A Fund Approach to Project Financing

This article explores a legal structure for asset financing. We will walk through the key problems, the legal structures, etc.

How does one make money from creating and managing large expensive assets? Such as skypscrapers, power plans, oil rigs, solar cells, and so forth?

A simple financing model

From a Cash Flow Perspective, this is really simple. Let’s look at the following image.

Cash Flow of an Asset Investment

Building costs: We have up-front installation costs (red). They represent the cost for project management, the obtaining of concessions and permissions, the purchase of raw materials and workers one one side. The cost of building the asset. And on the other side, we also have the cost of creating a legal structure, or company, to operate the asset, or the OpCo installation cost.

Operating costs: We assume now that the asset is fully built. It still needs to be operated. What does that mean? It needs to actually operated – lights turned on and off, control systems need to be used, etc -, it needs to be maintained – repairs, replacements, supervision and cleaning. Thos are the simple G&A costs. But more often than not, the output of the asset that creates the revenue stream for the asset also needs to be marketed and sold. Power plants need to trade the power they supply into the grid or consumers. Hotels need to find visitors. Buildings need tenants. And so forth. On top of G&A we have sales and marketing costs.

Now here we already have an issue. It is not super easy to get top talent for a very small asset. The low quality of talent of the asset means that the expected maintenance and operating cost might be off, and that the lifetime of the asset also might be shorter than expected. That is all decently managable, however. But: the marketing and sales of the output of the asset is crucial. If the talent that markets and sells the assets and generates the return of the asset are bad, there is a very high risk that the revenues take a nose dive. And this goes further, it means that the break even point moves into the wrong direction, and that takes a hit on the net present value of the investment by having positive cash flows discounted even more, due to being more in the future, and the WACC or discount factors are going down. This is then bad for financing the investment.

Operating Income and Project Return: In the above example, the asset is created by a asset financing and building company, and is then sold off to a potential investor or future owner of that asset. The buyer of that asset is essentially buying the operating income cash flow. In this case, green is total revenue from the asset (not shown) minus total cost of the asset (yellow) equals operating income (green). And this green cash flow pattern is bought and paid for in the blue cash flow pattern. Which is the return for the building company that has to offset the red building costs.

Again looking at the parties involved.

  • A construction and financing company, or the „ProjectCo“
  • A buyer of the asset, or the „BuyerCo“
  • An operating company for the asset, the „OpCo“

The ProjectCo needs now a financing mechanism for the project. Or a FinancingCo.

Project Funding

Next we will look into how such financing will work.

The classic approach: Corporate Finance

The project company talks to a corporate finance advisor. The corporate finance advisor finds investors willing to directly invest into an SPV that finances the project. The investors will likely secure credit facilities and use own cash reserves to jointly put them as capital contributions into the SPV. The SPV will then incubate the OpCo and pay the ProjectCo to procure the assets and execute the installation of the operative OpCo.

The traditional Fund Approach

Another approach commonly seen is the pooling of subsidies funds or institutional funds, who then provide assets to ProjectCos or Intermediary Banks who then distribute to ProjectCos to finance assets.

A Modern Fund and Portfolio Approach

The asset-by-asset and project-by-project financing of both the classic and traditional fund approach are flawed.

The flaws are severalfold.

  • Investing in an asset-by-asset approach makes the scale of the operations too small to attract top talent for marketing the asset products
  • The asset-by-asset approach has low synergies and promotes low-quality, low-automation G&A processes that have adverse effects on the operating cost of the asset, as well as the lifetime and pricing of the products.
  • Both the classic and traditional fund approach obtain financing from investors that have insufficient oversight and expertise in the particular asset.

In other words, many projects need to be bundles as portfolios under larger holding OpCos in order to attract more capable general management and sales and marketing talent. And having more of such larger HoldCos makes a market for specialized, properly incentivized, and actively managing fund managers.

The agglomeration and consolidation of small project companies and the creation of such larger companies is hence the key to obtaining higher returns on capital deployed and invested. Which is the following is proposed.

The asset management structure

A specialized asset manager is creating Funds with clear covenants and limits and risk measures in place. These funds can to a certain extent, due to possibly guarantees or securities from the beneficial owners of the funds, be leveraged up to increase their size.

