Project Finance Structuring Debt Introduction to Some Issues
Project Finance – Structuring Debt
Introduction to Some Issues Covered in the Course • • • • Using a case study evaluate: (1) bullet payments, balloon payments and mini-perms; (2) partial exposure to floating rates, (3) Currency Issues and local bank debt, (4) terminal value assumptions; (5) aggressive development fees and development costs; (6) partial sale of equity investment to other investors, (7) debt sculpting on assumed inflation; (8) letter of credit in lieu of DSRA; (9) assumed re-financing to avoid step-up margins; (10) use of staged investments to partially finance equity investment; (11) earning profit on maintenance contracts; (12) equity bridge loans at variable interest rates are compared to pro-rate financing. 2
Five Parts of Debt Structure with Nuanced Issues • Part 1: Debt Size • Part 2: Debt Funding • Part 3: Debt Repayment • Part 4: Interest and Fees • Part 5: Credit Enhancements • In addition, the re-financing strategies must be evaluated
Introduction and Step Backward
Success and Failures in Project Finance • What is project finance and why it is applied. • The idea is to take a step backwards and consider what project finance is and how it is designed • Understand how cash flow analysis and ring fencing can allow risk to be isolated and defined and projects to be constructed. • A few case studies of famous project finance successes and failures will be used to demonstrate fundamental concepts of: a risk matrix, general risk allocation, proven technology, strong sponsorship, back-to-back contract design and, the importance of economic viability of projects. 5
Idea of Risk Allocation Matrix and Use of DSCR, PLCR and LLCR to Measure Break-Even • Risk allocation matrices will be used to demonstrate how the DSCR and LLCR can be used to determine acceptable unmitigated risks: • The formula: break-even cash flow reduction = (DSCR-1)/DSCR. • Also break-even cash flow over life of loan = (LLCR-1)/LLCR • Different project finance structures that involve: availability payments versus output-based revenues; commodity price (merchant) risk; traffic or volume risk (pipelines), and resource risk (wind, solar and run of river hydro) will be derived. • For each of the project finance types, an illustrative risk allocation matrix and project diagram will be developed. 6
Risks of Commodity Prices versus Traffic 7
General Idea of Optimising Project Finance Debt • The general idea the project finance debt falls somewhere around BBB- and how credit spreads are driven by the probability that the DSCR will fall below 1. 0 will also be addressed. 8
Target Rating and Credit Spreads 9
Project Finance Loan Agreements versus Corporate Loan Agreements • Project finance debt differs from corporate debt in a number of ways: • Corporate Debt Re-finance from strength of corporate financial position Evaluate credit quality from profit potential and interest coverage Bullet maturities • Arranged to be self-liquidating Payout through cash flows No planned re-financing Loan Tenor 8 to 15 years In some cases bullet maturities Cash sweep structures Interest Capitalized During Construction
Why Is Maximum Debt Capacity An Objective • Reduce Income Taxes • Bankruptcy Cost (Enron Example) • Pecking Order Theory (P/E Ratio) • Information and Expectations (Enron) • Relation to Project Finance "Many finance specialists remain unconvinced that the high-leverage route to corporate tax savings is either technically unfeasible or prohibitively expensive. "
Creating or Destroying Value through Contract Provisions Including Liquidated Damages, Penalty Provisions and Efficiency Incentives 12
Basic Diagram of Project Financing for Discussion
Parties in Project Finance: Risk and Return • Different parties in project finance including EPC contractors, O&M contractors, insurance companies, financial institutions and sponsors are paid for taking risk. • The general idea that if parties are paid too much or too little for accepting risk, the off-taker will pay too much for the service and/or sponsors will not receive an adequate return will be demonstrated. • Off-taker economics as well as the technical aspects of the facility must be fully understood to effectively negotiate project finance terms. • The theory and practice of computing delay liquidated damages, availability penalties, target heat rates and other items through the central idea of minimizing the sum of off-taker costs and IPP costs. 14
Alternative Way to Look at PF Structure – Key is Risk versus Return 15
Difference between Structuring and Risk Analysis • Bank perspective in project finance for credit analysis. • The difference between risk analysis (portfolio management) and risk structuring. • The theory and practice of credit spreads and the manner in which banks measure returns (RAROC). • Downside scenarios for risk analysis and credit reports will be introduced along with covenants, cash flow sweeps and reserve accounts. • Understanding PLCR, LLCR and DSCR in terms of percent reduction in cash flow before which loans cannot be repaid. 16
Structuring and PPA Bidding • Importance of project finance loan elements for different electricity technologies in different regions of the world. • Elements of a term sheet in the context of both the equity IRR and the bid price. • The theory of using real and nominal LCOE to evaluate the economics of a project: the LCOE formula --NPV(revenues)/NPV(generation) from an RFP • The theory of why LCOE applies NPV(generation) will be summarized. 17
Effects of Debt Structure on the Bid Price • The effects of: debt sizing, debt tenor, debt repayment type, and debt pricing Context of alternative technologies. Items of a term sheet such as the minimum DSCR, maximum debt to capital, step-up credit spreads, debt sculpting, debt funding, DSRA’s, MRA’s and cash sweeps will be used to evaluate financial impacts of various financing and timing issues on the required bid price for a renewable project. 18
Illustration of Effects of Debt Structuring on Capital Intensive and Non-Capital Intensive Projects 19
Alternative Debt Provisions, Bidding and Carrying Charge Rate 20
Effects of Financing on Bid Price – Capital Intensive 21
Effects of Debt Provisions on Fuel Intensive Diesel Technology 22
Permanent Project Finance Debt • Non-recourse financing Payback through cash flow Secured by project assets, contracts, not corporate assets • Long-term Commitment Typically 10 -15 years or more Longest payback of any other investor • Capital at Risk or Debt Capital Typically 50%-90% of project cost • Capped Return on Capital Return fixed at the margin over an index rate plus any maintenance fee. No upside; substantial downside • Successful projects frequently refinanced • Limited Control over Collateral Assets in the hands of the owner/manager Contractual arrangements critical
Debt Sizing Theory 24
Market Data on Project Finance • A basic principal of finance is to use market data in assessing value and risk. Examples include: Beta calculations from market data P/E ratios Implied volatility • Market data in project finance can be assessed using DSCR and the Debt/Capital Ratio • Project Finance Lenders are Cash Flow Lenders Measures revolve around DSCR rather than balance sheet ratios Equity to capital is derived
Example of Project Finance as Risk Measurement Survey of Electric Plants
Debt Structuring - General • The structure of debt (the draw down and term to maturity) can have more important impacts on the value of a project than the size of the debt and certainly more than the interest rate on the debt. • Average life is the general way in project finance to measure the length of the debt although duration is a is better way in theory to measure the effective term of the debt. • The debt structure should depend on the economic characteristics of a project such as the revenue and expense contracts.
