Category: Uncategorised

 

Equity injection style	Up-front; or Pari-passu with debt; or Back-ended, subject to full acceleration rights and bank guarantees in the amount of the equity cheque to be provided.
Availability period	Construction period + a few months
Term of the Facility	Dependent upon project. Usually ~75% of the offtake contract, leaving an ungeared tail.
Repayment profile	Capital & interest grace period during construction. Capital fully amortises over the repayment period. Capital & interest payments three- or six-monthly in arrears Capital may be repaid by o    Equal principal repayment; o    Mortgage-style redemption; or o    Sculpted to fit revenue profile, subject to achieving the minimum base case DSCR.
Covenants	Debt:Equity, ADSCR, LLCR and PLCR may be used as covenants affecting lock up of distributions to shareholders, or leading to default. The level of the lockup and default covenants will be determined with respect to the volatility of the cash flows and market standards for similar projects. “Annual Debt Service Cover Ratio” (“ADSCR”) is the value of Cash Flow Available for Debt Service (“CFADS”) (excluding all cash and bank balances) in the applicable measurement period, divided by any debt principal and interest due in the same period.
	CFADS of the Borrower is defined as cash generated in the period, after operating expenses and tax, but before debt service . “Loan Life Cover Ratio” (“LLCR”) is the net present value of future CFADS (excluding cash) until the final scheduled maturity of a Facility (discounted at the weighted average of the forecast Facility interest rates projected in each period) to the total aggregate of loans outstanding under the Facility. “Project Life Cover Ratio” (“PLCR”) is the net present value of future CFADS (excluding cash) until the final scheduled maturity of a Project (discounted at the weighted average of the forecast Facility interest rates projected in each period) to the total aggregate of loans outstanding under the Facility.
Hedging Strategy	Borrower usually required to hedge a minimum of 50% of the interest rate exposure under each facility (subject to sensitivity tests). All fx risk during construction usually required to be hedged.
Debt Service Reserve Account	A Debt Service Reserve Account is required equivalent to the next 6 months’ scheduled interest and principal payments under the facilities and in place at Commercial Operation Date (“COD”), usually funded from debt and equity draw downs and topped up, if required, during the operations period. The DSRA is kept in reserve to provide liquidity when the Project has poor performance and is unable to fund its debt repayment (although it will already be in default when using the DSRA). The DSRA may be funded from project cash flows rather than prior to COD.
Major maintenance Reserve Account (“MMRA”)	Either an adequate MMRA or acceptable guarantee may be required. The MMRA is a reserve account gradually funded over a course of several years against very large future maintenance requirements, such as  refurbishment of turbines or repaving of a road.
Performance Bonds – EPC	Design and Construction: An Engineering, Procurement & Construction Performance Bond (acceptable to the lenders), to be put in place, to provide security for Delay- and Performance Liquidated Damages. If the EPC provider fails to meet its obligations to provide the asset (e.g. power plant) up to specification and on time, it will pay delay and / or performance liquidated damages (“LDs”) to the project. These LDs are secured by an unconditional, on-demand bank bond as well as guarantees from the parent company of the EPC contractor.
Performance Bonds – O&M	Operations and Maintenance: The performance of the O&M Company to be guaranteed by either corporate or bank guarantees (acceptable to the lenders). As per EPC performance bonds, the Operator will pay pre-agreed liquidated damages to the project if it does not perform to contracted specification. These LDs are secured by an unconditional, on-demand bank bond and / or a guarantee from the Operator’s parent company.
Security Structure of the Facility	Common security for project finance facilities, including: Notarial bonds over movable assets; Mortgage bonds over immovable assets; Security cession of all debtors balances and claims which the Borrower may have against third parties, security cession of Project Accounts (other than the Distributions Account) including Debt Service Reserve Account, cash balances and investments of the Borrower; Security cession of Project Documents & related direct agreements, including the right, title and interest of the Borrower to the offtake contract – note that lenders will have the option to step into the project upon default, run the project, and then sell it in order to exit; Security cession of all guarantees (including parent company guarantees) and performance bonds; Cession over all licenses and permits; Pledge over all shares in the Borrower; and Direct agreements between the Lenders and EPC contractor, land owner, operator, offtaker, and concession giver.
Conditions Precedent (“CPs”) to Financial Close	A Project Finance facility will include an extremely long list of CPs, including without limitation: Lender satisfaction to the following: The provisions of the EPC Contract, which as a minimum is usually a fixed priced turnkey contract; The provisions of the Operations & Maintenance Contract and all other sub-contracts (where applicable); That the guarantees and performance bonds provided by the EPC and O&M contractor/s are in place; The audited base case financial model to achieve the minimum base case covenants levels; Satisfactory External Legal Opinions, as required. Review of the final technical, environmental, insurance, model (including taxation) and legal due diligence (including review of external legal opinions) to the Lenders’ satisfaction;
	Inter-creditor agreement (including voting rights) to be finalised (where applicable); and Excon approval, if required.
Information Undertakings	The Borrower may be required to provide the Lender with various items of information, including the following: Annual reports on the operation of the Project and, prior to the  Scheduled COD, quarterly reports on the construction and equipment supply progress of the Project; Certificate of fulfilment of the Project completion tests), issued by the Lenders’ Technical Advisor (“LTA”); Prior to the commencement of each financial year, a copy of the operating Project budget for the next 12 months; Notice of any material loss or damage; Notice of any material breach, variation or termination of, or right to terminate or material dispute under any of the Project Agreements Details of material claims, litigation, arbitration or other similar proceedings commenced or threatened by a third party against the Borrower or any project party ·       any indemnity claim made pursuant to any of the Project Agreements.
Events of Default	Standard terms typical to Project Finance transactions include the following: Any events of default under the other Project Documents (offtake contract, EPC, O&M) but usually at a lower threshold than under the relevant Project Document; Non payment; Borrower infringes Assignment or Change in Control obligations; Acts of Insolvency, also for guarantors; Any breach of a material clause in the Finance Agreement; Misrepresentation – linked to lists of [repeating] representations and undertakings which the Borrower must make; Failure to meet a Ratio test and; Changes to the EPC Guarantee and the O&M Guarantee.
Consequences of Event of Default	Upon an event of default, the Lender will have the right to do any of the following: Cancel all remaining commitments; Call all amounts due and payable under the Facility and accelerate their repayment; Realise Security; Exercise any “step-in” rights that they might have, assuming control of the project; Apply the Project revenues as directed by the Lender;
Priority of Payments	All revenues will be applied in the following order of priority: Operating and maintenance expenditure, and project taxes; Costs and fees under the Finance Documents; [Sometimes scheduled Capex, but usually not]; Interest of the Loan and hedging counterparties to the Term Loan; Capital in respect of the Loan and any crystalised hedge break amounts; Any amount necessary into the DSRA and MMRA to require the maintenance of the required balances; Payment of subordinated interest and principal; and The remaining amount may be transferred to shareholders.
Fees and margins	Dependent upon the particulars of the transaction, but including: Upfront (arranging and underwriting) fees Commitment fees Interest, split into base rate, liquidity costs, statutory costs and credit margin

