RETURNS ON PROJECT‐FINANCED INVESTMENTS: EVOLUTION AND MANAGERIAL IMPLICATIONS

In the past, project finance was used primarily to fund relatively low‐risk natural resource projects with highly predictable cash flows. Today project finance is used for a wide range of assets, such as satellite telecommunications systems, amusement parks, and microprocessor factories, and in developing as well as developed countries. The author explores how the evolution into riskier assets has changed expected returns on project‐financed investments. Higher return variability and greater failure rates have caused project debt capacities to fall. What is notable about project‐financed investments, however, is that the best returns are not very high. And because the nature of most projects limits the upside potential, a much higher fraction of project‐financed investments must be successful for capital providers to earn acceptable returns on their investments. The move into riskier assets has also led to increased emphasis on the risk management role of project finance; that is, through careful structure and design, a firm can use project finance to reduce the collateral damage caused by a failing investment and also to limit sovereign risks. But even so, the author suggests that the original structures were never designed to handle projects with significant asset risk. For this reason, in cases of riskier projects, single‐asset project loans are likely to be replaced by either traditional corporate financing vehicles or hybrid structures involving elements of both project and corporate finance. One example of such hybrid financing is Calpine's revolving construction facilities that are used to finance portfolios of merchant power plants.