Working Mechanism of Project
Financing
Project financing is a structured method where the funding for a specific project is arranged
through a Special Purpose Vehicle (SPV), and the repayment relies solely on the cash flows
generated by the project itself. The diagram illustrates the core structure and
interrelationships of the entities involved in a typical project financing model.
Special Purpose Vehicle (SPV)
At the center of the project financing mechanism is the SPV, a legally independent entity
created specifically for the project. The SPV is responsible for contracting, financing,
owning, and operating the project (Yescombe, 2014). It acts as a financial firewall, isolating
project risks from the sponsors’ balance sheets.
Sponsors and Equity Investment
The project sponsors, typically private companies or public agencies, provide the initial
equity capital to the SPV. In return, they receive ownership stakes and future returns from
project cash flows. Equity investment is critical for securing debt financing, as it reflects the
sponsors' commitment (Esty, 2004).
Lenders and Debt Financing
Lenders, which may include commercial banks, development finance institutions, or
bondholders, provide the majority of the project capital in the form of non-recourse or
limited-recourse loans. These loans are secured by the project's assets and future revenue,
not by the sponsor's assets (Gatti, 2013). Lenders conduct due diligence and impose
covenants to mitigate risks.
Engineering, Procurement, and Construction (EPC) Contractor
The SPV signs a contract with an EPC contractor to design and build the project. The
contractor is responsible for delivering the project on time and within budget. This contract
is crucial to reduce construction risk and ensure technical quality (Yescombe, 2014).
Operation and Maintenance (O&M) Contractor
Post-construction, the O&M contractor ensures the efficient operation and maintenance of
the facility. A long-term O&M agreement ensures performance standards and reliability,
which are critical to maintaining stable cash flows (Gatti, 2013).
Offtake or Revenue Agreement
The SPV enters into a long-term offtake agreement (e.g., Power Purchase Agreement, Toll
Concession, etc.) with a customer or government agency. This ensures predictable revenue,
which is essential for loan repayment. The offtaker’s creditworthiness directly affects the
project’s risk profile (Esty, 2004).
Cash Flow Waterfall
Project revenues flow into the SPV’s account and are distributed according to a cash flow
waterfall:
1. Operation and maintenance costs
2. Debt service (interest and principal)
3. Sponsor dividends
This order ensures that operating and financial obligations are met before profits are
distributed (Yescombe, 2014).
Government and Regulatory Role
Government involvement may include granting licenses, regulatory approvals, guarantees,
or subsidies. In public-private partnerships (PPPs), government participation is critical in
minimizing political and regulatory risks (Gatti, 2013).
Conclusion
The project financing model relies on a clearly defined structure with multiple stakeholders,
each with specific responsibilities. The SPV acts as the central unit, linking contracts and
financial flows. By allocating risks among specialized parties and relying on future project
cash flows for repayment, this mechanism allows for the development of large-scale
infrastructure projects while minimizing sponsor exposure.
References
Esty, B. C. (2004). Modern project finance: A casebook. John Wiley & Sons.
Gatti, S. (2013). Project finance in theory and practice: Designing, structuring, and financing
private and public projects(2nd ed.). Academic Press.
Yescombe, E. R. (2014). Principles of project finance(2nd ed.). Academic Press.
