Overview
Businesses may seek business loans at a sooner or later growth stage for any general or specific financial requirements going anywhere from managing day to day business or undertaking mega projects. However, whether to or not seek loans might need careful consideration of several factors such as duration of the project, purpose for seeking loan, risk involved, ways to obtain funds required for the project, etc.
Therefore, where an organization does not have adequate cash flows required by the project and conventional financing methods don’t seem like a good option, using the projected revenue out of the project itself to secure funding might be the answer. Keep reading to find out how project finance works, its unique features, pros and cons, etc. and more to find out whether it could be the right choice for your business endeavours.
Project Finance-Meaning and Purpose
Project finance could be understood as a procedure of financing long term projects aimed by businesses where the debt and equity to be repaid are made out of the income generated from such projects only. It is generally applied towards infrastructure or industrial projects with a specific structure being used to provide funding for capital intensive projects.
Thus, the project finance loans structure depends on the cash inflows for repayment apart from the assets, rights and interests assigned as secondary collateral for repayment security purposes. This attribute attracts private sector businesses specifically as the debt applied for long-term projects does not have any adverse impact upon their balance sheet, their borrowing capacity or credit rating.
Key Features, Process, and Benefits of Project Finance
Key Features of Project Finance
Capital intensive in nature-
Normally, the projects funded by project finance loans are capital intensive in nature with a long gestation period. Such projects need a considerable amount of money with huge developmental costs. Thus, the investors offer funds on the basis of the anticipated cash flows and not on the basis of business balance sheets.
Requires proper risk allocation-
Due to the substantial capital requirement in any project finance, there is need for proper risk allocation between the different stakeholders involved in the transaction i.e. lenders, investors, project sponsors, etc. on the basis of the amount contributed, expected returns and the risk appetite of the specific party.
Involves multiple stakeholders-
Generally, multiple stakeholders come together to fund the projects under project finance. For instance, private sponsors (offer equity and undertake management functions), lenders (financial institutions offer long-term debt for the project), investors (offer equity in the project in exchange for a certain stake), and government bodies (offer funds, permits and guarantee for projects), etc.
Creation of a Special Purpose Vehicle-
Usually such long-term projects are undertaken by creating a special purpose vehicle by the project sponsor responsible to build and operate the project. The Special purpose vehicle created for obtaining project finance, is a separate business entity (generally a limited company/ limited liability partnership) that enables protection against financial woes in the project.
Limited Recourse-
In case of a project finance loan, the lenders can seek repayment only from the revenue generated from the project or the business assets which minimizes risk for the project sponsors.
Comes with tax benefits-
Project finance offers tax benefits to the stakeholders involved in the transaction. For instance, project sponsors could benefit from different tax deductions available under income-tax regulations or seek credit available for certain projects (i.e. infrastructure projects).
Risk Mitigation and Exit Strategy –
It is important to know the risks involved in any project, this helps to plan for contingencies in advance. Often the project sponsors will plan ahead to mitigate risks by hedging, diversification etc. And as a final step it is prudent to have an exit strategy by either delegating, selling or restructuring the project at a later conducive stage. Thereby making the project profitable for sponsors and stakeholders
Components of Project Finance
The project can be financed in several ways but the major contributions are either from the sponsors themselves or lenders. Thus the two main parts of project finance are:
Equity Contribution- Funds provided by sponsors for the long-term project to cover initial production costs in exchange of ownership stake known as equity contribution. Over time, the equity stakeholders aim to generate higher returns used to facilitate the high capital needs of large projects.
Debt Financing: When banks or other financial institutions provide a loan for a project and expect interest repayments in the long period, it is known as debt contribution. However, before approving finances for such long-term projects, lenders must make careful assessment of risks involved in the transaction
Process Involved in Obtaining Project Finance
- Pre-financing Stage- The process initiates with the project sponsor evaluating all the risks involved in the transaction and minimizing risks in the transaction to ensure viability of the project. Next, he also studies the technical and financial feasibility of the project, identifies the project’s potential and funding requirements.
- Financing Stage- Next, the project sponsor identifies potential investors and other stakeholders who could offer funding to the project. Once they identify investors, negotiate contract terms with the parties and decide on the capital structure for debt and equity.
- Due Diligence- Due Diligence is carried out carefully considering legal, technical and environmental aspects are reviewed to be compliant with regulations.
