1 Introduction
2 Project finance definition and characteristics
The primary addressees of BASEL II are banks who provide debt to a project. The accord outlines two constituting characteristics of PF: First and unlike traditional corporate finance, a PF loan is awarded to a separate project company that is financially and organizationally separated from the sponsoring firms. Second, in true PF, banks relinquish the right to recover the loans from the equity sponsors in the event of default. Loan securitization is based solely on the projected cash-flows of the project and not on the creditworthiness of the investing sponsors. As a result, banks take on extensive risks related to the non-performance of the project.Project finance may take the form of financing of the construction of a new capital installation, [...] The lender is usually paid solely or almost exclusively out of the money generated by the contracts for the facility’s output [...]. The borrower is usually an SPE (Special Purpose Entity) that is not permitted to perform any function other than developing, owning, and operating the installation. The consequence is that repayment depends primarily on the project’s cash flow and on the collateral value of the project’s assets. (Basel Committee on Banking Supervision 2004, p. 61)
3 History and market for project finance
Sector | Mio. USD | Percent (%) |
---|---|---|
Power | 106,338 | 38 |
Transportation | 61,903 | 22 |
Oil and gas | 55,753 | 20 |
Petrochemicals | 13,592 | 5 |
Industry | 12,097 | 4 |
Leisure and property | 11,203 | 4 |
Mining | 8637 | 3 |
Water and sewerage | 6049 | 2 |
Telecommunications | 1064 | 0 |
Waste and recycling | 312 | 0 |
Total | 276,950 | 100 |
Year/region | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | 2015 |
---|---|---|---|---|---|---|---|
Americas | 19,277 | 24,357 | 38,305 | 39,397 | 51,368 | 93,191 | 93,276 |
Africa/middle east/central asia | 18,321 | 18,731 | 17,440 | 23,631 | 37,295 | 22,126 | 32,520 |
Europe | 44,447 | 66,015 | 67,443 | 46,298 | 52,715 | 70,466 | 75,670 |
Austral/asia-pacific/japan | 56,421 | 97,510 | 91,317 | 88,199 | 62,762 | 76,679 | 75,482 |
Total | 138,468 | 206,615 | 214,506 | 197,526 | 204,140 | 262,463 | 276,949 |
4 Empirical benefits of project finance
The same isolation benefit applies to the local context. While firms commonly operate in a multitude of institutional contexts, the institutional environment of a PF can be isolated much more effectively. This facilitates measurement and improves causal inference. As a result, PF lends a uniquely clean setting for the analysis of institutional effects on the governance and performance of foreign investments. In addition, the special purpose nature of PF means that the project company and its’ governance structure is initiated as a clean sheet and for a clearly defined special purpose. Hence, it is influenced to a much lesser extent by pre-existing structures and corporate imprinting (Marquis 2003; Marquis and Tilcsik 2013). In PF, partners join to create a new venture under a tailored governance structure. They are assembled as a function of the specific project rather than past interaction. As a result of superior clarity, PFs lend themselves in a unique way to quantitative empirical studies. Support for the clarity benefit comes from empirical results in quantitative finance. Studies have shown that PF loans are priced more effectively than corporate loans (Blanc-Brude and Strange 2007; Kleimeier and Megginson 2000). The separation of the project from the companies’ reduces information asymmetries between the lender and the investment and allows for more efficient credit appraisal. The same information benefit manifests when researchers use PF, rather than companies, as research sites. In sum, PF provides a superior research setting that is free from portfolio effects, institutional overlap and historic precedents and clearly defined in terms of project context.PF provides an attractive controlled environment free from various influences that are present in corporate finance. As a stand-alone entity, PF’s structural details [and the performance outcomes] are easily observable to outsiders, whereas structural decisions of corporations can be obscured by other corporate activities (Byoun and Xu 2014, p. 124; Esty 2004b, p. 217).