Debt Sizing • Detailed analysis of the term sheet and loan agreements begins with debt sizing. • Difference in sizing debt on the basis of: the debt-to-capital ratio the DSCR • Involves the notion of whether forward looking cash flow can be relied upon or alternatively whether the amount of “skin in the game” measured by accounting costs is more reliable. • Notion of negotiated base case
Illustration of DSCR and Debt to Capital Constraint 29
Which Constraint is in Place • Items have an effect on whether the debt to capital constraint or the debt to capital constraint applies: • Need to Understand that NPV of Debt Service is Loan Value • High Project IRR More Likely Debt to Constraint; • Long Tenor More Likely Debt to Capital Constraint; • Sculpting More Likely Debt to Capital Constraint; • Low Interest Rate Morel Likely Debt to Capital Constraint. • Low Project IRR More Likely DSCR Constraint; • Short Tenor More Likely DSCR Constraint; • Level Payment More Likely DSCR Constraint; • High Interest Rate More Likely DSCR Constraint 30
Evaluation with Geometry and NPV Formula 31
Effects of Non-Cash Increases in Project Cost • When does asset increase matter and when does it not • Importance of paying cash or not paying cash • Examples of non-cash increases in project cost Development fees Owner costs Some development costs Contingencies • Items that can increase the cost of a project affect returns primarily when the debt to capital constraint applies and have less or no importance when the DSCR drives debt capacity. 32
Debt Sizing: Including Items in Project Cost that do not Involve Cash Outflow • Accounting allocations to the project can have large effects on the equity IRR through debt sizing derived from the debt to capital ratio. • If the DSCR drives debt sizing, the accounting allocations, fee allocations and other adjustments have no effect on the equity IRR. • Accounting allocations and non-cash contributions can change the structure of returns when multiple investors are involved in the project. If one party is allowed to include non-cash allocations the return is much higher. • Depending on the manner in which project costs are accounted for, multiple investors pay debt service and receive dividends, but the investor who did not invest as much cash effectively borrows less. 33
Illustration of Non-Cash Accounting 34
Debt Sizing: Profits from EPC Contractors or O&M Contractor when Investor is also Contractor • The final debt sizing issue involves how the contract structure can affect the size of debt. • If the EPC profits do not affect the debt size and there is only one investor, placing profits at the EPC contractor level or the investor level does not influence overall returns. • Depending on whether the debt to capital constraint applies or there are multiple investors, EPC profits can increase debt size. • Cash Flow Waterfall and issues associated with including profits in O&M contract rather than in SPV cash flow. Profits on the O&M contract versus including O&M costs at the SPV level can affect the distribution of dividends as the O&M fee is paid before debt service. 35
Development Fee Theory • Account for the probability of success • Use a multiple of cost • Can give a percent of the equity income • Better to put development fees into cost with debt to capital constraint 36
Debt Funding Theory 37
Draw Request and Funding - Introduction • When a borrower uses cash during construction, the funding request includes: Notice of Borrowing Payment and draw details Construction certificate Schedule of construction costs and cumulative amounts Insurance certificates Financial reports and other documents
Project Finance Loans – Drawdown during Construction (Reference) • Prior to satisfying the options conditions, it is the usual practice for the financiers to: fund the project, even though operating cash flows have not yet commenced; be able to rely on other contractual or financial resources (recourse to sponsors) to repay that funding [if the project fails to be completed]; and to roll up the capitalized interest-during-construction (“IDC”) into the financing. • During the construction phase, equity and debt funds are used to finance the project construction with funds generated from the project cash flow covering the operation period. • Lenders will not normally demand repayment of capital on the loans until the construction phase has been completed and the project is generating cash.
Nuanced Issues with Pre-Commercial Cash Flow • The effects of accounting for pre-commercial cash flows as either equity or reduction in project cost. • In terms of accounting, pre-commercial cash flow is income and should be part of equity. • Alternatively, one could call the pre-commercial cash flow a reduction in the cost of the asset. • Related issues include the issue of government grants and early production. • With an extreme case the labelling the pre-commercial cash flow as equity results in improved returns but from banker’s perspective is not “skin in the game. ”
Illustration of Accounting for Pre-commercial Cash Flow 41
Nuanced Issues with Equity Bridge Loans • Debt draw discussion in term sheet. • In pure project finance, equity should be contributed before debt during the construction period to assure that equity does not walk away from the project during construction. • Pro-rata debt and equity contributions or equity bridge loans require some kind of sponsor support and can in theory distort the equity cash flow. • An equity bridge loan requires parent support, the cost of which is not included in the equity IRR. The effects of IDC on equity bridge loan on project taxes and the effects of equity bridge loans in different interest rate environments and on different types of projects will be discussed.
Issues with EBL • If there are multiple sponsors, one of which provides a guarantee, how should the benefits of the EBL be allocated • The IDC increases the cost of the project and increases other debt capacity if there is a debt capacity constraint 43
Nuanced Issues with IDC on Shareholder Loans • Shareholder loans seem to have no effect on senior debt. All of the covenants and waterfall issues occur after the senior debt is paid. • If senior debt limits the dividends to shareholders, it will also limit the shareholder loan payments • Equity IRR should consider the shareholder loan and any other equity as combined cash flows • The shareholder loan may affect taxes which will increase the cash flow (and cause a circular reference problem).
Standby Loans for Construction Cost Over-run and the Issue of Cost Under-run • With a cost over-run facility, the commitment fee can increase the cost of the project. • If the debt is subordinated to senior debt the over-run facility is similar to shareholder loans. • If there is a cost under-run and the debt has been committed with and EBL or pro-rata, a question arises as to whether the debt should be reduced or whether the proceeds should accrue to shareholders.
Evaluation of Delays in Construction • In evaluating delays in construction, it is generally better not to change the S-curve but rather to assume there is dead time. • After accounting for the reductions in PPA revenues, the liquidated damage can accrue to reduction of debt to maintain the DSCR.
Complex IDC Calculations with Portfolios • The IDC calculations can be complex if some parts of the project are completed while others are continuing to be constructed. • This is a typical problem in real estate and solar roof-top • To resolve the problem: Keep track of plant in service and construction work in progress in separate accounts Allocate interest from the ratio of CWIP to (CWIP + Plant in Service) IDC itself will also be in CWIP and Plant in Service 47
Up-Front Fees • If there are up-front fees rather than higher credit spreads, the fees must be funded during construction. • Assume the Debt IRR or the all-in interest rate is the same. • If the debt fees are paid and the debt is determined by the debt to capital ratio, the amount of equity increases and the fees reduce the equity IRR to the project. • If the debt fees are paid and the debt is set in advance, all of the funding comes from increased equity and the pain is even worse. • If the debt fees are capitalized, the debt must be paid later on. • Similar issues arise with the Debt Service Reserve Account 48
Draw-downs and Management of Disbursement of Funds • The strict control of fund disbursements can provide a mechanism to maintain leverage over contractors and thus help to minimize construction risk in the better rated projects. • Loan documents typically give lenders the right to closely monitor construction progress and release funds only for work that the lender's engineering and construction expert has approved as being complete. • Third-party trustees, acting in a fiduciary capacity, will generally manage disbursement of funds to protect debtholders' interest in the project. (Multiple Investors)
Draw-downs and Retention of Funds • Retention of all debt-financed funds in a segregated account by a trustee experienced in management of power project construction, preferably an experienced bank or other lender for these projects; Payment structures that retain a small portion of each amount payable, about 5%, until the project reaches commercial completion; Disbursements made only for work certified as complete by an independent project engineer retained by the construction trustee solely for approving disbursements; Right to suspend or halt disbursements when the trustee concludes that construction progress is materially at risk (reversals or revocations of necessary regulatory approvals or changes in law or cost outside the levels anticipated by the budget and schedule) • Authority to approve all change orders or authority to limit change orders to a pre-determined amount (example MCV)
Debt Repayment Theory 51
Debt Repayment Structure and Risk • A project's debt amortization schedule often influences the rating, more so than the degree of leverage. • Front-loaded principal amortization schedules that capitalize on the more predictable project cash flows in the near term may be less risky that those with whose delayed amortizations seek to take advantage of long-term inflation effects. • Flexible re-payment structures can be developed where the project has irregular cash flows.
