Introduction to Project Finance - A Guide for Contractors and Engineers

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	Introduction to Project Finance – A Guide for Contractors and Engineers June 3, 2002


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Diagram of a Typical Project-Financed Deal (below)

More and more major construction projects involve project financing. Contractors, engineers and designer-builders are finding their work, compensation and risks are shaped by this method of financing. The following guide is provided to help them understand the overall process, their role in it and the risks involved.

By Leslie E. Sherman
Thelen Reid Brown Raysman & Steiner LLP

Introduction

Definition. Project financing involves non-recourse financing of the development and construction of a particular project in which the lender looks principally to the revenues expected to be generated by the project for the repayment of its loan and to the assets of the project as collateral for its loan rather than to the general credit of the project sponsor.

Rationale. Project financing is commonly used as a financing method in capital-intensive industries for projects requiring large investments of funds, such as the construction of power plants, pipelines, transportation systems, mining facilities, industrial facilities and heavy manufacturing plants. The sponsors of such projects frequently are not sufficiently creditworthy to obtain traditional financing or are unwilling to take the risks and assume the debt obligations associated with traditional financings. Project financing permits the risks associated with such projects to be allocated among a number of parties at levels acceptable to each party.

Principal Advantages and Objectives

1.	Non-recourse. The typical project financing involves a loan to enable the sponsor to construct a project where the loan is completely "non-recourse" to the sponsor, i.e., the sponsor has no obligation to make payments on the project loan if revenues generated by the project are insufficient to cover the principal and interest payments on the loan. In order to minimize the risks associated with a non-recourse loan, a lender typically will require indirect credit supports in the form of guarantees, warranties and other covenants from the sponsor, its affiliates and other third parties involved with the project.

2.	Maximize Leverage. In a project financing, the sponsor typically seeks to finance the costs of development and construction of the project on a highly leveraged basis. Frequently, such costs are financed using 80 to 100 percent debt. High leverage in a non-recourse project financing permits a sponsor to put less in funds at risk, permits a sponsor to finance the project without diluting its equity investment in the project and, in certain circumstances, also may permit reductions in the cost of capital by substituting lower-cost, tax-deductible interest for higher-cost, taxable returns on equity.

3.	Off-Balance-Sheet Treatment. Depending upon the structure of a project financing, the project sponsor may not be required to report any of the project debt on its balance sheet because such debt is non-recourse or of limited recourse to the sponsor. Off-balance-sheet treatment can have the added practical benefit of helping the sponsor comply with covenants and restrictions relating to borrowing funds contained in other indentures and credit agreements to which the sponsor is a party.

4.	Maximize Tax Benefits. Project financings should be structured to maximize tax benefits and to assure that all available tax benefits are used by the sponsor or transferred, to the extent permissible, to another party through a partnership, lease or other vehicle.

Disadvantages. Project financings are extremely complex. It may take a much longer period of time to structure, negotiate and document a project financing than a traditional financing, and the legal fees and related costs associated with a project financing can be very high. Because the risks assumed by lenders may be greater in a non-recourse project financing than in a more traditional financing, the cost of capital may be greater than with a traditional financing.

Project Financing Participants and Agreements.

1.	Sponsor/Developer. The sponsor(s) or developer(s) of a project financing is the party that organizes all of the other parties and typically controls, and makes an equity investment in, the company or other entity that owns the project. If there is more than one sponsor, the sponsors typically will form a corporation or enter into a partnership or other arrangement pursuant to which the sponsors will form a "project company" to own the project and establish their respective rights and responsibilities regarding the project.

2.	Additional Equity Investors. In addition to the sponsor(s), there frequently are additional equity investors in the project company. These additional investors may include one or more of the other project participants.

3.	Construction Contractor. The construction contractor enters into a contract with the project company for the design, engineering and construction of the project.

4.	Operator. The project operator enters into a long-term agreement with the project company for the day-to-day operation and maintenance of the project.

5.	Feedstock Supplier. The feedstock supplier(s) enters into a long-term agreement with the project company for the supply of feedstock (i.e., energy, raw materials or other resources) to the project (e.g., for a power plant, the feedstock supplier will supply fuel; for a paper mill, the feedstock supplier will supply wood pulp).

6.	Product Offtaker. The product offtaker(s) enters into a long-term agreement with the project company for the purchase of all of the energy, goods or other product produced at the project.

7.	Lender. The lender in a project financing is a financial institution or group of financial institutions that provide a loan to the project company to develop and construct the project and that take a security interest in all of the project assets.

II.

First Step in a Project Financing: The Feasibility Study.


