Also working to its advantage is the globalization of financial markets, which has helped create a broad spectrum of financial instruments and new classes of investors
For developing markets, project finance holds out the hope that a well-structured, economically viable project will attract long-term financing even if the project dwarfs its sponsors’ own resources or entails risks they are unable to bear alone. With such a mechanism for sharing the costs, risks, and rewards of a project among a number of unrelated parties, a privatization or infrastructure improvement program will have a greater chance of raising the volume of funds it requires.
As a result, it is now standard practice for large and complex projects in the major developing markets to employ project finance techniques. The total volume of project finance transactions concluded in 1996 and 1997 before the financial crisis (an estimated 954 projects costing $215 billion) would have been hard to imagine a decade ago. The number of active participants in these markets also increased as many international institutions (investment banks, commercial banks, institutional investors, and others) moved quickly to build up their project finance expertise.
The financial and economic crisis of late 1997 in East Asia, the site of much recent growth, and in other countries since then has dramatically slowed market evolution. The financial capacity and willingness of many banks in these countries and of other potential investors to support large projects has also been eroded. As a result, sponsors in East Asia, both private and public, have canceled or deferred numerous major projects. The ones still under implementation, particularly those financed during the past few years, have come under increased stress in the face of reduced market demand for their output or related sponsor problems.
With the prospects for economic growth slowing worldwide, other countries and regions are also structuring projects more conservatively. It is not yet clear how prolonged these difficulties will be. When the growth of new productive investment picks up again, however, project financing is likely to increase, particularly in countries where perceptions of risk remain high and investors could be expected to turn to structuring techniques to help alleviate these risks.
In the appropriate circumstances, project finance has two important advantages over traditional corporate finance: it can (1) increase the availability of finance, and (2) reduce the overall risk for major project participants, bringing it down to an acceptable level.
For a sponsor, a compelling reason to consider using project finance is that the risks of the new project will remain separate from its existing business. Then if the project, large or small, were to fail, this would not jeopardize the financial integrity of the corporate sponsor’s core businesses. Proper structuring will also protect the sponsor’s capital base and debt capacity and usually allow the new project to be financed without requiring as much sponsor equity as in traditional corporate finance. Thus the technique enables a sponsor to increase leverage and expand its overall business. 1
By allocating the risks and the financing needs of the project among a group of interested parties or sponsors, project finance makes it possible to undertake projects that would be too large or would pose too great a risk for one party on its own. This was the case in 1995 when IFC helped structure financing for a $1.4 billion power project in the Philippines during a time of considerable economic uncertainty there. Sharing the risks among many investors was an important factor in getting the project launched.
A project that can be structured to attract these investors-to supplement or even to substitute for bank lending-may be able to raise longer-term finance more easily
To raise adequate funding, project sponsors must settle on a financial package that payday loans New Mexico both meets the needs of the project-in the context of its particular risks and the available security at various phases of development-and is attractive to potential creditors and investors. By tapping various sources (for example, equity investors, banks, and the capital markets), each of which demand a different risk/return profile for their investments, a large project can raise these funds at a relatively low cost. By contrast, traditionally project sponsors would have relied on their own resources for equity and on commercial banks for debt financing. Particularly significant is the increasing importance of private equity investors, who tend to take a long-term view of their investments. These investors are often willing to take more risk (for example, by extending subordinated debt) in anticipation of higher returns (through equity or income sharing) than lenders. Further details on the main financial instruments and sources of financing for project finance appear in box 1.1.