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Pivotal180 is excited to share a Spanish subtitled extract from our Renewable Energy Project Finance Modeling course. This video is titled “What is Project Finance”.
Participants in our renewable energy project finance modeling course build a renewable energy project finance model from scratch and gain insights into the key terms of the main Agreements used in deals.
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This is an extract from Pivotal180’s project finance courses: Great for those new to project finance! Understand the core concepts of non-recourse, limited liability, special purpose vehicles, and more.
Now that you’ve completed the pre-course materials, I suggest that we launch into the full course with a question, a deceptively hard and almost impossible question. How do you convince lenders and equity investors to provide hundreds of millions of dollars to a company that has no credit history, has no employees, has never operated or generated any revenue and has no guarantees from anyone credit worthy, promising to repay the money and make good on the investment?
When I pose the question this way, it sounds like an exercise in the impossible, right? It would seem to violate every rule of prudent lending out there and it’s not like equity is going to fill the gap, right? Because this hardly sounds like a promising set of circumstances to support an equity investment, but these conditions are really how hundreds of billions of dollars of infrastructure assets get financed every year.
Given the title of this course, you’ve probably figured out that the answer to that huge impossible question is of course project finance, and you’re right. So let’s jump right into it and talk about the key elements of what project finance is all about.
First and foremost, project finance is about non-recourse obligations. What do I mean by non-recourse? Well, a new venture will establish a project company what’s oftentimes called a special purpose vehicle or a special purpose company or a special purpose entity. The terms are used interchangeably, they all mean the same thing and sometimes they’re abbreviated as SPV as PC or SPE. That project company will typically borrow a lot of money to acquire some assets or build some assets, but the obligation to repay the loan stays at the level of that project company, and not at the level of the investors in that company. It doesn’t matter if some of the wealthiest people in the world are the owners of that project. Like, even if Bill Gates and the Queen of England invested together to build a wind farm, the lenders to that project company cannot go after the personal assets of Bill Gates and the Queen, in the event that the project fails to repay the loan.
So, non-recourse means that the creditors are relying only on the special purpose company to repay that loan or any other obligations out there. Financial obligations are recourse only to the project company and they are non-recourse to the sponsors or the investors in the project. Next: project finance is cashflow based. And by this, what I mean is that our basis evaluation is cashflow and not collateral. When you think about, a home loan or an automobile loan or an airplane loan, most of the time that’s predicated on some kind of appraisal that puts a value on the actual asset. Lenders will advance some percentage against that value based upon a loan to value ratio. So in the United States for example, you can typically borrow 80% of the appraised value of a home.
The idea being if you fail to repay, your lender can repossess the home, they will foreclose, they’ll sell the home, and then they’ll use the proceeds to repay themselves and by only extending loans for 80% of the value of a house, there’s a very good chance that they’re going to recover all of their money. Except maybe during a housing crisis, but how often does that really happen? Oh, too soon. I should not joke about that.
Anyway, in project finance, it doesn’t work that way. If you were to foreclose on a wind farm, take it down and sell all of the pieces for spare parts or reassemble it somewhere else, you would never ever recover the value of that wind farm. The only way that your investment is money good, both the debt and the equity is if the project operates in place and in service. The valuation of that project is based on its ability to generate cash.
So, if you need reliable cashflow to make the project financeable, how can you get there? Especially if you don’t have any employees.
Well, what project companies typically do is assemble a network of contracts that allocate who is going to do what. So who is obligated to build the project? Who’s obligated to operate the project? Who’s obligated to purchase the output of the project?
You get the idea.
And for project finance to work, you need to line up all of these contract counter parties who are experienced and capable to do the work and contractually obligated to do that work. And not insignificantly, they need to be financially strong enough to bear the risk of paying penalties if they fail to deliver on their obligations. Now, even with rock solid contracts, this whole thing only works with proven technologies.
You can’t just do project finance with new equipment that’s never been around before. Unless you can line up a guarantee from someone who’s going to pay for everything in case it doesn’t work. So lenders and infrastructure investors would have a really hard time getting comfortable with equipment that has a serial number 001 or 002, which probably explains why the big manufacturers of major energy infrastructure equipment tend to be companies like General Electric or Mitsubishi or Siemens. They’re names that you know, and people that you trust.
Finally, there’s a concept of limited liability, so just like the loans to the project company are non-recourse, any other liabilities that are created at the project company need to stay at the project company. So a lawsuit, for example, would remain at the project company level and it would not come back to harm Bill Gates and the Queen of England if they just so happened to be the owners of that project company. Well, that’s assuming that they had the good sense to create the right form of legal entities to that project and that they structured everything correctly from the beginning.
But we’ll get back to that in the next module.