What Is Project Finance?
Put simply, project finance is an alternative financing approach that allows investors to participate in high-value projects by using the future cash flow generated by the project to repay the capital debt. There are many types of financing available to meet the needs of various business requirements, but project finance stands out as a popular choice for new projects for several reasons. In addition to being a simple and expedient form of financing , project finance differs from traditional financing in that it focuses on the future revenue generation of the business rather than the physical, tangible assets of the business. With project financing, the investors become involved in the project from the onset and are generally the ones who coordinate the legalities involved, including the structuring of the company. Continuing with our focus on the infrastructure and energy industries, this is very commonly used in large-scale infrastructure and energy projects.
Essential Legal Issues in Project Finance
The intricate web of regulations and contractual obligations surrounding project finance cannot be overstated. As such, understanding the key legal factors that contribute to the success or failure of a project is indispensable. These considerations extend far beyond the scope of mere compliance; they underpin the very structuring of the financing.
One of the primary legal factors in project finance is regulatory compliance. Given the vast matrix of local, state, and federal regulations that potentially impact a project, particularly in sectors such as energy, telecommunications, and infrastructure, an early and thorough regulatory review is essential. This includes not only environmental and labor laws, but also foreign investment regulations and sector-specific guidelines. Failure to comply with these regulations can result in severe delays and financial penalties, and ultimately, to project foreclosure in some jurisdictions.
Another major legal factor is contract management. Within the framework of project finance, contracts govern every relationship whether between sponsors, investors and lenders, or between the parties to the project themselves. The wording of these contracts must be precise, leaving no room for misinterpretation or loopholes that could impact the financial structure of the project. Clarity in allocation of permissions and responsibilities under the contract, coupled with enforceability, are crucial to smooth project advancement. Furthermore, these contracts must be readily updatable to account for evolving regulatory requirements and project conditions.
Finally, due diligence processes are pivotal legal factors that affect the structuring of project finance. To accurately assess project viability and quantify risks, a rigorous, independent due diligence process is necessary before financing is committed. This involves both legal and financial diligence, which includes analysis of the regulatory, fiscal, and legal aspects of the project. The findings from the due diligence phase influence the entire structure of the project’s financing: how much equity is required, how strong the guarantees for repayment need to be and how attractive the return on investments.
A further area that requires careful attention is the identification of liens and the possibility of creditor intervention. Depending on the seniority of the debt, the lenders may impose the right to foreclose on the project in the event of default. This can lead to a situation where the loan becomes senior to the preferred and common equity interest holders.
The due diligence will also identify, analyze and attempt to mitigate risks to the proposed project to an extent that all later responsibilities and obligations of the parties can be accurately assessed. This allows a picture to be drawn of the enforceability of the project finance contracts discussed above. It also allows the project to be segmented such that risks can be allocated to more appropriate parties, allowing the project to move forward while protecting the lenders’ interests.
Typical Legal Structures in Project Finance
An essential component of project finance is the underlying legal structure. The emphasis for purposes of legal structures is on allowing investors and lenders to limit their recourse to the project assets, and on allowing the owners and developers to separate the high-risk activities from the owner’s other business lines. On the other hand, project finance must be structured in a way that protects the interests of the lenders, who will want to ensure that they receive payment of projected debt service amounts out of cash flow generated by the project. To achieve these objectives, project financing typically requires the creation of special purpose legal entities designed to isolate the project from the other businesses of their owners.
The use of sub-holding company structures permits project sponsors to create "ring-fenced" structures with an added layer of corporate isolation. A "sub-holding company" is a group company in which the booking of group liabilities takes place; that is, a company that assumes the risks of a group of projects. From a technical point of view, a sub-holding company is usually a joint venture, which is owned by a "parent company", the group company from which the project companies are held. For project financing purposes, the project companies will usually be joint ventures between one or more sponsors and one or more financial investors (i.e., equity funds or institutions). The equity funds/institutions will subscribe for shares in the project companies and will be the sole shareholders in these companies.
The project companies will usually be funded by the project companies themselves through shareholder loans which the shareholders should subordinate to any senior project debt. The project companies will also owe debt to banks and other financial institutions to fund their respective schedules of capital expenditures and working capital. By ignoring the subordination of shareholder loans to senior project debt, the banks and financial institutions could find themselves with less security than they had expected for a project funded by shareholder loans. Such security would be even less than the amount they were actually expecting as a result of the fact that the project companies would be unlikely to have any other assets on their balance sheets sufficient to pay off the extended loans.
Managing Risks and Avoiding Problems
With the high costs of project development, financing parties look to manage and mitigate the risks involved in the project from inception, construction and operation. These mechanisms can be used in various phases of project finance. For example, a project may require an investment grade credit rating for the debt financing and/or a significant guarantee to secure financing in addition to or as an alternative to insurance. Contractual arrangements, such as indemnification clauses and limitations on liability in contracts with suppliers, contractors and other third parties, can shift risk away from the funding source for the project.
