Reviewed by Bill Chew
Project finance remains an important financing technique despite the ebbs and flows in market interest and volume. The current focus on large and growing infrastructure capital needs in both developed and emerging markets will likely continue to propel project finance for some time. Against this background, John Finnerty's new textbook, Project Financing: Asset-Based Financial Engineering, is timely. It provides an expansive general discussion addressed chiefly to those involved in raising project capital -- project sponsors, bank and institutional lenders, and financial, legal, and engineering consultants.
Although the book's subtitle's reference to financial engineering smacks of boom market enthusiasm, Finnerty approaches project finance from a broad economic and financial perspective and with a good sense of the practical issues that project financings entail. With its comprehensive framework and wealth of detail and examples, his approach is most welcome.
Finnerty defines project finance as "raising funds on a limited or nonrecourse basis to fund an economically separable capital project" in which lenders and investors look primarily to cash flow from the project to service debt and provide equity returns. He argues that project finance has a practical rationale behind it: Project finance is used to raise money for capital-intensive projects when it can provide a lower risk-adjusted cost of capital than other forms of corporate financing. In addition, he holds that project finance benefits the economy as a whole by reducing the likelihood of firms' underinvesting in potentially beneficial capital projects.
In making these arguments, Finnerty necessarily assumes that projects are appropriately structured and executed. He emphasizes that project finance is inappropriate for weak projects with less than adequate returns to sponsors, lenders, and investors. Although this point may seem obvious, it should be carefully noted by corporate investors and even project sponsors, who sometimes think that projects can be financed without analyzing standalone strength. They reason that under stress, project financings can potentially benefit from the implied support of their sponsors. But the record of sponsors kicking in to support weak, limited, or nonrecourse projects is mixed at best. Finnerty appropriately focuses on standalone project assessment, based on bottom-up analysis of cash flows and the factors driving them under both expected and stress conditions.
Finnerty's framework for project finance covers the following key elements:
- Rationale for project finance
- Project viability
- Designing security agreements
- Structuring the project
- Project financial plan
- Financial modeling and project evaluation
- Managing project risks
His discussion of project evaluation is particularly good, with a detailed comparison of net present value and discounted cash flow approaches.
In addition, Finnerty covers specialized topics that are important for some projects:
- Real options analysis for resource projects
- Sharia-compliant financing
- Issues for host countries
- Renewable energy projects and social/environmental investment standards
The author strengthens his analysis with examples of both U.S. and non-U.S. projects and concludes the book with four detailed case studies: Indiantown Cogeneration, Tribasa Toll Road, Euro Disneyland, and Eurotunnel. Illustrating different types of project financings, these case studies document actual project performance, both positive and negative. They should prove especially valuable for readers with limited knowledge of how project financings work in both developed and emerging markets.
Project Financing has a few weaknesses. Finnerty could have devoted more attention to the following:
- Project investors' perspective. The book contains a good discussion of the principal sources of capital for projects and provides some data on performance of rated project debt. But one of the ongoing arguments for project finance has been its potential to provide superior risk-adjusted returns to lenders and investors. Additional material on the investment performance of project debt and equity would have been helpful.
- Limitations of some hedging and risk management techniques. Finnerty provides a comprehensive chapter on risk management for projects, including the use of derivatives. But derivative contracts may entail risks of unexpected counterparty disruptions and collateral/margin calls; Finnerty’s analysis of derivative hedging would benefit from including more on these risks.
On the whole, however, the strengths of Finnerty's book substantially outweigh its weaknesses. Project Financing is a comprehensive and well-documented guide for project finance in the current markets. It should be valuable reading for project sponsors and their consultants. Also likely to benefit are investors and asset managers considering investments in infrastructure and in such capital-intensive corporate sectors as power, energy, telecommunications, resources, and transportation. They have a stake because corporate, structured, and synthetic debt may be materially exposed to the performance of project financings.
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