Debt financing is the most important source of finance for infrastructure projects. In most infrastructure projects, the majority of the project is funded using debt-based financial instruments. Equity holders invest a significantly smaller amount. However, they bear all the risks.
The size and scale of debt financing make it an important decision for any company engaged in developing an infrastructure project. When it comes to debt, companies generally have two options. They can either approach a bank or a syndicate of banks in order to obtain funding for the project. Alternatively, they could also issue bonds and sell the same off to private investors. Each of these methods has its own advantages as well as disadvantages. However, it is generally said that banks are a more reliable source of finance, particularly for infrastructure projects.
In this article, we will compare the two methods of raising debt finance in order to understand what makes bank loans more viable.
The Advantages of Using Bank Loans
- Experience: The biggest banks in the world are extensively involved in funding infrastructure projects. As a result, almost all of them have separate departments that have developed considerable expertise in infrastructure financing. Therefore, when a company executing an infrastructure project applies for a bank loan, they also get to benefit from this expertise. Anyone lending money to the project has an implicit role in monitoring the project in order to protect their own interests. The significant experience and resources in which banks have just make them more suitable to perform this task.
- Flexibility: Bank loans can be significantly more flexible as compared to other sources of debt funding. This is one of the major reasons that bank loans are more suitable for infrastructure projects.
For instance, infrastructure projects need money in phases. Once they complete a certain milestone, they want more money to be disbursed. Such complicated disbursement schedules can be easily managed by a bank. On the other hand, it is difficult to obtain this flexibility using bonds.
In case of a bond issue, the infrastructure company will be forced to collect the proceeds from the sale of bonds all at once. Then, they will be forced to pay interest on the money even though they might not be using the same. If they want to obtain the loan amount in installments, they will have to raise money using different bond issues. Different bond issues will create their own set of complications viz. seniority of debt etc.
- Restructuring: Delays, cost overruns, and such other difficulties are commonly experienced while executing infrastructure projects. If such a problem arises during a project, the infrastructure company would be glad to have taken bank loans instead of having issued bonds. This is because delays in the execution of the project also delay the cash flows to be received from the project. As a result, the repayment schedule has to be changed.
Sometimes the loans become riskier as the infrastructure company may require a higher moratorium period. In such cases, if the infrastructure company is negotiation with a bank, they will find it easier to restructure the loan. This is because the bank is just one party, and their interests are completely aligned with that of the project equity holders. They are unlikely to receive any benefit from stalling the project.
On the other hand, if any sort of negotiations has to be done with bondholders, the process becomes extremely complicated. First of all, there are multiple parties that are included in the negotiation. Then, it is quite possible that these multiple parties have conflicting interests.
As a result, when the cash flow structure is modified, all parties may not agree to it. This could create a legal hassle, and the issue could end up reaching court. Also, if the company is unable to pay its bondholders, some of them may file insolvency proceedings against the company and try to send the company into liquidation.
- Evidence shows that when it comes to restructuring, banks are much easier to deal with as compared to bondholders.
- Risk Profile: Also, it needs to be understood that bonds are mostly purchased by funds such as municipal funds, pension funds, and even insurance companies. The law requires these companies only to buy investments that have very low risk. The problem is that in many parts of the world, infrastructure investments are considered to be risky. Therefore, in these countries, companies do not have the option to issue bonds. Instead, they are forced to take bank loans by default.
- Signaling Effect: Lastly, even if a company plans to raise debt using bonds at a later stage, they are better off using bank loans, to begin with. This is because when banks lend money to a project, the other investors who have limited monitoring capacity feel comfortable investing their money in the project. This is because they feel that since banks are involved, they will be monitoring the project. Hence, their money would be safer than it would have been otherwise.
The only disadvantage that banks have is that they are funded using relatively short term liability. Hence, they cannot make really long term loans. To overcome this, banks usually finance the construction stage of a project, whereas once the company starts to create positive cash flow, bonds are generally issued to repay the banks.
