A look at what is bankability and the fundamental requirements to make project documentation bankable
While a majority of world-class infrastructure projects will be project financed, to put this financing in place, these projects will have to be bankable. This article aims to consider what is meant by bankability and also looks at some of the fundamental requirements for making project documentation bankable. Without bankable project documentation, financing will be difficult to obtain and the project is unlikely to succeed.
What does 'bankable' mean and what are the lenders' requirements?
A contract can be described as 'bankable' if it satisfies the requirements of lenders. Their requirements will be quite similar to that of the project sponsors, but they 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 take 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 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 would have otherwise.
In addition, the project company will have to satisfy the lenders on the technical risk of the project. Price is also a factor, even though this is usually considered separately.
As a general rule, it is preferable from the lenders' point of view 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 possible to state that a certain allocation will not be bankable and therefore also to discuss the general requir- ements and optimal position for bankability.
Project financing
In order to discuss these general requirements for bankability, it is necessary first to explain what is meant by project financing. Project-financed projects are those for which the financing is secured only by the assets of the project itself. This means that the revenue from the project must be sufficient to support the financing without recourse to sponsors. Because of this, project financing is often referred to as non-recourse or limited-recourse financing. Although these terms are used interchangeably on many occasions, 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 only occur at certain times and the amount sponsors are forced to contribute is limited. In most projects, the sponsors will be obliged to contribute additional equity in certain defined situations.
Financing documentation
While this update is focusing mainly on the bankability of project documentation, it is also useful to discuss the basic framework of the financing documentation and outline what will be required of the project company by the lenders to make a project bankable.
There are certain requirements that the lenders will almost certainly have as regards the financing documentation.
- The lenders will require that the sponsors adequately capitalise the project company and provide a sufficient proportion (usually between 20-40 per cent) of the total project cost.
- The lenders will not take a risk of change of law. This is often a difficult issue for project companies undertaking work in Asia, who may be required to obtain political risk insurance.
- 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 begins, payment of distributions will still be dependent on meeting and maintaining coverage ratios.
- The lenders will not allow the project company to bear any risk which is not reasonable to expect it to bear or that which it cannot reasonably be expected to manage.
Risk allocation and bankability of project agreements
The risk allocation, which will be acceptable to the lenders, is likely to vary depending on the type of agreement in question, as will the bankability. A discussion of risk allocation and bankability issues in relation to the concession agreement, construction contract, fuel supply agreement and offtake agreement follows.
Concession agreement
In terms of the concession agreement, the risk allocation that will be acceptable to lenders will, to some extent, depend on whether or not the project company is able to pass risks down to the engineering and procurement contractor, the operations and maintenance contractor, any offtaker and any other 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 change in law which adversely affects the project company's return. Although in the context of PFI/PPP projects there is a relatively sophisticated mechanism for achieving this, it does mean the project company will usually bear a portion of the change of law risk, at least for the periods between benchmarking exercises.
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, given that the financial model will be based on earning revenue throughout the entire concession period. The lenders' interest in these two issues will depend both on the term of the concession and 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 project company should also be entitled to the profit it would have earned if the concession agreement was not terminated.
Construction contract
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 operating facilities such as power stations and process plants.
- Uncapped liquidated damages, payable if the performance guarantees are not met with or if completion is late.
- 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 is 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. Generally, lenders will be prepared to accept caps on liability and also provision for varying the contract price in the event of delays, variations, suspension, change of law and possibly also if unexpected site conditions are discovered. 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.
The fuel supply agreement
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 and lenders are thus forced to make more limited demands.
There are two main areas on which lenders tend to focus:
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 case such a situation arises.
'Take-or-pay' obligations: 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, for example, by the inclusion of a provision that a project company would be able to cease paying for fuel on the occurrence of a force majeure event. For this purpose force majeure should be given a broad definition. However, a balance must be struck since, if the definition is too broad, it will derogate from the security of supply which will also be a risk in the eyes of the lenders.
The offtake agreement
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 less prescriptive than where the project company is 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 either case the lenders will require:
- A currency pass through as the project company should not bear the foreign exchange risk.
- Income should therefore be in the same currency as the debt.
- An assumption by the purchaser of much of the force majeure risk.
- A 'take-or-pay' obligation under which the offtaker would be obliged to pay for the product regardless of whether or not it takes delivery.
If the agreement relates to a process plant there should also be provision relating to storage of physical product which the offtaker has failed to remove. Once the storage area is full, and assuming the project company cannot find alternative buyers, the facility will have to be shutdown. Ideally, the offtaker should bear the cost of the shutdown and try and restart in this scenario.
O&M contract
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 within the set parameters 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.
The above provides a general overview of the bankability issues which will need to be considered for most projects. These issues will, of course, have to be considered in more detail, along with other project-specific issues, for each particular project.
By Andrew Rae
© businesstoday 2005
