By David Johnston
Project finance loans are provided against project cash flows, rather than the assets of the project company. Any risk to the project cash flows endangers the lender’s ability to recover the debt capital. The lender, therefore, needs to ensure that the terms of the project documents are satisfactory and will both facilitate and protect the project’s ability to generate the necessary revenue to satisfy the loan repayments, particularly where – as happens all too often – the project runs into difficulties. As part of this, the lender will seek to ensure that the risk allocation between the project company and any third parties is acceptable and, therefore, that the project is considered bankable.
But what does this concept of bankability mean for construction contracts in project finance transactions, and what types of issues can sponsors expect to face when negotiating the terms of such contracts?
A project is arguably at its most risky period during the construction phase. Therefore, sponsors can expect that the lender will be heavily involved in reviewing and approving not only the terms under which the contractor builds out the project, but also the identity of the contractor itself. A failure during the construction phase of the project potentially threatens the viability of the entire project, but any security provided by the contractor is unlikely to repay the debt provided by the lender.
The lender will also be aware that where the value of the construction contract represents a substantial portion of the contractor’s turnover, any problems encountered on the project may have potentially fatal financial ramifications for the contractor. Therefore, contractors will be required to establish at the outset that they have sufficient financial and economic standing to satisfy these concerns.
In addition, given the value of the construction contract and its central importance to the project, contractors will also be required to convince the lender that they have the necessary experience and expertise to carry out the works (including in relation to design and project management, as well as construction).
The lender will seek further comfort from the form of construction contract, and will invariably prefer an EPC (engineering, procurement and construction) or “turn-key” form, which will set out the design and the technical and performance requirements for the project. This form of contract provides a single point of responsibility for the design, execution and completion of the works. As such, contractors should expect to bear full responsibility, and accept liability, for the design and buildability of the project, including any conceptual or outline design that was prepared in relation to the project prior to the contractor’s involvement.
In addition to the form of contract, the lender will seek to have all key construction risks addressed through the terms of the construction contract. Some of these risks, and the approach that lenders will want to take, include:
• Completion risk: In a project finance transaction, repayment of the debt occurs after completion of construction when the project has become operational and has started to generate revenue. While you would typically expect a grace period between construction completion and repayment of the loan, any delay to completion of the works could potentially lead to the project company being unable to commence repayments as scheduled and thereby incurring increased financing costs.
Delays may also lead to the project company incurring penalties under other project documents such as fuel supply contracts or off-take agreements. Therefore, the lender will look to ensure that the completion risk is assumed by the contractor by way of a fixed date for completion and the right of the project company to levy liquidated damages for delay. Liquidated damages will generally be established to cover any increased financing costs or other penalties incurred by the project company due to a loss of revenue arising from delayed start-up. Entitlements to extensions of time will be strictly limited.
• Price risk: The contractor will be expected to bear the risk of any construction cost overruns since the lender will be reluctant to reduce his cover ratios by providing additional debt, although many debt packages incorporate a limited standby facility for some costs overruns scenarios and variation claims. Sponsors will also be unwilling to provide funds through additional equity and thereby diminish their rate of return. To this end, the construction contract will be in the form of a fixed-price, lumpsum contract with payment linked to defined milestones. As is the case with additional time, entitlements to additional cost will also be strictly limited.
• Performance risk: The contractor must guarantee the performance of the project by reference to detailed output or performance specifications. The construction contract will include performance-related liquidated damages which the project company will be entitled to levy in circumstances where the project fails to meet the stipulated performance requirements (but only up to a certain level of performance failure, after which – in the absence of an agreed rectification plan and procedure – the lender will generally require full repayment of the contract price). Where the project requires the installation and operation of new and/or untested technology, the contractor may be required to provide longer-than-usual defects liability warranties.
• Permits: The contractor will be required to obtain and maintain key project permits, which will include approvals issued by government departments, executive agencies and regulatory authorities, as well as environmental oversight bodies. The lender may require that the contractor obtains some of the key permits as a condition precedent to drawdown.
• Site conditions: It is generally assumed that the contractor is the party best able to manage ground conditions risk. Provided it has adequate access to the site during the bidding phase of the project, the contractor will have carried out the appropriate investigations and verified that the design and construction of the project is compatible with the ground conditions existing at the site and priced the risk. However, there is always a risk of the occurrence of unforeseen ground conditions such as fossils, archaeological remains or undetected environmental factors. These can have a detrimental effect on both cost and schedule, yet may not be foreseeable, particularly in cases such as projects built on “brownfield” sites or large-scale road or pipeline projects, where the usual investigations may not be as effective or even feasible. Notwithstanding that, the lender will try to ensure that the project company passes down any such risk to the contractor as far as possible.
• Security: The lender will also look closely at the security package being provided by the contractor to ensure that it is providing the usual combination of financial bonds and performance guarantees (which might include a performance bond, a parent company guarantee and a retention bond – or retention of a percentage of monies due to the contractor). These security instruments are typically assigned to the lender as a condition precedent to funding.
• Insurance: The lender will scrutinise the contractor’s insurance package very closely, including a review carried out by its independent insurance advisors, and will require that it is a named beneficiary under the contractor’s insurance policies.
• Direct agreements: As with the other key project parties such as the project company and the O&M (operation and maintenance) contractor, the lender will require that the contractor enter into a direct agreement giving the lender the right to “step in” to the construction contract, enabling it to effectively take the place of the project company where the project company is in default. The contractor will be required to waive any rights to terminate the construction contract in such circumstances, at least until the lender has been given the opportunity to take the place of the project company directly, or procure that another entity takes over from the project company. The lender’s objective is to enable construction to be completed notwithstanding the project company’s default, allowing the project to generate revenue and the lender to be repaid.
These issues represent some, but by no means all, of the issues of particular concerns for lenders. Although such an analysis is general by necessity, and each case will be different and should be judged on its own merits, sponsors should keep in mind the general approach of lenders in project finance deals.
It is the lenders who provide the majority of the finance on such transactions and, as institutions, they are generally able to bear less risk than the sponsors. As part of an overall risk strategy, lenders will be looking to ensure that as many of the project risks as possible are moved away from the project company sponsors to those parties best able to manage them.
Gulf Construction