The following is a guest post from Lukas Hofer. Lukas studied business and economics in Germany and started his career in investment banking and management consulting. He currently works as freelance writer and translator focusing on business & finance, economics and conflict & security. For more information on him, you can visit his site at www.LJHofer.com
Everybody concerned with investment banking knows about areas like sales and trading, mergers and acquisitions and equity capital management. But have you ever heard of Project Finance? If not, no worries, we can change this today.
Project Finance is a rather small area of investment banking. The main purpose is to help companies to finance long-term projects that require a huge amount of external financing. Constructing a new office building can usually be done with a single credit facility. But if a company wants to build a nuclear power plant or an offshore wind park, there is a need for much more money than one bank is willing to provide.
Financing is provided off-balance sheet
The biggest difference between an ordinary bank credit and Project Finance is that an ordinary bank credit goes directly to the client. In Project Finance the money is given to a separate legal entity – the so-called special purpose entity (SPE). This SPE is created just for one specific project.
Let’s take a look at an energy producer who wants to build a nuclear power plant. He would found a new company – the SPE – having the power plant and other project related assets as its only assets. The other side of the balance sheet would consist of the debt provided by the banks and the sponsor’s equity. The sponsors are in most cases the company who initiated the project itself and private equity investors.
There are several reasons for the creation of the SPE:
- Risk allocation: The risk for the sponsor is reduced. If the power plant will not generate enough cash-flow to pay off debt and interest rates, the SPE will get into financial distress. However, the sponsor’s assets will be protected.
- Credit standing: The bank’s decision to provide debt is mostly dependent on the future cash flows of the SPE, not on the credit standing of the sponsor. Therefore, it is possible for a company with a bad credit standing to get access to external financing.
- Debt-to-equity ratio: These projects usually require a huge amount of debt financing. Therefore, taking the project on to their own balance sheet would significantly increase the sponsor’s debt-to-equity ratio. Instead, maintaining the assets and debt related to the project on the SPE’s balance sheet will mean that the sponsor will only show his equity stake in the project.
Several banks form a syndicate
As no bank wants to finance a nuclear power plant alone, a syndicate of banks is formed to bring in the required money. The sponsor mandates one bank to be the leader of the syndicate, the so-called Mandated Lead Arranger (MLA).
The MLA’s role is to handle the communication between all participating banks and the sponsor. He has a lead role in underwriting the project and usually he also provides a portion of the debt. The other participants just provide their tranche. A banker once explained it to me with the following words: ‘As a participant you get offered a piece of the cake but as an arranger you make the cake.’
A project includes more parties than just the sponsors and the banks. There are also technical advisers, legal advisers, public agencies, and sometimes even more, depending on the project. While the participants handle all their communication with the MLA, the MLA itself has to talk to all parties.
This is especially important because the MLA has to collect all the information for the financial model for the underwriting process. Generally speaking, financial models in Project Finance are more complex than other models in corporate finance. The projects have a long time horizon and therefore quite a lot of different risk scenarios have to be covered. Hence sensitivity analysis is one of the most important concerns in this kind of financial modeling. Examples for different scenarios could be a change in revenue after a certain number of years, the construction will take longer than expected, increasing costs, etc.
The market is growing
Projects have mainly three things in common: They are long term, the required amount of money is huge and the financing is off the sponsor’s balance sheet. Most of these projects are in the areas energy, mining, transportation, public institutions (for example universities) and telecommunications.
According to the European Investment Bank (EIB), the market volume in Project Finance is around 450 Billion USD per year. The market is growing at an annual rate of 15%. The main reasons for this growth are the growing population, industrialization in emerging markets and the aging infrastructure in developed countries. The EIB estimates that until 2030, there will be cumulative investments over 50 Trillion USD for roads, energy, water, airports, telecommunication and rail in OECD countries alone.
Banks can earn money in different ways
Obviously, banks can earn money from the loan’s interest rate. However, after providing the loans, some banks sell them on the secondary market, often as part of a bigger package. Various entities have the appetite to purchase these loans as investments. For example insurance companies have an interest in such long living cash flows, because they can use it for duration matching. And finally, the MLA can gain profit from theadvisory fee.
Daily work is not always easy, but it creates a good feeling
Especially now, in the wake of the financial crisis, many banks hesitate to take over such projects. They know it would involve a substantial amount of money and involvement in the project for many years, so there is a significant risk. Moreover, the Basel II regulations do not favor long-term investments. In fact, banks are reducing their risk-weighted assets.
This makes the actual work in Project Finance sometimes difficult. Whenever you want to take over a new project, at first you have to fight a troublesome war against various internal authorities to get the credit approval.
Those internal restrictions can sometimes be a bit depressing. However, from my personal point of view, Project Finance is still one of the most interesting areas in investment banking. You actually create something real, something you can touch and something that helps people. If the project is completed you can say: ‘I helped to build this power plant’. That is indeed rewarding.