Gergely Szalóki

Legal Aspects of Capital Structure in project finance





         1) What is the project finance?


The Black’s Law dictionary provides such a definition that emphasizes the security aspect of the project finance. Namely, project finance is “a method of funding in which the lender looks primarily to the money generated by a single project as security for the loan.[1] Many other definitions give emphasis for this attribute, that the loans are not backed up by assets of the project sponsor, but rather by the receivables of the project company;[2] however, mentioning other factors which are important.[3] Finnerty highlighted the investors’ interest and the separate nature of the project from every other participant as well.[4] Wallenstein[5] stresses even more that the project requires an entity on its own that carries out the project; Huang and Knoll[6] join to this view. Esty went further giving more emphasis on the independence of the project, and naming the two most relevant financial source of fund raising (lenders’ loan as non-recourse debt and sponsors’ equity contribution) in project finance.[7] Collins, Zhang and Facciolo also stress the non-recourse nature of project finance.[8] These definitions, however, do not reflect every aspects of project finance which are important. For instance, that project finance may be constructed in a not completely non-recourse basis, when the lenders find the future revenues of the project insufficient for financing the repayment of the loan.[9] In this hybrid, limited recourse system, the lenders have opportunity, in certain circumstances, to look to the assets of the project sponsors.

Other definitions also stress that the main feature of project finance is that the lenders look primarily to the cash of flow of the project, however, put emphasis on the legal nature as well, when stating that project finance is a set of contracts. Penrose’s definition emphasizes the independence of the project and the projects company that the loan is repaid solely from the revenue generated by the project, and states that project finance is mainly a group of contracts.[10]

Other definitions highlight that project finance is a solution for off-balance sheet accounting treatment, which means that the project sponsors does not have to report the project debts in their balance sheet, therefore they can increase their ability to take more credits.[11] However, the product of the post-Enron legislation, the Sarbanes-Oxley Act has taken almost completely away this “safety-net”.[12]

Wood’s definition, involving banks, is quite different when stating that project finance is the financing of long-term infrastructure and industrial projects based upon a complex financial structure; it is a set of transactions under which a single project (e.g. construction of a cable network or a bridge) is developed; it is often referred to as a special area of banking.[13]

Miyamoto cites the ‘OECD agreement on new rules for project finance’ when defining its meaning.[14] To this definition seven essential criteria is added, which are attributable to the project finance: setting up a special purpose company, appropriate risk sharing, project cash-flow is sufficient for the repayment of the loan, priority deduction from project revenues of operating costs and debt service, no sovereign repayment guarantee, asset-based securities for proceeds/assets of the project, limited or no recourse to the sponsor.[15]

There are various possibilities of defining the notion of project finance; however, we think that emphasis should be put on its two main features: the non-recourse debt and that usually the receivables of the completely independent project company serves as security for the loan, because these features are the most distinctive from the other types of financing. There are, of course, other distinctive factors, such as the magnitude and complexity of the project which requires the sharing of project risk; allocating of which used to be one of the reasons of inventing project finance. The usual involvement of the host country/municipality (not rarely both of them are involved) which provides concession, the land for the project or provides other incentives for the investors such as money aids or tax allowances.

we think, therefore, that the proper definition should give an emphasis to other factors as well. Thus, according to our opinion, project finance is a set of transactions for establishing, building and financing a single, long-term project, which is meant  to allocate the project risks among the project participants and to keep the project debt out of the project sponsors balance sheet and which is usually of high importance for the host country, (which therefore usually supports the project); by setting up a new – usually domestic – corporate entity, based upon a complex financial structure where the non-recourse or limited recourse debt is repaid primarily from the money, assets and rights generated by the project itself.[16]