Derivatives are used to hedge against uncertainty in macroeconomic factors influencing project cash flows, in particular interest rates, exchange rates, and to a lesser extent CPI and sometimes fuel prices.

Projects make use of such hedges to immunise their cash flows against adverse changes in the underlying factor, thereby  decreasing the volatility of cash flows available for debt service and allowing the project to leverage higher than they would otherwise be able to.

Corporates and Parastatals engaged in infrastructure projects also make use of hedges if they have significant borrowing programs, and more commonly, to lock in exchange rates when they purchase significant capex in a foreign currency.

Hedges, however, come at a cost, with the result that the banks offering them to the projects earn a considerable return. In particular, with the implementation of Basel III, and the Credit Risk Transfer (“CRT”) requirement, also called Counterparty Valuation Adjustment (“CVA”), spreads have widened considerably.

As an indication of how profitable a hedge may be to the investor, banks recognising PnL from derivatives in their trading books up front may earn as much as 2.0% – 3.5% of the notional debt amount on day 1 of the trade. (This is because profit and loss on the trading book is measured as the change in the mark-to-market, or NPV, of each derivative in the book.

Spreads on commodities (fuel) and on CPI are significantly wider than on interest rate swaps and fx swaps, with CPI swaps in particular being of interest because of the investor demand for CPI-linked debt.

Hedging instruments incur both market risk and credit risk. Market risk can be hedged by the investor in turn by entering into an equal and opposite position with its own trading counterparties. However, credit risk is a function of the unknown, but statistically predictable, future fluctuations in the underlying macroeconomic factor(s). Unlike the derivative trading activities which an institution typically enters into with banks, derivatives with a project will not be governed by a collateral agreement or CSA, with the result that the credit exposure can spike. Helpfully, hedges typically rank similarly to the tranche of debt which they are hedging, and are therefore typically senior in both the pre- and post enforcement payment waterfalls. This results in a probability of default (“PD”) and a loss given default (“LGD”) very (very) similar to that of the senior debt. However, the exposure at default changes in accordance with a probability distribution function, as touched on above.

