fairly simple, quick,

and cheap to arrange.

A Project Company, unlike a corporate borrower, has no business record to

serve as the basis for a lending decision. Nonetheless, lenders have to be confident

that they will be repaid, especially taking account of the additional risk from the

high level of debt inherent in a project finance transaction. This means that they

need to have a high degree of confidence that the project (a) can be completed on

time and on budget, (b) is technically capable of operating as designed, and

(c) that there will be enough net cash flow from the project’s operation to cover

their debt service adequately. Project economics also need to be robust enough to

cover any temporary problems that may arise.

Thus the lenders need to evaluate the terms of the project’s contracts insofar as

these provide a basis for its construction costs and operating cash flow, and quan-

tify the risks inherent in the project with particular care. They need to ensure that

project risks are allocated to appropriate parties other than the Project Company,

or, where this is not possible, mitigated in other ways. This process is known as

§2.5 Why Use Project Finance? 13