2)    The capital structure of the project


The lenders provide the vast majority of the money necessary to the projects.[17] The debt-equity ratio is usually ten-twenty percent equity and eighty-ninety percent debt.[18] The debt from these lenders are usually senior debt, which means that they have the first right to the project assets.[19] The debt is non-recourse to the project sponsors; it remains off of its balance sheet, because the borrower is the project company, not the project sponsor itself. This is a disadvantage from the lenders’ point of view, since the number of available security interests is potentially lower; the security package focuses only on the project company’s assets, especially on its cash-flow.[20] Therefore the lenders usually require the project sponsors,[21] to provide guarantees, warranties or covenants.[22] In some case the project lenders set forth that there may be no changes in the project plans without their consent.[23] These commitments may turn the non-recourse debt into a limited recourse one, according to which the lenders have some recourse to the assets of the project sponsors.[24]

When providing credit, the project lenders rely on the feasibility study prepared by the project sponsor. The feasibility study shows the viability and profitability of the project, which is the main ground for the lenders when deciding whether to provide the loan or not. The feasibility study analyzes the technical, financial, and other aspects of the project; it contains the project description, sponsors’ arrangements, governmental arrangements, construction, etc. agreements, sources of funds, market study, financial projections and assumptions.[25]

In this article, we shall discuss the different kinds of sources from which the capital to the project may arise: first, equity provided from the projects sponsors (2.1.); second, senior debt coming from the lenders (2.2.); third, mezzanine debt which may be provided also by the lenders (2.3.); moreover, there are special type of financing instruments apart from the rather orthodox lender-borrower scheme, such as the project leasing (2.4.) and the issuance of bonds by the project company (2.5.).



       2.1. Equity


Equity is the part of the capital, which is contributed by the sponsors.[26] The sponsors might opt to make an initial payment, which means that the sponsors provide the equity contribution even before they would approach the lenders.[27] The advantage is that it might ease to find lenders to the project, and the lenders might lend for lower interest, as at the early stages of the project less debt capital is necessary.[28] The disadvantage of the initial payment is the opportunity cost, as they could have invested the amount paid as equity in other transactions.[29]

The other option for the sponsors is to make a final payment, meaning that they will provide the equity contribution only when the debt capital is paid by the lenders.[30] The main advantage of this solution lies in leaving open the opportunity for making other investments; on the other hand, on this way the lenders take higher risk, therefore the interest rate might raise as well.[31]

In practice, however, sponsors take the interim solution, the make stage payment, which is to contribute the equity capital in tranches, combining the advantages and disadvantages of the initial and final payment, construing a fair balance between the different interests of the lenders and the sponsors.[32]



       2.2.Senior debt


This contribution to the project coming from the lenders is secured by a security interest which provides for priority over other creditors; meaning, that in the event of bankruptcy, senior debt must be repaid before other creditors receive any payment. Such security interest is commonly provided in the form of mortgages over assets; however, in the case of project financing the receivables of the project company is used mainly as collateral e.g. by way of charge or security assignment.

The secured loan is usually not provided up-front but it is drawn by tranches as the project company needs funds. Moreover, the credit facility is divided according to the aim of the funding.[33] The largest amount, called as base facility, as a not revolving facility meaning that the amount repaid by the borrower cannot be borrowed again, is provided at the construction phase in order to cover the upcoming costs of the construction.[34] The working capital facility, as its name also indicates, is used in case of shortage in cash in order to finance e.g. the payments made towards the contractors.[35] Stand-by facility is an accessory part of the credit drawn only when the first two facilities are proven to be insufficient. This facility represents therefore a higher risk to the lenders, who stipulate higher interest rate in consideration.[36] VAT facility is for the early stages of the project, if advance payment of the tax must be made.[37] The last three facilities are commonly disbursed as a revolving facility.



