A look at some of the fundamental requirements for making project documentation bankable
Most world-class infrastructure projects are project financed. For this financing to happen, the project must be bankable. Without banka-ble project documentation, financing will be difficult to obtain and the project is extremely unlikely to succeed.
Bankability and risk perception
A contract can be described as bankable if it satisfies the requirements of lenders. These requirements will be similar to the requirements of the project sponsors, but will not be identical. This is because of the differing levels of risk and reward to which the sponsors and lenders are exposed. While the lenders will not get the benefit of the upside on a successful project in the same way as sponsors, they are nevertheless exposed to the downside if a project is unsuccessful. Because of this higher ratio of risk to reward, lenders are, on the whole, likely to be more risk averse than sponsors. If lenders are not happy with the risk allocation on a project, this could have a big impact on the viability of the project as the sponsors will then be required to provide a greater amount of equity support than they otherwise would.
In addition, the project company will have to satisfy the lenders on the technical risk of the project. Price is also a factor. Although price relates more directly to the bankability of the project as whole, it is usually considered separately with regard to the bankability of the contracts themselves.
As a general rule, from the lenders' point of view, it is preferable for the project company to bear as few risks as possible. As lenders' requirements vary from project to project and jurisdiction to jurisdiction, it is not possible to specify a risk allocation that will definitely be bankable. However, it is usually possible to state that a certain allocation will not be bankable and therefore, define the general requirements and optimal position for bankability.
Project financing
To understand the general requirements for bankability, it is necessary to explain what is meant by project financing. Project-financed projects are those projects for which the financing is secured only by the assets of the project. This means that the revenue from the project must be sufficient to support the project without recourse to the sponsors. Because of this, project financing is often referred to as non-recourse or limited recourse financing.
Although these terms are often used interchangeably, their meanings are not identical. Non-recourse applies to a situation where there is no recourse to the sponsors at all. In fact, this is very rare in practice. More common is limited recourse financing which means, as the name suggests, that there is limited recourse to the sponsors. In this case, the recourse can occur only at certain times and the amount the sponsors are forced to contribute is limited. In most projects, the sponsors will be obliged to contribute additional equity in certain defined situations. The lenders will not allow the project company to bear risk which it is not reasonable.
Risk allocation
The risk allocation that will be acceptable to the lenders is likely to vary depending on the type of agreement in question, as will bankability. The risk allocation will be influenced by bankability issues relating to the concession agreement, construction contract, fuel supply agreement and offtake agreement.
In terms of the concession agreement, the risk allocation that will be acceptable to lenders will, to some extent, depends on whether or not the project company is able to pass risks down to the EPC contractor, the O&M contractor, any offtaker and contractors.
The unwillingness of lenders to accept any change of law risk is particularly relevant in the context of the concession agreement as the counterparty is a government entity and is therefore in a position to influence changes of law. Therefore, the concession agreement should provide that the terms of the concession be amended should there be a change in law which adversely affects the project company's return.
The concession agreement should also make provision for the concession to be extended should a force majeure event occur or should the concession be suspended by the government. The lenders' interest in these two issues will depend both on the term of the concession and the repayment schedule for the debt.
The lenders would also like the agreement to provide that should the concession agreement be terminated other than for the project company's default, the project company would be entitled to receive at least an amount equal to all the outstanding debt, and ideally also the amount necessary to close down the project. From the sponsors' point of view, in such a situation, the company should also be entitled to the profit it would have earned had the concession agreement not been terminated.
From the lenders' point of view the construction contract should be a turnkey contract providing single point responsibility for the design, engineering, procurement, construction, commissioning and testing of the facility, and should include the following:
- A fixed price which cannot be varied
- A fixed completion date
- Performance guarantees for facilities such as power stations and process plants
- Uncapped liquidated damages payable if the performance guarantees are not met or if completion is delayed
- Provision limiting claims for extensions of time to claims for delay caused by the project company and for defined force majeure events. Even then the contractor should only be granted an extension of time if it submits its claim at the correct time and provides the necessary supporting information
- Unlimited liability of the contractor
However, although these terms are what lenders would like to see, a contractor would be very unlikely to sign up to such terms. Lenders will, therefore, usually compromise on some issues, depending on the nature and location of the project. The lenders will also want the applicable risks imposed on the project company under the concession agreement to flow down to the contractor, particularly risks such as completion dates, level of performance and amounts of liquidated damages.
It is usual for the project company to have less bargaining strength in respect of the fuel supply agreement than in respect of most of the other agreements (see box).
The lenders' requirements as regards the offtake agreement will vary with the type of project being financed. The requirements for an agreement under which the project company is a price taker will usually be much less prescriptive than where the project company is a price-setter. An example of a situation where the project company is a price-taker is an offtake agreement for urea produced at an ammonia/urea facility. In this case, the urea is an internationally traded commodity and therefore, the project company cannot really negotiate price independently of the market. On the other hand, under a long-term power purchase agreement, the project company is a price-setter, with an ability to negotiate price and other terms directly with the offtaker.
In the case of the O&M contract, the interests of the project company and the lenders are closely aligned as it is in both parties' interests for the operator's remuneration to be linked to performance. The operator should receive a bonus if production targets are exceeded, whilst at the same time be responsible for operating the facility safely and within all the operating limits, and should be liable for damages if production targets are not met. These targets should be linked to the performance levels reached during the construction contractor's performance testing.
BARGAINING FOR FUEL
There are two main areas lenders tend to focus in a fuel supply agreement
SECURITY OF SUPPLY
The lenders will require certainty that the project company will be able to procure enough fuel to operate without interruption. They will want the fuel supplier to be liable should the supply be interrupted and will want the project company to be able to source alternative supplies in such a situation
TAKE OR PAY
Ideally the lenders would prefer a 'take and pay' to a 'take or pay' obligation as there is a risk under a 'take or pay' obligation that the project company could be required to pay for fuel that it cannot use. If there is a 'take or pay' obligation the lenders would require that the project company be reasonably well protected against such a situation
WHAT THE LENDER WANTS
There are certain requirements that the lenders will almost certainly insist on with regard to the financing documentation
The lenders will require that the sponsors adequately capitalise the project company and to provide a sufficient proportion (usually 20-40 per cent) of the total project cost
The lenders will not a risk of change of law. This is often a difficult issue for project companies undertaking projects in Asia, which may be required to obtain political risk insurance cover
The lenders will not accept a risk of discriminatory or project specific taxation
The lenders will not permit any funds to be distributed to sponsors unless and until debt service has commenced. Once servicing has started, payment of distributions will still be dependent on meeting and maintaining coverage ratios
The author is resident partner, Trowers & Hamlins, Muscat Tel: +968 7715500 Email: arae@trowers.com
Andrew Rae
© businesstoday 2004
