The rise of project finance proves that financing structures are important to project success. According to Kleimeier and Versteeg (2010), project finance is a superior financial instrument because of its features that enable it to become a financing substitute for underdeveloped financial markets. Project finance is, therefore, fundamental for improving investment management and governance, and, consequently, economic growth.
The use of project finance has sharply increased, rising from $12.5 billion in 1991 to $113.4 billion in 2005 (Kleimeier and Versteeg 2010). In the seven Asian countries covered in this chapter, project finance has also grown robustly, totaling $258 billion from 2011 to 2017, reflecting the region's strong economic growth. Project finance has also become a significant financing vehicle for natural resources and infrastructure.
Esty (2002) defines project finance as "the creation of a legally- independent project company financed with nonrecourse debt for the purpose of investing in a capital asset." It is important to distinguish between the asset (the project) and the financing structure in this definition. While firms and assets are potentially suitable candidates for project finance because of their specific characteristics, the financing structure itself is developed and organized based on these asset features and the contracting environment. Esty (2002) argues that the net cost of financing these assets is significantly reduced by using project finance. Merton and Bodie (1995) and Kleimeier and Versteeg (2010) find that project finance is designed to reduce project transaction costs, which are driven by the lack of information on potential investments and capital allocation, inadequate corporate governance, risk management, and the inability to mobilize and pool savings, among other factors. The impact of project finance on economic growth and development should, therefore, be more pronounced in countries where financial development is weak, such as low-income countries. This is supported by Kleimeier and Versteeg (2010), who find that growth in low-income countries is buoyed by project finance transactions. This is because transaction costs are significantly larger compared with middle- and high-income countries, where financial markets are more developed.
Project finance is used for new stand-alone complex projects that involve substantial risks and costly problems of information asymmetry. Most of the financing for these projects are nonrecourse syndicated loan tranches.3 During a project's initial screening and structuring phase, the loan syndicate's lead arranger works closely with the project's sponsors. The lead arranger is also responsible for putting the syndicate together by attracting other banks in the global syndicated loan market to the project (Gatti et al. 2013). The syndicate bears most of the business risks since these loans are nonrecourse. The business risk must, therefore, be significantly reduced to an acceptable level for the loan syndicate, given that these projects are highly leveraged. Here, project finance allows the allocation of project-specific risks-completion and operating risk, revenue and price risk, and the risk of political interference or expropriation-to the parties best able to manage them, making this a key comparative advantage (Brealey, Cooper, and Habib 1996; Kleimeier and Versteeg 2010).
The contractual structures of project finance, which are similar to the features of well-developed financial markets, make them suitable for project finance to be a substitute for underdeveloped financial markets. And, like other financial instruments, project finance works better when sound legal, regulatory, and institutional frameworks are in place. Transaction costs rise when contracts are not respected, and markets do not function well. Adjusting project finance structures to deal with large transaction costs, along with other market failures, is expensive and burdensome, and undermines the rule of law, quality of regulatory environment, and the role of legal institutions in enforcing contracts (Kleimeier and Versteeg 2010).
Project finance is a highly flexible financial structure in the sense that it can be easily adapted to economic and political conditions. Project finance is designed to withstand shocks from political risk and a market's inability to manage risk, pool savings, and facilitate transactions. As well as these characteristics, Esty (2002) describes the three main motivations for using project finance-agency cost, debt overhang, and risk management. The author argues that these are fundamental for reducing the cost of agency conflicts inside project companies, and the opportunity cost of underinvestment because of the leverage and incremental distress costs in sponsoring firms.
In sum, these characteristics and motivations prove that project finance creates value. For Esty (2002), the best way of understanding this is to recognize that firms bear deadweight costs when they make investment decisions. These costs-transaction costs, agency costs, distress costs, information costs, and taxes-come mainly from capital market imperfections. The author argues that, when total deadweight costs are much lower than the total costs of corporate-financed alternatives, the use of project finance is an efficient alternative. Thus, financing assets separately with nonrecourse loans can create more value than financing assets jointly with corporate debt.