Understanding the Basics of Project Finance

Project finance has been the backbone of many public infrastructure and industrial projects, easing the financial burden of spending billions and ensuring smoother project execution. According to the World Bank, India will require over $840 billion in infrastructure investments by 2036 to meet urbanization demands. Thus, increasing private financing alongside government efforts is important for sustainable and inclusive urban development. The National Bank for Financing Infrastructure and Development’s (NaBFID) planned $17 billion loan disbursement exemplifies this shift. 

Ampin Energy's 200 MWp solar-wind hybrid project in Rajasthan serves as a prime example of project finance in the renewable energy sector. Financed through a combination of debt and equity, the project's future revenue stream is earmarked to repay the debt, showcasing how project finance facilitates efficient capital allocation and risk mitigation for such large-scale undertakings.

Before we get into the features, models, risks, and advantages of project finance, let us first understand some basics about it.

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What is Project Finance?

Project finance is a long-term financing mechanism for large-scale infrastructure or industrial projects and public services. In this model,  the debt and equity used are repaid solely from the cash flow generated by the project itself, while the project's assets, rights, and interests serve as collateral. 

With non-recourse or limited-recourse terms, lenders can claim only the project’s assets, making it ideal for high-capital industries like energy and transportation where long-term revenue potential is expected.

This method allows companies to pursue large-scale projects while limiting risk to their primary balance sheet, making it especially attractive for high-capital industries. Project finance's success is underpinned by various contracts, such as off-take agreements (for securing future revenue), supply contracts, and construction agreements. These agreements ensure that key elements like revenue generation and operational stability are guaranteed.

Common Sponsors of Project Finance

• Contractor Sponsors: Typically construction or engineering firms, these sponsors contribute equity or subordinated debt and play a key role in the project’s setup and operational success.
• Financial Sponsors: Include investment firms and private equity investors seeking high returns. Their primary goal is maximizing profits through strategic financing.
• Industrial Sponsors: Companies with a vested interest in the project align their core business with the project, leveraging it for long-term strategic benefits.
• Public Sponsors: Governments and public institutions invest in projects critical to infrastructure, public services, or economic growth, supporting social benefits and stability.

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Key Features of Project Finance

1. Special Purpose Vehicle (SPV)

A key feature of project finance is the creation of an SPV, a legal entity established solely for the project. The SPV owns the project’s assets and manages its operations, debt, and equity. This structure is a critical tool for risk containment as it isolates the project's financial risks from the sponsors' other assets and operations. 

As a standalone entity, the SPV can secure financing based on the project's revenue potential, limiting the financial exposure of the sponsors while maintaining focused, streamlined project management. SPVs allow for non-recourse or limited-recourse financing, meaning lenders can only claim project assets in case of default, not the parent company’s assets. This makes SPVs an ideal tool for risk management, particularly in large-scale infrastructure projects.

2. Non-recourse or Limited Recourse Financial Structure

In project finance, non-recourse and limited recourse financing structures are commonly used to protect the sponsors from significant financial exposure while ensuring the project has access to necessary funds.

• Non-Recourse Financing: Under this structure, the loan is secured solely by the project’s assets and future cash flows, meaning repayment depends entirely on the project's success. This structure encourages investment in high-risk projects by limiting sponsor exposure.

• Limited Recourse Financing: This is a variation where the lender can claim some additional assets or guarantees from the sponsors, but only up to a certain limit or under specific conditions. Limited recourse financing provides a middle ground between non-recourse and full-recourse lending, allowing lenders some protection while limiting the sponsor's risk.

Both structures are designed to reduce risk for project sponsors, encouraging them to undertake large infrastructure projects while allowing lenders to manage and assess their risk based on the project’s performance and viability.

3. Project's Assets and Rights as Collateral

These include physical assets like infrastructure, equipment, and facilities, along with contractual rights such as revenue agreements and licenses. If the project defaults, lenders can seize these assets to recover their investment rather than pursue the parent company’s broader assets. This structure limits risk for sponsors while providing lenders with a clear pathway to recoup their funds.

Now, let us understand how project finance differs from corporate finance.

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A Comparison Between Project Finance and Corporate Finance

Thus, project finance provides greater risk containment for the sponsor by isolating liabilities within an SPV and keeping the financing off the company’s balance sheet. In contrast, corporate finance integrates all financial liabilities into the company's overall balance sheet, exposing more of the company's assets to potential risk.

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Popular Models and Structures in Project Finance

Several models and structures are used to tailor financing arrangements based on the type of project, risk-sharing, and stakeholders' interests. 

1. Role of Private-Public Partnerships (PPPs)

In a PPP, the public sector partners with private firms to finance, build, and operate projects. The specifics of the structure and risk-sharing can vary depending on the agreement. PPPs have proven highly effective for executing large-scale infrastructure and development projects.

Usage: Widespread use in infrastructure, healthcare, education, and transport.

Risk Allocation: Risk is shared between the government and the private sector. The private entity typically manages construction and operational risks, while the public entity may offer guarantees or subsidies.

2. Build, Operate, and Transfer (BOT) Model

A type of PPP, a BOT model, involves a private entity financing, building, and operating a project for a specified period, after which ownership is transferred to the government or another entity.

