Project Finance - Documents (Intro)

Project finance is a long-term method of financing extensive infrastructure and industrial projects based on the projected cash flow of the finished Project rather than the investors' finances. Project finance structures usually involve several equity investors as well as a syndicate of banks who will provide loans to the Project

The types of projects for which project finance is commonly used include the following:

• Infrastructure projects, such as government buildings and transport systems;
• Oil and gas exploration projects;
• Sports stadia, and
• Liquefied natural gas development projects.

Globally, most project financings have been carried out under the Government's private finance initiative (PFI) and are known as Public Private Partnerships (PPPs). PFI was introduced in the early 1990s and aimed to introduce private sector skills and finance into the provision of public sector services. PFI is structured so that the private sector obtains finance - usually from a bank - to design, build and operate a facility for the benefit of the public. In return, the public sector grants this private sector partner a long-term contract to run the facility - usually for 25-30 years. Once the facility has been built, the public sector pays the private sector a monthly fee over the life of the Project, which is used to service the bank loan which financed the Project which is used to service the bank loan which financed Project.

PFI has traditionally been used because:

• It is argued that the public sector gets better value for money in the long term by transferring the risks of building and running the facility over the Project's life to the private sector. This means that the private sector, which is generally perceived as more efficient, manages the risks of the Project and
• since the public sector is essentially purchasing a service rather than outlaying the significant capital cost of building, for example, a school or a hospital, it does not need to account for this cost as a liability on its balance sheet. This means the public sector needs help to borrow to finance the capital cost.

Key parties to a project financing

Private sector partner/owner: Usually a corporation or a limited partnership created for the sole purpose of the particular Project. This party is at the centre of all contracts, borrowings and the construction and operation of the Project. For simplicity, we refer to this party as 'Projectco'.

Project sponsor: The person who takes on the active role in managing the Project. The project sponsor owns Projectco and will receive profit, either as a result of the ownership of Projectco or via management contracts, if the Project succeeds. The project sponsor often has to cover specific liabilities or risks of the Project by providing guarantees or entering into management or service agreements.

Lenders: Commercial banks, investment banks or other institutional investors who provide the debt portion of the project financing. The sheer scale of typical project financing means that a single lender can only undertake some lending. Instead, a group of lenders form a syndicate.

Agent: one of the lenders will be appointed as the agent and act on the other lenders' behalf to administer the loan.

Account bank: a single lender will hold the accounts through which all the cash generated by the Project will pass.

Equity investors: lenders or project sponsors who do not expect to be active in the Project. Lenders will have a shareholding in addition to lending by way of debt to receive an enhanced return if the Project is successful. In most cases, any investment by way of shares is coupled with an agreement allowing the equity investor to sell its shares to the project sponsor if the investor wishes to exit the Project. Similarly, the project sponsor may have the option to repurchase the shares.

Suppliers, contractors, and customers: The Project's material suppliers, the contractors responsible for designing and building the Project, and the Project's customers.

Construction company: the construction contractor is one of the key project parties during the Project's construction phase. Typically, a construction contractor's remit will be based on one of two models:

• Turnkey model: where the construction company designs, engineers, procures and constructs the project output, assuming all responsibility for timely completion or
• EPC model: where the construction contractor engineers, procures and constructs the project output but does not design it.

Consortia of contractors may be involved in larger projects. As far as liability is concerned, those contractors can be either severally or jointly and severally liable. Several liability means that each contractor is only liable for its contribution to the Project, while under joint and several liability, any contractor can be pursued for the whole of the obligation, and it will then be the responsibility of the consortium to sort out the extent of each contractor's obligations. Lenders prefer joint and several liability since the risk of failure of performance is the total responsibility of each consortium member.

Multilateral credit agencies: some projects - particularly in developing countries - are co-financed by the World Bank or its investment bank division, the International Finance Corporation, or regional development banks such as the European Bank for Reconstruction and Development or the Asian Development Banks. Multilateral agencies such as these can ensure the bankability of a project by providing commercial banks with a degree of protection against political risks, such as the failure of a government to make agreed payments or provide the necessary regulatory approvals.