Statistics on Project Finance Debt Tenor • Commercial Bank Market Up to 15 years • Private Placement Market Up to 20 years • Rule 144 A Up to 30 Years Requires investment grade rating • Project Finance average maturity 8. 6 years • PF loans more likely to be fixed rate loans (14% of loans are fixed rate loans)
Alternative Repayment Patterns • Given a DSCR constraint and the formula that the present value of debt service equals the amount of debt at COD, use geometry to maximize debt. • The general idea of maintaining a constant DSCR over the life of a project in sculpting when the risks can increase over time. • Contrasts to the requirement that banks must increase capital with longer terms and that an implicit assumption of constant credit spreads is increasing risk over time. • Sculpting versus alternative methods in the context of different revenue patterns (indexation, flat fee-in tariffs, tax depreciation, etc. ) 54
Multiple Capacity Charges and Optimisation of Debt Repayment • For some countries and financial institutions, DSCR constraints and debt repayment patterns are given. • In these cases, synthetic sculpting can be developed with alternative tariff structures that have a step down element (Malaysia, Pakistan). • In other cases a flexible maintenance contract can be used to create synthetic sculpting (Brazil). • Incentive issues associated with step-down tariffs where sponsors can have an incentive to walk away from the project and techniques to measure the cost and benefits of alternative maintenance structures will be addressed as part of the session. 55
Example of Synthetic Sculpting with O&M Payments 56
Mini-perms and Balloon Payments • Move from the repayment structure to the repayment tenure. • Matching the tenor of repayment to the life of the project and even considering terminal value in the repayment in the context of both achieving a higher DSCR and an improved equity IRR. • Problems with multi-lateral agencies that allow long-term maturity can be contrasted with commercial banks and bond financing that may be more flexible and sometimes could have lower costs. • Specifically, the effects of hard and soft mini-perms on the profitability of a project along with the difficult problem of required re-financing assumptions. • How the DSRA could be used to re-finance debt at end of loan life and how potential terminal value can be used to justify partial bullet repayment at end of loan. 57
Credit Analysis of Mini-Perm • To evaluate the effects of being unable to re-finance a cash sweep assumption can be used. • You can then see how low a variable can go before the loan will not be re-paid. 58
Complex Sculpting Issues • Complex sculpting issues can involve: Letter of credit fees Balloon payments as a percent of the loan amount Interest income on sweeps for balloon payment Taxes and net operating losses DSRA as final debt payment • To resolve these issues use equations and some fancy excel. Do not try to use brute force. 59
Sculpting Equations • Basic Formulas • One of the main ideas about the repayment process in project finance is that the modelling is much more effective when you combine formulas with other excel techniques. If you try and solve these things with a brute force method that uses a copy and paste method or goal seek things will get very messy. Formulas used for repayment and debt sizing are listed below: The fundamental two sculpting formulas are: • (1) Target Debt Service Period = CFADS/DSCR • (2) Debt Amount at COD = PV(Interest Rate, Target Debt Service) • Non-Constant Interest Rates • However this is by no means the only formula you should use when working on repayment. In cases when the interest rate changes, a simple present value formula cannot be used. Instead, an interest rate index can be created that accounts for prior interest rate changes as follows: • (3) Interest Rate Indext = Interest Rate Indext-1 x (1+Interest Ratet) • (4) Debt Amount at COD = ∑ CFADSt/Interest Rate Indext • Use of LLCR with Target Debt to Capital • One of the first issues is how to compute sculpted debt repayments when debt is sized with the debt to capital ratio and the DSCR is not given. When the Debt is Sized by Debt to Capital the LLCR can be used to size the debt. Formulas in this case include: • (5) Target Debt Service = CF/LLCR • (6) LLCR = NPV(Interest Rate, CFADS)/Max Debt from Debt to Capital • (7) DSCR Applied = MAX(Target DSCR, LLCR with Max Debt) 60
Sculpting Equations Continued • Multiple Debt Issues • Another issue arises when there are multiple debt issues and one of the debt issues (defined as Last) is used for sculpting. In this case the basic formula can be adjusted and the process if straightforward. You can start with the DSCR formula and derived the debt service for the last formula. • (8) DSCR = CF/(Other DS + Last DS) • (9) Other DS + Last DS = CF/DSCR • (10) Last DS = CF/DSCR - Other DS • (11) DS for Last Facility = CF/DSCR - Other DS • Discount Rates and Model Timing • When a monthly model is used but the debt repayment is semi-annual, the discounting can become more complicated. In general, when you are working with interest rates you simply divide by the number of months in a period. However when you are discounting target debt service to arrive at the amount of debt, you need to use different discount rates. The adjusted equations for discounting the target debt service is shown below. • (12) Annual: Rate for Discounting in Semi-Annual Model = (1+Annual Rate/2)^(1/6)-1 • (13) Monthly: Rate for Discounting = (1+Monthly/12)^(1/12)-1 61
Sculpting Equations Continued • Adjusting Sculpting Equations for Debt Fees • Debt fees such as the fee on a letter of credit is part of debt service. To include the fees in the sculpting equations, you should subtract the fees when you compute the net present value of debt, as the fees reduce the amount of debt service that can be supported by cash flow. To make the sculpting work you should also make the repayment lower by the fees as shown below: • (14) Repayment = CFADS/DSCR - Interest - Fees • (15) Debt = NPV(Interest Rate, Debt Service-fees) = NPV(rate, Debt Service) - NPV(rate, Fees) • Note Debt Service in the above equation means debt service without fees and debt is reduced by PV of fees • Adjusting LLCR for Debt Fees • The sculpting analyses include calculation of the LLCR to evaluate whether the debt to capital constraint is driving the constraint. In this case the PV of CFADS is not the correct numerator for the analysis. Instead, the PV of the LC fees should be added to the denominator of the LLCR as follows: • (16) LLCR = PV(CFADS)/(Debt + PV of LC Fees), where • (17) Debt = Project Cost x Debt to Capital • Sculpting and Changes in the DSRA balance including Final Repayment • After working through letters of credit for the DSRA, taxes, interest income and other factors that cause difficult circular references, the final subject addressed is using the DSRA to repay debt. A similar result occurs when changes in the DSRA are included in CFADS. Incorporating these changes in a financial model without massive circularity disruptions can be tricky, but it can be solved by separately computing the present value of changes in the DSRA. Changes in the DSRA can be modelled using the following equations: • (18) Debt Adjustment = PV(Interest Rate, Change in DSRA/DSCR) • (19) Repayment = Repayment from Normal Sculpting + Change in DSRA/DSCR 62
Mini-Perm and Re-financing Assumption 63
Borrowing Base and Resource Transactions • Computation of borrowing base • Debt repayment and borrowing base – must pay-off debt that is below the maximum borrowing base • Rational for borrowing base Rate of production extraction • Problems with borrowing base Declining prices and acceleration of loan re-payments Increasing prices and reduction of loan re-payments • Modelling of borrowing base
Interest Rate and Fee Theory 65
Discussion of Interest and Fees • Consistent with the discussion of debt as having five components, interest and fees between the time debt draws occur and debt is fully repaid is the next topic. • The first issue discussed is the question of credit step-up credit spreads – why they are present in many transactions and what they mean in terms of re-financing. • The issue of whether step-up credit spreads should be included in base case analyses and how risks of changed circumstances after refinancing is considered. • A second topic discussed in the context of interest rates is the subject of hedging and interest rate swaps with use of the ISDA master agreement. • Alternative structures that incorporate some interest rate risk with caps and floors and the types of transactions that have some natural hedging against varying interest rates will also be addressed. 66
Currency Risk • Continuing discussion of interest rates in project finance addresses the subject of currency risk and cash flows. • The general theory of purchasing power parity and the idea that currencies can deviate from inflation parity introduces the issue. • In addition, the notion that nominal interest rates with seemingly high credit spreads can be lower in real terms than interest rates from multilateral agencies is demonstrated. • The general idea of computing an all-in interest rate that includes upfront and commitment fees is considered. • As with other topics, the assessment of fees versus credit spreads will consider re-financing and debt to capital versus the DSCR constraint. 67
Illustration of Evaluating Cash Flows in Different Currencies 68
Currency Risk and Purchasing Power Parity • Theory of PPP is that real prices do not change if the prices are indexed. • The problem is that PPP does not remain in place and political risk arises. 69
Use of Floating Rate Debt • Project Financings are generally funded on a floating-rate basis due to the necessity for: Flexibility in the timing of draw downs Flexibility in early repayment. • Floating rates computed as the LIBOR average for the prior six months. • 86% of Project Finance Loans are floating rate. • But the floating rate loans can be fixed with interest rate swaps. • Because of flexibility in take downs and repayments, there would be significant interest rate risk with fixed rate transactions. Extension risk Contraction risk
Floating versus Fixed Rate Debt • Premium for fixing rates is very expensive.
