A guide through the term sheet

While the basics of project finance are fairly simple, the jargon tends to get in the way. This article offers a guide to some of the key phrases, such as pro forma, amortisation, due diligence and debt service coverage ratio.

Project finance might be described as the art of managing risks in such a way that lenders can gain sufficient comfort to lend without recourse to the balance sheet of the operator. The fundamental principles are pretty simple. Lenders want to get paid back with interest. Risk, or more correctly the lack of it, is really important. The way a loan is structured or managed decides the level of risk. Project loans are based on the assets of the project and do not have any (or possibly very limited claims in highly defined situations) on a project investor or sponsor.

While the basics are fairly simple, the jargon tends to get in the way. Here is a guide to some of the key phrases.

The Pro Forma is the economic/financial model of the project accepted by both parties. It forecasts cash flows for the duration of the financing. Good Pro Forma models allow for the development of alternative cases, often called "Sensitivities," which demonstrate the impact of various factors on the economics of a project.

Amortisation is the way a loan is paid back. Typical amortisations involve equal payments of principal or equal blended payments (which means that the split of payments between interest and principal is structured so that over the life of the loan the amount of debt service remains constant). Other amortisations are common.

Debt Service Coverage Ratio is the margin in the Pro Forma between the total operating costs plus debt service on the one hand and the expected revenues on the other. There are other ratios, but this is the one that really defines how much a project can borrow as it is often set by the lending institution as a matter of policy. Consequently when one knows the interest rate, the term, the amortisation and the debt service coverage ratio, one knows how much debt a project will carry. When one knows how much debt can be borrowed, one also knows what the likely internal rate of return (IRR) will be and whether one's boss is going to be very interested in going much further with said project.

Reserve Accounts are cash reserves (which can usually be supplanted by a letter of credit on the sponsor's bank) which provide for "rainy days." They cover major maintenance and various other things, but the most important is the debt service reserve.

Institutional Lenders include insurance companies and pension funds which must invest their clients' money in long- term investments. This gives them an appetite for very long-term situations, enabling longer amortisations than is typical in the bank market.

Banks are the competitors of project financiers. In some circumstances, banks and institutions will jointly lend to a project, in what is often known as a "dual tranche" loan. The advantage of this is that it combines the advantages of both type of lender (banks tend to be more flexible, institutions tend to have longer terms for repayment) in one loan facility. Also in a capital constrained industry such as wind, larger deals -- typically in the $100 million plus class -- need all hands to the pumps. The disadvantage of this is the extra expense of negotiating and documenting the inter-creditor relationship.

Due Diligence is the business of finding out whether a prospective project financier has been told myth or reality about the project. Generally due diligence takes two forms: legal (such as land ownership issues) and technical (in particular the wind resource estimate and the wind turbine technology).

Financial Close is the point at which the financial documents are executed and often when you get the money. The pain of beating your head against the brick wall of the financial community begins to subside.

Financial Advisors are people you get to help you if you didn't understand every word of this article.

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