A.	Generally. As one of the first steps in a project financing the sponsor or a technical consultant hired by the sponsor will prepare a feasibility study showing the financial viability of the project. Frequently, a prospective lender will hire its own independent consultants to prepare an independent feasibility study before the lender will commit to lend funds for the project.

B.	Contents. The feasibility study should analyze every technical, financial and other aspect of the project, including the time-frame for completion of the various phases of the project development, and should clearly set forth all of the financial and other assumptions upon which the conclusions of the study are based, Among the more important items contained in a feasibility study are: Description of project. Description of sponsor(s). Sponsors' Agreements. Project site. Governmental arrangements. Source of funds. Feedstock Agreements. Offtake Agreements. Construction Contract. Management of project. Capital costs. Working capital. Equity sourcing. Debt sourcing. Financial projections. Market study. Assumptions.

III.

The Project Company.

Legal Form. Sponsors of projects adopt many different legal forms for the ownership of the project. The specific form adopted for any particular project will depend upon many factors, including:

The amount of equity required for the project
The concern with management of the project
The availability of tax benefits associated with the project
The need to allocate tax benefits in a specific manner among the project company investors.

The three basic forms for ownership of a project are:

1.	Corporations. This is the simplest form for ownership of a project. A special purpose corporation may be formed under the laws of the jurisdiction in which the project is located, or it may be formed in some other jurisdiction and be qualified to do business in the jurisdiction of the project.

2.	General Partnerships. The sponsors may form a general partnership. In most jurisdictions, a partnership is recognized as a separate legal entity and can own, operate and enter into financing arrangements for a project in its own name. A partnership is not a separate taxable entity, and although a partnership is required to file tax returns for reporting purposes, items of income, gain, losses, deductions and credits are allocated among the partners, which include their allocated share in computing their own individual taxes. Consequently, a partnership frequently will be used when the tax benefits associated with the project are significant. Because the general partners of a partnership are severally liable for all of the debts and liabilities of the partnership, a sponsor frequently will form a wholly owned, single-purpose subsidiary to act as its general partner in a partnership.

3.	Limited Partnerships. A limited partnership has similar characteristics to a general partnership except that the limited partners have limited control over the business of the partnership and are liable only for the debts and liabilities of the partnership to the extent of their capital contributions in the partnership. A limited partnership may be useful for a project financing when the sponsors do not have substantial capital and the project requires large amounts of outside equity.

4.	Limited Liability Companies. They are a cross between a corporation and a limited partnership.

Project Company Agreements. Depending on the form of project company chosen for a particular project financing, the sponsors and other equity investors will enter into a stockholder agreement, general or limited partnership agreement or other agreement that sets forth the terms under which they will develop, own and operate the project. At a minimum, such an agreement should cover the following matters:

Ownership interests.
Capitalization and capital calls.
Allocation of profits and losses.
Distributions.
Accounting.
Governing body and voting.
Day-to-day management.
Budgets.
Transfer of ownership interests.
Admission of new participants.
Default.
Termination and dissolution.

IV.

Principal Agreements in a Project Financing.

Construction Contract. Some of the more important terms of the construction contract are:

1.	Project Description. The construction contract should set forth a detailed description of all of the work necessary to complete the project.

2.	Price. Most project financing construction contracts are fixed-price contracts although some projects may be built on a cost-plus basis. If the contract is not fixed-price, additional debt or equity contributions may be necessary to complete the project, and the project agreements should clearly indicate the party or parties responsible for such contributions.

3.	Payment. Payments typically are made on a "milestone" or "completed work" basis, with a retainage. This payment procedure provides an incentive for the contractor to keep on schedule and useful monitoring points for the owner and the lender.

4.	Completion Date. The construction completion date, together with any time extensions resulting from an event of force majeure, must be consistent with the parties' obligations under the other project documents. If construction is not finished by the completion date, the contractor typically is required to pay liquidated damages to cover debt service for each day until the project is completed. If construction is completed early, the contractor frequently is entitled to an early completion bonus.

5.	Performance Guarantees. The contractor typically will guarantee that the project will be able to meet certain performance standards when completed. Such standards must be set at levels to assure that the project will generate sufficient revenues for debt service, operating costs and a return on equity. Such guarantees are measured by performance tests conducted by the contractor at the end of construction. If the project does not meet the guaranteed levels of performance, the contractor typically is required to make liquidated damages payments to the sponsor. If project performance exceeds the guaranteed minimum levels, the contractor may be entitled to bonus payments.