7. 00 6. 00 5. 00 10 YR Swap Rate Total Rate assuming BBB Spread 10 YR Swap Rate 12. 00 10 YR Swap Rate 10. 00 1 -Dec-16 1 -Aug-16 1 -Dec-15 1 -Apr-16 1 -Aug-15 1 -Dec-14 1 -Apr-15 1 -Aug-14 1 -Dec-13 1 -Apr-14 1 -Aug-13 1 -Dec-12 1 -Apr-13 1 -Aug-12 1 -Dec-11 1 -Apr-12 1 -Aug-11 1 -Dec-10 1 -Apr-11 1 -Aug-10 1 -Dec-09 1 -Apr-10 1 -Aug-09 1 -Dec-08 1 -Apr-09 1 -Aug-08 1 -Dec-07 1 -Apr-08 1 -Aug-07 1 -Dec-06 1 -Apr-07 1 -Aug-06 1 -Dec-05 1 -Apr-06 1 -Aug-05 1 -Dec-04 1 -Apr-05 1 -Aug-04 1 -Apr-04 1 -Aug-03 1 -Dec-02 1 -Apr-03 1 -Apr-02 1 -Aug-02 1 -Dec-01 1 -Aug-01 0. 00 Merrill Lynch BBB Adj Spread 11. 00 9. 00 8. 00 4. 00 3. 00 2. 00 1. 00 72
Increasing Credit Spreads and Re-financing • Risk of a project generally decreases • Increasing credit spreads encourage re-financing • Should be with no pre-payment penalty • With pre-payment penalty, credit spreads may decrease • Big Question Will re-finance in base case and up-side case Increasing credit spreads only apply to downside case So why include increasing credit spreads in base case 73
Credit Spreads, PD, LGD and RORAC • Credit spreads have to cover loss given and default as well as loss given default. They also should cover the capital that a bank puts up and the administrative expenses. 74
IRR and Changing Risk 75
Pre-payments Maturity Extensions • Pre-payments If fixed interest rates are in the transaction and rates are high, the borrower wants pre-payment option and the lender does not. There can be a set of defined pre-payment penalties. Pre-payments can come from a “divorce” clause were the borrower pays back the loan instead of taking some action. • Maturity Extensions If cannot meet the required maturity payments from cash flow, allow the maturity payments to be extended Issues are the remaining life of the project and if cash flow sweeps are included
Contraction Risk (Declining Interest Rates) • Borrower Perspective When interest rates decrease, if the loan is at a fixed rate, the borrower will want to re-finance. Prepayments accelerate (people re-finance). • Lender Perspective From the lenders perspective, the high interest rates are lost and the lender must issue loans at lower rates. Form the borrowers perspective, the proceeds will be re-invested at a lower rate and that bonds will be more expensive. • The results are like selling a call option for debt holders -- the upside is limited but the downside is not
Analogy to Project Debt – Contraction and Extension • Pre-pay when times are good, credit spreads are low and general interest rates may even be low. For example, electricity prices and oil prices were higher during late 1990’s. The pre-payment meant proceeds would have to be re-invested at low rates (through a sinking fund or through re-payment). Yield spreads are also low. • Extend payments when times are bad, credit spreads are high. For example, electricity prices and oil prices are relatively low due to economic conditions. The extension means debt has to remain in projects when financial institutions don’t want to lend. If lending occurs, yield spreads would be higher, so opportunity cost is more.
Interest Rate Swaps (Reference) • Notional Amount • Fixed rate in swap Project company pays variable rate to bank If variable rate is below the fixed rate, Pay (Fixed Rate – Variable Rate) x Notional Amount If variable rate is above the fixed rate Receive (Variable Rate – Fixed Rate) x Notional Amount • Value of swap is zero at inception • Swap has positive or negative value after the start date
Interest Expense and Financing Costs of Swap Settlements • "Financing Costs" defined in the DSCR are found on the income statement after the completion date and should include: amounts in the nature of interest paid or payable by the Borrower (including default interest); all commitment, agency and other fees, commissions, costs and expenses and other payments not in the nature of principal paid or payable; and [net payments paid or payable by the Borrower under the Hedging Documents (expressed as a positive number) but excluding any termination payments due under the Hedging Documents]. • Note that financing costs do not include amortization of fees or debt issue costs nor the costs of unwinding a swap.
Costs and Income from Swap Settlements (Reference) • Bank financing in project finance generally uses floating interest rates rather than fixed rates (e. g. LIBOR plus 150 basis points). • Because floating rate financing can create risks particularly in projects with tight debt service cover such as PFI, projects often use interest rate swaps to convert floating rates to fixed rates. • Swaps that convert floating rate to fixed rate debt involve: Establishing a notional amount that corresponds to the face amount of the loan; Paying interest on the floating rate loans; Receiving settlements on the swap if the floating interest rate rises so that the effective interest rate is fixed; Paying settlements on the swap if the floating interest rate declines so that the effective interest rate is fixed. The net value of the swap is generally zero when the swap is established.
Re-financing and Unwinding Swaps (Reference) • If a swap is terminated before its contract date, the swap will generally have a positive or negative value. For example if floating rates have declined, the counterparty to the swap is better off by receiving fixed payments and the value of the swap is negative to the project. The project must make payments to get out of the swap which is analogous to a maturity payment. Every time interest rates decline, one could in theory extinguish the swap, make cash payments and enter into a new swap. The effect of these cash payments on the DSCR depends on where the proceeds come from and how the cash payments affect the cash flow waterfall. • Similarly, if fixed rate debt is re-financed, pre-payment penalties must generally be paid. • Payments to terminate a swap or pre-payment penalties are cash outflows for the project but should be charged as interest expense over the remaining life of the loans.
