What is Project Finance?
Project finance differs from other forms of funding primarily because it is based on the future cash flow of an enterprise that is housed in a ‘special purpose vehicle’ or SPV. This is normally a company that has one specific purpose, be it a mine, industrial plant or factory.
Unlike other loans, which are based on a balance sheet (the lender’s income and assets), an SPV needs to start making money before it can begin repaying its loans. First, this can take years, and second, there is no guarantee the project will bring in cash unless every eventuality is looked at in the feasibility and planning stage of the project, and every risk is mitigated. The financier needs to be assured that the project can make the cash the developers and operators say it can. This is what makes a project bankable.
A large focus
By their very nature, projects are large. Some form of infrastructure needs to be built, engineers and environmental impact studies must be involved and often rights and concessions need to be secured. The loans involved in projects of this nature range anywhere from R70 million to the upper hundreds of millions, and banks will not even look at small projects asking for small amounts.
“There simply is no point for banks to finance small projects,” explains Johan Greyling, a director at Cresco Project Finance. “Banks involved in project finance will hire a team of experts with a deep understanding of the industry in question to go through the proposal with a fine-toothed comb. This is an expensive process and whether the project is asking for R5 million or R500 million, the team needs to do the same amount of work. It’s just not feasible for banks to get involved in small projects – the margins of return are too low.”
Sharing the risk
No financier will grant a 100% loan. Financial institutions will simply not take on the risk of a project alone. Both development finance institutions (DFIs) and commercial banks require the lender to have skin in the game – in other words, some form of equity commitment.
“The logic behind this is simple: before the bank loan gets defaulted on, shareholders must feel the pain,” says Greyling. “The developers are often the only people who can ensure the project’s success, which, from the bank’s point of view means they should also be at risk, and therefore driven to resolve any problems.”
Lenders will generally look to share the project’s risk with the sponsors and other financial partners. It is not unusual to have multiple financiers involved in a project. Luckily however, it often just takes getting one financier on board for others to follow suit. The Industrial Development Corporation (IDC), for example, will identify other suitable international and local DFIs, commercial and merchant banks and even export credit agencies as potential participants in the deal. A commitment from one reputable financier may often serve to convince others to come on board, particularly since the risk is being shared.
Common misconceptions in Project Finance
Getting a project off the ground often seems complex to entrepreneurs. The nature and size of project finance, and the fact that it involves millions, if not hundreds of millions, of rands, makes it seem unattainable. Add to this the fact that project developers and sponsors sometimes believe that cash available to finance projects is hard to come by, and project finance seems elusive at best – if not impossible to obtain.
But financiers are telling a very different story. One of the Industrial Development Corporation’s (IDC) core principles is the development of new entrepreneurs. So why do entrepreneurs involved in project development believe that project finance is unavailable? According to Anthony Sykes from the International Project Finance Association (IPFA), there is an acute lack of bankable projects in Africa: not an acute lack of finance, but rather of projects that are worthy of being financed.
“Project finance is often viewed as higher risk than other finance,” says Cresco’s Johan Greyling. “This isn’t really true. Yes, there are risks involved in financing a project, largely because it is years before the project can actually start making money and paying off its loans. There is also a certain amount of crystal ball gazing that needs to take place – the sponsors of the project and the financiers need to predict how much money the project can make, and gear the loan accordingly. It’s a very precise science. “Because of this, every possible component of the project is looked at, and each risk mitigated, leaving no room for error. That makes project finance less risky than it’s often assumed to be – but much harder to receive.” For those who put together an air-tight project finance proposal, based on a solid feasibility study in which all risks are mitigated, and have a strong sponsor backing them, project finance doesn’t need to be a pipe dream – it can be a reality.
The Key Players in Project Finance
Like any venture, projects are all about spotting the right opportunity at the right time. What will the next big commodity boom be? Is South Africa ready for a slew of biofuel and renewable energy projects? The entrepreneur who not only recognises the possibility of a project, but is able to put together an exciting and commercially viable project, with the risks allocated and addressed appropriately, will be able to access the holy grail of the funding world: project finance. As an entrepreneur, if you have the vision and the patience to see a project through, there is no reason why you shouldn’t be successful.