- Post Financing- Now, as financing is arranged the sponsors track project progress and ensure the project is completed on time. On fulfilment of the project, the sponsor repays the due sum to the stakeholders.
Documents Required for Project Finance
-
- Project Feasibility report providing inclusive breakdown of the project feasibility including technical reports, financial, environment and social facets.
- Comprehensive projections for expenses and revenues, profits and losses, cash inflows, etc establishing viability of the project.
- Detailed project report offering the aims and objectives of the projects, designs, implementation plan and stakeholders involved.
- Detailed presentation of the anticipated cash inflows and outflows demonstrating debt servicing ability of the sponsor.
- Proof of address for the project site (sale deed/lease agreement)
- Proof of business registration and requisite business licenses for project sponsor.
- Proof of identification and address proof for the project sponsors.
- Legal agreements such as risk allocation agreement stipulating risk allocation among stakeholders and security agreement specifying collateral for payment security.
Project Finance Loan Eligibility Requirements
- Mid / Large corporate entity with an annual turnover above 500 crores or more or project expenditure of Rs.500 Crores or entities with lowest exposure (Funded + Non-Funded) of Rs.25 Crores
- Businesses (plus Special purpose vehicles) implementing long term projects under various industries like Power, Construction, Water supply channels, Telecommunication, Housing, Agricultural inputs, educational institutions, hospitals, Industrial parks or public facilities, or any similar public facility notified by RBI from time to time.
Project Finance Vs Working Capital Loan
Dimensions |
Project Finance |
Working Capital Loan |
| Purpose | Project finance loans facilitate funding resources for long term projects. | Used to meet day to day business requirements such as payment of staff salaries, purchasing raw material, meeting marketing or promotional expenses, etc. |
| Time Involved | Project finance loans are often long term in nature spanning over several years. | Working capital Loans are usually short term in nature focusing on current assets and liabilities within a business cycle. |
| Cash Flows | Project finance loans are dependent upon the income generated from the project only. | Working capital finance reflects the overall financial health of the business. |
| Collateral | Under project finance, the project assets act as the collateral, | Working capital financing does not involve any specific asset as collateral. |
| Applicability | Project finance loans are usually associated with infrastructure projects like transportation systems or housing facilities, etc. | Working capital finance is essential for all businesses to manage day-to-day operations. |
Project Finance Vs Corporate Finance / Business Loan
| Dimensions | Project Finance | Corporate Finance/ Business Loan |
| Cash flows | Project finance loans rely on cash flows generated from the project only. | Corporate Finance/ Business Loan rely on the overall business revenue and cash flows. |
| Timelines | Project Finance always has a fixed timeline that matches the tenure of the project. | Corporate Finance/ Business Loan can be availed for an in-definitive period, it can be renewed or repaid in advance. |
| Size of finance and transaction costs | Project finance often involves huge credit, highly customized and are generally non-reuseable in nature, involving high transaction costs. | The size of the Corporate Finance/ Business Loan is flexible between lower working capital needs and high long-term investments. It is recurring and renewable in nature and generally involves lower transaction costs. |
| Purpose | Project finance loans are customized for specified large scale projects with a long gestation period with specified assets like power plant or equipment, etc. | Corporate Finance/ Business Loan could be for any specific or general purposes such as meeting operational costs, starting a new business unit or purchasing new business assets. |
| Limited Recourse | In project finance loans, the lenders tend to have restricted recourse to the assets of the sponsor in the event of any failure or dispute. | Lenders have wider recourse to the assets of the borrower’s business in the event of disputes. |
| Special Purpose Vehicle (SPV) | Project finance loan requires creation of a Special purpose vehicle for ownership of business assets and debt management. | Corporate Finance/ Business Loan does not require creation of a SPV.
|
Project Finance Pros
Risk Allocation
Project financing enables proper risk allocation among multiple stakeholders through detailed risk assessment measures and contractual agreements between parties in the events like delay in project completion, incurring costs more than anticipated, instabilities in revenues, regulatory hurdles, etc. Such risks could be allocated among stakeholders with expertise in concerned areas which makes it more attractive for investors to come onboard.
Off-Balance Sheet Financing
The greatest advantage of project finance is that it allows businesses to keep the expenditure and revenues of the Project off their balance sheets bearing no impact on their borrowing capacity helping businesses to maintain their financial score. Likewise, businesses could present a financially sound picture making it more convenient to raise funds in future for other business purposes.
