Project finance contracting, transaction costs and capital structure

I develop and test a transaction costs-based theoretical framework for explaining how project finance off-take arrangements mitigate transactional hazards and affect the capital structure of project firms. In an organizational form called project finance, firms create legally-separate and bankruptcy-remote project companies that are responsible for managing over several years or decades a single asset such as a mine or power plant typically worth hundreds of millions or billions of US dollars. Project off-takers contract with the project company to purchase project output at pre-set prices and quantities over the life of the project. To the extent that transaction hazards related to project off-take arrangements affect the likelihood of project failure and, thus, non-payment to creditors, they will also affect project capital structure and require more equity from project sponsors. In a sample of 329 project finance companies announced in 51 countries from 1990-2006, I investigate the individual and cumulative effect of four types of off-take "protections" on project capital structure: (1) having more than one off-taker to avoid bilateral dependency (2) having off-taker equity ownership to align incentives (3) having a more secure off-take contract for greater revenue protection and (4) avoiding state-owned off-takers to mitigate institutional risk. I observe robust empirical evidence for the cumulative effect of off-take protections: Projects with more types of these off-take protections exhibit higher project leverage than project companies with fewer or no off-take protections. Robust evidence also indicates that one of the individual off-take protections, having a more secure type of off-take contract, plays a large role in explaining project leverage. There is also evidence that project finance arrangements with more than one off-taker and thus less opportunistic risk associated with bilateral dependency exhibit higher project leverage. These results call attention to the substantial effects of transaction-related risks on capital structure in project companies and, by implication, other business contexts where long-term contractual agreements are crucial to firm survival and success. Because project finance-based firms exhibit a relatively transparent and measurable link between transactional hazards and governance mechanisms to reduce those hazards, the findings in this dissertation also provide for researchers and practitioners alike useful methods to reduce investment risk when long-term buyer agreements are key components of those investments.