Finding the right sponsor or sponsor group is perhaps the most important step for an entrepreneur looking to secure project finance. The project developer always needs to provide an appropriate level of own-capital to attract project finance loans from financiers. A sponsor’s expertise and experience will carry weight with the banks.
So who are these sponsors? Essentially, they identify an opportunity and take advantage of its commercial realisation. Sponsors could be big local and international groups that sell the equipment or supply the services for big projects, be it the technology needed to put up a solar plant, or the engineers to design and build a processing plant. They benefit from projects, which is why they are always on the lookout for a good opportunity. For the entrepreneur, the individual might be small, but the sponsor group is big. Sponsors lend weight and much-needed industry experience to the idea, one of the first things financiers look for in a deal.
Depending on the project, developers can approach development finance institutions (DFIs) such as the International Finance Corporation (IFC), which is the commercial arm of the World Bank, the Industrial Development Corporation (IDC) and the Development Bank of Southern Africa (DBSA), or commercial banks, and export credit agencies or funds.
Development Finance Institutions
DFIs are financial institutions established by governments with specific mandates to develop and promote key sectors considered to be strategically important to the overall socio-economic development objectives of various countries.
These strategic sectors include agriculture, small and medium enterprises (SMEs), infrastructure, maritime, the export-oriented sector as well as capital-intensive and high-technology industries. Many DFIs belong to global or continent-based initiatives (such as the World Bank), and will operate in other countries or across various continents.
Most commercial banks have a project finance division and are extremely good at evaluating feasibility studies. Approach banks early in the project finance cycle to judge whether there is interest in your project, and which banks have an appetite for the sector you are working in.
Structuring Your Deal
The rules for project finance are the same globally, which means banks and DFIs from around the world can be involved in African and South African projects. It also means that local projects are competing globally for funds. Proposals have to be air-tight in order to receive funds. Whether a developer approaches a DFI or commercial bank for finance, there are certain criteria that must be met in order to obtain finance. Here’s what financiers are looking for, and how to give them what they want.
1. Get a sponsor
The first thing an entrepreneur who has recognised an opportunity needs to do is engage with a large operator in the sector to be the project’s sponsor. “Many emerging players encounter a barrier to entry into this field because the initiator of a project needs to be a strong player,” says Charles Marais, project finance expert and a consultant at Eversheds law firm. “The only way this can be circumvented is for the entrepreneur to partner with a strong sponsor.
“Once an entrepreneur has recognised a good idea or a gap in the market, he should find a sponsor who will benefit from the project being commissioned,” he explains. “Project finance is all about cash and risk. These risks can loosely be categorised into three parts: environmental risks, construction risks and operational risks. Large sponsors probably have experience in recognising and mitigating these risks, so an entrepreneur who wants to get his project banked should get the experts in.”
Stephen Vermaak, principal investment officer, IFC, offers another reason why entrepreneurs should partner with sponsors: “The formation of partnerships between big industry players with experience and up-and-coming entrepreneurs is good for the industry as a whole because it brings new skills into the market place, but for the entrepreneur, it really is a way of accessing finance,” he says. “Over 50% of our financing is to existing clients. If you get finance once, chances are you will receive finance on your next project too, with less effort needed than the first time round. Partnering with a big sponsor puts you on the radar of financiers.”
2. Put together an expert team
Finding the right sponsor is only the first step however. According to Greyling, lenders are reliant on the project generating cash flow, which means they are interested in everything in your business, from where you are sourcing your electricity, and who your suppliers and buyers are, to the costs of the process of designing, building and finally running your project. They evaluate everything.
Many entrepreneurs misjudge the costs involved in the early stage development of a project. Engineering and design costs, environmental studies and management plans, raw material procurement and negotiation, power supply, operating and logistical regimes and getting the documentation watertight are all lengthy and expensive processes. “But without getting all these aspects right from the beginning, the project won’t be financed,” says Greyling. “The best way to get your project right from the word go is to involve experts and advisors. This includes engineers, architects, consultants and lawyers.”
