Project finance

Somebody wants to build a power station, a toll road, or a port. It costs an enormous amount, takes years, and produces nothing at all until it is finished.

Project finance is how that gets funded. A company is created that exists only for this project. It borrows the money, builds the thing, and repays the loan out of what the finished asset earns. If the project fails, the lenders lose their money — they cannot go after the sponsors' other businesses.

That last point is why the diligence is so different. There is no borrower with a track record to assess. There is a set of contracts and a plan. So the lenders read every contract instead: who is building it, for what fixed price, who has agreed to buy the output, for how long, and what happens if any of them fails to perform.

The one thing that makes the whole structure possible is a long contract for what the project produces. Twenty years of somebody agreeing to buy the electricity turns a construction site into predictable cash flow. Without it, there is no project financing — only a bet.

Who bears what

• Construction risk — the contractor, under a fixed-price, date-certain contract with penalties.
• Operating risk — an operator under a long-term agreement with performance standards.
• Demand or price risk — the offtaker, under a contract to buy the output whether or not it needs it.
• Supply risk — a fuel supplier, under a matching long-term contract.
• Political and regulatory risk — sometimes the host government, sometimes an insurer, sometimes a development bank whose presence deters interference.
• Whatever is left — the lenders, and they price it or refuse it.

Financial close

The date when every permit, contract, consent and insurance is in place and the first money can be drawn. Reaching it takes months or years after the commercial terms are agreed, and projects die here more often than anywhere else — not because anybody disagrees, but because one consent does not arrive.

Completion

During construction the sponsors typically guarantee the debt. Once an independent engineer certifies that the asset performs as promised, those guarantees fall away and the lenders are on their own. That moment is the single most important date in the financing, and everything before it is a different credit from everything after.

The cash flow waterfall

Revenue is applied in a fixed order: operating costs, then debt service, then reserve accounts, and only then distributions to the sponsors. Lenders sit ahead of the owners in the actual bank account, which is a stronger position than any covenant.

Why the debt can be so large relative to the equity

Because the cash flow is contracted rather than forecast. A business whose revenue depends on winning customers can support only modest leverage; one with a twenty-year contract at a fixed price from a creditworthy counterparty can support a great deal more. The leverage is a function of the certainty, not of the asset.

Which also means the credit is really the offtaker's. Lending to a power station with a twenty-year contract with a strong utility is lending to that utility, wearing different clothes.

Debt service cover, and why it is the covenant that matters

The ratio of cash available to debt service, tested regularly, is the central test. Below one level, distributions to sponsors stop; below another, it is a default. Sizing the debt so that the ratio holds through a downside case is the whole of the credit analysis, and the downside case is negotiated as hard as the price.

Where these go wrong

• Construction overruns beyond what the contractor can absorb, particularly if the contractor itself fails.
• The offtaker deteriorates, and a twenty-year contract is only as good as who signed it.
• The regulatory regime changes — a tariff altered by a government that granted it is the classic risk in this market.
• The resource is not there: less wind, less sun, less traffic than the study said.

Where it connects

The output of this desk is frequently refinanced in the bond market once construction risk is gone — a completed, contracted asset is a much simpler credit than a building site. And the equity in these projects is what infrastructure funds hold, which is where a reader on the markets side meets the same asset from the other end.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.