Project and Principal Finance: Basics and Project Loan Securitizations

Book: Structured Finance and Insurance: The ART of Managing Capital and Risk Author: Christopher L. Culp Publisher: Wiley Finance, 2006 ISBN: 978-0-471-70631-1

Chapter 21 is one of the longer chapters in the book, so I’m splitting it in two. This first part covers the fundamentals of project and principal finance plus how project loans get securitized. The next post will handle future flow securitizations and synthetic commodity-based project financing.

What Is Project Finance?

Project finance is extending credit to finance an economic unit where the future cash flows from that unit and the market values of its assets serve as collateral for the loan. It’s for long-term, capital-intensive projects. Think roads, rail lines, power plants, oil exploration, water treatment facilities. Big stuff that costs a lot of money upfront and generates revenue much later.

The key distinction is that the loan is backed by the project itself, not by the full balance sheet of whoever started the project. The project is ring-fenced. If it fails, the lenders can go after the project’s assets but not (usually) the sponsor’s other businesses.

Principal finance is economically the same thing but applied to non-infrastructure projects: venture capital deals, M&A activity, R&D, intellectual property. Wall Street treats project finance and principal finance as different departments, but Culp argues the structures and economics are identical. The only real differences are terminological and institutional.

The Cast of Characters

A typical project has a lot of participants, and understanding who they are matters because many of them bear some of the project’s risks.

The sponsor initiates and often retains significant equity in the project. Many sponsors would happily keep the project on their own balance sheet if they could afford to. The project SPE ring-fences the project’s assets and liabilities. It must be bankruptcy remote from the sponsor, though it doesn’t necessarily need to be deconsolidated.

The prime contractor supervises development work and often has equity-like compensation (which can create FIN46R headaches). The operator manages assets on an ongoing basis, sometimes under a build-operate-transfer model. Contractors provide services and are generally a source of risk through nonperformance.

Input suppliers and output purchasers are part of the supply chain. Agricultural projects buy seed and sell crops. Energy projects buy fuel and sell electricity. These are often significant sources of risk.

Lenders and investors provide external debt. (Re)insurance companies are almost always involved because projects are full of both financial and nonfinancial risks. Derivatives counterparties hedge financial risks that aren’t core to the project. Government agencies and multilateral institutions (World Bank, IFC, export credit agencies) often participate with guarantees, subsidies, or direct lending. And of course there’s a structuring agent to design the financial architecture.

Project Phases and Risks

Most capital-intensive projects go through five phases: preproject design, development, construction and asset development, testing, and operation and maintenance (O&M).

The first four phases share what Culp calls project completion risk. The project might not get finished at all. Or it might not finish on time. Or it might finish but not be in compliance. Or it might go over budget. Managing these risks means using proven technology, strong contracts, surety bonds, experienced contractors, reserves, and flexible input purchase agreements.

The O&M phase has different risks: declining demand, rising costs, asset destruction, business interruption, insecure property rights, labor problems, liability exposure, and noncore financial risks like exchange rates. Risk management here is similar but focused on maintenance contracts, operator incentives, and external guarantees.

Why Structured Finance Helps

Culp gives several reasons why structured finance is useful for project financing.

Capacity relief for banks. Banks are major project lenders, but they fund themselves short-term and project loans are very long-dated. That asset-liability mismatch is expensive. Securitization lets banks synthetically refinance these loans, treating them as shorter-term for risk management purposes.

Diversification of funding. Bringing in non-bank investors reduces credit concentration. It also helps banks that might be at internal credit limits with other banks already involved in the project.

Fewer covenants and agency costs. Banks love covenants and approval rights, which can bog down a project. Banks are also hypersensitive to negative information and tend to pull the plug too soon. Including non-bank debt that relies on credit ratings rather than extensive covenants reduces these costs.

Managing sponsor equity issues. Project sponsors often feel their equity stake is more important than its size suggests. This creates governance problems and interequity agency conflicts. Structured solutions can create more granular financial claims, like giving the sponsor 100 percent of the common while bringing in preferred shares from other investors.

Better credit enhancement. Ring-fenced projects are easier to credit enhance than commingled balance sheet projects. CDO technology is particularly good at apportioning credit risk across tranches and facilitating guarantees.

Reducing underinvestment. Too much debt on a company’s balance sheet can cause equity holders to reject positive NPV projects (the debt overhang problem). Financing a project separately breaks this cycle and can increase total debt capacity.

Project Loan Securitizations

Now we get to the actual structured finance. Project loans get securitized for three main reasons: a single lender wants to offload exposure, long-dated loans need refinancing with shorter-term funding, or banks want synthetic risk transfer.

Single-loan securitization typically happens when a multilateral agency fronts a big loan but doesn’t want to keep the whole thing. The Apasco deal is a clean example. Apasco was Mexico’s largest cement producer in 1995, right after the peso crisis. It needed $154 million for expansion. The IFC extended a $100 million loan but wanted to keep only $15 million. So it set up a Delaware trust, sold an $85 million loan participation to the trust, and the trust issued BBB+ rated notes at 9 percent (LIBOR+275). Four insurance companies bought the whole issue. Simple and effective.

Portfolio securitization bundles multiple project loans into a single CDO-like vehicle. The Eiffel 1 deal from October 2004 is a good example. Portugal was building toll roads through public-private partnerships. The major construction firms (all below investment grade) formed consortiums to serve the contracts. Eiffel 1 securitized the construction payments from four toll road concessions.

What made Eiffel 1 interesting was that it was backed solely by the construction phase of the projects, not the entire project lifecycle. Traffic, O&M, and other phases were excluded from both risk and return. The structure ended up rated higher than any of the sponsors without being totally delinked from their credit. The primary credit enhancement was massive overcollateralization, about 500 percent. Plus two reserve accounts funded by excess spread.

Synthetic project loan securitization uses SCDO technology. The EPIC deal (Essential Public Infrastructure Capital) from late 2004 is the example here. Depfa Bank had a portfolio of 25 U.K. public infrastructure loans worth about 394 million pounds. Rather than selling the loans, EPIC issued 31.75 million pounds in six classes of floating-rate notes. The SPE bought credit-linked notes from KfW, which in turn sold credit protection to Depfa on the first-loss piece. KfW also sold protection on the super-senior piece and hedged it with another swap dealer.

This gave Depfa partially funded credit protection on its project portfolio, freeing up credit lines for more infrastructure lending at a very favorable cost. Without this structure, Depfa might not have been able to do more project lending at all.

My Take

Project finance is where structured finance feels most tangibly connected to the real economy. We’re not just moving risk around between financial institutions. We’re building roads, power plants, and water systems. Real physical infrastructure that people use.

The structured finance toolkit is genuinely useful here. Long-dated project loans create real problems for bank balance sheets. Ring-fencing a project creates real benefits for sponsor capital structure. And the ability to tranche and distribute project credit risk to different investors with different appetites is what makes many of these projects financially feasible in the first place.

I also appreciate that Culp calls out the practical distinction between project and principal finance as mostly organizational. Investment banks put them in different departments, but the economics are the same. It’s all borrowing against future cash flows from a specific set of assets. Whether those assets are a toll road or a patent portfolio, the structural logic doesn’t change.

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