Marais agrees. “It takes a team to compile a quality proposal, with different experts addressing different areas,” he says. Greyling advises approaching financiers early. “Show them the deal and the structure,” he says. “Test their interest and create an appetite for the deal, and while you are doing this, you can extract their main concerns and work on them.”
There is no point in approaching the banks until a proper team is in place. “On the other hand, many developers don’t approach professionals until late in the process because they are trying to save money,” says Marais. “The problem with this approach is that by that stage you either haven’t maintained the bank’s appetite because there were problems with the packaging of the deal, or poor documentation actually sets you back six months or more when the banks return your proposal for reworking.”
Project documents are what make a project come together because they capture the agreements that the project is based on, including operator, construction and supplier agreements. They make projects work. If an entrepreneur really cannot afford to engage lawyers because the feasibility stage is simply too expensive, Marais suggests negotiating with the firm in question. “As in other areas, fees can be negotiated and budgeted for. Some firms may even be prepared to work on risk for a portion of their fees,” he says.
Either way, don’t skimp on your team if you want your project financed. Just as financiers share the risk of funding a project, so too does a team of experts run a higher chance of success by covering all possible eventualities. Advisors bridge the gap between a project and a bankable project.
3. Conduct an air-tight feasibility study
The feasibility stage is about three things: the financial model, which highlights risk and how risks will affect servicing the project’s debt, sponsor support, and an independent expert/technical report. This can take at least eight months to complete. Legal, commercial, financial structuring and engineering decisions are made during this stage based on the team doing its due diligence and extensive research.
“The feasibility stage of a project is expensive,” explains Greyling. “It takes on average eight months to complete this stage. During this time, engineers, lawyers and consultants need to be paid, and studies such as environmental impact assessments (EIAs) must be conducted.“Many entrepreneurs – particularly first-timers to project finance – do not realise how expensive the feasibility stage can be. DFIs can be approached to help, but banks typically will only get involved once the project is proven and bankable, in other words, once the feasibility stage is complete. “Never expect the financier to complete your feasibility with their due diligence,” he warns. “They have hundreds of proposals to work through and their interest will lie in those deals that offer the least resistance, where the team has done their work and all the banks need to do is check that the commercial viability stacks up.”
Gearing refers to the level of debt that a project can realistically afford to repay. Any uncertainty around a project’s revenue line will impact the level of gearing. Take mining commodities as an example. “Commodities prices are generally cyclical,” explains Greyling. “If the project depends on the sale of a commodity, the gearing will be adjusted accordingly and the sponsor might have to put in more equity to mitigate the risk of not being able to meet the loan repayments while commodity prices are at the bottom end of a cycle.”
This takes careful study and planning during the feasibility stage, because the sponsors need to be able to prove exactly how much of the commodity can be mined, at what grade, and what the market’s appetite is for the commodity. The same would be true for renewable energy, manufactured goods or even telecoms services. What is the market’s appetite, and how much of this appetite does the project provide for, and at what cost? The gearing of the project will be based on assumptions around these issues.
- Mitigating Risks
Marais insists that properly understanding the risks involved in projects is the most important part of the feasibility study. “Cash and risk, that’s all a project is really about,” he repeats. To understand the pitfalls of a project, research and due diligence are vital. Simply recognising the risks is not enough though. Each of those risks must be mitigated. If they are not, the project will not receive finance.
According to Greyling, project risk can generally be broken down into 16 core categories. Each of these categories should be carefully evaluated and the project’s sponsors must present financiers with action plans of how each potential risk can be mitigated. This will then affect the project’s bankability. Of the risks cited, the most important is probably completion risk. What can stop the project from being completed and commissioned (and therefore making money), and how can the team ensure that this does not happen? It is vital that this is addressed in the funding proposal.
“The whole risk mitigation and project finance process is designed to ensure cash flow,” explains Marais. “Once this process is complete and the project is given the green light, cash must come how and when it is expected to. If that happens, the project makes money, the lenders get their return on investment and the sponsors get their project.”