       2.3. Mezzanine debt


It is a hybrid form of capital, since it combines the features of debt and equity.[38] Mezzanine debt varies as to the forms it may take: hybrid financial products with many equity characteristics (e.g. it increases the ratio of the equity in the capital[39]); loan to the sponsors secured by an equity interest in the project company; and loan to the project company subordinated to the senior debt.[40] In some mezzanine financing the lender provides only equity either to the sponsor or the project company directly; in turn, it will gain option or warrant to the shares of the companies taking the mezzanine debt respectively.[41] Mezzanine debt differs significantly from equity, because in the latter case the equity provider already has an equity ownership interest and does not need to foreclose to gain an equity ownership interest in the borrower.[42]

Mezzanine debt is usually more expensive from the borrowers’ point of view as the senior debt, because mezzanine debt is practically unsecured[43] since it is subordinated to the senior debt.[44] It represents higher risk, so the lenders look for higher return, though not by stipulating a higher interest rate.[45] The real consideration for the lenders taking the higher risk, however, is that the mezzanine debt embeds equity instruments (usually warrants) attached, which increases the value of the subordinated debt, and allows for greater flexibility, making mezzanine debt look more like equity.[46]

In a usual scheme the project company would be provided with the senior debt using its revenues as collateral and the mezzanine debt would be taken by the sponsors encumbering their equity in the project company. Therefore, the mezzanine lender would have a claim against the equity interest in the project company, but would have no claim against its assets. Default under the mezzanine loan would not trigger the foreclosure under the senior loan and vice versa.[47] The project company obtains separate financing from a senior lender; thus, the mezzanine lender and senior lender do not share the same collateral and borrower. Furthermore, the mezzanine debt is subordinate to the senior debt; therefore foreclosure of the senior debt will leave the mezzanine lender with valueless equity interest collateral.[48]

The mezzanine debt allows the sponsors to raise the capital needed to the project for the least cost, and, on the other hand, does not endanger the position of the senior lenders.[49] Mezzanine debt entails an inherent conflict between the senior and the mezzanine lenders,[50] therefore, mezzanine loan documents, particularly the loan and intercreditor agreements, must not conflict with the senior loan documents.[51] It must also note that mezzanine debt can complicate senior loan negotiations by virtue of the need for the two lenders’ cooperation.[52]



        2.4. Project Leasing


This way of raising capital to a project has appeared only recently in structured finance.[53] In this scheme the project company shifts the risks associated with the planning and construction (e.g. the completion risk, permitting risk) to a leasing company which undertakes to build the project (in the United Kingdom it is widely utilized to finance independent power plants[54]), and in consideration it receives leasing fee from the project company once the operation has been started; the technique might be useful in PPP, especially in BOT transactions;[55] however, might be suitable for other project finance schemes as well.[56] The project leasing entails three elements and advantages that are worth to be mentioned and discussed in detail: funding, asset and risk management and taxation as the latter might be a huge incentive to utilize this financing technique.[57]

In the field of funding this is an introduction of a new financing scheme, under which the project may be carried out.[58] The leasing company raises capital to the completion of the project usually from banks. So, the project lenders provide the loan to the leasing company, not to the project company.[59] Transferring of the risk is an inherent characteristic of this scenario,[60] as the title to the project assets remains with the leasing company until the completion of the project; it bears all the risks that may arise during this phase.[61] Moreover, it is a financial benefit to have an earlier access to the tax allowances (depreciation allowances most commonly, however, it depends on the tax regulation of the host country) which the leasing company may pass over at least partly to the project company by reducing the leasing fee, which enhances the project viability.[62]



      2.5. Project Bonds


This is an alternative way of raising capital to the project; the sponsors obtain funding through the private placement of project bonds, usually to certain institutional investors.[63] The use of bonds when raising capital to a project may take various forms, which may be categorized according to the stage of the project in which the bonds are issued, or participants issuing the bonds. However, in either way the project sponsors have to take into account when structuring the deal the role and perspective of the rating agencies. The rating agencies analyze the terms of the financing, in particular focusing on the rights of the lenders, as these rights will form the basis of the rights of the purchasers of the bonds.[64] The rating agencies shall also take into consideration which stage of the project is to be financed by the issuance of bonds, as e.g. in the contraction phase higher risk is assumed.[65]

The most common way of utilization is to issue bonds when the project is already established and performs well.[66] In such case by issuing bonds the project company either refinances its former financial obligations or expands the already existing operation of the project.[67]

The other way is to raise the initial capital to the project by issuing bonds. In this way, just like in the orthodox lender-borrower scheme, the revenues generated by the project services the repayment of the debts.[68] Although, arguing with Croke stating that despite cost of issuance (e.g. cost of the rating agency) capital markets offer cheaper source of money,[69] this way of financing might be more costly than taking senior or mezzanine debt, since at this stage all of the risks are assumed yet (and the risks are not diversified as only one project is at hand), which might cause the interest rate increased, and the non or limited recourse nature does not encourage prospective investors to contribute money to a project which does not have any assets at the early phase.

