Risks in Project Finance: Proven Risk Management Techniques

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Starting from global projects involving thousands of people to one-month renovations of a local store, learning how to handle risks is the key to effective finance management. Regardless of your industry, it’s essential to be transparent and serious about potential risks in project finance. 

These problems can snowball into serious blows to your organization’s financial well-being, reputation, and employee loyalty. This is why it’s important to implement effective risk management techniques that will ensure the success of your business ventures.

Companies invest in their risk management strategies, and the majority of entrepreneurs and project managers believe that risk management is becoming more complex and vital in the future.  

Project finance explained

Project finance is a term that refers to strategies that are used for funding large-scale business ventures that often include large investments and pre-made assumptions regarding returns and success chances. 

This term is often associated with vast infrastructure developments, power plants, housing projects, and other major construction and expanding endeavors. It’s not often used in smaller-scale situations as they often lack the potential to justify the need for project finance. 

There’s limited recourse in project finance that incentivizes careful risk assessment and management. In case the project faces difficulties, investors behind the project can seize the project's assets and cash flows.

What further puts an importance on risk management is debt and equity financing. Projects need to manage between having debt provided by banks or bond markets while equity comes from project sponsors, investors, or equity partners. The mix between these two sources of resources needs to be balanced according to the project’s characteristics and risk profile. 

What’s typical for project finance is that it involves the creation of a legal entity known as a Special Purpose Vehicle or Special Purpose Entity (SPV or SPE). This entity is responsible for minimizing interrupting other operations and businesses from the investors. 

The project structure includes exit strategies which include ways of refinancing or selling the project. This means that once the project is operational, investors and lenders can receive their returns. 

Risk management methods

There are many more ways to manage risks, but this list should give you a bigger picture of how they are commonly handled. These methods, even proven throughout various examples, aren’t always the best options depending on the specific situation your project lies in. 

As mentioned before, there are multiple types of risks, and you can utilize different methods for different risks. You can accept the risk of environmental damage while buffering the risk of the financial market fiasco.  

1. Fraud detection 

Even large-scale corporations are susceptible to risks related to fraud. We’ve seen the downfall of companies, such as Yahoo, that lost user data. Physical projects need to have security protocols and NDAs. In the digital world, there are also ways of preventing fraud. 

For example, ecommerce fraud is detected through fraud detection software and adequate protocols. This can include training for your employees or implementing firewalls and VPNs. 

The larger the project, the larger the impact that fraud can have on its finances and problems. Large corporations need to be careful when it comes to their reputation, as it can lead to immediate consequences for the well-being of the project. 

2. Risk sharing

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Large projects don’t involve a single entity, there are also business partners, stakeholders, and third parties present in the process. Through effective and transparent communication, the parties involved in the project agree on sharing their responsibility and consequences.

This approach is common with risks that are unavoidable, and people involved in the project decide to minimize its impact by sharing the troubles. The key to risk sharing is properly communicating, as the lack of transparency can shake the bonds between partners. 

3. Risk avoidance

Avoiding risks has always been present in everyday life. For example, you have a friend who you gave money in the past, yet he either didn’t return it or didn’t respect the deadline. A logical way of handling this is by simply avoiding lending them money.

In terms of project finance, avoiding getting into situations that can lead to risks is essential. 

4. Risk reduction

Reducing the chances of risk occurrence is another obvious way of handling potential problems. Yet, this can sometimes lead to significant expenses. Reducing risks helps enhance the security of the company, and it’s capabilities to handle them.

This method requires identifying risks beforehand and openly working on reducing them. 

5. Acceptance

One of the most straightforward ways of risk management is risk acceptance. This method is pretty much the same as saying that you’re ignoring the risk. However, even though it might sound strange, this is a totally legitimate way of handling risks.

It’s often implemented when the likelihood of the risk happening is low and the impact it would have is insignificant. The cost of addressing such risks can sometimes be much higher than accepting them -- thus, this method is born. 

However, if you mistakenly identify the impact and likelihood of a risk, acceptance can lead to a serious blow to your project finances. 

Risks in project finance

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There are multiple sources of risks. Some of them really depend on your company’s organizational capacities, while others are external. Regardless of their source, you need to be ready to handle them and minimize their negative impacts on your project’s performance. 

External risks

External risks include market-related changes, such as fluctuations in the market. Changes in interest rates can have a negative exponential impact on your finances, but economic fluctuations are also accompanied by inflation and lower chances of acquiring funding. 

These problems impact your supply chain and are characterized by an increase in costs and a decrease in revenue. 

All projects have some costs that occur constantly. These are usually utilities, energy, and the rent prices of equipment and real estate. Mentioned costs can change heavily, which can lead to severe problems in handling finances. 

Regardless of the country where the project takes place, regulatory changes can often lead to uncertainty regarding project management and finances. Changes in laws and regulations in another part of the world can be a concern for you, let alone changes in the local government. 

Another type of external risk is problems with finances. Difficulty in raising capital or experiencing currency fluctuations can be a negative turning point for your projects success. 

Internal risks 

Operational risks are internal, and while they can sometimes be unpredictable as well, they are usually tied to your organization’s operational efficiency. Project execution can sometimes depend on a certain team or a member. If the important part of the organization stalls, the whole project might experience delays, additional costs, and revenue deferral.

In the midst of the artificial intelligence craze, many projects are turning to new, untested technologies to help them with their projects. While this can prove to be a game-changer, untested technology can lead to technical failures and implementation challenges. 

Once again, even if you’re in the part of the world that’s considered protected from certain dangers, you shouldn’t completely exclude the possibility of them happening. When you say environmental risks, you might think about tsunamis, earthquakes, or fires. But even much smaller environmental problems lead to trouble in project finance.  

Identifying risks 

Regardless of my spine-chilling style in the previous sections, I must admit that the majority of these risks can be handled by identifying them on time. Their damage can be anywhere between a couple hundred up to a couple of million dollars, and the difference lies in the fact of recognizing them on time and choosing the proper management method.

Before you make the decision about which risk management method you want to choose for your project, you need to categorize the risks according to the types of risks above. Every type of risk has a value that’s calculated by multiplying the chances of it occurring with the amount of damage it can lead to. 

Handling risks in project finance is critical for success

It’s unlikely that any successful entrepreneur ignores potential risks altogether, yet many international companies suffered severe blows in the past. Sometimes the place where risk comes from is ignorance, but sometimes unexpected events happen. 

We can’t predict whether a new Covid-19 or a war is going to start in the near future. What’s up to decision-makers in companies is to acknowledge predictable, but also unpredictable, risks and mitigate them effectively. 

This list of risk management techniques is only a portion of various ways in which you can lower the chances of your company suffering blows to its stability. Keep in mind that these methods won’t improve your profit or help you reach new customers, but they are a safety net for periods of crisis. 

About Writer

Veljko is a student of information technology that paired his passion for technology with his writing skills. He enjoys researching topics such as robotics and programming and cultivates his knowledge in philosophy, classical literature, and fitness. Veljko’s favorite writers are Borislav Pekić, Miloš Crnjanski, and Ernest Hemingway.