Hedging derivatives can create a significant return kicker for traditional debt instruments, and may constitute an opportunity for a debt investor in that:

• The work to determine the project’s credit quality may already have been done to evaluate more traditional investments; and
• The credit exposure can become negative if the underlying moves in the “right” direction, leading to an implied funding benefit.

The investment banks typically reserve credit lines to cover credit risk associated with a hedging instrument provided to a project in the amount of the potential future exposure which will not be exceeded with a  98% probability, sometimes referred to as the swap’s PFE. This is calculated quantitatively by running, for example, 10 000 monte carlo simulations on the underlying asset, for example the interest rate curve. For each simulation, the hedge is revalued at each duration. The exposures at each duration are then sorted in, say, descending order and the 200th largest exposure at each duration is plotted to form the PFE curve. Similarly, expected exposure can be modelled by using the 5000th (or median) exposure at each duration. This process is relatively straight-forward to carry out for interest rate swaps using every-day tools, provided that the original market data is available and the investor is comfortable to rely upon simulated spot rates and forward curves. The same exercises for fx swaps would be more challenging because of the need to maintain a realistic arbitrage-free forward exchange rate curve in simulations.

Using market data available at the time of writing, the PFE for a 12-year vanilla amortising interest rate swap was approximately 15% of the original notional loan amount and decayed rapidly towards zero at later durations as the number of remaining payments contributing towards the NPV reduced.

More details on project finance hedging to follow in later posts…

Full recourse or corporate debt differs from non-recourse debt in that it is the sponsor that borrows the funds, rather than an insolvency-remote SPV. While funds borrowed may be for the purposes of conducting a project to build a specific infrastructure item, recourse is to the full balance sheet of the borrower. Consequently if the project fails, the borrower must still repay.

Borrowers are typically large corporates or parastatal entities. Evaluation of the debt opportunity presented by these entities is no different to that traditionally used to evaluate corporate or full recourse debt.

Similarly, corporates and parastatals frequently issue bonds. The spreads available on these bonds are readily available on Reuters, INet Bridge or similar.

Corporates with significant infrastructure assets may also issue bonds. However, the funds from such bonds may not in all instances be used to create infrastructure assets, but rather for general corporate purposes.

Infrastructure funders may issue bonds or seek to obtain loans, the proceeds of which are earmarked for infrastructure investments.

 

This is debt advanced on traditional Project Finance principles:

• Lent against projected cash flows;
• Either pre-contracted offtake arrangements with credit-worthy offtaker or statistically predictable or provable retail offtake (e.g. toll road traffic, supported by traffic studies);
• Risk allocation to project parties, such as Engineering, Procurement and Construction contractor, Operator, etc; but…
• Usually no risk allocated to sponsor: Debt is non-recourse;
• Comprehensive due diligence process including technical, legal, insurance, tax and model audit;
• Complex legal documentation suite with back-to-back agreements.

Non-recourse debt is predicated upon the predictability and stability of the future cash flow stream, with the consequence that much time and effort goes into contracting away risk which may lead to the cessation of or volatility in such payment stream. This results in risk being allocated to as many third parties as possible outside of lenders and equity. A particular characteristic of such risk transfer is back-to-back provisions in the project contracts. For example, an event which gives rise to the offtaker gaining the right to terminate the offtake contract will usually be mirrored in the EPC and Operations and Maintenance (“O&M”) contracts, conferring the right to terminate such contracts upon the Project. Usually, and ideally, the threshold for obtaining such rights will be lower in the EPC and O&M contracts than the offtake contract.

Maximum liability for equity investors in a non-recourse financing is limited to their investment, while there may be carve outs to such limitation of liability in a limited-recourse financing.

A typical project structure is as below. Blocks represent parties, while arrows represent contracts and therefore contractual relationships.

Non- and limited-recourse debt is typically documentation-intensive, and the project documents and finance agreements are often voluminous.

Project finance debt providers will seldom allow the project to be funded by debt. Consequently the project will almost always require at least some equity investment. Equity investors can be categorised into strategic or financial investors. Strategic investors include the project developer, construction counterparty, operator or supplier.

Financial investors will have no interest in the project other than their investment. Private equity infrastructure funds invest in industries such as electricity, gas, water, telecoms, roads and airports, to acquire a steady return over a long period of time. Infrastructure funds aim to maximise gearing to increase equity returns, possible because of the typically stable cash flows on infrastructure transactions.

