Project finance in Nigeria is a loan-based funding predominantly used to finance activities in the energy sector and in infrastructure. Project financing can be immensely complex deals that takes years to come to fruition.
What is Project Finance?
Project finance brings together lenders from developed economies to help construct infrastructure project in emerging economies. What makes them different from standard commercial lending is that they are often limited recourse or non-recourses meaning that the lenders will not look to (have recourse to) the borrower for repayment.
At first sight this sounds crazy – banks not expecting repayment from the borrower? But in fact it means simply that they look to the income from the project to repay the loan, not the borrowing vehicle set up to initiate the project. That’s a non-recourse deal. In a limited recourse one the banks reserve the right to seek repayment from the borrower if the project income isn’t sufficient.
The borrower will be a special purpose vehicle project vehicle project company which builds, owns and runs the project once built. The project sponsors are the multinational companies keen to get the project off the ground, often the contractors that build the project or supply heavy plant (such as turbines) to it. Then there are the banks funding the project and the government in whose country the project is being built, which will either buy the project’s output or guarantee the purchase of it.
The key to the financing is how the borrowing will be repaid. This is done through an offtake contract where the government agrees to buy the project’s output (such as electricity) to distribute to its citizens. Not all projects have an offtake agreement – for instance a motorway operating on a toll basis simply earns money from the users, while an oil project will usually have its product sold in the open market. But where the only customer will be the state or a state agency, the offtake arrangement will be critical since it will be the sole source of the project’s income and, therefore, viability – which is why the agreement is also called a take-or-pay (meaning that the project output has to be Paid for whether or not it is wanted or used).
Most projects are built on a turn-key basis – after the builder has finished, the project is ready to go (like starting a car). There will be a long-stop date by which the project should be completed and a drop-dead date by when the project must come on-stream to meet the debt service and repayment projections.
Once the project comes on-stream the money earned by the project from the offtake or take-or-pay agreement will be paid first to the banks (so they start to recoup the interest and principal of their loans) and then to the project. So the income generated from the project is often paid into offshore escrow accounts (escrows means a trust account) over which the banks have charge, to ensure they are paid out first.
Types of Project Finance
A typical project might be a dam that creates hydro-electric power in an emerging market, a typical natural resource project: or infrastructure improvements (ports, airports, roads, bridges and tunnels); or new industrial plant projects (such as paper mills and aluminium smelters). In fact the techniques to do this, which were exported from developed economics in the 1970s and 1980s to emerging markets, have since been re-imported by those developed economies in order to build public sector projects such as hospitals, schools and road but with private sector financing. This keeps them off government balance sheet (like securitization, another example of OBS financing) so reducing the apparent level of government borrowing. They are called public private partnership (PPP) and private finance initiative (PFI) deals
Advantages of Project finance
- Many of the countries in which project financings have traditionally taken place such as Nigeria are poor credits. They may have borrowed extensively in the international financial markets and even rescheduled. So project financing is a way of continuing to lend to such countries but without lending directly to the indebted government. In this sense project financings are often ringfenced: the money must be used for the project and the project only.
- A major source of complexity in a project financing is the time it takes to come on-stream. Funds will go into the project during its construction phase and will only be recouped during its operation. This means there is always a risk – compounded by the complexity of vast construction projects in markets not used to them – that the project will run out of money before it is completed. So, during the project’s construction, the bank have step-in rights to take over the project to ensure it is finished. Having lent money once they won’t want to do it again so funds necessary to take the project forward to completion will be provided under a completion bond (a form of insurance) provided by a monoline insurer (an insurance company specializing in one line of business, namely insuring construction projects). Completion bonds are also used in the movie business to ensure a film can be finished and distributed (movies can also be funded through finance leasing – see above).
Disadvantages of Project finance
- There is one other risk: that the government likes the look of the project so much it nationalizes it. This is called political risk and is neutralized by a different form of insurance – political risk insurance. This is provided by export credit agencies (ECAs). Every developed country has a ECA which helps to finance the sale of its exports to other markets. They include US Exim (the US Export-Import Bank), the japan bank for international Co-operation (the Japanese equivalent) and COFACE (France). ECAs will help companies from their country participate in major projects (often the project sponsors seeking export markets) by proving soft loans to the project, that is, loans on preferential terms (called co-financings where funding comes from commercial banks as well as ECAs) and by providing political risk insurance. Multilateral lending agencies (such as the World Bank, Asian Development Bank and EBRD – the European Bank for Reconstruction and Development) which are like ECAs but have a supranational remit (and are often called supranational banks) will become involved in major projects. Their involvement (by providing finance or guarantees) often encourages commercial banks to participate.