What is Project finance?

Project finance is the long term financing of infrastructure and industrial projects based upon the projected cash flows of the project rather than the balance sheets of the project sponsors. Usually, a project financing structure involves a number of equity investors, known as sponsors, as well as a syndicate of banks or other lending institutions that provide loans to the operation. The loans are most commonly non-recourse loans, which are secured by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modeling. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets, and are able to assume control of a project if the project company has difficulties complying with the loan terms.

Generally, a special purpose entity is created for each project, thereby shielding other assets owned by a project sponsor from the detrimental effects of a project failure. As a special purpose entity, the project company has no assets other than the project. Capital contribution commitments by the owners of the project company are sometimes necessary to ensure that the project is financially sound, or to assure the lenders of the sponsors’ commitment. Project finance is often more complicated than alternative financing methods. Traditionally, project financing has been most commonly used in the extractive (mining), transportation, telecommunications and energy industries. More recently, particularly in Europe, project financing principles have been applied to other types of public infrastructure under public–private partnerships (PPP) or, in the UK, Private Finance Initiative (PFI) transactions (e.g., school facilities) as well as sports and entertainment venues.

Risk identification and allocation is a key component of project finance. A project may be subject to a number of technical, environmental, economic and political risks, particularly in developing countries and emerging markets. Financial institutions and project sponsors may conclude that the risks inherent in project development and operation are unacceptable (unfinanceable). To cope with these risks, project sponsors in these industries (such as power plants or railway lines) are generally completed by a number of specialist companies operating in a contractual network with each other that allocates risk in a way that allows financing to take place. "Several long-term contracts such as construction, supply, off-take and concession agreements, along with a variety of joint-ownership structures, are used to align incentives and deter opportunistic behaviour by any party involved in the project." The various patterns of implementation are sometimes referred to as "project delivery methods." The financing of these projects must also be distributed among multiple parties, so as to distribute the risk associated with the project while simultaneously ensuring profits for each party involved.

A riskier or more expensive project may require limited recourse financing secured by a surety from sponsors. A complex project finance structure may incorporate corporate finance, securitization, options (derivatives), insurance provisions or other types of collateral enhancement to mitigate unallocated risk.

Project finance shares many characteristics with maritime finance and aircraft finance; however, the latter two are more specialized fields within the area of asset finance.

Parties to a Project Financing

Contractual Framework

The typical project finance documentation can be reconduct to four main types

• Shareholder/sponsor documents
• Project documents
• Finance documents
• Other project documents

Engineering, Procurement and Construction Contract – (EPC Contract)

The most common project finance construction contract is the EPC Contract. An EPC contract generally provides for the obligation of the contractor to build and deliver the project facilities on a turnkey basis, i.e. at a certain pre-determined fixed price, by a certain date, in accordance with certain specifications, and with certain performance warranties. EPC contract is quite complicated in terms of legal issue therefore the project company the EPC contractor shall have enough experiences and knowledge about the nature of project in order to avoid their faults and minimize the risks during the contract execution. Other alternative forms of construction contract are project management approach and alliance contracting. Basic contents of an EPC contract are:

• • Description of the project
  • Price
  • Payment
  • Completion date
  • Completion guarantee and Liquidated Damages (LDs):
  • Performance guarantee and LDs
  • Cap under LDs

Operation and Maintenance Agreement – (O&M Agreement)

An agreement between the project company and the operator. The project company delegates the operation, maintenance and often performance management of the project to a reputable operator with expertise in the industry under the terms of the Operations and Maintenance (O&M) agreement. The operator could be one of the sponsors of the project company or third party operator. In other cases the project company may carry out by itself the operation and maintenance of the project and may eventually arrange for the technical assistance of an experienced company under a technical assistance agreement. Basic contents of a O&M contracts are:

• • Definition of the service
  • Operator responsibility
  • Provision regarding the services rendered
  • Liquidated damages
  • Fee provisions

Concession Deed

Agreement between the project company and a public-sector entity (the contracting authority). The concession agreement concedes the use of a government asset (such as a plot of land or river crossing) to the Project Company for a specified period of time. A concession deed would be found in most projects which involve Government such as in infrastructure projects. The concession agreement may be signed by a national / regional government, a municipality, or a special purpose entity set up by the state to grant the concession. Examples of concession agreements include contracts for the following:

• • A toll-road or tunnel for which the concession agreement giving a right to collect tolls / fares from public or where payments are made by the contracting authority based on usage by the public.
  • A transportation system (e.g. a railway / metro) for which the public pays fares to a private company)
  • Utility projects where payments are made by a municipality or by end-users.
  • Ports and airports where payments are usually made by airlines or shipping companies.
  • Other public sector projects such as schools, hospitals, government buildings, where payments are made by the contracting authority.