Also the idea came up when securitization became a preferred tool in financing[70] and raising capital to securitize project revenue thereby raising capital directly from the capital markets.[71] Croke mentions to possible way to arrange such transaction: on one hand, he suggests to set up a special purpose vehicle in which the project assets and the accompanying risks are pooled and which would then issue the securities back up by the assets transferred; on the other hand, assets along with the risks may be transferred to an already established securitization vehicle, which better access to liquidity and credit enhancement devices.[72] He also states that the first way seems to be more costly as disclosure requirements are more strict,[73] however, it is more flexible as to the sale point of view, as the securities are issued in tranches which are subordinated to each other, and the lowest in the rank will absorb the losses first, thereby providing a more secured position to the holders of the higher level securities.[74]

Wallenstein, however, is rather skeptic about the viability of combining securitization with project finance. He argues that there is only a limited or no incentive for the sponsors to securitize the revenue stream coming from the project company. The sponsors already achieved the off-balance treatment and non recourse nature of the transaction by setting up the project company, so establishing a special purpose vehicle with the one and only aim to issue securities back up by the project revenues gives nothing to them in this regard; meanwhile, this scheme brings higher costs.[75] However, he does not deny the possibility of securitizing the project revenues once the project is completed and generates stable income; which would practically mean refinancing of the initial financial obligations by issuing bonds.[76] His idea that such a securitization would stimulate the local capital markets especially the bond market[77] is also worth to be considered when the project participants, most probably the host country, tries to achieve the twin goals of project finance.





In our view, there might be project finance transactions that are of lower risks along with stable and predictable revenue which enables the sponsors to utilize securitization when raising capital to the project more easily and cheaper than loan by providing more attractive investment opportunity to the investors; however, it might be difficult to achieve as in case of high interest rates the sponsors are more likely turning to the capital markets, but investors might be satisfied with the relatively high and safe bank interest rate and give their money to the banks rather. On the other hand, in case of low interest rates, the investors might seek higher return investments and take more risk therefore, but sponsors might be satisfied with taking the loan and financing the project by senior and mezzanine debts. Although, refinancing the existing debts by issuing project bonds may be still a viable option once the completion risk is behind and more of the risks are not assumed anymore, and the project has started to generate income.


[1] Black’s Law Dictionary, 8th ed. 2004, see: financing

[2] “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.” Nevitt, P.K., F.J. Fabozzi: Project Financing, 7th edition, Euromoney Books; London 2000 p. 1

“Project finance is debt finance technique used for the development of a public infrastructure project, where the lenders look primarily to the cash flow produced by the project to service their debt rather than to other sources of security…” Catherine Pédamon: How is convergence best achieved in international project finance?; Fordham International Law Journal, April 2001 p. 1274;

“…building and operating a large-scale, long-term, revenue generating infrastructure project…capital…is provided principally by the lenders who rely for repayment on the receivables.” Carl S. Bjerre: Project finance, securitization and consensuality, Duke Journal of Comparative and International Law, Spring 2002 p. 416

[3] “…when the lenders place primary reliance on the revenues of the new project for repayment. Also […] lenders will use the assets and contracts of the project as security.” Katharine C. Baragona: Symposium: Markets in Transition: Reconstruction and development part two – Building up to a drawdown: International project finance and privatization – Expert presentations on lessons to be learned, Transnational Lawyer 2004 p. 140

