The following is a summary of Dentons’ Neil Cuthbert’s article that analyses the key risks associated with the development and implementation of large-scale international energy and infrastructure projects. It assumes that the project will be financed on limited recourse terms, by one or more bank(s) or financial institution(s). Specifically, it looks at what makes, or does not make, a project ‘bankable’ and how a project’s risk allocation must be adjusted in order to make it bankable.
Bankability means the acceptability to the lenders of a project’s overall structure, including parties, products, markets, legal regimes and contracted documentary terms, as a basis for raising finance for the construction and operation of a project on a limited recourse basis. ‘Limited recourse’ means the lenders to the project look primarily, but not necessarily exclusively, to the property, assets and revenues of the project as the primary source of repayment of their loans. The shareholders of a project that is financed on limited recourse terms would expect their liability for such loans to be limited to their equity in the project and other support or guarantees, typically but not exclusively, related to completion of the project that they have agreed to provide to the lenders. This is one of the main advantages for shareholders in raising limited recourse financing. Other advantages for shareholders might be balance sheet considerations and/or a desire on their part to share project associated risks with others.

The approach in this article is primarily to consider the risks associated with a project from the lenders’ perspective. It is axiomatic that many of these risks will also be of equal concern to shareholders. Indeed, in many cases, the interests of the lenders and shareholders will be aligned. What will not necessarily be aligned, however, is the respective appetites of the two to assume risk. The lenders, on one hand, will earn fees and interest for assuming such risks, whereas the shareholders will look for a return on their equity, which will be many multiples of the income that the lenders will expect to earn on their loans. It follows, therefore, that the lenders will have a considerably more conservative approach to evaluating these risks. The higher the shareholders’ expected return on investment, the more risk they will generally be prepared to assume. Also, as industry participants, the shareholders will have a much deeper understanding of the construction, operational, technological, marketing and other (non-financial) risks associated with the project, making them generally more comfortable with assuming these risks.

It is important to understand that the essence of limited recourse financing of a project is that the risks are allocated by the developer (or project company) to the party that is best able to manage and mitigate these risks. This provides the greatest opportunity to effectively manage and reduce these risks. An arbitrary allocation of risk or allocating a particular risk to a party that does not have the competence to understand and manage that risk will inevitably lead to problems. The end result of a carefully structured project utilising limited recourse financing should be that very little risk will be left with the project company. This is the ideal outcome for the shareholders, lenders and key stakeholders, as in reality, for most projects, the project company is essentially just a vehicle (often referred to as a special purpose vehicle or SPV) established to develop and operate the project by the shareholders and others, including the contractor, operator, suppliers, offtakers, technology providers and buyers, who will each assume pivotal roles in the successful development and operation of the project. If too many risks are ‘parked’ with the project company without support from other project parties the end result will be that the shareholders, to the extent of their equity (and guarantees, if any) and lenders will end up sharing the risk brought about by such default.

General bankability principles
Approach to risk sharing
The lenders will expect a fair and reasonable approach to the sharing of risk among the various project parties. How this will be achieved will, of course, depend on detailed discussions and negotiations between the parties but, broadly speaking, the optimal approach will be that each material individual risk should be allocated to, and assumed by, the party best able to manage that risk. The lenders will not accept risks arbitrarily being allocated to the project company as the project company is not in a position to manage or allocate those risks to other parties. As noted above, from the lenders’ perspective, risks that are ‘parked’ with the project company are, essentially, being assumed by the lenders, particularly in a default situation (and to a lesser extent, the shareholders).

Change in law
The lenders may require protection against changes in law that may have a material and adverse effect on the project or the project’s economics such that the risk profile of the project is changed in a material way. Where there is no specific government involvement in a project, the lenders’ recourse is likely to be limited to political risk or commercial insurance, which may offer some relief or recourse to the shareholders. However, where there is a significant government involvement in a project (whether as a sponsor or shareholder, concession grantor and/or perhaps fuel or utilities supplier) typically, the lenders will expect direct contractual commitments from the government under the concession agreement (if there is one) or a host government agreement (or similar arrangement). The scope of change in law protection that may be acceptable to a government will of course differ from project to project. Blanket protection for the project company against all changes in law that have a material impact on the project or the project’s economics would be rare. More typical is to share these risks and for the government to provide relief only against ‘discriminatory’ changes in law, that is changes in law that directly impact the project company (and not other companies) or other companies undertaking similar (concession) projects in the relevant country (and not other companies).