Shareholders Agreement

The agreement between the project sponsors to form a special purpose company (“SPC”) in relation to the project development. This is the most basic of structure held by the sponsors in project finance transaction. This is an agreement between the sponsors and deals with:

• • Injection of share capital
  • Voting requirements
  • Resolution of disputes
  • Dividend policy
  • Management of the SPV
  • Disposal and pre-emption rights

Off-Take Agreement

An agreement between the project company and the offtaker (the party who is buying the product / service the project produces / delivers). In a project financing the revenue is often contracted (rather to the sold on a merchant basis). The off-take agreement governs mechanism of price and volume which make up revenue. The intention of this agreement is to provide the project company with stable and sufficient revenue to pay its project debt obligation, cover the operating costs and provide certain required return to the sponsors. The main off-take agreements are:

• Take-or-pay contract: under this contract the off-taker – on an agreed price basis – is obligated to pay for product on a regular basis whether or not the off-taker actually takes the product.
• Power purchase agreement: commonly used in power projects in emerging markets. The purchasing entity is usually a government entity.
• Take-and-pay contract: the off-taker only pays for the product taken on an agreed price basis.
• Long-term sales contract: the off-taker agrees to take agreed-upon quantities of the product from the project. The price is however paid based on market prices at the time of purchase or an agreed market index, subject to certain floor (minimum) price. Commonly used in mining, oil and gas, and petrochemical projects where the project company wants to ensure that its product can easily be sold in international markets, but off-takers not willing to take the price risk
• Hedging contract: found in the commodity markets such as in an oilfield project.
• Contract for Differences: the project company sells its product into the market and not to the off-taker or hedging counterpart. If however the market price is below an agreed level, the offtaker pays the difference to the project company, and vice versa if it is above an agreed level.
• Throughput contract: a user of the pipeline agrees to use it to carry not less than a certain volume of product and to pay a minimum price for this.

Supply Agreement

An agreement between the project company and the supplier of the required feedstock / fuel. If a project company has an off-take contract, the supply contract is usually structured to match the general terms of the off-take contract such as the length of the contract, force majeure provisions, etc. The volume of input supplies required by the project company is usually linked to the project’s output. Example under a PPA the power purchaser who does not require power can ask the project to shut down the power plant and continue to pay the capacity payment – in such case the project company needs to ensure its obligations to buy fuel can be reduced in parallel. The main supply agreemnts are: The degree of commitment by the supplier can vary.

• Fixed or variable supply: the supplier agrees to provide a fixed quantity of supplies to the project company on an agreed schedule, or a variable

supply between an agreed maximum and minimum. The supply may be under a take-or-pay or take-and-pay.

• Output / reserve dedication: the supplier dedicates the entire output from a specific source, e.g. a coal mine, its own plant. However the supplier may have no obligation to produce any output unless agreed otherwise. The supply can also be under a take-or-pay or take-and-pay
• Interruptible supply: some supplies such as gas are offered on a lower cost interruptible basis – often via a pipeline also supplying other users.
• Tolling contract: the supplier has no commitment to supply at all, and may choose not to do so if the supplies can be used more profitably elsewhere. However the availability charge must be paid to the project company.

Loan Agreement

An agreement between the project company (borrower) and the lenders. Loan agreement governs relationship between the lenders and the borrowers. It determines the basis on which the loan can be drawn and repaid, and contains the usual provisions found in a corporate loan agreement. It also contains the additional clauses to cover specific requirements of the project and project documents. Basic terms of a loan agreement include the following provisions.

• General conditions precedent
• Conditions precedent to each drawdown
• Availability period, during which the borrower is obliged to pay a commitment fee
• Drawdown mechanics
• An interest clause, charged at a margin over base rate
• A repayment clause
• Financial covenants – calculation of key project metrics / ratios and covenants
• Dividend restrictions
• Representations and warranties
• The illegality clause

Intercreditor Agreement

Intercreditor agreement is agreed between the main creditors of the project company. This is the agreement between the main creditors in connection with the project financing. The main creditors often enter into the Intercreditor Agreement to govern the common terms and relationships among the lenders in respect of the borrower’s obligations. Intercreditor agreement will specify provisions including the following.

• Common terms
• Order of drawdown
• Cashflow waterfall
• Limitation on ability of creditors to vary their rights
• Voting rights
• Notification of defaults
• Order of applying the proceeds of debt recovery
• If there is a mezzanine funding component, the terms of subordination and other principles to apply as between the senior debt providers and the mezzanine debt providers.

Tripartite Deed

The financiers will usually require that a direct relationship between itself and the counterparty to that contract be established which is achieved through the use of a tripartite deed (sometimes called a consent deed, direct agreement or side agreement). The tripartite deed sets out the circumstances in which the financiers may “step in” under the project contracts in order to remedy any default. A tripartite deed would normally contain the following provision.

• Acknowledgement of security: confirmation by the contractor or relevant party that it consents to the financier taking security over the relevant

project contracts.

• Notice of default: obligation on the relevant project counterparty to notify the lenders directly of defaults by the project company under the

relevant contract.

• Step-in rights and extended periods: to ensure that the lenders will have sufficient notice /period to enable it to remedy any breach by the borrower.
• Receivership: acknowledgement by the relevant party regarding the appointment of a receiver by the lenders under the relevant contract and that the receiver may continue the borrower’s performance under the contract
• Sale of asset: terms and conditions upon which the lenders may transfer the borrower’s entitlements under the relevant contract.

Tripartite deed can give rise to difficult issues for negotiation but is a critical document in project financing.

Common Terms Agreement

Terms Sheet

Agreement between the borrower and the lender for the cost, provision and repayment of debt. The term sheet outlines the key terms and conditions of the financing. The term sheet provides the basis for the lead arrangers to complete the credit approval to underwrite the debt, usually by signing the agreed term sheet. Generally the final term sheet is attached to the mandate letter and is used by the lead arrangers to syndicate the debt. The commitment by the lenders is usually subject to further detailed due diligence and negotiation of project agreements and finance documents including the security documents. The next phase in the financing is the negotiation of finance documents and the term sheet will eventually be replaced by the definitive finance documents when the project reaches financial close.