Careful negotiation of construction contracts is one of the most important factors in ensuring that lenders are willing to finance a PPP project, write Neil Cuthbert and Atif Choudhary of Dentons.
The broad concept of public-private partnership (PPP) projects is becoming increasingly understood across the world, however, more work is required in understanding the key factors that make a PPP successful. One such factor is ensuring that the PPP project is “bankable”.
“Bankability” refers to the overall structure of a project being such that lenders are prepared to finance it. As lenders fund the vast majority of capital required to undertake projects (in some cases, up to 90 percent of required capital), bankability is of critical importance during the project structuring phase. In addition, PPP projects are unique to other more traditional procurement methods, as financing by lenders depends heavily on the ability of the project to repay lenders’ loans. Therefore lenders have a very close eye on the structuring of the project, including all project agreements (and not just the financing agreements). Put simply, if the parties are unable to find a bankable structure, the project will not proceed.
In most concession-based PPP projects, the construction contract is one of the most important agreements that will be entered into. The price to be paid to the contractor under the construction contract is generally the largest capital expenditure and as such is one of the key areas of focus for all stakeholders in PPP projects, not least the lenders.
Sponsors’ involvement in the project is motivated largely by the return on their equity contributions. They want to balance achieving a competitive price for the construction works with protecting their expected returns by ensuring that construction risk is borne by the contractor to the greatest extent possible and not borne by their project vehicle, the project company.
Lenders will carefully check the terms and risk allocation under the construction contract and the experience of the contractor before committing to financing the project. They will also look to minimise the construction risk taken on by the project company, given that repayment of the project loans could be directly impacted where the project company takes on a greater level of risk than it should. This is even more so where the contractor is an affiliate of one of the sponsors.
The concession grantor/employer obviously has an important interest in the construction contract as the relevant infrastructure asset is the whole purpose of the project and it will be relying on the asset to function and produce the relevant output during the concession period (and after handover to the grantor at the end of the concession period in the case of a BOT type PPP).
As the party charged with constructing the facility, the contractor needs to ensure that the contract is crafted in such a way that it is only bearing risks which it can control and manage and which generally limit its exposure. Mechanisms for doing so are discussed below.
The requirements for a project to be bankable are not fixed and it is common to see different approaches to bankability, whether it be from sector to sector or between different jurisdictions or regions of the world. The purpose of this article is to explore some of the common/generic aspects of bankability and the usual base position for negotiation of construction contracts when it comes to those aspects.
A key premise to be mindful of is that the parties to a project tend generally to agree that project risks (including construction risk) should be allocated to those parties that are best in a position to manage that risk or at least make a reasonable determination of that risk. Where the lenders are required to take on a greater degree of risk, thereby rendering the project less bankable, the cost of financing is likely to be higher than it otherwise would be and/or the lenders will look to the sponsors to provide additional security or support. This is likely to impact on the project’s viability.
The “back-to-back” principle
Under a typical BOT-style PPP project the concession agreement (or off-take agreement) will be the overarching agreement that sets out the rights and obligations of the grantor and the project company. The primary obligation of the project company is to construct and operate the relevant facility, be it a power plant, toll road, water desalination plant or otherwise. The project company will, through separate agreements such as the construction contract, pass through various risks to third parties, including of course the construction contractor. To ensure that the risks and obligations are properly passed down, the project company will seek to ensure that the obligations that it passes down under the construction contract are “back to back” with the corresponding obligations it has under the concession agreement, so that there are no gaps between the obligations being taken on by it and those delegated by it to third parties.
Ensuring that the “back-to-backing” is undertaken properly is a key priority for lenders. After all, the project company is usually a special purpose vehicle and financing will be provided on a limited recourse basis (such that the lenders only have recourse to the project company and the project assets). As such, a bankable construction contract is usually one under which the back-to-back principle has appropriately been applied and which ensures that minimal risks are parked with the project company.