In sum, PF provides both clarity and complexity benefits for empirical research and promises new applications for Finance and Management theories, as well as managerially relevant insights. Despite the economic relevance and the empirical benefits of PF, research on PF has been scarce and fragmented. In the following, I review PF research in Finance, Management and IB.Never has systematic and valid knowledge about megaprojects therefore been more important to inform policy, practice, and public debate in this highly costly area of business and government. (Flyvbjerg 2014b, p. 7)
5 Review of research on project finance
Year | Publication count |
---|---|
1976 | 1 |
1980 | 1 |
1987 | 1 |
1988 | 2 |
1989 | 1 |
1990 | 2 |
1991 | 3 |
1995 | 2 |
1996 | 3 |
1997 | 1 |
1998 | 4 |
1999 | 1 |
2000 | 2 |
2002 | 2 |
2003 | 4 |
2004 | 3 |
2005 | 1 |
2007 | 7 |
2008 | 3 |
2009 | 3 |
2010 | 4 |
2011 | 2 |
2012 | 7 |
2013 | 10 |
2014 | 6 |
2015 | 11 |
2016 | 10 |
2017 | 2 |
Total | 99 |
Journal | Publication count |
---|---|
International Journal of Project Management** | 11 |
Journal of Applied Corporate Finance* | 7 |
Project Management Journal* | 4 |
World Development*** | 4 |
Journal of Financial Intermediation**** | 3 |
European Financial Management*** | 3 |
Journal of World Business **** | 3 |
Financial Management*** | 3 |
Journal of Finance***** | 3 |
Organization Studies**** | 2 |
International Journal of Production Economics*** | 2 |
Regional Studies*** | 2 |
European Journal of Operational Research**** | 2 |
Long Range Planning*** | 2 |
Journal of Financial and Quantitative Analysis**** | 2 |
Energy Policy** | 2 |
Harvard Business Review*** | 2 |
Journal of the Operational Research Society*** | 2 |
Review of Quantitative Finance and Accounting*** | 2 |
Other (37) | 37 |
Author | Count |
---|---|
Gatti* | 7 |
Esty* | 2 |
Steffanoni | 2 |
Megginson* | 2 |
Byoun | 2 |
Borgonovo | 2 |
Caselli | 2 |
Kleimeier* | 2 |
Corielli | 2 |
Ramamurti | 2 |
Davies | 2 |
Doh | 2 |
Xu | 2 |
Others (100) |
Discipline | Publication count |
---|---|
Finance | 34 |
Management | 31 |
Other* | 25 |
International Business | 6 |
Accounting | 3 |
Total | 99 |
Rank | Author | Keywords |
---|---|---|
1 | Project Finance | 23 |
2 | Megaproject | 8 |
3 | Risk management | 4 |
4 | Governance | 3 |
5 | Political risk | 3 |
6 | Capital | 2 |
7 | Capital structure | 2 |
8 | Complexity | 2 |
9 | Contracts | 2 |
10 | Coordination | 2 |
11 | Debt ratio | 2 |
12 | Equator principles | 2 |
13 | Event study | 2 |
14 | Finance | 2 |
15 | Foreign direct investment | 2 |
16 | Infrastructure | 2 |
17 | Innovation | 2 |
18 | Project | 2 |
19 | Project management | 2 |
20 | Public–private partnership | 2 |
Despite this prominent encouragement, PF research found much more traction in the financial research community.Whereas most prior studies of corporate finance have worked out of a composite-capital setup, I argue that investment attributes of different projects need to be distinguished. (Williamson 1988, p. 576)
5.1 Financial research
5.2 Management and IB research
6 Theoretical implications for management and finance theory
6.1 Interdisciplinary perspectives
Author/year | Disc. | Type | Theory | Contribution |
---|---|---|---|---|
Wynant (1980) | M | Practitioner | Risk-spreading and improved debt capacity for sponsors in capital-intensive investments | |
Shah and Thakor (1987) | F | Formal | Capital structure theory (Trade-off theory), Incorporation theory | Optimal capital structure in PF differs from optimal capital structure in corporate finance. Risky projects will be more likely to be financed with higher leverage and with separate incorporation (PF) |
Williamson (1988) | F | Theory | Transaction cost theory | Corporate finance and corporate governance are compatible and need to be integrated. Projects which are easy to finance by debt should be financed with debt (physical asset specificity low to moderate). Projects with high asset specificity will be affected negatively by preemptive claims of bondholders |
Kensinger and Martin (1988) | F | Practitioner | History of PF and benefits for sponsoring firms | |
Berkovitch and Kim (1990) | F | Formal | Financial contracting theory, Capital structure theory, Agency theory | Project financing with non-recourse is the most effective method in minimizing the total agency costs associated with risky debt when there is no difference in information between lenders and borrowers |
Beidleman et al. (1990) | M | Conceptual | Risk management and risk allocation to partners is the most important success factor in PF | |
John and John (1991) | F | Formal | Capital structure theory (Trade-off theory), Agency theory | Project financing allows for capital structure optimization and increases value by reducing agency costs and increasing the value of tax shields |
Wells and Gleason (1995) | M | Practitioner | Obsolescing bargaining as a major risk in foreign infrastructure investment. Proposes managerial strategies used in PF as a risk mitigation tool | |
Lyles and Steensma (1996) | IB | Conceptual | Grounded theory, Obsolescing bargaining | Guidance for infrastructure finance in Asia. Local firms and government officials as key intermediaries in project awards. Host country prioritizes knowledge transfer, use of local firms and adaptation to local risk |
Chemmanur and John (1996) | F | Formal model | Capital structure theory, Signaling theory, Incorporation theory | PF capital structure allows optimization of control, hostile take-over threats and bankruptcy cost |