Host governments/awarding authorities: The Government of the country where the Project is based is likely to issue consents and permits at the start and throughout the Project's life. The awarding authority is the contracting local authority that enters into the project agreement with Projectco.

Purchasers: In infrastructure projects, Projectco typically contracts in advance with a purchaser who will purchase the Project's long-term output.

Insurers: insurers are vital to a project. If a catastrophe affects the Project, the sponsors and lenders will look to the insurers to cover the losses.

Key documents in a project financing

Project agreement: the principal agreement for any PFI project, the project agreement governs the relationship, rights and obligations between the public authority and Projectco throughout the project term. It can also be called a concession agreement.

In early PFI projects, it was common to have separate agreements for different project phases, such as a development agreement for the design and construction phase and an operating or facilities management agreement for the operating phase. However, having a single project agreement covering all aspects of the Project is more common.

Property documents: where the Project involves land-based development, property documentation will be required to reflect the interests of the public authority and Projectco and the intended ownership position at the end of the project term. Some common structures are:

• The public authority grants a licence to Projectco – this would occur where no property interest could be granted or would be needed by Projectco;
• The public authority grants a lease to Projectco with a lease back to the authority – this has occurred in several hospital projects where Projectco acquired the interest in land to construct the Project, but the authority was to occupy the building throughout the term of the contract;
• The public authority retains the freehold interest and grants a lease to Projectco with no lease back for the term of the contract or
• Projectco retains the freehold interest and grants a lease to the authority for the contract term.

The type of structure used will depend on the type of facility comprised in the Project and who will be responsible for its operation once the construction phase is completed.

Construction contract: Projectco will enter into a construction contract with the building contractor, under which the building contractor will assume Projectco's construction obligations under the project agreement.

The building contractor and design team provide warranties for the authority and the lenders. The lenders generally have the first right to enter the construction contract in place of Projectco. Any rights the Authority has are usually subject to the lenders' rights.

Service contracts: Projectco enters into service contracts with service providers and passes on its service obligations under the project agreement to those contractors. As mentioned above, the service providers provide warranties in favour of the authority, and the authority has step-in rights in certain circumstances—again, subject to the lenders' rights.

Funding agreements: the facilities agreement is the primary document between the lenders and Projectco and contains the terms of the project funding. The lenders will also require a security package and guarantees to protect the funds lent.?

The lenders' direct agreement: this is a three-way agreement between the authority, Projectco and the lenders under which the authority agrees to give the lenders a period of advance notice of the impending termination of the project arrangement. This agreement will also allow the lenders to step in, either directly or through a nominee or representative, to remedy the termination event or to find another party acceptable to the authority to take over the rights and obligations of Projectco under the project agreement.

Authority collateral agreements have emerged as an extension of the concept underlying the lenders' direct agreement. Authority collateral agreements are entered between the authority and the contractors who contract with the Project. The intention is that if Projectco defaults on its responsibilities under the contract during the construction phase, the authority can ensure that the Project is completed by taking over the relevant contract from Projectco. In addition, the authority can take over the operating contract from Projectco if the Project is terminated.

Sub-contracts: Projectco establishes various sub-contracts to pass down the risks it undertakes under the project agreement. It is common for Projectco not to undertake any of the key activities itself but to instead act as a vehicle for forming the suite of contracts associated with the Project—hence the term 'special purpose vehicle'.

Performance bonds: there are two main scenarios Projectco will have to pay for where performance bonds may be used:

• Where the authority requires a performance bond to be issued in its favour by an acceptable surety to cover claims which may arise against Projectco during the construction phase when, if a default were to occur, it is likely that Projectco would not be able to meet a claim. The authority will ultimately meet the bond and the cost. As a result, their use is not common;
• Where the lenders require performance bonds to be issued on behalf of a key contractor because they are not satisfied with that contractor's financial strength.

Collateral warranties: The lenders and the authority typically seek contractual warranties from key contractors and consultants appointed by Projectco. The value of collateral warranties, to the authority in particular, is that they protect the authority's position following the termination of the Project where the authority's losses exceed the value of the built (or partly built) Project.