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Home > Financing Best Practice > How and When to Use Nonrecourse Financing

Financing Best Practice

How and When to Use Nonrecourse Financing

by Thomas McKaig

Table of contents

Executive Summary

  • Nonrecourse financing is debt where the loan is completely secured by collateral, which is often real estate. In case of default, the borrower is not liable because the lender is limited to collateral pledged for that loan—the lender has “no recourse” to the borrower’s other assets.

  • Nonrecourse financing is typically found in infrastructure projects such as the construction of toll roads and bridges. In this case, the borrower (a large construction company) is under no obligation to make payments on the loan if the revenue generated from the project on completion (the bridge or the toll road when built) is insufficient to cover the principal and interest payments on that loan.

  • Although the benefits of such financing are obvious (the borrower is not using its balance sheet for the loan and can therefore undertake more leveraged projects than it could otherwise), such financing comes at a cost. Lenders often seek other credit guarantees and will almost certainly charge more for the loan than with more traditional, recourse financing.

  • Nonrecourse financing does not mean “no risk,” and some companies may undertake projects that have a riskier profile than they should otherwise assume, as will be shown in a case study.

Introduction

When companies are negotiating loans from lenders, there are many clauses that are important points for negotiation over and above the amount of the loan and interest charged. These items can include assignment of the loan (on the part of either the borrower or the lender), future fund advances, and prepayment capability. Another key clause is the nonrecourse clause, under which the lender agrees not to hold the borrower (the company) liable in the event of default on the loan.

Typically, therefore, nonrecourse financing is different from personal loans, such as mortgage loans, where the lender holds the borrower personally responsible for the sum borrowed if the value of the item being financed (the house) is insufficient to repay the total amount of the loan. Such loans are often called recourse loans. On the corporate side, most small business start-up loans are recourse loans—if the business fails, the owner is still liable to repay the loan amount in full.

Not all nonrecourse financing is the same—the phrase itself is very broad. Nonrecourse clauses in loan agreements, for example, may state the specific conditions under which the lender will not hold the borrower personally liable in the event of default. If these conditions are not met, then the borrower becomes liable. Such financing is sometimes referred to as limited-recourse financing.

It is also important to remember that, while nonrecourse loans relieve the borrower of corporate liability, they do not release whatever property is used as collateral for the loan—the lender still has an interest in the property as security for the loan.

Nonrecourse financing is the norm in the world of project financing for major projects that are government or quasi-government sponsored (infrastructure projects such as toll roads, hospitals, or power generating plants). It is so much a part of project financing that many textbook definitions of “project finance” specify that it is a key component: a project is financed based on, and secured by, the project itself, with the lender being repaid out of the project’s cash flow, rather than the project being secured by the general assets or creditworthiness (the balance sheets) of the sponsors (the engineering companies, the construction companies, or even the government bodies) of an infrastructure project. In most of these cases, the companies undertaking the project are either not sufficiently creditworthy, or else unwilling to assume the high debt loads associated with traditional financing for large, multibillion dollar projects. Nonrecourse financing is also the norm in the commercial real estate world for the construction of major projects such as office buildings or shopping malls.

The benefits of nonrecourse financing to the borrower are obvious. Borrowers are able to enter into agreements that they could not afford under traditional financing methods. Project financing deals are also highly leveraged, allowing borrowers (more accurately called “the sponsoring parties” to the agreement) to put fewer of their own funds at risk. Furthermore, depending on the structure of the loan agreement, borrowers may not be required to report any of the project debt on their balance sheet.

A large firm undertaking a project may use nonrecourse debt as a way of limiting its risk exposure by effectively isolating a new project. For example, a large university might use nonrecourse financing to fund the construction of a new building because the institution as a whole would not want to put its balance sheet at risk to fund the construction of one building.

However, some dangers accompany this increased exposure to risk. “Non-recourse” is not a synonym for “no downside risk,” though some companies may come to believe that. The Case Study illustrates some of the dangers when companies forget about increased risk exposure.

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Further reading

Books:

  • Liaw, K. Thomas. The Business of Investment Banking. New York: Wiley, 1999.
  • Ling, David C., and Wayne R. Archer. Real Estate Principles: A Value Approach. 2nd ed. New York: McGraw-Hill, 2006.
  • Slee, Robert T. Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests. Hoboken, NJ: Wiley, 2004.
  • Tjia, John. Building Financial Models: A Guide to Creating and Interpreting Financial Statements. New York: McGraw-Hill, 2004.

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