Feedstock Supply Agreements. The project company will enter into one or more feedstock supply agreements for the supply of raw materials, energy or other resources over the life of the project. Frequently, feedstock supply agreements are structured on a "put-or-pay" basis, which means that the supplier must either supply the feedstock or pay the project company the difference in costs incurred in obtaining the feedstock from another source. The price provisions of feedstock supply agreements must assure that the cost of the feedstock is fixed within an acceptable range and consistent with the financial projections of the project.

Product Offtake Agreements. In a project financing, the product offtake agreements represent the source of revenue for the project. Such agreements must be structured in a manner to provide the project company with sufficient revenue to pay its project debt obligations and all other costs of operating, maintaining and owning the project. Frequently, offtake agreements are structured on a "take-or-pay" basis, which means that the offtaker is obligated to pay for product on a regular basis whether or not the offtaker actually takes the product unless the product is unavailable due to a default by the project company. Like feedstock supply arrangements, offtake agreements frequently are on a fixed or scheduled price basis during the term of the project debt financing.

Operations and Maintenance Agreement. The project company typically will enter into a long-term agreement for the day-to-day operation and maintenance of the project facilities with a company having the technical and financial expertise to operate the project in accordance with the cost and production specifications for the project. The operator may be an independent company, or it may be one of the sponsors. The operator typically will be paid a fixed compensation and may be entitled to bonus payments for extraordinary project performance and be required to pay liquidated damages for project performance below specified levels.

Management Agreement.

Loan and Security Agreement. The borrower in a project financing typically is the project company formed by the sponsor(s) to own the project. The loan agreement will set forth the basic terms of the loan and will contain general provisions relating to maturity, interest rate and fees. The typical project financing loan agreement also will contain provisions such as these:

Disbursement Controls. These frequently take the form of conditions precedent to each drawdown, requiring the borrower to present invoices, builders' certificates or other evidence as to the need for and use of the funds.

Progress Reports. The lender may require periodic reports certified by an independent consultant on the status of construction progress.

Covenants Not to Amend. The borrower will covenant not to amend or waive any of its rights under the construction, feedstock, offtake, operations and maintenance, or other principal agreements without the consent of the lender.

Completion Covenants. These require the borrower to complete the project in accordance with project plans and specifications and prohibit the borrower from materially altering the project plans without the consent of the lender.

Dividend Restrictions. These covenants place restrictions on the payment of dividends or other distributions by the borrower until debt service obligations are satisfied.

Debt and Guarantee Restrictions. The borrower may be prohibited from incurring additional debt or from guaranteeing other obligations.

Financial Covenants. Such covenants require the maintenance of working capital and liquidity ratios, debt service coverage ratios, debt service reserves and other financial ratios to protect the credit of the borrower.

Subordination. Lenders typically require other participants in the project to enter into a subordination agreement under which certain payments to such participants from the borrower under project agreements are restricted (either absolutely or partially) and made subordinate to the payment of debt service.

Security. The project loan typically will be secured by multiple forms of collateral, including:

a.	Mortgage on the project facilities and real property.

b.	Assignment of operating revenues.

c.	Pledge of bank deposits.

d.	Assignment of any letters of credit or performance or completion bonds relating to the project under which borrower is the beneficiary.

e.	Liens on the borrower's personal property.

f.	Assignment of insurance proceeds.

g.	Assignment of all project agreements.

h.	Pledge of stock in project company or assignment of partnership interests.

i.	Assignment of any patents, trademarks or other intellectual property owned by the borrower.


G.	Site Lease Agreement. The project company typically enters into a long-term lease for the life of the project relating to the real property on which the project is to be located. Rental payments may be set in advance at a fixed rate or may be tied to project performance.

Insurance. The general categories of insurance available in connection with project financings are:

Standard Insurance. The following types of insurance typically are obtained for all project financings and cover the most common types of losses that a project may suffer.

1.	Property Damage, including transportation, fire and extended casualty.

2.	Boiler and Machinery.

3.	Comprehensive General Liability.

4.	Worker's Compensation.

5.	Automobile Liability and Physical Damage.

6.	Umbrella or Excess Liability.

Optional Insurance. The following types of insurance often are obtained in connection with a project financing. Coverages such as these are more expensive than standard insurance and require more tailoring to meet the specific needs of the project.

1.	Business Interruption.

2.	Performance Bonds.

3.	Cost Overrun/Delayed Opening.

4.	Design Errors and Omissions.

5.	System Performance (Efficiency).

6.	Pollution Liability.

VI. Diagram of a Typical Project-Financed Deal

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For more information about the issues covered in this report, please contact Leslie E. Sherman in our San Francisco office at 415-369-7002 or at lesherman@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.

© 2002 Thelen Reid Brown Raysman & Steiner LLP