Project Financing

Godfather Revisited Part III: Bringing in the Dough

*note: this illustration presumes knowledge of events in the Lord of the Rings. There is a less context-heavy explanation on the veritable website known as ChambersStudent*


The year is ROTK 1. Following the events in Return of the King, Frodo, Samwise, Merry and Pippin are finally on their way home. The tortious conversion case of Sauron v Frodo having been dismissed on grounds that “the claimant has ceased to exist”, Frodo and friends now find themselves back in the Shire. Alas, it is in shambles when they arrive.


The group pledge to rebuild the Shire. Their key project is the construction of a wood fired conservatory dedicated to the study of the Ring (the “Ring Conservatory”), which will cost roughly 3,500 Hobbit Dollars, otherwise known as Hobos. Upon completion, the Ring Conservatory will also boil enough water to power steam engines across the Shire.


Like other budding hobbits who took a gap year out to explore Mordor and survived, Frodo and friends are rich in experience but short on cash. And height. They take up quarters in Bilbo’s now dilapidated cottage, styling themselves as Frodo and Co. Using scraps of paper left over from Bilbo’s memoirs, they send letters to friends and foe alike hoping to raise 3,500 Hobos.


At the same time, Frodo susses out a nice piece of swamp land for the construction of the Ring Conservatory. A small bag of finest tobacco leaf secures the blessings of the Shire Elders, who grant Frodo and Co permission to build on it.


Obscenely Rich Bank, located just 5 miles from the Shire, receives Frodo and Co’s letter and decides to lend the group some money. But first, Frodo and Co has to answer some tough questions from the bank. The correspondence is reproduced below:


Messrs Frodo and Co,


In the event that Frodo and Co run out of funds, will the director, one Frodo of the Shire, personally guarantee the payment of the 3,500 Hobos loaned?


ORB (Obscenely Rich Bank)”


Dear Obscenely Rich Bank,


As you know, I was mortally wounded at Weathertop by the blade of the Nazgul. My heart is too weak to sustain another shock, especially that of waking in the morning to find that I am indebted. Frodo and Co was set up with my medical needs at heart (I apologise for the pun in this serious letter). If Frodo and Co runs out of funds, neither I, Frodo, nor any of my friends will be liable for the 3,500 Hobos loaned. I can however give you a guarantee that my true-est of friends, King Aragon, is more than willing to give you 1,500 hobos should you seek him out in Gondor. You just need to round them up from the destitute quarters.

Frodo, Director of Frodo and Co”


Messrs Frodo and Co,


That is all and well. We note that you are experienced adventurers, but your CV does not mention any house-building credentials. Can you construct the Ring Conservatory by the target date?


Given the lack of dragon hoards in the vicinity (excluding the one that Obscenely Rich Bank is sitting on), how does Frodo and Co intend to repay the 3,500 Hobos plus 5 years’ interest by the year ROTK 6? We do not find jokes about Hobos and hobos amusing.


With the exception of Samwise who is used to drudgery like cutting firewood and cooking potatoes, what makes Frodo and Co think any of its directors have the ability to run the wood fired Ring Conservatory in a competent manner? Who is going to supply you with firewood? What about the —”


And we’ll have to pause the exciting conversation right there for now.
We hope our illustration has made the point clear. Project finance is simply the process of finding money to complete a project.


Key Players – Dramatis Personae


At the heart of any project financing, is the project itself. The parties wishing to have a stake in the project, are known as the Sponsors.


Projects are often “capital intensive”, which in plain English means they require a lot of cash. A solar cell plant in China for instance, can cost USD $1m for every MW produced. Power plants and hydroelectric dams fall within the same category of expensive undertakings.

Applying the age old maxim that one does not make haggis from the same sheep if one can help it, Sponsors often choose to borrow money instead of spending their own cash. This, coupled with the limited recourse nature of project financing (which we explain further afterwards), limits the Sponsor’s risk. Who then do the Sponsors borrow money from to fund the project?


That’s where Lenders come into the picture. By lending money to the Sponsors and collecting interest, they make more money at the end of the loan period than they started out with. Lenders tend to be large corporations, banks, or export-import credit agencies. Having said that, an interesting new trend involves the financing of projects via bonds. These bonds are known as Project Bonds. Simply put, a Sponsor borrows money in the form of bonds. The principal sum loaned and interest rates due can be paid off using the steady income streams that the project, once completed, will generate.


Many projects also have a governmental aspect to them, particularly in developing countries. The most obvious manifestation of this would be the State granting a piece of land to the project developers of an upcoming power plant.


Another important party in a project is the Contractor. This is an organisation with expertise in constructing buildings. Once the project is completed, there may also be an Operator, which helps to run the project on a daily basis. For instance, think of a power plant. Coal needs to be purchased, delivered to the plant and used to boil water. A constant supply of coal must be maintained. Other issues like maintenance of generators also fall under the Operator’s purview.

