INTRODUCTION TO PROJECT FINANCE

A

CHAPTER 2 INTRODUCTION TO PROJECT FINANCE

Anyone who lives wilhin their means suffers from a lack of imagination.

- Oscar Wilde. Irish dramatist, novelist, A poet (1854 - ¡900)

A number of financing options are available for infrastructure projecis. and for PPP projects in particular. One of the most common, and often most efficient, financing arrangement* for PPP projects is "project financing", also known as "limited recourse" or "non-recourse" financing. Project financing normally takes the form of limited recourse lending to a specially created project vehicle which has the right to carry out the construction and operation of the project. One of the primary advantages of project financing is that it provides for off-balance sheet financing of the project which will not affect the credit of the shareholders or Ibe grantor, and shifts some of the project risk to the lenders in exchange for which the lenders obtain a higher margin than for normal corporate lending. This chapter provides an introduction to project financing.

2.1 OFF-B\LANCE SHEET

Project financing may allow the shareholders 'o keep financing and project liabilities "off-balance sheet". Project debt held in a sufficiently minority subsidiary is not consolidated onto the balance sheet of the respective shareholders. This reduces the impact of the project on the cost of the shareholder's existing debt and on the shareholder's debt capacity, releasing such debt capacity for additional investments. Clearly, any project structure seeking off-balance sheet treatment needs to be considered carefully under applicable law and accountancy rules.

To a certain extent, the grantor can also use project finance to keep project debt and liabilities off-balance sheet, taking up less fiscal space. Fiscal space indicates the debt capacity of a sovereign entity and is a function of requirements placed on the host country by its own laws, or by the rules applied by supra- or international bodies or market constraints, such as the IMF and the rating agencies Those requirements will indicate which project lending will be treated as otT-balancc-sbcel for the government, for example the statistical office of the European communities (Eurostat) in decision 1R/20O4 requires that such transactions must

49

SB

r\nan Sr, ur tiwani in l*/nutnicBirr

(I) place instruction risk on the private party (i.e. no completion guarantee from the government), and (2) the private party must bear either availability or demand risk (Le. service delivery or market risk).

It should be noted that keeping debt off-balance sheet does not reduce actual liabilities for the government and may merely disguise government liabilities, reducing the effectiveness of government debt monitoring mechanisms. As a policy issue, the use of off-balance sheet debt should be considered carefully and protective mechanisms should be implemented accordingly."

2.2 LIMITED RECOURSE AND SPONSOR SUPPORT

Recourse financing provides the lenders with full recourse lo the assets or cash How of the shareholders for repayment of the loan in the case of default by the project company. Where the project otherwise fails to provide (he lenders with the repayments required, the lenders will have recourse to the assets and revenue of the shareholders, with no limitation.

One of the advantages to the shareholders of project financing is the absence, or limitation, of recourse by the lenders to the shareholders. The project company is generally a limited liability special purpose project vehicle, therefore the lenders' recourse will be limited primarily or entirely to the project assets (including completion and performance guarantees and bonds).

Non-recourse (sometimes, confusingly, called "limited recourse-) financing limits the lenders' recourse to the assets of the project at band in case of default by the project company. Limited recourse financing may be structured in a variety of ways but will usually only provide the tenders with recourse to the assets of the shareholders in certain specified situations, up lo a limited maximum amount and over a limited period,

A key question in any non-recourse financing is whether there will be circumstances in which the non-recourse nature of the borrower's liability is to fall away and the lenders are to have recourse to part or all of the shareholders' assets. Generally, the type of breach of covenant or representation which gives rise tn this consequence is a deliberate breach on the part of the shareholders, and, in particular, the shareholders not using appropriate efforts to ensure thai the project is successful by. for example, committing a breach of the operating or joint venture

Sec sections 1.2.3 and 1.5 for further discussion of off-balance sheet financing.

51

agreement which governs the running of the project. It should also be noted thai applicable law will restrict the extent to which liability can be limited, for example liability for jieisonal injury or death.

Difficult questions arise in relation to the obligations of the shareholders lo lake up the participation of joint venturers who drop out or default on their obligations, and, in particular, the question of when the shareholders are lo be entitled to abandon the project in the event of catastrophe or in the event that the project no longer proves economic. These issues will either be resolved in the drafting of the financing agreement or at law (generally through the law of tort or contract).

Where some portion of the project involves more risk than another, recourse may be provided to the lenders to the extent of that risk or until that high risk period has passed. Alternatively, (be amount of recourse allowed to the lenders may be limited in value. The extent to which some recourse is provided is commonly called "sponsor support". In project financing, the construction phase involves particular risks for the lenders. The value of the project against which the lenders provide financing is usually in the operation and the payment stream suppotled by the concession agreement and not in the equipment and materials, the physical assets of the project. Since the lenders will bear more risk until construction is complete, sponsor support is sometimes provided for the period up to completion of the works, which will generally be defined in the concession agreement and marked by the issue of a certificate or (he passing of specified tests. It may also be provided for the period until certain financial ratios are achieved, or until the works have achieved a period of operation al a certain level. Another approach is lo provide the lenders with limited recourse to sponsor assets in the even( of certain breaches of (he financing agreements by the project company or the shareholders.

Sponsor support may include:

- shortfall guarantees, where the banks, after enforcing all other security rights, experience a shortfall;

> buy-down undertakings, a promise (o prepay projec( debt to ensure specified ratios, in certain circumstances;

> price guarantees, to ensure pricing of offtake;

- market price purchase guarantees, lo purchase a minimum quantity of product al market price over a set period;

- tax loss purchases, where a shareholder agrees to purchase certain tax losses from the project company;

51

Prtvalc Srcior Imtatment m !<".....

> technical support, extended warranties and maintenance arrangements; and

> contingent equity or subordinated debt commitments to cover construction or cither price overruns.

The project company will want to limit the type of breaches resulting in recourse lo the shareholders, such as egregious or intentional breaches of essential covenants or representations which may alter the lenders' risk matrix. Sponsor support may involve the establishmenl of a fund, normally pledged or secured, which can be used, for example, where there is a deficiency of funds or an increase in costs during the period of limited recourse."

Due to the limited recourse and highly leveraged nature of project financing, the majority of project risks borne by the project company will therefore be borne by the lenders. This makes for extremaly risk averse lenders. Therefore lender due diligence on a projeel will include detailed review of whether project risk allocation protects the project company sufficiently. This is known commonly as verifying the project's ""bankabilily","

2 J TAKING SECURITY

The lenders will want lo put in place as much security for the financing as possible. Security is both 'offensive" and "defensive": offensive lo the extent the lenders can enforce the security to dispose of assets and repay debt where the project fails; defensive to the extent that senior security can protect Ihe lenders from actions by unsecured or junior credilors. Complete control requires comprehensive fixed and floating charges (which terms differ by country) over all projeel assets, which in common law jurisdictions may allow the lenders to appoint a receiver to manage the business in the event of insolvency. If such comprehensive security rights are not available, the lenders may seek lo use nng-fenctng covenants in an effort to restrict other liabilities, security over project company shares to allow the lenders to lake over control of the company or the creation of a special golden share that provides the lenders with control in the event of default. Security righls may also

Tinslcy. Practical

...