Dynamic Financing Structure
By offering a combination of debt as well as equity financing, project finance enables a flexible capital structure for the business designed to precise requirements of the project. It also allows sponsors to identify investors and seek debt in a perfect mixture that could keep the cost of capital at minimum and offer maximum returns for investors.
Access to funds in a simple manner
Project finance enables access to substantial funding for projects which are otherwise considered risky or too capital intensive from conventional sources of financing. Leveraging assets and future cash flows from the project itself reduces equity requirements and attracts a diverse pool of investors.
Steady source of revenue in long term
Projects funded through project finance loans enjoy steady flow of income as there are long term contracts in place till the span of project completion. Further having a steady flow of income also enhances the creditworthiness of the sponsor business reducing the likelihood of default which naturally gives it an edge to negotiate favourable contractual terms with lenders and investors.
Access to Wider Capital Market
The project-based structure under a project loan gives access to a varied group of investors and stakeholders which increases chances of securing capital for the sponsors.
Project Finance Cons
Complex structuring- Project finance transactions often invite complexity due to the involvement of elaborate legal, financial and technical measures demanding expertise of several stakeholders such as technicians, consultants, engineers, and lawyers, etc. which makes it challenging to structure the transaction eventually giving way for lengthy negotiation process, incurring more costs and even more administrative burden.
High due diligence requirements-
Since there are a lot of stakes at risks associated with the long-term project, usually lenders and investors do a comprehensive due diligence assessing project viability, regulatory risks and market dynamics study etc. before they sanction the project finance loans. It could be time -consuming and keep more resources tied up, eventually delaying project initiation or sometimes a project might not take off.
Limited scope-
Although beneficial for large scale standalone projects with recognizable sources of revenue like infrastructure development or natural extraction, etc. which limits the ability of the sponsor business to explore other financing options.
Highly sensitive to market conditions-
Generally project finance transactions are sensitive and prompt quick reactions to conditions such as changes in interest rates, exchange rate fluctuations, higher commodity prices, and regulatory policies related changes, financial slowdowns, geopolitical instabilities or any other market conditions which might have an adverse impact on project revenues potentially leading to higher chances of default and cash inflow disruptions causing further hurdles in refinancing or in refinancing debt.
Limited exit opportunities-
Another drawback of project finance is its limited exit opportunities for the investors due to the long-term nature of the project and liquidity challenges of the assets involved in the project. Investors may need more choices to divest their ownership stakes or transfer their interests which further restricts their ability to realize quick return on investments
Hence as seen, the smaller businesses may find it difficult to avail this type of funding from the banks. They may wish to avail other types of business loans and funding. To be sure they are not being overcharged or ensure proper credit against collateral, for better negotiations and for better understanding of the sanction letter, they may take the help of experts like BankKeeping. We help businesses handle their banking needs by negotiating better terms and ensuring timely submissions of important documents to avoid unnecessary bank charges or penalties.
Components of a Project Report
The major components of a project finance report are listed below:
Executive Summary of Project Finance Report:
Executive summary offers a detailed overview regarding the project to capture the attention of the investor or lender like a business pitch. It would include-
- Business description
- Problem it aims to resolve
- Market research backed by data
- Key Competitors
- Market trends
- Unique selling proposition of the project
Detailed Project Plan for which Project Finance Report is being made-
It details the primary activities, the period over which it is to be done, and key milestones, and also includes a clear understanding of the manpower, equipment and material resources required.
Financial Projections for the Project Report –
Next the sponsor business needs to establish the viability of the project, its ability to generate revenues and above all to achieve profitability including projections, and break-even analysis. It also includes past data and industry standards to facilitate comparison and increase the appeal of the overall pitch.
Risk Assessment of the Project for Project Finance Report.
Next, the project report contains the assessment of risks in the project and the manner of getting rid of such risks such as market instabilities, disruptions in supply chains, or regulatory changes, etc. Adding strategies to alleviate unanticipated risks will demonstrate skills to problem solving.
Management Team Handling the Project-
Lenders feel confident to lend funds to a business entity helmed by expert professionals with specific qualifications, knowledge and experience to handle tricky situations. Thus, include the name and specifications of the team members along with their qualification and experience, work history, and accomplishments.