These funds create special purpose vehicles with long time-horizons that are charged with building OpCos around assets and consolidating OpCos of successful projects. Those funds again can be leveraged up based on the security of the expected cash flows of the underlying assets.

The SPV II levels are now incubating holding companies for the OpCos. The HoldCos will hold the asset and employ the OpCos. That has the benefit that the OpCo can be replaced for each asset and that several HoldCos can contract the same asset. The HoldCos themselves can be marketed and sold off to outside investors with interesting in owning the assets. Which securitizes the cash flows from the SPV II vehicles, who now can generate cash flow from the assets by either operating the assets or selling parts of the operating assets to third parties.

The equity share of third parties with an interest in the asset can also support the asset and the OpCo in staying connected with the local regional jurisdictions and risk to the assets.

The HoldCo itself can of course also lever up, depending on the stability of its cash flow and distribute profits to the SPV IIs.

The multiple layers of leverage combined with the potential size of a Fund and specialized SPV managers can be used to employ a classic private equity structure with carried interest structure. This will likely have a strong impact on proper staffing of OpCos and driving the efficiency and returns of the entire investment operations.

Structure of a Financing Company

Who is in charge of creating the asset manager?

The big questio now is: are asset managers increasingly pushing for building relationships with Project Companies to deploy their assets. Or are ProjectCo owners and managers pushing for adding dedicated fund management vehicles and asset management capabilities to their businesses.

Looking at barriers to entry, my guess is that the development will come from the ProjectCos who will manage the asset management capabilities, be it by employing third party asset managers or by pushing for own asset management capabilities. In any case, this requires a consolidation of ProjectCos and this cycle has to be driven by private equity investors.

At least that is my guess.

Where to go from here to save the planet?

Now this article and the discussions is inspired from talking to a friend who just wrote a thesis about it and is into saving the planet. Whether you talk ESG or renewable or green investments.

So while structuring the above was a fairly easy exercise and would require marketing to a major private equity house to look into a ProjectCo or in that case EPC consolidation. The big questions in solving this puzzle are not in the structuring of the financing of ESG projects only. It is also a question about why returns from such projects overall are maybe low due to a early stage maturity of the market.

What does that mean?

Market Maturity in the global ESG sector

The normal problem with all small and immature market is that low talent pool quality dominates the market. Entrepreneurs operate in environments with high technology uncertainty and have to spend a sufficient amount of time networking with thought leaders and top scientists in the area to stay in touch with the development. The potential future returns from hitting the right technology at the right time makes the space a defensive and potentially intransparent one. And on top of that, most scientific entrepreneurs will likely oversize their P&Ls and will struggle with maintaining cash flow and solvency and thereby lose track of the networking part. This slows down the market.

In such intransparent and underconnceted markets, free riders and sales-oriented actors have a higher chance of obtaining attention from institutional money, which we saw was funneled through entitites with lower quality controls and insights on the market. The market itself being not very clear already on how it is supposed to operate. This leads that there is a higher risk of any dollar deployed into this market leading to misallocations. Whether it is from gross misconduct – e.g. financing Porsches and fancy offices -, from suboptimal management – operational, financial, cultural -, from suboptimal reporting – towards investors, stakeholders, thereby creating volatility. The chances are high that capital is wasted, return expetations are low and overall outcomes are not as expected. Which is a classic sign for an immature market.

With technology uncertainty and low performance of existing projects in investor portfolios, the overall capital deployment remains low. Which means that the industry is facing capital draught all over. This leads to the creation of self-help institutions and forums where the wrong topics are possibly being pushed. The more important part is, that without velocity in creating and executing business plans, the overall convergence towards certainty and information transparency in the market is low. Which means there is a slow down in getting to a level of technological clarity that warrants a political and regulatory unification. Without technological clarity, there is likely no final conclusion and unity on which forums and which frameworks to use to regulate the industry and how the industry itself is meeting and discussing itself. Which then slows down willingness of regulators to unify regulations, frameworks and policies. And that of course increases the volatility and risk of the otherwise long-term horizons of the investments. Which exacerbates the access to much needed capital.

The potential biggest impact in this ecosystem is the driving influence from successful entrepreneurs form major ecosystems who are coming from other fields and can be converted into supporting the ESG cause. This way, more money can be funneled in highly peforming ESG projects portfolios, whch can drive stability of technology, operations and frameworks in the market.

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