The private equity sector is dominated by a number of large firms, mainly based in the USA, but operating internationally. Compared with top US buyout groups, European private equity firms tend to be small and confined to national markets.

The expected returns required for investment at each stage of the project lifecycle vary, as does the risk of such investment. The cost of investment is typically measured on a discounted cash flow basis, possibly with probability-weighted elements or simple scenarios. (Anecdotally, I have heard of stochastic project models, but never seen one, and am a little dubious as to the additional value that they might add to an investment decision.) The price of equity is then typically determined by back-solving for a required return (which will be, mathematically, the risk discount rate).

Generalising grossly, equity returns might look something like the following:

Lifecycle stage	Return
Development	Very high. Returns for developers may be extremely high because the development fee is often used as a free carry in the project. Relatively little cost  compared to the capex is expended in the development stage, but can all be lost if the project does not go ahead.
Pre construction	Medium-high
Post construction / operating phase	Low-medium

There are four main asset classes commonly used within the Infrastructure Asset Class, not accounting for hybridisation, being:

• Equity
• Non-recourse or limited recourse debt
• Full recourse or corporate debt, including bonds
• Derivative instruments, particularly used for hedging.

In addition, there are a number of risk overlay products which transfer various portions of the risk of investment into infrastructure transactions to third parties. Setting aside the obvious example of physical damage and business interruption insurances, these are, in particular, Export Credit Agency products and political risk insurance.

 

Supply contracts will typically contain provisions relating to the following:

• Price and price escalation
• Take-or-pay provisions. I.e. how much the project must pay to the supplier irrespective of whether it is able to receive the supplied goods
• Quality specifications for the supplied goods (e.g. calorific value of coal, sulphur content, ash content, etc for a coal power plant)
• Details on any performance tests including what tests must be undertaken, when, what constitutes a pass, and whether they may be repeated
• Pass through provisions for events outside of the project’s control, such as force majeure and change in law. In particular, these will be based on the offtake contracts
• Consequences of failing to meet obligations for each counterparty, and the rights which will arise therefrom. In particular, termination rights and consequences of termination
• Guarantees (delivery date and performance levels), including limitations of liability for the supplier, rates of accrual of liquidated damages and performance security (liquid bank bond, vs parent company guarantees)

Similarly to under the EPC and O&M arrangements, the Project will attempt to pass as much risk through to the Operator as possible.

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This is achieved through the following:

• Fixing prices in advance, or, if not feasible, indexing them in the same manner as the fuel-pass-through revenue component of the offtake price (or water, etc, as applicable)
• Any compensation for risks outside of the control of the supplier which the supplier may enjoy will typically be limited to the compensation which the project enjoys from the offtaker. This is typical for, amongst other provisions, force majeure and change in law
• Any provisions which may lead to termination of the offtake contract, or any of the project’s other contracts, will, to the extent applicable, be mirrored in the supply contract, often with a slightly more onerous threshold, so that the project can terminate the supplier before the other contract is terminated and attempt to fix the situation.
• The supplier will pay liquidated damages at a pre-defined rate per day of plant unavailability resulting from failure to supply, or, if applicable, upon failure to meet the guaranteed quality specifications of the goods supplied (e.g. calorific value of coal supplied to a coal power plant). These liquidated damages are typically capped, and usually guaranteed by either a liquid, on-demand bank performance bond or a parent company guarantee.

Projects will often, but not always, have one or more supply contracts. Supply contracts are those for major items which are required to run the plant. Examples include:

• Fuel supply agreements
• Water supply agreements
• Electricity supply agreements
• Reagent supply agreements

Projects such as this include conventional thermal power plants (fuel supply and transport, sometimes water and reagants) and desalination plants (electricity supply).

Some projects will not have any supply agreements. Most renewable energy projects fall into this category, since sun and wind are free to the project.

O&M contracts will typically contain provisions relating to the following:

• Price and price escalation
• Scope of work, detailing the Operator’s responsibilities and who will pay for the work (is it a pass through cost?)
• Mobilisation provisions (when the Operator must ready itself to start performing its obligations)
• Details on any performance tests including what tests must be undertaken, when, what constitutes a pass, and whether they may be repeated
• Pass through provisions for events outside of the project’s control, such as force majeure and change in law. In particular, these will be based on the offtake contracts
• Consequences of failing to meet obligations for each counterparty, and the rights which will arise therefrom. In particular, termination rights and consequences of termination
• Guarantees (delivery date and performance levels), including limitations of liability for the Operator, rates of accrual of liquidated damages and performance security (liquid bank bond, vs parent company guarantees)
• Variation procedures