Brealey et al. (1996) | F | Conceptual | Capital structure theory, Agency theory, Information economics | PF reduces agency costs between borrower and lender. The separation of the project allows for more efficient risk appraisal by both parties. PF can also be devised as a tool to address political risks in a host-country. PF is evidence that financial structure matters |
Dailami and Leipziger (1997) | F | Quantitative | Institutional theory, Comparative institutional economics | Credit risk premium in PF is affected by host-country institutional environment, the macro-economic environment (inflation), and project-specific risk-attributes |
F | Case study | Cash-flow theory, Capital structure theory, Agency theory | PF involves high transaction costs but allows sponsors to capture tax benefits, lower cost of financial distress and reduce agency conflicts. Efficient risk allocation in a project is pivotal to realization and lower cost of debt. The structure of PF prevents from host-government opportunism | |
Kleimeier and Megginson (2000) | F | Quantitative | Capital structure theory, Institutional theory, Agency theory | Compares corporate finance syndicated loans with PF syndicated loans. PF loans have longer maturities, more third-party guarantees, and more common in high-risk country investments. Despite non-recourse, PF loans have lower credit spreads. Project financing efficiently reduces agency costs |
Esty (2002) | F | Theory | Capital structure theory (trade-off theory) | In high risk contexts, contractual structures become less efficient. Predicts hybrid structures between PF and corporate finance. Banking regulation will affect PF lending |
Smit (2003) | F | Quantitative | Real options theory | Infrastructure investments involve managerial flexibility which create valuable real options and need to be evaluated appropriately in project appraisal |
Farrell (2003) | M | Theory | Agency theory | Each PF must be custom built. Agency risk increases with the number of project participants due to asset substitution |
Esty and Megginson (2003) | F | Quantitative | Comparative institutional economics, Institutional theory | Host-country institutional context influences banking syndicate composition. Countries with strong creditor rights, reliable legal enforcement encourage concentrated syndicates to facilitate monitoring and low cost contracting. Under high country risk, lenders create diffuse syndicates as a way to deter strategic default |
Doh and Ramamurti (2003) | IB | Case study | Obsolescing bargaining | Investors in high risk countries can address obsolescing bargaining by leveraging international agreements (Bilateral trade and investment agreements), using PF, pursing first-mover positions and engaging all relevant stakeholders |
Ramamurti and Doh (2004) | IB | Conceptual | Obsolescing bargaining, Institutional theory | PF allows MNCs to mitigate political risk and counter obsolescing bargaining |
F | Conceptual | Agency theory, Financial contracting theory, Capital structure theory | PFs and large PFs in particular, are strategic research sites because of the clear window of analysis resulting from organizational and financial separation of the project from the sponsoring companies’ portfolios | |
van Marrewijk (2007) | M | Case study | Grounded theory | Focuses on cultural, social and organizational problems in megaprojects. Project culture is a key success factor |
Leland (2007) | F | Quantitative and Formal | Capital structure theory (Trade-off theory) | Separate incorporation is beneficial for high risk projects, allowing for greater additional debt financing |
Gatti et al. (2007) | F | Conceptual | Monte Carlo simulations as a means of measuring PF risk | |
Dailami and Hauswald (2007) | F | Quantitative case study | Financial contracting theory, Agency theory | PF as a nexus of financial contracts. Credit spreads for bank loans depend on financial contracts such as supply agreements, debt covenants, and a debt-service guarantee contingent on output prices |
Blanc-Brude and Strange (2007) | F | Practitioner | The cost of PPP debt is thus determined only by systematic risks. All project specific risks are addressed through contractual means. PF is a highly developed and customized form of corporate governance | |
van Marrewijk et al. (2008) | M | Case study | Grounded theory | Focuses on cultural, social and organizational problems in megaproject. Project design and culture as a key success factor |
Vaaler et al. (2008) | IB | Quantitative | Institutional theory, Agency theory, Transaction cost theory | Develop a target risk framework, separating levels of project risks (country-,industry-, syndicate-, firm-, and project-related factors). Identifies effects on project capital structure from institutional country-level factors, syndicate structure factors and lead sponsor experience and project size |
Sorge and Gadanecz (2008) | F | Quantitative | Unlike other forms of debt, PF loans appear to exhibit a hump-shaped term structure of credit spreads. Political risk and political risk guarantees have a significant impact on credit spreads for PF loans | |
Davies et al. (2009) | M | Conceptual | Derives operational process models for megaprojects | |
Chen (2009) | M | Case study | Grounded theory | Provides a framework for project development process and organization |
