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The Viewpoint The Vagaries of Project Finance
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The Viewpoint The Vagaries of Project Finance

Bar & Bench

By Piyush Mishra

Lenders’ Dilemma

Project Finance is a leap of faith for lenders. The distinguishing feature of project finance from other forms is its limited/non-recourse nature, which makes it imperative to factor in the risks of the underlying project. The breadth of risks involved in a project is quite significant. A Liquefied Natural Gas project will entail project risk of the gas fields, pipelines and/or tankers and ports, liquefaction plant, re-gasification plant and the facilities/projects of the off-takers. If it is a cross-border transaction it will also entail country risk and project risk in relation to each jurisdiction. Significant disruption in any part of the chain is likely to have a cascading effect.

Non–recourse implies that the lenders will only look at the revenue stream and assets of the project being financed to recover their dues and will not have recourse to the Sponsors. This is achieved by way of a special purpose company where all the project assets are parked or through ring-fencing the project assets held by a company that has other assets. Sponsors only provide a certain level of equity, technical and managerial support. One may also encounter a limited guarantee from sponsors in a few instances.

Since it is a limited recourse/non-recourse financing and the funding is debt heavy, lenders have a significant risk in the project. Unlike Sponsors they do not share in the upside. The down side cushion for lenders is also pretty thin– upfront equity (later equity injections may not be available if the project is open to substantial risk) and sponsor support/guarantee of limited value.

Risk Measurement

There are some standard project related risks (technological, construction, resource, environmental, legal etc.) that are inherent in any project financing structure. Lenders do not have appetite for indeterminate or open –ended risks and some semblance of objectivity is required rather than a complete gamble on the project.

Since we have not yet made great scientific strides in astrology, banks have to rely on the next best mode of predicting risk- seeking help of various experts in identifying and measuring risks. Projects are a paradise for advisers – technical, financial and legal. Since expert views are not gospels they come with qualifications and their own set of assumptions, but nevertheless they are helpful in identifying and reducing the risks to identifiable margins should the historical assumptions hold true. Of course a Black Swan can change the dynamics completely.

Detailed feasibility studies and stress scenarios are prepared to measure and mitigate the risks. Based on the inputs on various scenarios and issues a business plan, an information memorandum and a base case model are prepared. The base case generally pegs the performance at a level lower than the optimal scenario so that there is a built in head-room.

However, assumptions and scenarios are but pure projections and reality has a queer propensity to deviate from the best of predictions. Therefore, besides the feasibility studies and opinions, other measures such as Insurance, security and strong contracts are also important for the bankability of the project.

Allocation of Risk: The Contractual Framework of a Project

From the perspective of lenders, project risks should be well allocated among the parties- government, the sponsors, the project company and the down stream parties through to end consumer. This idea is expressed in the form of ‘pass through of risk’ and for a lawyer it implies back to back arrangement of contracts. For example, a force majeure event under an offtake agreement should take into account the force majeure under the fuel supply, concession agreement and the fuel transport agreement for the project. Similarly damages and warranties under the EPC contract should match those under the concession for the Project Company. Therefore, the first contract (typically concession) for the project is the key to bankability- since other contracts will largely have to follow it- and should be well drafted and negotiated. While it makes perfect theoretical sense, in practice unfortunately things go awry from the very start.

The concession agreements in India are typically standard form agreements that are negotiated without any input from lenders. Lenders are presented with a deal agreed between the sponsors and the government where they have limited bargaining power. The sponsors are naturally more comfortable with more risks being parked at the project company level rather than at their level. In effect this means that the risk pie of the lenders increases since they are most heavily invested in the Project. This presents serious issues from a macro perspective as financial institutions are systemically important institutions with significant public interest. It is all the more so in a country like India where most of the project funds come from PSU banks.

Turnkey contracts, performance guarantees from contractors, are but forms of allocation of risks by way of contracts. Project contracts have some unique features.  These include, among others- (a) pass through of risk in the project chain; (b) take-or-pay obligations (i.e. obligation to pay for a guaranteed contracted quantity tendered by a supplier irrespective of whether the purchaser is able to offtake such quantities or not) in certain offake agreements (e.g. power or fuel); (c) detailed force majeure clauses  which contractually extend the common law doctrine of frustration; and (d) clauses on security and lenders’ right since most project documents regulate creation of security (National highways in India for instance). The contracts also have detailed clauses on quantities, specifications, testing and commissioning, measurements etc. (as applicable). Other important issues to consider for lenders are warranties, indemnities, liquidated damages, limitation of liabilities, single point responsibility (in case of bifurcated EPC contracts), and termination events and payments.

Addressing Residual risk: Acts of God (& Mankind)

Due to a long construction and gestation period of a project, the lenders are exposed to various natural (e.g. fire), political (e.g. expropriation) and other risks (e.g. strike, third party liability). The occurrence of certain events are not predictable even by best of experts. Therefore, adequate insurance of the project is an important consideration and voila, there are insurance consultants who can help in determining the adequacy of insurance. There is also now a new genre of experts known as country risk consultants who can provide a good overview of political and cultural landscape though there is no definitive way of predicting natural/political forces.

The insurances are generally assigned in favour of the lenders who are also named as loss payees so that in the event of total destruction of the project or any of its assets the insurance proceeds are available to the lenders if reinstatement of assets is not feasible.

The Optimal Financing Structure:

As a logical corollary to non/limited- recourse, lenders will want to ensure, among others, that the financing documents provide them the following comforts:

(a) segregation of assets and revenues of the project so that there is no leakage of revenue or compromise on security. It is also important to ensure that the SPV is ‘bankruptcy remote’ and the project proceeds (including equity and loan) are disbursed through a trust and retention account that is charged in favour of lenders. This helps them keep a tab on fund flow and usage (theoretically) and allows them to exercise claw back over disbursed amounts at the earliest possible moment of trouble. Typically, returns on equity are way down in the waterfall after project expenditure and lenders’ dues have been paid.

(b) step- in rights in the event of default of concessionaire which is ensured through direct agreements and/or assignment of rights of the concessionaire under the project contracts by way of security.  Pledge over controlling stake of the SPV also helps.

(c) security over project assets to the extent possible. Most concessions regulate the granting of security over project assets in one form or another.

Of course, no amount of diligence or negotiation can guarantee a perfect outcome and all parties end up bearing some risk or other. At any rate law is not the best substitute for religion- one can only pray that if things go wrong, thanks to a decent allocation of risk, someone else will pay for it.

Piyush Mishra, is a Partner at Luthra & Luthra Law Offices. The views expressed in this article are the personal views of the author and do not represent the views of the firm. It is informational and not an expression of opinion or advice.