This makes the model popular for public infrastructure projects like highways and energy plants, allowing governments to leverage private investment and expertise, while the private entity recoups its investment and generates profit during the operational period.

Usage: Common in infrastructure projects like highways, bridges, and power plants.

Risk Allocation: The private entity assumes construction and operational risks, while the government often assumes political or regulatory risks.

3. Joint Ventures (JV) or Collaboration Arrangements

A JV is formed when two or more parties come together to finance, construct, and operate a project. Each partner shares risks and rewards based on their ownership stake.

This structure boosts balanced investment, making them especially useful in complex, large-scale projects like energy, mining, and infrastructure development.

Usage: Used in both public and private projects, particularly in energy, mining, and real estate.

Risk Allocation: Risks are shared among the JV partners based on their respective agreements, each bearing financial, construction, and operational responsibilities.

These models allow for flexible risk-sharing and tailored financial structures, ensuring that both private and public stakeholders can effectively manage large-scale projects.

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Risks and Challenges in Project Finance

When it comes to money, risks and challenges are inevitable. Yet, there are tactics to control or overcome them.

1. High Capital Risk 

High capital risk due to the absence of immediate revenue during a project's early stages can make securing returns and managing cash flows difficult until the project becomes operational and starts generating income.

To tackle this, several strategies are used:

• Construction Financing: Short-term loans convert to long-term debt post-construction.
• Milestone-Based Funding: Funds released as the project progresses.
• Off-Take Agreements: Secure future buyers and revenue.
• Government Guarantees: Provide financial backing.
• Sponsor Equity: Extra funds from sponsors for risk coverage.

2. Seizure of SPV Assets in Case of Default

If the project defaults, lenders can seize the SPV's assets as collateral. Since the SPV is legally separate, only its assets—infrastructure, equipment, and revenue-generating contracts are at risk and not the sponsor’s broader assets.

Key strategies for tackling:

• Strong Contracts: Ensure stable revenue streams.
• Risk Sharing: Distribute risks among capable parties.
• Debt Restructuring: Adjust loan terms to avoid default.
• Insurance: Protect against major risks.
• Sponsor Support: Inject capital to prevent defaults.

3. Limited or No Offtake Agreements During the Construction Phase

During the construction phase, limited or no off-take agreements can increase revenue uncertainty, as there are no guaranteed buyers for the project's output once it's operational.

How to tackle this?

• Early Negotiations: Secure buyers before completion.
• Bridge Financing: Use short-term loans to cover costs.
• Guarantees: Obtain government or sponsor backing.
• Phased Operations: Start partial operations early.
• Diversified Revenue: Explore alternative income sources.

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Financing Options

1. Loans from Banks or Lending Institutions

Traditional bank loans are one of the primary sources of funding in project finance. Banks or lending institutions provide long-term debt based on the project’s future cash flows, and the project’s assets typically secure the loan. Interest rates and repayment terms depend on the project’s risk profile and financial projections. 

Bank loans in project finance align repayment with the project's revenue generation, offering flexibility through long-term debt structures. With project assets as collateral, banks can manage risk and often provide favorable rates, particularly for projects with predictable cash flows.

Depending on the project's credit rating, specific interest rates are based on the project risk and financial status, typically ranging from 8.5% to 11.5%.

2. Equity Investors from Private Organizations and Individuals

Equity investors, who can include private organizations or individuals, provide capital in exchange for ownership stakes in the project. These investors take on higher risks than lenders but expect higher returns if the project succeeds. Equity financing typically covers a portion of the project cost, with investors sharing profits once the project becomes operational. Equity also helps attract debt financing by showing the sponsor’s commitment.

3. Grants from Governments for Public and Local Projects

Governments often provide grants to support public infrastructure or local development projects. These grants do not require repayment and are used to cover part of the project costs, especially for projects that provide social or economic benefits, like schools, roads, or renewable energy initiatives. Grants reduce the financial burden on sponsors and make the project more attractive to private investors by lowering overall project risk.

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Advantages of Using Project Finance

1. Efficient Financing for Large-Scale Projects

This allows companies to secure funding for massive infrastructure or industrial projects without impacting the overall balance sheet.

2. Effective Allocation of Debt

Project financing enables sponsors to borrow independently of their parent company’s credit limits, structuring the loan as a standalone transaction. This relies on the project’s potential rather than the sponsor’s creditworthiness, allowing for flexible and favorable loan terms tailored to the project’s value and revenue outlook.

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Conclusion

It is evident that project finance offers a robust solution for funding large-scale infrastructure projects while minimizing risks for sponsors and maximizing efficiency. As India faces significant construction and infrastructure needs, leveraging project finance will be critical to meeting future urbanization demands. By combining government support, private investment, and innovative financial structures, we can drive sustainable development and economic growth nationwide.

Many fast-growing startups and SMEs are now partnering with Recur Club for project financing. Recur Club funds various sectors, including D2C, SaaS, Logistics, and Co-working, offering project financing of up to ₹100 crores. Explore a range of debt structures, both unsecured and secured, tailored to suit the specific needs of your business project.

Interested in learning more? Book a free one-on-one financing advisory call with one of our dedicated capital experts today!

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