Equity contributions
The lenders will require the shareholders to contribute an ‘appropriate’ level of equity to a project. What this appropriate level of equity is, will depend on many factors, including the risks perceived by the lenders in such project, whether the shareholders are actively participating in the project (e.g. as a contractor, operator or offtaker) and prevailing market conditions. Thus, for example, if a project has little active shareholder involvement other than through equity contributions and is a project that the lenders perceive to be at the higher end of the risk spectrum, then the lenders will likely require a higher debt-to-equity ratio for that project (say, 60:40 or even 50:50). Probably the starting point with most projects will be roughly 70:30 and this will be adjusted according to the particular project and market conditions. A related issue will be the timing of equity contributions. Typically, lenders will want equity to be injected into a project either up front or, possibly, on a pro rata basis with their loans during the construction period. Shareholders will prefer to back-end their equity. It is sometimes possible to bridge these different expectations through the use of equity bridge loans under which the project company borrows the equivalent of the equity contributions of the shareholders from commercial banks that are prepared to lend to the project company on an unsecured basis (but subordinated to the project loans) with the support of shareholder guarantees.Dividends and distributions
The lenders will want to prevent shareholders from taking out dividends or receiving other distributions (whether in the form of equity returns or under management, services or similar contracts) from the project company before the lenders have been repaid. Such a position is not usually acceptable to most shareholders (except, perhaps, where it is accepted by the shareholders that the level of project risk is very high). The compromise is usually that the lenders will permit dividends and other distributions to be extracted once the project has been commissioned and has started repaying the loans; and even then, only so long as the key project financial cover ratios have been met, the debt service reserve account is fully restored, the project is not in default and possibly some further project-specific conditions or restrictions must be met. The timing of payment of dividends and distributions to shareholders can have a material impact on the shareholders’ return on equity and so these terms will be heavily negotiated between the lenders and shareholders. Where all or part of the equity has been contributed through a shareholder loan, similar restrictions will be imposed on the payment of interest or repayment of these loans to the shareholders.

Related projects
Where a project is dependent on the successful completion and/or operation of another project, the lenders to each project in the chain will want to carefully analyse, assess and allocate the risks associated with delays and/or non-completion of the other project(s). The different groups of lenders in such a chain of projects are taking ‘project-on-project’ risk, which they will want to manage and mitigate. How these risks are allocated and mitigated will vary from project to project, but will invariably involve complex intercreditor and interface issues that need to be understood and agreed from the outset of the first project in the chain.

Finance risks
Lenders will want to make sure that interest rate, currency and commodity risks of the project are hedged (where appropriate) or otherwise mitigated. In particular, given the current very low interest rate environment, lenders are likely to require appropriate interest rate hedging for the life of the loans in the expectation that interest rates can only rise over the life of the project. Where there is a mixed currency financing package, it may be that it is not possible to obtain long term hedging for a local currency as the market is simply not deep enough. In this case, the lenders will have to settle for the maximum term the local market will offer and renew the maturity of the hedge in due course. If the majority of the capital costs for the project and loans are denominated in the same currency as the project’s income stream, there should not be a requirement for currency hedging. If there are significant currency mismatches in a project’s structure, the lenders may require that this risk is hedged or otherwise mitigated. In certain projects, particularly mining projects, commodity price hedging may be required.

Discrimination risks
In many concession agreements, the nationalisation or expropriation of any of the project’s property or assets, or the shares in the project company or some other overt discrimination against a project or the project company, such as treating a potentially competing project more favourably or imposing discriminatory taxes or duties, will be a specific termination event entitling the project company to terminate the concession agreement and claim termination compensation from the grantor. In such cases, the level of termination compensation will usually be a sum equal to the aggregate of the total debt and equity invested in the project. However, this will not always be the case, and even where there is a contractual right to compensation, there may be disputes and protracted proceedings in the local courts, which may or may not produce the right result for the project company and shareholders.

Early termination risks
A project can terminate (or be terminated early) for many reasons. Usually the reasons can be categorised as either a grantor default, a project company default, a prolonged force majeure event or a grantor risk event1. In most concession-based projects, once the project assets have been returned to the grantor, they will either have to find a new concessionaire or develop and/or operate the concession itself. Most concession agreements will prescribe that the grantor must pay the project company a sum of ‘termination compensation’ to compensate the project company for transferring the project assets to the grantor. The amount or calculation of termination compensation, and specifically the elements that it will include, can materially affect the risk profile of a concession. If limited resource financing has been raised by the project company to finance the project, the lenders will hope to ensure that the termination compensation always includes, at a minimum, outstanding loans and interest (and related sums). The shareholders for their part will hope to ensure that their contributed equity at least will be covered and, where the reason for the default is a grantor default or grantor risk event, a sum on account of future foregone equity returns is paid to them. There are, of course, a great many different ways of calculating termination compensation, and clearly one of the key factors is the time when termination occurs.

Construction risks
For most projects, the construction of the project is the time when it faces its most significant risks, certainly true for most infrastructure and utility projects. The most significant construction risks are cost overruns, delays and technology/commissioning risks. But there are many other risks associated with delivering a project on time and on budget. That is not to say there are no risks for a project once it’s commissioned and in operation. These can also be significant, particularly with projects that have multiple independent plants or trains where there are ­­­­­­plants or trains in a process chain relying on others in that chain for raw materials or feedstock. The identity of the construction contractor will also be critical. As well as being an experienced and creditworthy contractor, in many projects the shareholders will want a turnkey solution with a single point of responsibility, and at the same time managing or reducing sub-contractor risks.

At the bottom of page 38 is a diagram highlighting the most common potential risks with any project, along with a possible mitigation measure.

While not all of these risks will be relevant to every project, many of them will be, and the shareholders, governments and other key stakeholders will need to structure the various elements of the project with the bankability requirements addressed in this article in mind.

In many (but not all) cases, the interests of the shareholders (and sometimes the governments) and the lenders, will be aligned in relation to these risks.

1. A ‘grantor risk event’ might include events (other than natural force majeure events) that have been allocated to the grantor or are the ‘fault’ of the grantor, e.g. non-renewal of project permits, nationalisation, change in law, non-availability of utilities, non-renewal of project consents.

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