Sawant (2010) | IB | Quantitative | Transaction cost theory, Obsolescing bargaining | PF allows strategic use of capital structure not only through equity but also through debt. High leverage pre-commits cash flows and global syndication creates a reputation effect for host-government |
Corielli et al. (2010) | F | Quantitative | Financial contracting theory | PF as a nexus of financial contracts. Non-financial contracts (offtake agreements, supply contracts, Equipment Procurement Contracts, Guarantees etc. in PF are used to transfer risk to counterparties. However, the counter-party to the contract determines effectiveness of risk transfer |
Esty and Sesia (2011) | F | Descriptive | Provides an overview of PF market history, trends and characteristics | |
Hainz and Kleimeier (2012) | F | Quantitative | Institutional theory, Financial contracting theory | Political risk encourages use of PF and participation of development banks. Terms of the loan contract depend on political risk and the legal and institutional environment |
Haack et al. (2012) | M | Case study | Grounded theory Institutional theory | Categorizes CSR strategies adopted by banks in PF (Equator Principles) |
Kardes et al. (2013) | M | Theory | Prospect theory | Exploratory identification of success and failure factors in megaprojects. Risk management framework. Analyzes decision failures based on prospect theory, self-justification theory, and sunk cost effect and concludes that systematic risk-management improves success of projects |
Gatti et al. (2013) | F | Quantitative | Signaling theory | Certification of PF loans by prestigious banks reduces risk spreads and cost of borrowing of a project but involve higher banking fees. Certification effect is stronger in times of financial crisis |
Byoun et al. (2013) | F | Quantitative | Capital structure theory (Trade-of theory) | Contract structures in PF are important hedging mechanisms. Project companies use more leverage when project risk is high, but less when contracts reducing risk are in place (offtake agreements) |
Banal-Estañol et al. (2013) | F | Formal | Capital structure theory, Incorporation theory | PF is advantageous when risk-contamination losses of a well-performing project outweigh standard coinsurance gains |
Gkeredakis (2014) | M | Case study | Social practice theory, Grounded Theory | Proposes a framework for coordinated action in situations of task-specific and “external” interdependencies |
M | Conceptual | Agency theory, Prospect theory | Introduces a framework to explain frequent cost overruns in PF. Actors get trapped in mega-project thinking | |
Byoun and Xu (2014) | F | Quantitative | Agency theory, Institutional theory | PF allows for optimization of risk allocation. Concession grants and offtake agreements benefit both public and private sponsors in the presence of political risk. Contract choice and government involvement depends on institutional context and in particular on political risk |
Esty et al. (2014) | F | Descriptive | Provides an overview of PF market history, trends and characteristics | |
West (2015) | F | Conceptual Quantitative | Introduces a CSR-based project valuation framework including financial returns, environmental impacts and social effects. PF involves trade-off between cost, return and social aspects | |
Subramanian and Tung (2016) | F | Quantitative | Comparative institutional economics, Agency theory | PF is contractual and organizational substitute for investor protection laws. Contract enforcement and separate incorporation mitigates institutional risk in host-country. PF is more likely in host-countries with weak investor protection |
Müllner (2016) | IB | Conceptual and Quantitative | Transaction cost theory, real options theory, Institutional theory | PF as a risk management-based, cooperative entry mode into high risk markets as opposed to high uncertainty. PF allows for more efficient diversification, financial contracting of risks and socio-economic risk management (alliances and networks) |
6.2 Financial theory
6.3 Management and IB theory
The high leverage used in PF pre-commits cash-flows to fairly powerful banks. This reduces free cash-flows of a project that would be available for opportunistic expropriation and maximizes the repercussions of opportunistic behavior by the host-government (Brealey et al. 1996; Esty 1999b, 2001). At the same time, non-recourse provisions align sponsors interests with those of banks, directing lenders’ efforts, to protect an investment against a potentially opportunistic host-government, rather than relying on sponsors’ collateral. Therein, PF supports secondary or indirect bargaining strategies in risky foreign investments, as described by resource-dependence scholars (Emerson 1962; Gargiulo 1993; Granovetter 1985). In essence, investing MNCs can make use of macro-economic dependencies and financial strategies to influence power dependence to their favor (Alcacer and Ingram 2013; Rangan and Sengul 2009).The involvement of financial institutions (particularly large international banks) deters host governments from squeezing the IPPs [infrastructure investments] opportunistically to a level that would affect debt coverage. Indeed, every government official interviewed for this study who had been involved in a renegotiation identified debt payments as a hard constraint on their willingness to pressure a project. (Woodhouse 2006, p. 180).