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Project finance has today emerged as the preferred method of financing large-scale power and water projects - and nowhere more so than in the Middle East.

The concept involves non-recourse or limited recourse financing of the development and construction of a project. Thus, loans from a lender, usually a syndicate of banks, are secured by the project itself and paid entirely from its cash flow. In the case of a project deemed to involve a greater level of risk, the loans might be secured primarily by the project with some additional reassurances from the sponsors, i.e limited recourse financing.

The lender therefore looks not to the general credit of the project sponsor but to the revenues expected to be generated by the project for the repayment of its loan and to the assets of the project as collateral.

Though project finance is more complicated, and more expensive, than alternative financing methods, and it can take a long time to draw up and finalise the agreements, it also has big advantages. It is most desirable in capital-intensive, long-term projects, so comes into its own for power and water plants.

The sponsors of such projects, who themselves invest some equity, often do not have a sufficient credit rating to obtain traditional financing, or are unwilling to take the risks and assume the debt obligations associated with it. Project financing sees that the risks are allocated among a number of different parties, acting in contract with one another, at reasonable levels - and simultaneously ensures profits for each of them.

Risk-factor

"You have to look at many risks," says Ravi Suri, head of project and export finance at Standard Chartered for the Middle East and South Asia. "The construction should be well mitigated. You have to look at the operation and maintenance risk, you look at the offtake risk, how expensive the power is, what the demand for power will be. You look at the country issues...the entire gamut of risk has to be looked at."

"Project finance is primarily about the identification and the allocation of risk," agrees Christopher Clement-Davies, a partner in the London office of law firm Fulbright & Jaworski International who has worked on power projects in the Middle East and around the world. With the deals being so contract-driven, the documentation can become so complex that legal firms are themselves crucial to the success of project finance and act for all the parties involved.

"The key things really would be: where are the stress points? Where are the most difficult risks likely to be found? What approach are the different parties going to take to them? Who will be expected to bear which risks and how will that pan out in the negotiation process as the documents are drafted and finalised?

"There are lots of other threshold questions whenever you are dealing with emerging markets," Clement-Davies continues, "because some of the features that lawyers will often take for granted on project financing structures are not there. You may encounter individual difficulties in some areas: aspects of the security needed to be granted, aspects of government empowerment, aspects of legal capacity and so on, in specific jurisdictions - and that can compound the challenge of making these projects work."

Teaming up

So how does the whole process begin and who would approach the lenders in the first place? "There are two ways," says Suri. "When you do government advisories, the governments approach. Or you can work with the private developers when they bid.

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