Credit Enhancements
Credit Enhancements - Introduction • The fifth and final aspect of project finance debt are the various added provisions that are included in loan agreements to provide additional protection to lenders. • These provisions that can include DSRA’s, MRA’s, Cash sweeps and dividend lock-up covenants are addressed after the other project finance terms. • It is emphasised that while the credit enhancements can be the subject of intense negotiation, they cannot change a failed project into a good project from a lender perspective. • Instead, they can only either limit dividends or reduce the amount of effective net debt associated with a project. 84
Cash Sweeps, Reserve Accounts and Covenants • Cash sweeps, reserve accounts and covenants can have negative effects on the equity IRR of a project. • Methods to consider the risk benefits to the bank versus the costs to sponsors are addressed. • Mechanics of cash sweep with different triggers and theory of what kinds of transactions would be relevant for cash sweep (e. g. hydro but not solar because of volatility) are addressed. • The theory of what kind of triggers make sense (Debt/EBITDA but not DSCR and operational triggers). • Contrast between cash sweeps and cash trap covenants. As with other issues, the effects of cash sweeps on equity returns should be addressed with and without re-financing assumptions. 85
Importance of Re-financing Analysis with Cash Sweep • Cash Sweeps seem to dramatically reduce the cash flow • But after the sweep, the project can be re-financed • You can even lock-in interest rates 86
Financial Enhancements • Cash flow capture covenants Cause debt to be re-paid early or debt service reserves to be built-up if debt service coverage ratios are low. • Cash flow sweep covenants Cause debt to be re-paid early or debt service reserves to be built-up if cash flow is high. • Debt service reserves Assure debt service can be paid if market prices or other risks cause cash flow to be low for an extended period of time. • Subordinated debt and mezzanine finance Protects the cash flow coverage of senior debt instruments. • Contingent equity or sponsor guarantees Provide for additional equity funding in downside cases.
Cash Flow Waterfall • A cash flow waterfall defines the priority of uses of cash flow that is received for a project. • The import of a cash flow waterfall is what happens if there is not enough cash flow to pay all expenses, debt service and debt service reserve requirements. • If sufficient cash is available to pay dividends, the cash flow priority defines how and when a distribution can be made.
DSCR, LLCR and PLCR • In understanding credit enhancements, the difference between analysis with the DSCR, LLCR and PLCR will be discussed. • This will deal with computational problems of LLCR in the context of changing interest rates and multiple debt facilities. • The economics of DSRA’s and MRA’s will be addressed from theoretical perspective of net debt. • Economics of Maintenance Reserve Accounts for inverters and other equipment. • Cost of maintaining maintenance reserve account for items such as inverter replacement relative to including costs in maintenance contracts. • Effects of major maintenance on tax expense and DSCR.
Example of Cash Flow Priority • All revenues accrued on and after the Commercial Operation Date will be deposited with the Trustee into the Operating Revenue Account. The Trustee will withdraw amounts on a monthly basis and make deposits in the following priority, but only to the extent funds are then available in the Operating Revenue Account: (1) the operations and maintenance expenses for the Project for such month, subject to certain limitations; (2) the Tax Equalization Account (3) (A) an amount that will not be less than the amount of interest on the Bonds to become due on such Interest Payment Date, and (B) an amount that will not be less than the amount of principal or sinking fund payment to become due on such principal or sinking fund payment date; (4) an amount, if any, sufficient to cause the amount on deposit in the Debt Service Reserve Account to equal the Debt Service Reserve Account Requirement; (5) an amount, if any, sufficient to pay amounts due pursuant to the Working Capital Facility; (6) an amount, if any, sufficient to pay the operating and maintenance expenses related to any transfer station which is acquired by the Partnership. (7) an amount sufficient to repay amounts advanced pursuant to the Waste Supply Support Facility or the Waste Supply Support Facility Guaranty; and (8) an amount equal to the balance of the Operating Revenue Account shall be deposited into the Surplus Account and will be transferred monthly to the Operating Revenue Account.
Risk Reduction from Cash Flow Sweeps • The model should assess the effectiveness of covenants that sweep cash flow to moderate risk. If the project experiences a high level of cash flow, the covenant restricts the ability to pay dividends because in the next year cash flow may be low. • This type of covenant only really makes sense in situations where the cash flow is volatile and/or there are potential downward trends in prices. • As with cash flow traps, to assess the effectiveness of the covenant, cases that incorporate realistic price volatility and potential price trends must be run in the model. • It may be the case the covenant is only valuable in extreme circumstances. In this case, alternative structural enhancements should be evaluated to assess risk.
Example of Risk and Return Analysis for Cash Flow Sweep
Covenants and Structural Enhancements Cannot Make a Bad Project into a Good Project • The most important aspect of the underwriting process is determining whether the plant is economically sound. This means that the cost structure and the technology of the plant must be viable. • However, once a plant is determined to be economically viable, the credit quality of a transaction can be enhanced by various structural features – covenants, debt service reserves, liquidation damages, subordinated debt, contingent equity etc. The potential for structural enhancements to improve the credit quality of a transaction is described in the statement by Standard and Poor’s below: Project structure does not mitigate risk that a marginally economic project presents to lenders; structure in and of itself cannot elevate the debt rating of a fundamentally weak project to investment-grade levels. On the other hand, more creditworthy projects will feature covenants designed to identify changing market conditions and trigger cash trapping features to project lenders during occasional stress periods.
Example of Cash Flow Priority and Distributions • Amounts in the Surplus Account will be annually transferred on the first business day of January to the Distribution Account and distributed to the Partnership within 90 days thereafter if: the Debt Service Coverage Ratio for the Project is equal to or exceeds 1. 20 to 1. 00 for the calendar year preceding the distribution date and is projected to be equal to or exceed 1. 20 to 1. 00 for the current calendar year; the Partnership does not have knowledge, or could not reasonably be expected to have knowledge, of the occurrence and continuance of an event of default under the Lease Agreement or an event which, with the passage of time, would constitute an event of default under the Lease Agreement, which event of default or event, in any case, would cause a Material Adverse Effect; Full Performance of the Facility under the Construction Contract has been achieved; and Working Capital Facility and the Waste Supply Support Facility have been fully restored. • If not so distributed, amounts in the Distribution Account shall revert to the Surplus Account.
Debt Service Reserve Language • On the Closing Date, an amount equal to 10% of the original principal amount of the Bonds will be deposited in the Debt Service Reserve Account of the Debt Service Reserve Fund from the proceeds of the Bonds. • The amounts in the Debt Service Reserve Account will be used only for the purpose of making payments into the related Interest Subaccounts, the Principal Subaccounts and Sinking Fund Installment Subaccounts for the Bonds • Debt Service Reserve Accounts may be established in the Debt Service Reserve Fund in connection with the issuance of Additional Bonds. • In lieu of the required deposits of Revenues into a Debt Service Reserve Account, or in lieu of funds already on deposit in a Debt Service Reserve Account, the Partnership may cause to be deposited into a Debt Service Reserve Account one or more Debt Service Reserve Account Facilities in an amount equal to the difference between the applicable Debt Service Reserve Account Requirement and the sums then on deposit in such Debt Service Reserve Account. • If a disbursement is made under a Debt Service Reserve Account Facility, the Trustee shall apply amounts transferred from the Operating Revenue Account to the applicable Debt Service Reserve Account to either cause the reinstatement of the maximum limits of such Debt Service Reserve Account Facility. The Trustee will apply moneys on deposit in a Debt Service Reserve Account prior to any drawing on any Debt Service Reserve Account Facility. • In the event that any amount shall be withdrawn from a Debt Service Reserve Account for payments into an Interest Subaccount, Principal Subaccount or Sinking Fund Installment Subaccount or there exists a deficiency in a Debt Service Reserve Account which is to be reinstated, such withdrawals shall be subsequently restored from Revenues available on a pro rata basis (based on the respective aggregate principal amounts of each series of Bonds Outstanding secured by a Debt Service Reserve Account) after all required payments have been made into such Interest Subaccount, Principal Subaccount and Sinking Fund Installment Subaccount, unless restored by the reinstatement of amounts available under the Debt Service Reserve Account Facility.