Format of a Project Loan Report
PROJECT REPORT
- Executive Summary –
| Project Cost and Source of Finance | |
Total Project Cost Equity Bank Loan |
– |
| – | |
| – | |
| – | |
| – | |
- Project Description
| CASH FLOW STATEMENT | ||||
| Particulars | Construction | 1st year | 2nd year | 3rd year |
| Period | ||||
|
– | – | – | – |
|
– | – | – | – |
| (Net profit +Interest) | – | – | – | – |
|
– | – | – | – |
|
– | – | – | – |
|
– | – | – | – |
|
– | – | – | – |
|
– | – | – | – |
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– | – | – | – |
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– | – | – | – |
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– | – | – | – |
|
– | – | – | – |
|
– | – | – | – |
|
– | – | – | – |
|
– | – | – | – |
| Total Disposition | – | – | – | – |
| C. Net Surplus (A -B) | ||||
| D. Closing Balance | ||||
- Market Analysis- This section includes information regarding market analysis performed in regard to the project, target market, industry and trends.
- Management Team – Includes details of the management team, their qualifications and roles in the project.
- Manpower Requirements
| Sl. | Designation | Rate | Salary |
|
|
|||
|
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| Manager | |||
|
- Technical Feasibility Report
- Financial projections Report
| PROJECTED BALANCE SHEET | |||
| Particulars | Ist Year | 2nd Year | 3rd Year |
| I. EQUITY AND LIABILITIES | |||
| (1) Shareholder’s Funds | – | – | – |
| (a) Share Capital | – | – | – |
| (b) Opening Balance | – | – | – |
| (b) Net Profit | – | – | – |
| Less: Drawing | – | – | – |
| Reserve & surplus | – | – | – |
| (2) Current Liabilities | – | – | – |
| 1. Long-term borrowings | – | – | – |
| Total | – | – | – |
| II.Assets | – | – | – |
| (1) Non-current assets | – | – | – |
| A. Fixed Assets : | – | – | – |
| Gross Block | – | – | – |
| Less: Depreciation | – | – | – |
| Net Block A | – | – | – |
| (b) Non-current investments | – | – | – |
| (e) Other non-current assets | – | – | – |
| (2) Current assets | – | – | – |
| (b) Inventories | – | – | – |
| (c) Trade receivables | – | – | – |
| 1. Consumable Stores | – | – | – |
| (d) Cash and cash equivalents | – | – | – |
| (f) Other current assets | – | – | – |
| Total | – | – | – |
- Collateral & Security- Details regarding assets such as inventory, plant and machinery or real estate related collateral.
- Appendices- Any other data or records such as market study reports or analysis which would enhance the overall impact of the project report.
- Conclusion- Summary of the entire project laying its impact and anticipated earnings on the investment.
Documents Accompanied with Project Finance Report
- Loan request letter including authority letter for the business representative
- KYC details of the directors of the company (Copy of Aadhar/PAN/Driving license or similar documents)
- Net worth statements of the directors
- Passport sized photographs (at least two) of the Directors
- Bank statements of the directors including their CIBIL report
- Copy of board resolution
- Business registration documents
- ITR copies of the business entity since past three years with date of filling clearly filed with income computations.
- Financial statements like Balance sheet and profit & loss a/c including all necessary attachments for proprietor/director/partner (at least 3 years)
- Statutory tax audit reports of the concerned business
- Copy of MOA and AOA of the business entity;
- Copy of shareholding structure of the business and list of all directors duly attested by a practicing Chartered Accountant
- Business bank statement for past one year
- List of projects completed by the business entity in the past.
- CMA data report along with the expenses, profits and revenues generated by the business.
- Credit rating of the business entity (where the proposed loan amt is more than 5 Cr.)
- Valuation report of the project property
- copy of property title
- All statutory approvals obtained
- Any charge on the property (where any) and lien amount
- Proposed sources of finance and total cost of project.
- Prior loans obligations and outstanding principal as on the date of application including track record of repayments.
- Loan request letter and proposed tenure.
- Copy of site visit of the property.
Conclusion
Therefore, project finance is a financing arrangement applicable to long term projects with high capital requirement assisting businesses where traditional financing options might not be available. While it helps the businesses to manage their cash flows with minimal risks, it allows the stakeholders to effectively share risks ensuring funds availability in the long period.
Although its sole reliance on the income streams generated from the project itself might make it a risky alternative however it allows businesses to present the finance related to the concerned project as off -balance sheet items which does not put immediate burden on the business finances.