Why doesn’t the Sponsor do all these things you ask? After all, if you build a house and live in it, don’t you clear the rubbish and fix the occasional light bulb that goes pop? Well, if you fix one light bulb every once in a blue moon, you’re not likely to keep too many spare light bulbs in your house. When you buy those bulbs, you’re not likely to get a decent price for them either. On the other hand, the regular light bulb repairman Danny, might be able to buy in bulk and get them cheap. Of course, he charges you a fee for fixing your light bulb, but his cost of fixing the bulb is lower than yours. Spending your time on what you do best, you can recoup the cost of hiring Danny.

Likewise, the Contractor and Operator have comparative advantages and economies of scale that the Sponsor normally does not. So it makes economic sense for the Sponsor to outsource the project’s construction and operation.


Features – Plot


SPV – A project has assets. Take a power plant for example. It sits on a piece of land, and the plant might have power generators, transformers, power cables, pylons, motors, coal furnaces, technicians and so on. An SPV, or special purpose vehicle (no you can’t drive it), is a legal construct which is used to hold the project assets concerned.

Limited Recourse – Project financing, strictly defined, is a type of limited recourse financing. Remember how project assets are normally held under an SPV? ‘Limited recourse’ means that the Lenders can only enforce their loan agreements against the SPV. They cannot sue the Sponsors in the event that things go awry. As we will see later, this aspect of project financing is advantageous to the Sponsors but also a source of uncertainty for the Lenders, who often demand other forms of reassurances from the Sponsors.

Method of Repayment – How do the Lenders get their money back? Once completed, projects like power plants generate income streams. A percentage of these income streams go towards the repayment of loans. This also answers the question of when the lenders can get their money back. In most cases, repayment will occur after the project is operational since income streams can only be generated after project completion.

Completion risk – Projects can fail for many reasons. Initial budget estimates could be too low. Environmental protests may prevent further construction. A change in state energy policy may mean that the project is no longer profitable. For instance, the state might discontinue its policy of granting subsidies to renewable energy projects. When projects fail, income is not generated. The Lenders can’t get their money back, which understandably makes them rather jumpy. The possibility of projects failing is known as completion risk. A large part of project financing revolves around the assessment of completion risk and mitigating that risk.

Mitigating Completion Risk – There are many ways to do this. Here are a few. But before you read the list below, try and come up with a few by yourself since you’ll often be asked at interviews to think of the potential risks that a particular transaction might face.


    1. Sponsor Completion Guarantee – this is a guarantee by the Sponsors to the Lenders that the project will be completed. Other banks might have to be involved to ensure that this guarantee is upheld.


    1. Project Overrun Undertaking – in such an agreement, the Sponsors agree to compensate the Lenders for delays in the project. Remember that income streams can only be generated after a project is completed. Any delay means the Lenders get their money back late. What’s the implication of that you might say, doesn’t the Lender get paid eventually? That’s where you need to understand the difference between the ‘present and future value of money’.


    1. Sponsor Equity Agreement – the Sponsor may offer the Lenders some of its company shares. These can be valuable to the Lender if the Sponsor is a well-established company. In return, the Lender might be willing to take on the project completion risk.


  1. Lender Debt Priority – most modern societies have monogamous family structures. You marry your fiancé, and generally, you stick with them. Companies are not like that. They don’t just have dealings with one entity for the entirety of their existence. In terms of debt, companies often borrow money from multiple entities at any one time (a form of leverage). For instance, they might have issued bonds or borrowed funds from other banks.


There are different ways to give debt priority to the Lender. Subordination of other debts to the Lender’s claim is one possibility. The Sponsor can also give Negative Pledge Clauses which prevent it from granting charges over any secured assets without the Lender’s permission. These measures help make the completion risk palatable to the Lender.


5. Turnkey Agreement – this is a contract with the contractor. Both parties agree at the outset, that is, before the project commences, what the price of the project should be, at each stage of construction. Completion risk, is therefore quantified and less uncertain for the Lender.


6. Liquidated Damages – these are damages that the project contractor agrees to pay in the event that the project is delayed or fails to be completed. The sums paid go towards compensating the Lender.


The Lawyer’s Role.


Project financing involves a variety of legal documents. These are some common ones you’ll encounter. Knowing about them puts you in an advantageous position when you’re writing your TC application as well as at the interview stage; it shows you’ve given careful thought to what you’ll be involved in as a trainee.


  1. Leases
  2. Engineering Procurement Contract (EPC)
  3. Operations & Maintenance Contract (O&M)
  4. Collateral Contracts (Warranties/Guarantees)
  5. Lender Loan Agreement
  6. Legal Opinion