Senior and Subordinated Debt • Senior Secured or Unsecured Negative pledge – prevents valuable assets being pledged to other debt Take security interest when default occurs Usually Banks Security Agent – acts on two thirds of the senior lenders One senior lender should not have advantage above others Cross-default – the default of one senior lender should cause defaults of others
Senior and Subordinated DSCR • For the senior DSCR, divide the CFO by the senior debt service obligations, exactly as it would if only one class of debt existed. • Two possible methods exist to calculate the subordinated DSCR. The first method calculates the ratio of the total CFO to the project's total debt service obligations (senior plus subordinated). This consolidated calculation provides the only true measure of project cash flow available to service subordinated debt. The second method takes the CFO and then subtracts the senior debt service obligation to determine the residual cash flow available to cover subordinated debt service. This method, does not, however, provide a reliable measure of credit risk that subordinated debt faces. A combination of small subordinated debt service relative to the residual CFO could result in a much higher subordinated DSCR relative to the consolidated DSCR calculation. Moreover, the ratio of residual CFO to subordinated debt is much more sensitive to small changes to a project's total CFO than the consolidated measure.
Subordinated Debt • A subordinated debt strategy may partially mitigate commodity electricity market risk, either initially or when a project faces unexpected market pressures. • Limited amounts of fully subordinated debt with defined payment restrictions can enhance a project's credit. • Fully subordinated, however, means what it says: holders should not be able to require payment without prior senior debt holder approval. Such debt must be deeply subordinated to senior debt with severely limited rights of acceleration or access to project collateral. • Repayment of such subordinated debt should be well below other cash claims, falling just ahead of equity dividends. In bankruptcy, a bankruptcy court should respect the terms of the subordination.
Risk Analysis with Senior and Subordinated Debt • The table below illustrates the required credit spread, the probability of loss and the loss given default for both senior and subordinated debt assuming different levels of senior and junior debt. Two scenarios are presented with junior debt – one with a junior debt issue that comprises 30% of the total debt and another where the junior debt issue is 50% of the total debt. • In all cases, the total senior and junior debt together represents 60% of the total cost of the project. The table demonstrates that use of junior debt dramatically reduces the risk of the senior debt – to the point at which if 50% of the debt is subordinated, the required credit spread for senior debt is below . 5%. Of course, the required credit spread and the risk of the junior debt exceeds the credit spread of the senior debt.
Covenant Issues • Theory of Structural Covenants and Sweeps • Dividend Restriction Covenants • Cash Sweep Covenants • Debt Service Reserves • Language in Covenants
General Concept of Negative Covenants • Project lenders will usually structure debt covenants to prevent sponsors from increasing the project's risk profile. A project risk profile can change if the project increases debt, sells assets, or takes on additional activities not originally anticipated at project inception. Moreover, once construction and financing plans are complete, a project should not have to issue additional debt. Project and financing documentation prevent potentially risky investment by forcing the project to disburse cash, via a disbursement agreement, first as operating expenses, then principal and interest to lenders, then as dividends to equity. • Thus, a project credit analysis will seek to determine how well project documentation supports the management of project risk.
Covenant Example • Insurance To the extent available on commercially reasonable terms, the Partnership shall at all times during the term of the Lease Agreement effect, maintain and keep in force, or cause to be effected, maintained and kept in force, certain insurance, which shall be with responsible insurance carriers • The Partnership will maintain and operate the Project, or cause the Project to be maintained and operated in good order and repair, in compliance with the provisions of the Project Agreements, the noncompliance with which could reasonably be expected to result in a Material Adverse Effect, and (iii) substantially in accordance with prudent engineering and operating practices. • Reporting Requirements The Partnership shall furnish to the Trustee and to any Bondholder or Beneficial Owner, upon their written request, (i) prior to the Full Performance Date, within 30 days after the end of each calendar quarter, construction reports which shall include current drawdown information, a comparison of the current budget with the drawdown schedule, a summary of the general status of construction, information on change orders, information concerning the sufficiency of funds, a report on the amount of waste secured under Waste
Covenant Example - Continued • Annual Forecast Not less than 60 days prior to (i) the Commercial Operation Date, and (ii) the commencement of each Fiscal Year thereafter, the Partnership shall submit to the Independent Engineer and the Trustee in draft form an operation plan and a budget, detailed by month (the "Annual Forecast"). Each Annual Forecast (other than the first Annual Forecast) shall specify the estimated power sales pursuant to the Electric Service Contract, the estimated rates and revenues for such sales, contract and spot waste revenues, revenues from the sale of recycled materials, the fixed operating and maintenance cost projected by the Partnership, pass through costs and Partnership expenses. • Prohibition. on Disposition of Assets Except as contemplated by the Project Documents, the Partnership will not sell or transfer (as transferor) any property or assets material to the operation of the Project, • Debt • So long as any of the Bonds remains Outstanding, the Partnership will not create or incur or suffer to exist any Debt, except: (a) Debt arising under the Project Documents (b) Subordinated Debt; (c) trade accounts payable (other than for borrowed money) arising, and accrued expenses incurred, in the ordinary course of business so long as such trade accounts payable are payable within 90 days of the date the respective goods are delivered or the respective services are rendered; and Prohibition on Fundamental Changes Except as described below under the heading "Transfer Stations", so long as any of the Bonds remains Outstanding, the Partnership will not enter into any transaction of merger or consolidation, change its form of organization or its business, liquidate or dissolve itself (or suffer any liquidation or dissolution). So long as any of the Bonds remains Outstanding, the Partnership shall not purchase or otherwise acquire all or substantially all of the assets of any Person.
Example of Distribution Definition • Distribution means any payment of dividends or other distribution and any return of capital including, without limitation, any payment in respect of, or on the redemption of, any share capital whether at a premium or otherwise, or any payment in respect of Indebtedness for Borrowed Money to any Sponsor or any person controlling, controlled by or under common control with any Sponsor or to any person on their behalf whether in cash or in kind and whether by way of interest, repayment of principal or otherwise and shall, for the avoidance of doubt, include any payment of or in respect of Junior Debt and any management or other fees payable to Sponsors or any person controlling, controlled by or under common control with any Sponsor other than payment to non-executive directors and Project Expenditure.
