Project finance: building risk-mitigated, long-term returns for private debt

The historic outflow of capital from the traditional banking network into the private debt and equity markets, branded by polite fiscal society as the ‘shadow banking’ sector, was, curiously, first exposed in the OECD’s 2006 Pensions Report. They were the first global authority of any description to acknowledge the most tectonic upheaval in 400 years of banking as we once knew it. Now, a decade and a half later, ‘shadow banking’ clearly overshadows traditional banking. Irony lives.

But the challenge for the entire sector has always been to identify opportunities, most often concealed in a sea of disjointed information, that can deliver the enhanced returns from alternatives that investors demand. Now, with the roll-out of covid vaccines and (for those it matters to) Brexit done, there is additional pull from increasingly buoyant equity markets with their built-in risk mitigation and liquidity.

From a wider perspective the sector is comprised of alternative investment funds, hedge funds, private debt and equity funds and the entire lexicon of private capital channels familiar to PDI subscribers. It is difficult to put a liquidity value on it all, but the Cap-Gemini World Wealth Report 2020 gives us a good starting point with its global population of 19.6 million ultra-high-net-worth individuals and total worth in 2019 of $74 trillion.

But it was the asset allocation chart in the report which is of most interest. We can set aside the 30.1 percent shown as going to equity as this will be for the mainstream markets.

To get an indication of what proportion of all this wealth goes to private debt and equity we need to look at the real estate (14.6 percent) and alternative investments (12.9 percent) allocations. This brings a total of 27.5 percent of $74 trillion of private capital equating to $20.4 trillion of ‘dry powder’ seeking out opportunities with returns expected to be superior, yet just as ‘safe’, as the mainstream markets deliver.

There is a well-established menu of financing categories open to private debt. M&A, venture capital, mezzanine et al, all have their own unique characteristics and risk/reward dynamics. But what separates project finance from all other categories is that the lending is never reliant on forecasts in a business plan, with all its attendant risks, but predicated on the track record and financial stability of whoever is contracted to buy the output from the built project. This long-term, risk-mitigated structure makes project finance the natural home for private debt.

At any one time there are many thousands of projects seeking finance, all over the world. They range across $20 million senior living through $250 million renewable energy to $500 million hotels or resorts and $5 billion or more transport, airport, roads and other infrastructure projects.

In the case of a waste-to-energy plant, the ‘contracted off-taker’ could be a national or regional electricity grid. Or, a hotel operator with a successful track record or with an operations and management agreement with a quality hotel operator, can call on project finance to build a new hotel or resort. The list is endless, with the same track record and financial credibility criteria applying to the contractors that are going to build it.

The flexibility of private capital which powers the so-called ‘shadow banking’ sector means that project finance is no longer the sole domain of mega-million and billion major infrastructure projects. It now reaches across all market sectors and deal values from $10 million to $5 billion-plus.

Genuine project finance leaves the principals, be they individual, corporate or government, free and clear of any financial liability. For private debt providers this ‘non-recourse’ financing demands in-depth due diligence, an acute understanding of the permits, permissions and other documentation requirements and dependable ‘third-party’ support from lawyers, surveyors and others. No price can be put on an exceptionally close working relationship with underwriters, the best of which will provide complementary support at the due diligence level.

It is interesting to note that the first recorded project financing was in 1299 when an Italian merchant bank, the House of Frescobaldi, funded a silver mine in Devon, England with the loan repaid with output from the mine. In itself, the very definition of ‘project finance’.

It has taken 722 years but project finance is now a nascent, maturing and potentially deeply liquid global capital market in its own right, witnessed by the opening of the Project Finance Exchange. This long-overdue initiative is transforming a deal-origination landscape currently populated by thousands of disconnected, parochial financier and intermediary networks into a structured marketplace, where projects and financiers can connect and engage seamlessly. PFX also provides an online project financing course suitable for private debt providers, as opposed to banks and institutional financiers.

David Rose has almost three decades of experience in project finance. He is author of The Raising Project Finance Handbook and chairman of the Project Finance Exchange.