[4] “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.” John D. Finnerty: Project Financing:  Asset-Based Financial Engineering; New York, 1996 p. 2

[5] “Project finance generally results in the creation of a new cash-flow producing asset.” Stephen Wallenstein: Situating project finance and securitization in context, Duke Journal of Comparative and International Law 2002 p. 450

[6] “…sponsoring entity sets up a project as distinct legal entity and raises funds through the project, which issues securities. The investors, thus, look to the project’s cash flow for their return.” Peter H. Huang, Michael S. Knoll: Corporate finance, corporate law and finance theory, Southern California Law Review, November 2000 p. 183

[7] “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.” Benjamin C. Esty: Modern Project Finance, Teaching Notes; New York 2004 p. 25

[8] “…borrowing gobs of money from large lenders on a non-recourse basis,” Cindy Collins: The few, the proud, the big…Booming international project finance work lures the heavy-hitters, Of counsel, November 18 1996 p. 9

“Project finance is a technique of non-recourse financing that is not primarily dependent on the credit support of the [project] sponsors or the value of the physical assets involved, but rather depends upon the expected performance of the project itself” Jay Facciolo: Project finance by Clifford Chance, Book review, Boston University International Law Journal, Spring 1993 p. 169; Nan Zhang: Moving towards a competitive electricity market? The dilemma of project finance in the wake of the Asian financial crisis, Minnesota Journal of Global Trade, Summer 2000 p. 718

[9] Wendy N. Duong: Partnerships with monarchs – Two case studies: Case two partnerships with monarchs in the development of energy resources: Dissenting an independent power project and re-evaluating the role of multilateral and project financing in the international energy sector, University of Pennsylvania Journal of International Economic Law, Spring 2005 pp. 75-76

[10] “A project company is a group of agreements and contracts between lenders, project sponsors and other interested parties that creates a form of business organization that will issue a finite amount of debt on inception; will operate in a focused line of business; and will ask the lenders look only to a specific asset to generate cash flow as the sole source of principal and interest payment and collateral.” James Penrose: Project finance and debt rating criteria, Journal of International Banking Law 2001 p. 220; James Penrose, Peter Rigby: Project Finance and debt rating criteria: part 1, International Energy Law & Taxation Review 2001 p. 227;

“…project finance is a set of legal contracts, arrangements, and relationships that, when put together, typically creates a single-purpose operating entity that, in turn, creates a product or service.” Collins 1996 p. 8

[11] “…project finance as a solution of balance sheet debt.” Katrina Dick: Project finance in telecoms, Computer and Telecommunications Law Review 2005 p. 183

[12] Duong 2005 p. 79

[13] “Under project finance, banks provide finance for a single project and take a large part of the risk of the success or failure of that project.” Philip R. Wood: Project Finance, Subordinated Debts and State Loans; London 1995 p. 3

[14] “Project finance transactions are defined as a financing of a particular economic unit in which a lender is satisfied to consider the cash flows 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.” Ken Miyamoto: Measuring local legal risk premium in project finance bonds, Virginia Journal of International Law, Summer 2000 pp. 1127-1128

[15] Miyamoto 2000 p. 1128

[16] Gergely Szalóki: Securing performance in power projects, Saarbrücken 2009

[17] Albert H. Savelberg: Einführung Projektfinanzierung, Euroforum Verlag 2008 p. 31

[18] Collins 1996 p. 11; Baragona 2004 p. 146

[19] Baragona 2004 p. 146

[20] Andrea De Gaetano: Risks and security packages in project finance transactions in the Italian public sector, Journal of International Banking Law and Regulation 2005 p. 38