Investors Need Some Dividends Before All Debt is Paid Off • The timing of debt service (i. e. loan interest payments and principal repayments) is one of the biggest factors that drives the rate of return for equity holders in a project. If the debt service is structured to allow no dividends until all debt is paid, return will be lower. This will generally be unacceptable to sponsors. The faster investors in a project are paid dividends, the better their rate of return. Investors therefore do not wish cash flow from operations of the project to be devoted to lenders at the expense of these dividends. Lenders, on the other hand, generally wish to be repaid as rapidly as possible. Striking a reasonable balance between these conflicting demands is an important part of loan negotiations. ER Yescombe, Principles of Project Finance
Financial and Contractual Enhancements – Covenants and Contracts • Structural enhancements (covenant, debt service reserves in loan agreements and contracts) can be classified into two general ways. The first way to mitigate risk for debt holders is through financial enhancements. This form of financial structuring which can take the form of financial covenants, debt service reserves or subordinated debt to assure that the senior lenders receive as much of the free cash flow as possible before equity holders take out cash in the form of dividends. The second way to mitigate risk through structural enhancements is to shift risk away from the project to other parties through revenue and supply contracts.
DSCR Covenants and Risk Mitigation • Covenants will not come into play if everything is working in a base case scenario. • Covenants cannot change an un-economic project into an economic project – they cannot prevent the inevitable • Effective covenants can allocate more of the free cash flow to debt holders and less to equity holders in a project that is marginally economic. • A project model should be able to: Measure which covenant is most effective in reducing risk Measure the level of the covenant that will materially reduce risk Evaluate whether a covenant does not do much in assisting in risk reduction for the economics of a project
Debt Service Coverage in Covenants • Model consistency with contractual language defining coverage ratios Example of Swap Premiums as Interest Cost or as a general operating expense. DSCR’s will be higher if swap premiums are not included in interest expense, but as operating expense. In theory, costs of swaps should be included as debt service – if a project uses fixed interest rates, it would have to pay the cost • Modelling debt service cover Model DSCR without cash balances – assess ability of cash to cover debt service Cash Balances in DSCR measure the ability of the cash balances to cover deficiencies in cash flow.
Re-financing and Early Project Sale • Timing strategies and sales value. How different types of projects have differences in risk reduction over time, and why wind projects probably have more of a risk reduction than other electricity projects. Show the effects of changing risk and selling to a Yieldco can be demonstrated with measuring IRR over time with changing buyer IRRs. Demonstrate how optimal holding periods can be computed with various IRR hurdle rate assumptions. 109
Appendix
Restrictions on Distributions • SECTION 6. 14 Distributions. The Borrower will not declare or make any Distribution if (a) a Default, Event of Default or Downgrade Event has occurred and is continuing or shall occur after giving effect to such Distribution, (b) the Ratio of Cash Flow to Fixed Charges of the Borrower determined as of the end of the immediately preceding fiscal quarter was not at least 2. 0: 1. 0 or (c) the Borrower fails to satisfy the requirements of the test set forth in Section 6. 15(b), or the Borrower fails to have a Consolidated Net Worth of at least $2. 15 billion, in each case calculated on a pro forma basis as of the end of the most recent fiscal period with respect to which financial statements of the Borrower are availabl; provided that the Borrower may declare and make Distributions of assets of or equity ownership interests in any Unrestricted Subsidiary at any time without complying with the foregoing.
Example of Financial Covenants • SECTION 6. 15 Financial Covenants. • (a) The Borrower shall not, as of the end of each fiscal quarter, permit the Ratio of Cash Flow to Fixed Charges to be less than 1. 5: 1. 0. • (b) The Borrower shall not, as of the end of each fiscal quarter, permit the Ratio of Debt to Capitalization to be greater than 0. 6: 1. 0. • (c) The Borrower shall not, at the end of each fiscal quarter, permit (i) Consolidated Net Worth to be less than the Minimum Consolidated Net Worth and (ii) Non-Trading Consolidated Net Worth to be less than the Minimum Non-Trading Consolidated Net Worth.
Definition of Revenues in Covenants • “Available Project Revenues” means, in respect of any period, the aggregate of all Project Revenues during that period which are not derived from: any Compensation, except to the extent that the Borrower has incurred expenditure during such period directly relating to such Compensation; the proceeds of insurance except (i) in respect of advance loss of profits or business interruption insurance or (ii) to the extent that Borrower has incurred expenditure during such period directly relating to such insurance proceeds; the disposal of any asset [(otherwise than as permitted pursuant to Clause 24. 4 (Disposals)]; any receipt from Hedging Document during such period; any monies received by way of subscription for share or loan capital; and any refunds of Tax of any kind other than VAT. • Reasons these items are not included in revenues for DSCR: Revenues will not recur and not be available for debt service Asset sales reduce earnings potential of project Receipts from unwinding swap affect future interest payments
Debt Structure and Negative Covenants • Project lenders will usually structure debt contracts and their attendant covenants to facilitate risk management by preventing sponsors from increasing the project's risk profile. A project risk profile can change if the project increases debt, sells assets, or takes on additional activities not originally anticipated at project inception. Moreover, once construction and financing plans are complete, a project should not have to issue additional debt. Project and financing documentation prevent potentially risky investment by forcing the project to disburse cash, via a disbursement agreement, first as operating expenses, then principal and interest to lenders, then as dividends to equity. • Thus, a project credit analysis will seek to determine how well project documentation supports the management of project risk.
Cash Trap and Cash Sweep Covenants • Cash flow capture covenants Cause debt to be re-paid early or debt service reserves to be built-up if debt service coverage ratios are low. Also known as dividend stop or lock up ratios Example: projected DSCR 1. 35; historic DSCR 1. 2 • Cash flow sweep covenants Cause debt to be re-paid early or debt service reserves to be built-up if cash flow is high. Alternative calculations; can set DSCR; can split cash flow at the bottom of the waterfall Applies when lenders are concerned with the tail risk • If cash flow cannot be distributed because of a covenant, any cash available may be used to reduce debt or held in a special reserve account, until the covenants improve.
Covenants in Models • Restriction on Distributions The Borrower shall not declare, pay or make any Distribution: if the most recent Forecast for then subsisting Calculation Period shows that as at the relevant Calculation Date: the Historic Debt Service Cover Ratio is equal to or less than ; the Projected Debt Service Cover Ratio is equal to or less than ; or the Loan Life Cover Ratio (after deducting the amount of the proposed Distribution from the Projected Net Cash Flow) is equal to or less than ;
Loan Life Cover Ratio • See above for use of term in Forecast, Restrictions on Distribution and Events of Default. Conditions Precedent to Initial Utilisation: [Confirmation from the Borrower that the Financial Model audited in accordance with paragraph 17. 1 above shows] [Production of a Forecast as at the Effective Date which shows] that, on each Calculation Date, the Loan Life Cover Ratio is equal to or more than [ ] [the relevant figures in the Base Case].
Dividend Restrictions • Financing documents should preclude a project's ability to distribute residual cash unless DSCRs exceed certain covenanted thresholds. • Investment-grade projects generally restrict such distributions unless the four preceding and four prospective quarters satisfy such thresholds. • Residual distributions should also be contingent on the full funding of all reserve funds, such as those earmarked for debt service and maintenance, and no existing or pending event of default.
Example of Dividend Restriction • Distributions are permitted monthly if fairly high DSCR thresholds are achieved, but thresholds decline as more trains are completed. • Provided that there are no defaults, distributions are permitted if DSCRs exceed 3. 0 x on a last-12 -months and next-12 -months basis. • When train 5 reaches completion, however, the test steps down to 2. 5 x, if the 3. 0 x historical test is passed. • Again, when train 6 reaches completion, the test drops to 2. 0 x, provided the 2. 5 x historical test is passed.
