Debt Finance — what is it? How does it work?
Loans for well-defined projects or working capital lines of credit (usually for ventures or trade finance) can be arranged through In3 services. Loan guarantees enable In3 Capital Partners to provide funding directly. What form or type of debt is right for your situation?
For project finance, “senior” debt is most widely used. Generally, as long as interest rates remain relatively low, it is best to leverage as much debt as possible (how much depends on the project’s tangible assets and owner or sponsor borrowing power) to optimize the equity owner’s financial returns. Why tie up money that isn’t generating optimized returns?
That said, both equity and debt are usually needed — 100% debt-only financing is rare, as institutional lenders use covenants to ensure the project’s performance stays within bounds proscribed by the lender’s policies and tolerance for risk. Equity invested alongside debt moderates lender covenant pressure.
What is senior debt? Long-term loans (3 years or more, typically up to 20 years), secured by assets via a pledge of collateral, with recourse (what can happen in the unlikely event of default; that is, if the borrower does not repay the lender) that is limited to the project’s assets and pledge of collateral. This is why lenders and some cutting-edge equity investors usually also require a loan guarantee (more).
What are the advantages of a loan guarantee? With credit enhanced by a loan guarantee, debt financing is particularly advantageous and affordable, as interest rates can go even lower (we can provide 3% APR fixed) and other terms become far more attractive and flexible. Projects benefit from some combination of debt and equity (see definition, below) to stay within bankability guidelines. Note that no reputable or honorable project financier will take on all the risks and provide 100% of the funding as debt. Beware of this — some investors may offer 100% debt financing but also will require a majority carried interest. A sure-fire way of losing control of your project!
If you wanted to sell the project assets outright, letting go of 100% of the rights to future cashflows, you would seek a buyout partner or “acquisitor”, not a lender.
What is project finance “equity”? Fortunately, project finance rules consider “equity” anything other than senior debt — such as subordinated debt, mezzanine debt, convertible debt (AKA “quasi-equity”, all defined below), grants, and of course direct equity, also called a carried interest or “shareholder” contribution of capital.
Other forms of debt besides “senior” (also called “term loans”) include
- subordinated debt — takes second position to “senior” debt, meaning that in the event of loss, is second in line to be made whole after the senior lenders.
- mezzanine debt — unsecured, higher-yielding loans that are subordinate to senior loans and secured loans but still rank above equity.
- convertible or promissory notes (sometimes called “quasi-equity”), where an investment starts as a loan but can or automatically does convert to a different asset class, such as an equity interest, based on milestones achieved. Can also serve as a bridge to future valuation and higher future share price, effectively preserving more of the owner’s equity.
- construction loans (short-term financing taken out by senior loan), bridge loans, and many others.
Who finances such loans? Debt instruments can be purchased by private family office investors, individual angels or “super-angels” (similar to a family office, but managed by an individual not an “office” or team), boutique impact investment funds, boutique “permanent” capital (not structured as a fund but more similar to a multi-family office), or institutional investors (managed funds, commercial banks, development banks, or other multilateral finance institutions). Some lenders focus on only one asset class; other project investors consider a range.
Which sources are best and in what combination? That’s precisely what In3 will help you determine. Optimal funding strategies, including the right forms and amounts of debt, are key to success. We remain entirely agnostic about loan products, and can originate loans from extremely diverse, high quality, mission-aligned sources. Let’s figure out what will be the best solution for your needs.
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