One of the key clauses that lenders will look for in this regard is an “equivalent relief” clause, which ensures that the contractor will only receive any time or costs relief from the project company for risks that are ultimately borne by the grantor (such as political force majeure relief) if the project company has received such relief from the grantor. In effect this transfers to the contractor the risk of the project company receiving an unfavourable outcome in respect of a disputed claim for relief from the grantor.
Key risk issues
To understand what constitutes a bankable construction contract, one must consider a number of bankability factors from the perspective of the various key stakeholders in the project. The following are some of the important aspects of construction contracts that are carefully considered by lenders, the project company, the contractor and the grantor alike when structuring the project:
The “single point turnkey contract” is generally considered to be the most bankable in large-scale infrastructure projects. Under a turnkey construction contract is that the lead contractor (appointed by the project company) bears the risk and responsibility for delivery of the entire facility (or, where the contractor is comprised of a consortium, on a joint and several basis). Any arrangements between the contractor and its subcontractors, suppliers and other third parties will be the responsibility of the contractor alone. The other parties to the project (project company, lenders and grantor) will not want to or need to look too far into the arrangements the contractor has with those third parties unless, perhaps, these are significant sub-contracts.
A bankable construction contract is generally one which is for a fixed price (subject to common “re-openers”) plus provisional sums, being amounts allocated for work which cannot be accurately priced at the time of entry into the contract.
From the lenders’ perspective the entire debt repayment profile will be based on a fixed amount of lending – any further advances which need to be made to the project could compromise the economics on which they have agreed to finance the project. These economics are often very precise and leave little room to manoeuvre, meaning sponsors cannot usually rely on lenders to agree to advance further amounts. In cases where there are significant cost overruns, the entire financing arrangements may need to be restructured, whether it be through additional sponsor equity injections or perhaps even selling an interest in the project, both of which have significant drawbacks.
Time for completion of construction is an important aspect of construction contracts, which is focused on by all key project parties. From a bankability perspective, the impact of delays on lenders and the project company must be carefully considered.
Failure to achieve the fixed completion date can have various ramifications which they want to avoid, for example delays in repayment of loans, additional interest payments and penalties.
A clear definition of when completion of construction is deemed to have occurred is a vital aspect of a bankable construction contract in a PPP project. Given the importance of the construction completion milestone, completion parameters are often very heavily negotiated. The point of completion of the facility usually triggers various actions, including commencement of the commissioning process of the facility, transfer of ownership of the facility to the grantor (in the case of a BTO project), and, with it, ownership risks associated with the facility, output payments becoming payable to the project, commencement of repayments under the financing agreements and insurance requirements transitioning into the next phase.
Liquidated damages for delay
One of the key remedies for sponsors (which is also a requirement of lenders for a construction contract to be bankable) is the requirement that the contractor pays delay liquidated damages where construction completion does not occur by the agreed time.
The amount of damages that are payable have traditionally been required to be a “genuine pre-estimate of loss or damages” that would be suffered and more recently the courts have looked to whether they are “proportionate to the legitimate interests” of the party that will receive the liquidated damages. In practice, delay liquidated damages are usually payable by reference to a daily rate for each day that completion is delayed.
Liquidated damages for performance
Lack of performance of the facility — for example, the power plant does not produce power to specifications or the toll road is not available for use — means the project company cannot deliver the required level of output under the concession and faces penalties. Therefore, these need to be passed down to the contractor through the construction contract.
Payment of the contract price
The precise times when payments are to be made to the contractor and the method of payment are a key bankability issue. The contractor wants to get its hands on funds as soon as possible in order to pay its costs and release profits, whereas lenders do not want to release funds until there is commensurate value in the facility. As for sponsors, they want to fund as late as possible given that some of their cost of funding decreases the later that payments need to be made.
Lenders will usually expect the construction contract to contain staged payments, drawdowns on the basis of payment certificates certified by an engineer, and the requirement for retention and advanced payment guarantees.
