The advantages of project finance for counterparties
What motivates sponsors and lenders to take the huge risks implied by a large infrastructure or power projects?
Advantages of project finance for Sponsors
The main advantage for Sponsors is to limits the risks they take.
Sponsors are industrial companies, the state and other financial sponsors that usually have a strong reason to support the project. For industrial sponsors, the realization of the project can participate in the economic activity of the company (for example a power company that need to increase the share of the renewable energies in its offer could be a sponsor for a wind farm project). For the state, the project can yield important positive outcomes on the economy and society. But these stakeholders may not have the balance sheet strength or willigness to take on this huge project themselves.
For them, the main advantage of using project finance is to:
- Limit in responsibilities: the sponsor can only loose the equity they invested, their own balance sheet isn't pledged into the project (which it would if the project had not been undertaken via a SPV). The project isn't affecting the sponsor's weighted average cost of capital. Because it doesn't display the project in its balance sheet and income statement, except through its shares in the project SPV.
- Losses are capped to initial investment: this is the outcome of the previous statement: the maximum risk is known from the beginning,
- From the point of view of the SPV, default risk is only linked to the activity of the project. The SPV is only taking care of one project, it is not sustaining other projects that could add-up risk of running out of cash.
Advantages for the lenders
Invest in a specific project instead of a full company.
From the point of view of an investor, lending to a company (the SPV) that undertakes one specific project and business gives exposure to a very specific market. Risk are easier to understand and the lender can diversify if needed.
- The viability of a project is somewhat easier to assess than that of a full company (but we are not saying investing in the SPV is less risky!). The project costs and cash flows are assessed with a financial model that will allow calibrating the level of debt, and doing scenario analysis.
- The lender can choose precisely to which project it will take exposure, and not invest in a bundle of projects with unequal attractivity (which would be the case if it invested in a traditional company).