Investment Management and Financial Innovations, Volume 14, Issue 1, 2017 João M. Pinto (Portugal) What is project finance? Abstract Project finance is the process of financing a specific economic unit that the sponsors create, in which creditors share much of the venture’s business risk and funding is obtained strictly for the project itself. Project finance creates value by reducing the costs of funding, maintaining the sponsors financial flexibility, increasing the leverage ratios, avoiding contamination risk, reducing corporate taxes, improving risk management, and reducing the costs associated with market imperfections. However, project finance transactions are complex undertakings, they have higher costs of borrowing when compared to conventional financing and the negotiation of the financing and operating agreements is time-consuming. In addition to describing the economic motivation for the use of project finance, this paper provides details on project finance characteristics and players, presents the recent trends of the project finance market and provides some statistics in relation to project finance lending activity between 2000 and 2014. Statistical analysis shows that project finance loans arranged for U.S. borrowers have higher credit spreads and upfront fees, and have higher loan size to deal size ratios when compared with loans arranged for borrowers located in W.E. On the contrary, loans closed in the U.S. have a much shorter average maturity and are much less likely to be subject to currency risk and to be closed as term loans. Keywords: project finance, structured finance. JEL Classification: G24, G32. Received on: 24 th of December, 2016. Accepted on: 15 th of February, 2017. Introduction © Typically used for funding public and private capital-intensive facilities and utilities, project finance (PF) is an economically significant growing financial market segment, but still largely understudied. Esty and Sesia (2007) report that a record $57.8 billion in PF funding was arranged in Western Europe (W.E.) in 2006, which compares with $35.0 billion invested in the United States (U.S.) – record $328 billion in PF funding was globally arranged in 2006, a 51.2% increase from the $217 billion reported for 2001. In 2014, $54.1 billion and $60.2 billion were arranged in W.E. and the U.S., respectively – $260 billion was arranged worldwide during 2014. According to Thomson Reuters, in comparison with other financing mechanisms in W.E., as well as in the U.S., the PF market was smaller than both the corporate bond and the asset securitization markets in 2014. However, the amount invested in PF was larger than the amounts raised through IPOs or venture capital funds, which indicates that the financial crisis has had a small impact on the financing of large infrastructures and still represents a promising segment of global lending activity. © João M. Pinto, 2017. João M. Pinto, Professor of Finance, Católica Porto Business School, Catholic University of Portugal, Portugal. This is an Open Access article, distributed under the terms of the Creative Commons Attribution-NonCommercial 4.0 International license, which permits re-use, distribution, and reproduction, provided the materials aren’t used for commercial purposes and the original work is properly cited. Nevitt and Fabozzi (2001) present PF as the process of financing ‘a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan’. Thus, the funding does not depend on the reliability and creditworthiness of the sponsors and does not even depend on the value of assets that sponsors make available to financiers. In this line of reasoning, Gatti (2008) refers to PF as ‘the structured financing of a specific economic unit that the sponsors create by means of share capital, and for which the financier considers cash flows as the source of loan reimbursement, whereas project assets only represent collateral’. Considering that debt repayment comes from the project only rather than from any other entity – nonrecourse debt 1 –, Esty (2004b) defines PF as a transaction that ‘involves the creation of a legally independent project company financed with equity from one or more sponsoring firms and nonrecourse debt for the purpose of investing in a capital asset’. Esty focuses on the following three key decisions related to the use of PF: (i) investment decision – involving industrial assets; (ii) organizational decision – creation of a legally independent company to own the assets (off-balance sheet form of financing); and (iii) financing decision – nonrecourse debt. This definition distinguishes PF from other structured financing vehicles like securitization, leveraged acquisitions, and structured leasing. 1 At the other extreme, in conventional corporate financing, lenders rely on the overall creditworthiness of the enterprise financing a new project to provide them security. 200