Infrastructure is the backbone of any prosperous regional economy. Power, communication and transportation systems lay a necessary foundation for economic development, and when underdeveloped, can be a major brake on growth. As the Lehigh Valley continues to grow and recover, the strength and quantity of local infrastructure projects will be a key element in the region’s overall outlook.
The most difficult hurdle most infrastructure projects must overcome is securing initial financing. One locally under-utilized financing structure that can be beneficial to all parties involved in a project, and act as an avenue to secure funding for some projects that otherwise might never have been built, is non-recourse project financing. Non-recourse project financing is a financing strategy that is ideally suited to certain infrastructure and industrial projects, in which the earnings of a project serve as the source of funds for repayment of a loan, the assets of the project itself serve as the collateral for the loan, and the loan is not otherwise guaranteed by the developer.
The basic structure of a non-recourse project financing is relatively simple. A developer will undertake the early stages of development – identifying a potential market, securing a site, and doing preliminary environmental and permitting work. The developer will form a special purpose entity (SPE) solely to undertake the particular project in question, which will hold the real estate, permits, and all other assets relating to the project. The SPE will then usually enter into negotiations with a primary offtaker for the product or service generated by the project. The offtaker will be the entity which will be buying the ultimate output of the project, e.g., the local utility for a power project or the municipality for a water or sewage facility. A strong offtaker is a key element in most non-recourse project financings, as it is the offtaker’s credit which is often the most important element of the lender’s credit analysis.
Once the preliminary work is done, the developer will seek financing. Lenders often prefer early involvement in a project, as they can then have input on the offtake contract and any key supply contracts before they are signed. Once the offtake contract has been signed and a potential revenue stream is identified, or, if no offtake contract exists, the lender is satisfied that a strong and quantifiable market exists for the project’s output, the lender, or lending group, will make a loan directly to the SPE, with no or limited guarantees and security coming from the developer parent company. The primary security will be a stock pledge over the SPE itself. In the event of a default, the lender will simply take possession of the SPE. There is no need to foreclose on the real estate or other property, assign contracts, etc., saving the lender a great deal of trouble. This is acceptable to the lender because a guaranteed revenue stream exists for the completed project. The lender would be able to sell the project or bring in a project manager to run it. The credit analysis the lender will perform depends on the strength of the project itself, and the credit-worthiness of the offtaker, who in any event is the ultimate source of the funds that will be used to repay the loan, and not the developer.
Of course, no lender will be willing to finance the entirety of a project with no credit support from developers or third parties. A variety of means exist to provide lenders greater security and comfort that they will ultimately see a return on their investment. Equity contributions from developers are universal, and it is quite common to require developers to fund cost overages, or a certain percentage of cost overages, with additional equity. There are a number of creative ways to look to third parties for credit support as well. Depending on the project, funding and guarantees may be available from a variety of government entities, the offtaker or construction entity may be willing to provide additional credit support, or some other third party with a current or future interest in the project may be willing to step in to provide credit support.
While the interest rate on a non-recourse loan will be higher than the rate on a conventional full-recourse obligation, the off-balance sheet nature of the loan allows developers to avoid tying up all their capital in one project, and to largely mitigate the risks of a catastrophic project failure. It allows smaller developers to secure financing they otherwise would have been unable to, and ultimately, it allows more projects to be built.
Non-recourse project financing can be an important engine of economic growth, and it is one the Lehigh Valley has not yet fully harnessed. An opportunity exists for those who will take advantage of it.