We at Financial Insight are cognisant of the fact that many SMEs in Zambia will never reach critical mass. It is not because we do not believe in these companies. Far from it. We spend each and every waking financial moment pushing agendas such as strategy, turnaround and improved performance just to get the topic on people’s lips. We do this because we understand that that is the only way sustainable creation of value can be achieved.
For the few that possess astute leadership, we have observed that part of their challenge lies in understanding some of the mechanics of modern finance that can allow them access finance that can drastically improve their present situation and allow them to rival some of the very best in their industry.
As an example, we focus on those in the infrastructure building industry (roads or energy). For those that do not have a big brother looking over their shoulders and facilitating transfer pricing, Project finance remains one of the best ways of implementing much desired projects for expansion. A hypothetical situation would be, a premier company that desires to invest in a new plant but has rather high gearing (exhausted its position with lenders) but seeks to make that one addition to its arsenal in order to achieve scale.
According to Investopedia, “Project finance is the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure, in which project debt and equity used to finance the project are paid back from the cash flow generated by the project.”
The journey begins with the setting up of a Special Purpose Vehicle (SPV). The great thing about project financing is that it allows shareholders to keep financing and project liabilities off-balance-sheet. This therefore allows the investing company pursue its desires of achieving scale.
This has an inadvertent effect of reducing the impact that the pursed project may have on the cost of the company’s already existing debt and addresses concerns of the company’s ability to acquire debt. The result of this action is that it allows that company to use its weak debt position for other things the company’s board deems necessary.
This particular way of financing projects is also known as non-recourse financing. According to the World Bank, “the project company is generally a limited liability special purpose project vehicle, and so the lenders’ recourse will be limited primarily or entirely to the project assets (including completion and performance guarantees and bonds) in the case of default of the project company”.
Non-recourse financing has also been extended to dealing with situations were some lenders require a sovereign guarantee before they drop a penny into a project. Although this raises the cost of finance and lenders may demand for a higher Internal Rate of Return (IRR) inadvertently leading to a higher price for the end product or service, this method offers insurance companies to step in and help the SPV and all associated parties manage the associated risks.
Understandably, this type of financing requires a nexus of contracts that clearly apportion risk. However, for scale projects, this is fast becoming one of the most sort after ways of financing projects even at a national level. The World Bank qualifies this by stating that “to a certain extent, a government can also use project finance to keep project debt and liabilities off-balance-sheet, taking up less fiscal space. Fiscal space indicates the debt capacity of a sovereign entity and is a function of requirements placed on the host country by its own laws, or by the rules applied by supra- or international bodies or market constraints, such as the International Monetary Fund (IMF) and the rating agencies.” The however is ensuring that the projects are executed with military precision and avoiding default.
So for SMEs that desire to achieve scale, taking time to understand the intricacies of complex debt are not unfounded. Development agencies are available that offer advice on how to structure these deals (e.g. Development Bank of Zambia). All they ask for is patience and the willing to see through the process.