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Project Finance: Definition, Participants and Agreements

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modern project finance - benjamin c. esty PROJECT FINANCE DEFINITION #1 (ESTY, 2004, p.25)

Project finance involves the creation of a legally independent project company financed with non-recourse debt (and equity from one or more sponsors) for the purpose of financing a single purpose, industrial asset.


Project finance is the raising of funds to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on the equity invested in the project.


Project finance is the financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.

Of these definitions, Professor Benjamin Esty's definition is a little more comprehensive than the other two. In his book he goes on to dissect his definition of project finance as follows:

"The definition recognizes three key decisions related to the use of project finance. First, there is an investment decision involving an industrial asset. Here, the term industrial asset is meant to include infrastructure projects as well. Bruner and Langohr (1992, p.2) differentiate between stock and flow-type projects. In stock-type projects, firms extract resources like oil or copper, sell the output, and use the proceeds to service debt and generate equity returns until the resource is depleted. In contrast, flow-type projects - toll roads, pipelines, telecommunications systems, and power plants - rely on asset use to generate returns for capital providers. The definition also highlights an organizational decision to create a legally independent entity to own the asset. As a result, project finance can represent a form of off-balance sheet finance, meaning that project assets and liabilities do not appear on the sponsor's balance sheet. The exact accounting treatment, however, is a function of the chosen organizational form (corporation, partnership, etc) and the sponsor's fractional interest in and control over the project. In many cases (e.g., when there is only one sponsor), project assets and liabilities appear on the sponsor's balance sheet. Finally, there is financing decision involving non-recourse debt. Because the project company is legally independent, the debt can be structured without recourse to sponsors. Legal independence also ensures that capital providers have a clear claim on the project assets and cash flows without concern for the sponsor's financial condition or for preexisting claims on its assets."

The other impressive thing about Professor Esty's definition of project finance is that he doesn't just stop at defining it, but goes on to list various financing structures, explaining in each case why it is not a project finance structure.

  • Secured Debt: No, because the debt has recource to corporate assets
  • Vendor-financed debt: No, because the debt has recourse to corporate assets (vendor finance is a kind of secured debt in which the manufacturer of the goods provides the debt).
  • Subsidiary debt: Not if the debt has recourse to corporate assets.
  • Lease: No, because the obligation has recourse and it does not involve asset ownership.
  • Joint ventures: Not unless funded with nonrecourse debt (note: many projects are structured as incorporated joint ventures).
  • Asset-backed securities (ABS) or real estate investment trusts (REITs): No, because they hold financial, not single-purpose industrial assets.
  • Privatizations or municipal development: No, because they lack a corporate sponsor.
  • Leveraged buyouts (LBOs and MBOs): No, because they lack a corporate sponsor.
  • Commercial real estate development: Yes, but real estate tends to have different institutional arrangements.
  • Project holding companies: maybe, but as the number of projects increases, it begins to look more like a corporation with cross-collateral debt obligations.


First let's dispel a mistaken idea that most people have about project finance:

Professor Esty's book points out that project finance dates as far back as 1299!

Because project finance rose to the fore in the early 1980s in both the United States and Britain, most investment bankers have tended to regard it as a new financing structure.

What has been the main driving force behind the rise of project finance as a financing structure? In the "good old days" governments were able to finance infrastructure and other projects of national importance from own resources, but as we entered the 1980s, even first world governments had to find alternative sources of finance in order to be able to finance infrastructure projects. Rising energy costs during the late 1970s and early 1980s, for example, led to the United States to pass legislation that made it possible for utilities to purchase electricity from Independent Power Producers ("IPP") by way of long-term power contracts.

Similar developments were taking place in Britain, mainly in the transport sector.

In developing countries all over the world it was also becoming impossible for governments to finance projects of national interest using public funds. Project finance became the only option for these governments too.


  • Government - this participant is responsible for creating an enabling environment for project finance transactions through its legal system and other associated legislation (e.g. agreements, permits, property rights etc).
  • Equity Funders - these are the owners of the project company and contribute the riskiest portion of the total funding of the project (equity). Their contribution is usually in the order of 40 to 50 percent, as a proportion of the total funding.
  • Nonrecourse Debt Funders - these are the providers of Long-Term loans to the transaction. They usually contribute about 60 to 70 percent of the total funding of the transaction. (these are usually commercial banks, Development Finance Institutions, Multilateral, Bilateral and Export Credit Agencies.
  • Operator - this is usually the Engineering Firm that is in control of the construction and operations/management of the project (e.g. Power Plant).
  • Construction/Engineering Consultants - this is the company responsible for the engineering, procurement and construction. >Equipment Supplier - this is the selected manufacturer of the key equipment to be used during construction of the project.
  • Environmental Impact Assessment (EIA) Consultant - this is the specialist who assesses whether the project meets the minimum standards of both national and international environment related legislation and agreements.
  • Affected Communities - these are important stake holders who are directly or indirectly affected by the project (e.g. communities that have to be relocated because of the construction of a power station, toll road, dam, mine etc.)

The last two mentioned participants (especially the last one) tend to be forgotten by most authors (and by the other key participants in the project) due to the fact that they are not directly involved in the funding or construction of the project.

Forgetting to take care of the EIA and affected communities early on can lead to delays (which in turn lead to cost overruns) when they become a big issue later on. We know for a fact that there are many projects around the globe that had to be abandoned because these two important issues when overlooked or not given proper attention.

The other important thing to highlight here is that there can be an overlap in terms participation in the project by the above mentioned project participants. For example, a bank may be both an equity and a debt lender. Another area where there is a tendency to be a big overlap in roles and responsibilities is in project operations, construction, and even equipment supply. So, it's possible that the operator, constructor, and the possible the equipment supplier is the same entity.

It should be noted, though, that this situation is now more of an exception than a rule due to the fact that separate Requests for Proposals (RFPs) for each of Operations, Construction and Equipment Supply are advertised to get as many bidders as possible in order to encourage competition and transparency. This also tends to reduce the project costs due to competitive pricing by the tendering companies.

Most Development Finance Institutions (DFIs) (e.g. World Bank, AfrDB, ADB, DBSA etc) will not participate in a project until the initial Environmental Impact Assessment is underway or completed. They would rather finance the impact studies than invest their money in a project where this issue has not been addressed.

The government (and the DFIs) will also tend to take greater interest in both affected communities issues and the environmental impact assessment report.

We can also give an example of a government that tended to be work against the interest of an affected community in their own country:

The Botswana government in Southern Africa has been trying for some time to remove the Khoisan people ("Bushmen") from their ancestral land in order to make way for the construction of a dam. The community won the court case giving them right to their ancestral land (towards end of 2006).

So, things are not always "straight and simple" due to the fact that interests of parties that are supposed to be working together may not be "aligned". Some governments may even go against their own legislated required minimum environmental impact standards just because they want to see a project happening (especially close to elections!).


  • Engineering, Procurement and Construction (EPC) Contract: - between the Project Company & the Engineering Firm.
  • Operations and Maintenance (O & M) Agreement: - between the Operations Contractor and the Project Company, obligates the Operator to operate and maintain the project.
  • Shareholders Agreement: - governs the business relationship of the equity partners
  • Inter-creditor Agreement: - an agreement between lenders or class of lenders that describes the rights and obligations in the event of default.
  • Supply Agreement: - agreement between the supplier of a critical key input and the Project Company (e.g. agreement between a coal supplier and a power station)
  • Purchase Agreement: - agreement between the major user of the project output and the Project Company (e.g. agreement between a metropolitan council and a power station)

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