Risk Mitigation from Cash Flow Traps • The model should assess how important and in what circumstances cash flow traps moderate risk. If the project cannot make debt service, the covenant takes the last bit of cash flow for the lenders, but it cannot delay the inevitable. • To assess the effectiveness of the covenant, downside cases that incorporate realistic price volatility and potential price trends must be run in the model. The model must be run in these possible circumstances. • It may be the case the covenant is only valuable in extreme circumstances. In this case, alternative structural enhancements should be evaluated to assess risk.
Cash Flow Traps in Project Finance Models • Covenants that restrict cash flow in periods when the project has low cash flow protect lenders from dividends being paid out when the project is having problems. • There can be a restriction on dividends if the DSCR falls below a certain level. For example, if the DSCR is below 1. 2, dividends cannot be distributed to sponsors. • There can be alternative contractual definitions – for example, if no dividends are paid, the debt service cover is higher. • From a modeling perspective, the model must establish what happens to the cash flow that is not distributed; Payoff debt early Increase debt service account
Contract Language in Cash Traps • If cash is not distributed to owners, the cash must go somewhere. If the cash is used to pre-pay debt, the language is straightforward. • If the cash is used to build-up a debt service reserve, language must be included to define when the excess cash that is built up can be distributed. • For example, assume the DSCR covenant is 1. 2 and the covenant is violated. If in the subsequent period, the DSCR is 1. 4, then the difference between 1. 2 and 1. 4 could be distributed from the surplus cash.
Cash Flow Sweeps and Cash Flow • A cash sweep covenant applies in periods when cash flow is high rather than when cash flow is low. The reason for restrictions on dividends in good time periods is because when prices higher than normal, cash flow can be kept for the debt holders to protect against default in later periods when cash flow and prices may be below normal. • Cash flow sweeps operate by computing the amount of dividends that will just limit the debt service coverage to the covenant – for example, dividends cannot be paid above a level that implies a DSCR of 2. 0 x. • Unlike the cash traps, if the cash sweep covenant is set to a low level it is more restrictive (the cash flow trap covenant described above was more restrictive with a higher level). If the cash sweep is tied to a relatively low level of the debt service coverage such as 1. 5 x, the dividend restriction will occur more often than if the dividend restriction is set to a relatively low level such as 3. 5 x.
Debt Service Reserve Accounts (Reference) • At a minimum, debt service reserve funds should equal the next six months' debt service of the rated obligation. Stronger transactions will have reserve funds equal to the highest remaining six-month obligation. • Higher levels, such as for 12 months, might be more appropriate, depending on market characteristics. For instance, peaking power projects with merchant exposure may require, 12 to 18 months' debt service reserve funds. The same is true with projects in the petrochemical and, equally possibly, the mining and metals industries. • O&M reserves should be funded at levels equal to the forecast maintenance costs over the next two years. Investment-grade projects should have all reserve accounts fully funded with cash by the start of commercial operations. Under certain circumstances, a letter of credit may substitute for cash.
Debt Service Reserve Example (Reference) • "Debt Service Reserve Requirement" • (a) for any date of determination occurring on a Six-Month DSR Date, an amount equal to (i) the principal and interest which will be due or has become due on the Senior Secured Obligations during the period from and including the day after the immediately preceding Bond Payment Date through and including the Bond Payment Date succeeding such date of determination (or, if such date of determination is a Bond Payment Date, through and including such date of determination), less (ii) the amount of Monies already on deposit in or credited to the Debt Service Reserve Account, if any, less (iii) the aggregate of the Drawing Amounts of any Debt Service Reserve L/Cs, less (iv) the aggregate of the Guaranteed Amounts under any Debt Service Reserve Guaranties; • (b) for any date of determination other than a Six-Month DSR Date, an amount equal to (i) the principal and interest which will be due or has become due on the Senior Secured Obligations during the period from and including the day after the immediately preceding Bond Payment Date through and including the next two Bond Payment Dates (or, if such date of determination is a Bond Payment Date, through and including the next Bond Payment Date), less (ii) the amount of Monies already on deposit in or credited to the Debt Service Reserve Account, if any, less (iii) the aggregate of the Drawing Amounts of any Debt Service Reserve L/Cs, less (iv) the aggregate of the Guaranteed Amounts under any Debt Service Reserve Guaranties.
Collateral 126
Project Collateral • Collateral Issues Assignment of contracts/insurances Offshore Proceed Account • Real Collateral is the going concern The collateral pieces are not worth much Examples: air permits, licenses etc. • Collateral Infrastructure projects Natural Resources Processing Industries
Project Collateral • Stronger projects will distinguish themselves by agreeing to give lenders a first perfected security interest in all of the project's: Assets (real estate, equipment) contracts, mineral rights permits, licenses, accounts other collateral so that the project can be disposed of as an entirety, should the need arise. • Lenders should receive a complete collateral package sufficient to allow lenders to take over the project and continue its operations in the event of a severe cash flow disruption. • In some instances, project credit strength will not be so much determined by the existence of offtake contracts which, along with a pledge of the project plant and real estate, often constitute collateral, as much as by the enterprise value of the project concern.
Cure Periods and Concessions • The concession should contemplate that the project company will pledge the concession as security for the bonds. • If the concession cannot be, or is not pledged, the transaction's creditworthiness may more resemble an unsecured loan. • Failure to pledge the concession might not affect the risk of the project a loss of the concession will not result in the loss of the project. • After cure periods Lenders have right to Accelerate the loan Foreclose on collateral Step into the shoes of the sponsor Assure the project can still perform with existing contracts
Inter-Creditor Agreements • Many project financings have separate recourse or repayment characteristics Layers require intricate linkage Establish workable repayment hierachies Inter-creditor agreement sets out the relationships • Can include senior lenders, lenders with different maturities, senior and subordinated lenders • Purpose: prevent disputes between creditors that would make all creditors worse off No lender allowed to take action outside of the agreement Problems could arise if one lender accelerates his loan and sets off a chain reaction. • Senior may not want an event of default when junior defaults – do not want to lose any economic value • If junior debt interest or debt repayments occur before senior, may want to limit cash flow drains so the senior debt is not exposed Analogous to a dividend restriction
Inter-Creditor Agreements • Inter-creditor agreements are used where there is more than one class of debt and where those classes of debt have different interests in the same collateral. Both capital markets (Rule 144 A) offerings and commercial bank debt financing, for example, require separate documentation when used in the same transaction, but some degree of coordination between the two types of debt are necessary. Typically, an agent bank is appointed as the representative of the syndicate of commercial banks and a trustee is appointed to act for the Rule 144 A bondholders in certain situations. A collateral trustee is also appointed to hold the security package on behalf of the banks and the bondholders.
Inter-creditor Agreements During Construction Period • The inter creditor agreement also generally provides that, while the banks' loans are outstanding, only the agent bank has the right to give instructions to the collateral trustee on behalf of both the banks and the bondholders. This is to prevent any ambiguity as to who is to give binding instructions in the event that a foreclosure becomes necessary. The agent bank is also authorized to waive certain conditions precedent and covenants of the borrower on behalf of both the banks and the bondholders.
Bond Covenants and Bank Covenants • The covenant negotiations for a bond issue is many times simpler than that with the banks. • Bondholders would never expect to actively exercise the style of stepin rights to the project documentation as would the banker.
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