As the contractor is the payee of the projects largest capital expenditure, its standing is of key importance to lenders. However, notwithstanding the extent of comfort lenders are able to get in relation to contractors before approving their appointment, there are mechanisms employed by lenders and sponsors to ensure contractors perform as expected. For example, under a parent company guarantee, the parent will guarantee performance of obligations under the construction contract. Under a performance bond the issuer is only guaranteeing payment of amounts following the guarantee being called.
In concession-based projects, design responsibility and risk lie primarily with the project company under the concession agreement. As with most construction-related risks, the project company will generally pass this risk down to the contractor (who may separately subcontract this work to a design contractor or consultant).
In keeping with the theme of the project company divesting itself of as many risks as possible, lenders will require the project to maintain certain levels/types of insurance. The challenge in large-scale projects is that certain insurances can be very costly or insurance is not always available to cover all types of risk. As such, the stakeholders must find a middle ground which is reasonable and, of course, bankable. The grantor may have to bear any risks which cannot be insured.
Typical types of insurances lenders will expect to see include construction all risks insurance, third party liability insurance, professional indemnity insurance and employee liability insurance. In addition, lenders will require to be named on the policies as a co-insured party, named as co-loss payee (or sole loss payee) and require the insurance policy to include endorsement wording noting the interest of the lenders in the insurance proceeds.
These requirements will be supplemented in the financing agreements with detailed provisions setting out how proceeds of insurance claims are to be applied, i.e. in early repayment of the loan, reinstatement of the facility or otherwise, and the lenders will also take a security assignment over the policies (if permitted) and the proceeds of insurance.
Contractors typically seek to limit their liability under the construction contract to the greatest extent possible. The lenders, of course, want to maximise the potential liability of the contractor as a means of protecting the creditworthiness of the project company, which is the beneficiary of claims under the contract.
The allocation of ground risk is usually driven by what (if any) ground risk the grantor is prepared to accept, which varies significantly from region to region. The contractor being responsible for ground risk, except in the case of unforeseeable risks, is generally considered a fair and practical approach. Any costs involved in remedying unforeseen risks are usually borne by the grantor (often on a deferred basis).
PPP projects rely to varying extents on legal/regulatory consents and permits being issued by governmental authorities of the jurisdiction where the project is being undertaken. Obtaining the required consents for the entire project is a condition precedent to financing being made available, ie lenders are unwilling to fund (or sign off on the construction contract) until and unless they are comfortable that the required consents are in place.
It is without doubt that interest in the PPP model will continue to grow rapidly, particularly in emerging markets such as many in the Middle East that have long relied on government balance sheets to fund infrastructure needs. Conceptually the PPP model makes for a win-win situation for all the key project stakeholders. As a consequence, many projects are enthusiastically pursued on an accelerated or “fast-track” basis. However, those looking to participate in PPPs will need to ensure that the process of risk identification, allocation and mitigation is as thorough and robust as ever. More investment in this stage of the procurement process can prove invaluable many years into the life of the project. However, many have been and continue to be caught short for failure to devote adequate time and resources to the process, leading to lengthy and costly disputes between parties arising.
In most large-scale projects, construction risks will be one of the risks, if not the key risk, that lenders and sponsors will focus on. The lenders’ position in relation to these risks is of critical importance, as the parties need to find bankable solutions to construction risk allocation for financing for the project to be made available. This requires the contractors and sponsors to clearly understand the lenders’ requirements when it comes to construction risk allocation — failure to do so has been one of the reasons why many PPP projects have taken far longer to reach financial close than intended.
Experienced contractors with track records of successful completion of large-scale projects will always find favour with project lenders. However, even with experienced contractors, if lenders see weaknesses in the construction arrangements and how construction risks have been allocated, they will look to the shareholders/sponsors to step in and cover these risks. Of course, the more guarantees the shareholders/sponsors have to give, the less attractive the project financing model becomes to them. Ultimately, there is a fundamental balance to be achieved between risk and reward.
Please find attached the link to the full article.