There are two main approaches towards the financing of major projects. The first is the traditional financing approach, and the second is the project financing one. Let's start looking at the traditional financing approach. There are three main actors involved. Firstly, there is the sponsor. Secondly, the lender. And thirdly, we have the project. This is a simplified version, as in reality, in major projects, there are many types of lenders and many classes of sponsors. But to keep things simple, let's assume we have a single sponsor and a single lender. In traditional financing, the lenders provide part of the funds directly to the sponsor. In this way, the sponsor invests the money in the project. The sponsor invests both his own money as well as the portion of funds borrowed from the lender. Usually, the project sponsor finances the construction of the project. Once the project reaches the operational stage, it starts to generate some revenue, which is collected by the sponsor. At this stage, the sponsor repays the loan to the lender. On the other hand, there is the project financing approach. This requires the incorporation of a brand new company known as the 'special purpose entity', or 'special purpose vehicle'. This brand new company is an incorporated organisational vehicle. It is used to collect and to convey specific finances associated with the project. As in the previous case, the sponsor provides a tiny portion of the initial investment. In project financing, the lender issues the loan to the special purpose entity rather than to the sponsor. The special purpose entity is a legal entity having the capability to borrow some money. During the project construction, the special purpose entity invests in the project. Once the project reaches the operational stage, the project generates some revenue, which is collected by the special purpose entity, who repays the loan first, and then repays the equity investment to the sponsor. So, this is the general framework of the two approaches. What's the difference between the two? You can see, there is a difference in the organisational and the financial structure of each model. These two approaches are different in terms of risk management. To understand that, let's consider what happens in the worst scenario, namely, when the project underperforms, and it is not able to repay the original investment. This scenario might take place for a variety of reasons; maybe because the project is delayed too much, or perhaps, because the performance levels reached during the operational stage don't provide enough revenue. In the worst scenario, the project doesn't generate any revenue at all. What happens in this case? In the traditional financing model, the sponsor doesn't recover the original investment. And so, it is forced to provide something else to the lenders. Regardless of the performance of the project, the sponsor has the legal obligation to repay the loan. Now, let's consider the second approach, project financing. In the other case, the project financing approach, the lender provides the money to the special purpose entity. Unlike the sponsor in the first approach, the special purpose entity in practice has very few or even no assets. It may have some assets that aren't necessarily material: for example, specific rights, licences, public concessions, etc. So in project financing, if the project underperforms, the special purpose entity is not able to repay the original investment to either the lender or to the sponsor. And therefore, the special purpose entity is forced to declare itself bankrupt. Now, in reality, the bankruptcy process may be more complex, But at this stage, we won't consider the practicalities of the bankruptcy. As you can appreciate, these two approaches differ extensively in terms of financial risk. The traditional approach is known as full recourse financing, because there is a collateral that can be used to repay the original debt. In project financing, there is no collateral available, and so, this is known as the non-recourse financing. In reality, when we are thinking about financing major projects, there is no lender that is willing to accept such an extensive and uncontrollable financial risk. The lenders often require alternative forms of collateral to be available. In practice, we talk about semi-recourse financing, meaning that there is a partial guarantee covering the loan. If we now think about what these two models mean in the context of public projects, there is a difference between the traditional public investment and the project financing. In public projects, the sponsor is the state, borrowing the money through sovereign or government bonds. The funds collected enable the state to invest this into the public infrastructure. This is the more traditional and the old way of doing things. In private major projects, the sponsor may be an industrial actor, such as a utility, which is willing to invest on infrastructure assets like a large industrial facility or a petrol chemical facility, a refinery or a mining facility, etc. Often, the major project is bigger, in financial terms, than the capitalisation of the sponsor. Therefore, the sponsor needs to raise money externally, employing a special purpose entity to fund the project. By doing so, the sponsor does not record a huge debt into their own balance sheet, and this is why project financing is also called off-balance sheet financing. Finally, let's look at public-private partnerships, or PPPs. These partnerships sometimes follow the project financing model. For example, Private Financing Initiatives, or PFIs for short, in the UK, are very connected to the idea of project financing. In such cases, you may have more than one sponsor. For example, you might have one private and one public sponsor, or you may have a public partner that provides guarantees to the lenders but does not invest directly into the equity of the special purpose entity. In practice, there are many ways to set up a public-private partnership, and so it's difficult to generalise. In summary, we have introduced and discussed two main financing approaches used in major projects, namely, the traditional financing, and the project financing. And you have begun to compare these two approaches focusing on the financing and risk-related aspects.