4. Packaging your proposal
Sponsors seldom ask someone else what is wrong with their project or proposal when they fail to receive funding, although often this would allow them to see the gaps in their plan which, once filled, might lead to a successful application. Seek advice from consultants, lawyers and financiers involved in project finance before putting together a proposal. An appealing proposal that meets project finance criteria can get you a ‘yes’ first time round.
Accessing project finance
- Seek expert advice
Charles Marais, consultant, Eversheds
“Get your advisors, lawyers and bankers involved in the project as early as possible. You can end up losing valuable time if things are not done properly from the word go. It is essential to understand exactly what the lender’s concerns are about the project and also to whet their appetite for the deal. Advisors also tend to be experienced and dispassionate, whereas entrepreneurs who have poured everything into their idea may be subjective and emotional. Expert advice can be invaluable in these situations. And don’t be too greedy. Many deals are delayed or fall through because the sponsor thinks the lenders are being unreasonable in their requirements. The most important thing is to get your project financed. Once the project has worked through the start-up and early operating risks, refinancing is always a possibility.”
- The power of networking
Paul Runge, MD, Africa Project Access
“There is no standard application for project finance because the lenders are judging you as an entrepreneur. The project should speak for itself and you should know and understand the industry intimately. In this, there is no substitute for ‘street wisdom’. You need to learn as you go along, so pay attention, speak to people in the industry, financiers, lawyers and experts and network as much as possible. Understand how project finance works.”
- Be realistic
Johan Greyling, director, Cresco Project Finance
“It’s vitally important to have a business development budget, realistic expectations around the project’s timeline and a clear view of where your equity is coming from. Your shareholder grouping should include participants that can give the requisite equity contribution for the project as well as providing operational and execution capacity. Never underestimate the value of a capable and passionate project director. Also remember that lenders are not there to sort out your problems. They merely look at viability.”
- Get your project off the ground
Stephen Vermaak, principal investment officer, IFC
“Package your proposal in a form that the bank can evaluate. The good ideas and knowledge of the sponsor and team should be clear. It is not the bank’s job to sift through the proposal for the pieces that are of value to them. Put time and money into your planning and research and present a proposal that is simple to evaluate. Don’t be too greedy on your first project. Concentrate on getting the project off the ground. Once you’ve got experience and have proven yourself to the financing community, it will be easier to secure financing the second time round, and you will be in a position to negotiate more favourable terms.”
- Always drive bankabilty
Conrad Hefer, Cresco Project Finance
“We want to be able to determine from the word go whether the project is bankable. This means identifying key issues that drive bankability. As a project promoter you need to make the financial modelling clear in the proposal. After all, as banks we make credit decisions, so we need to be given realistic plans that will get a project to financial close. This means the sponsors need to get the efficiencies right in order to break ground. Do not over-inflate the project’s worth to make it seem more attractive. This will ultimately achieve nothing.”
- Getting the right sponsorships
Michael Fischer, director, DEG (German DFI)
“Don’t under-estimate the power of corporate sponsorship. If the entire project is based on one or two people, the risk is much higher for the financier. What happens to the project if something happens to the partners? It will be dead in the water. Big corporates can always keep the project going, making the risk much smaller for the lenders.”
IFC – The International Finance Corporation is a member of the World Bank. Its mandate is to provide investments and advisory services to build the private sector in developing countries. Visit www.ifc.org for more information.
DBSA – The Development Bank of South Africa is one of several development finance institutions in South and Southern Africa. It plays the multiple role of financier, advisor, partner, implementer and integrator to mobilise finance and expertise for development projects. Visit www.dbsa.org for more information.
IDC – The Industrial Development Corporation is a self-financing, state-owned national development finance institution that provides financing to entrepreneurs and businesses engaged in competitive industries.Visit www.idc.co.za for more information.
IPFA – The International Project Finance Association is the only international, independent, not- for-profit association dedicated to promoting and representing the interests of private sector companies involved in project finance and Public Private Partnerships (PPPs) throughout the world. Visit www.ipfa.org for more information.