[21] Penrose 2001 p. 222; Penrose-Rigby 2001 p. 229

[22] Zhang 2000 p. 719-720

[23] Wood 1995 p. 27

[24] Duong 2005 p. 76

[25] Baragona 2001 p. 148

[26] Savelberg 2008 p. 58

[27] Savelberg 2008 p. 59

[28] Savelberg 2008 p. 59, 62

[29] Savelberg 2008 p. 62

[30] Savelberg 2008 p. 60

[31] Savelberg 2008 p. 62

[32] Savelberg 2008 p. 60, 62

[33] Savelberg 2008 p. 62

[34] Savelberg 2008 p. 63

[35] Savelberg 2008 p. 63-64

[36] Savelberg 2008 p. 64

[37] Savelberg 2008 p. 64

[38] See Jeanne A. Calderon: Structuring mezzanine investments with hope of achieving long term capital gains tax treatment, Real Estate Law Journal, Summer 2004; Savelberg 2008 p. 65-66

[39] Dr. Beda Wortmann: Projektfinanzierung, Rechtliche Seite, Euroforum Verlag 2008 p. 14

[40] See Calderon 2004

[41] See Steven Horowitz, Lise Morrow: Mezzanine financing, American Law Institute - American Bar Association Continuing Legal Education, January 12-14, 2006

[42] See Joseph Philip Forte: Mezzanine finance: A legal background, American Law Institute - American Bar Association Continuing Legal Education, ALI-ABA Course of Study, March 27 - 28, 2008

[43] Wortmann 2008 p. 14

[44] Savelberg 2008 p. 67

[45] See Calderon 2004 and Horowitz 2006

[46] Savelberg 2008 p. 66

[47] See Horowitz 2006 and David W. Forti, Timothy A. Stafford: Mezzanine debt: Suggested standard form of intercreditor agreement, American Law Institute - American Bar Association Continuing Legal Education ALI-ABA Course of Study, March 27 - 28, 2008 p.

[48] See Thomas R. Fileti: Subordinate and mezzanine real estate financing, American Law Institute - American Bar Association Continuing Legal Education, ALI-ABA Course of Study, July 30 - August 2, 2008

[49] See Calderon 2004

[50] See Forte 2008

[51] Jan Sternin, Stacey M. Bergen: Servicing mezzanine loans A to Z, Practising Law Institute, Real Estate Law and Practice Course Handbook Series, February 2003 p. 636

[52] See Horowitz 2006

[53] Stefano Caselli, Stefano Gatti: Structured finance: Techniques, products and market, Springer, 2005 p. 96-97

[54] Denton Wilde Sapte LLP: Public-Private Partnerships: BOT Techniques and Project Finance, Euromoney Books 2006 p. 130; Savelberg 2006 p. 131

[55] Denton 2006 p. 130

[56] Denton 2006 p. 132

[57] Caselli 2005 p. 98

[58] Denton 2006 p. 130

[59] Savelberg 2008 p. 72

[60] Caselli 2005 p. 102

[61] Denton 2006 p. 70-71

[62] Denton 2006 p. 130, 132

[63] Savelberg 2008 p. 73; James J. Croke Jr.: New developments in asset-backed commercial paper,  Practising Law Institute, Commercial Law and Practice Course Handbook Series, December 4-5, 2008 p. 941

[64] Croke 2008 p. 942;

[65] Croke 2008 p. 942-943

[66] James J. Croke Jr.: Project finance and securitization: A natural hybrid, Symposium: Markets in Transition: Reconstruction and Development Part Two – Building Up to a Drawdown: International Project Finance and Privatization Expert Presentations on Lessons to Be Learned, Transnational Lawyer 2004 p. 163; Wallenstein 2002 p. 452

[67] Loren Page Ambinder, Nimali de Silva, John Dewar: The mirage becomes reality: Privatization and project finance developments in the middle east power market, Fordham International Law Journal, April 2001 p. 1050-1051, fn. 93

[68] Croke 2004 p. 160

[69] Croke 2004 p. 160, 162

[70] Hal s. Scott, Philip A. Wellons: International Securities Regulation, New York 2002 p. 260-263

[71] Bjerre 2002 p. 422

[72] Croke 2004 p. 161-162

[73] Croke 2004 p. 162

[74] Croke 2004 p. 161

[75] Wallenstein 2002 p. 452

[76] Wallenstein 2002 p. 452

[77] Wallenstein 2002 p. 453