Insurance is a popular and often used risk mitigation tool in project finance transactions. While the supplier or contractor will have its own indemnification obligations for its work, the project owner will generally hold the majority of the risk for the various projects. This places a heavy importance on the project developer’s ability to obtain contractor performance bonds or letters of credit, as well as obtaining insurance coverage. Injury, failure to adhere to the financing documents requirements and even acts of God that may occur during the project period may be covered in the insurance policies. Since the insurance companies assume the risk after the fact rather than in advance as with the performance bonds and letters of credit, the cost of obtaining insurance can be less expensive than these other methods. This can be a critical factor when considering projects in certain parts of the world and with certain service providers. Contractors may be required to have certain coverage in order to perform under the contract. In some cases, if the contractor holds insurance for the work it is performing, the project owner will simply be added to the contractor’s insurance as an additional insured.
The insurance for a project may be cross-collateralized within a financing portfolio so that certain coverages and policies are shared among a group of lenders or investors. The lenders or investors will look at the amount of coverage, the financial strength of the insurance carrier and the expertise of the carrier in coverage such as possible environmental damage due to the project operations. Due to the nature of the insurance, it is often required that the insurance be maintained or renewed for the term of any financing.
Credit enhancements can help a project deal with credit risk. There are federal and state guaranteed loan programs available through institutions such as Export-Import Bank of the United States, the United States Agency for International Development and the Overseas Private Investment Corporation. The purpose is to promote advantageous borrowing rates or finance loans at favorable interest rates, which may only be available to certain borrowers that are deemed investment grade credit worthy. There are other credit enhancements that do not require government involvement. As mentioned above, these include bonds or letters of credit issued by contractors that are performing specific work. These are a common requirement for utility scale energy projects and can provide added assurances to lenders. Some banks may offer credit enhancement facilities, under which they issue guarantees or surety bonds.
Ownership of the facilities is often structured as a special purpose entity (SPE). This diminishes the possibility that the liabilities of the SPE could fall back to the lenders, investors, and other key counterparties. The project owner is the sole member of the SPE.
There are additional methods of risk allocation in project financing, such as indemnities and assigning of contracts. Indemnification provisions in contracts can provide assurances that the contractor will, for example, defend the project against losses resulting from breaches of contract or warranties. In addition, indemnification in certain contracts, such as power purchase agreements, can allow the buyer to make a claim with respect to damages suffered as a result of a default. The SPE structure and collateral assurances, including assignment of the collateral for the benefit of the lenders, are also important components of risk allocation. The lenders are provided with the collateral exclusive of borrower’s other assets as security for the loan. Requiring the borrower to assign the construction and consulting contracts to the lenders provide the lenders with additional comfort in the event construction is nonconforming, malperforming or terminated.
Key Legal Documents in Project Finance
Central to the success of any project finance transaction is the legal documentation that establishes the rights and obligations between the parties. Among the key legal documents involved are the loan agreement (also known as a credit agreement or facility agreement), security agreement (or deed creating security), and the financial covenants in the loan agreement.
The loan agreement will set out the amount and type of financing being provided, the interest rate, as well as the conditions for drawdown and repayment. It will also include provisions relating to default and default remedies, and will typically contain covenants by the borrower, including negative covenants, financial covenants (such as debt service ratios and minimum recurring capital expenditures), and positive covenants (methodologies for reporting debt service coverage ratios, and requirements for maintaining insurance). Where appropriate , the loan agreement may also provide for anti-embarrassment and right of first refusal provisions, in addition to customary exclusions.
The security agreement will create security over the project assets. A perfection opinion will likely be obtained from counsel (typically the lender’s counsel, who will also review the loan agreement) in respect of the enforceability and perfection of the security created. Perfection may require registration of the security interest on the applicable changes to title or property registry, or through other means, depending on whether the security is over real estate, personal property or chattel property.
An essential consideration in any project finance transaction is the allocation of risk, and the impact of that risk, or the mitigation of that risk, on the pricing of the financing, as well as the effect of that risk on financial covenants.
Issues and Solutions in Project Finance
Projects are conducted in a context where there are high levels of capital expenditure, long term commitments or a combination of both. They also involve many stakeholders making a contract solely with the Contractor impractical. The legal issues in engaging with multiple stakeholders and defining the relationship led to the development of Project Finance legal structures.
Standout features of project finance structures are:
a. Sponsors will typically accept a lower return on investment in order to participate in such a large scale investment;
b. Finance is normally raised from a variety of sources in order to manage the risk;
c. A key risk, particularly for long term projects, is the termination of an engagement with the Contractor. A well structured contractual framework will manage that risk, including insurance, guarantees, registered mortgages and creating security agreements over assets. In Aveng (Africa)(Pty) Ltd v The Master of the High Court, it was stated that an unregistered mortgage bond is nevertheless enforceable against a successor in title where there is a right to register such a bond in terms of legislation.
Many Developers do not have necessary provisions in place relating to the security requirement dealing with the release of security contemplated in a bonds registration. The proposed amendments to the Deeds Registries Act made the registration of a mortgage bond contingent upon the inclusion of the full cost of the construction in the security without regard to the mechanism for disbursement. The Court has held (Equity Aviation Services (Pty) Ltd v Corporacion Nacional de Fuerzas Aeronavales) that the purpose of the prohibition is to ensure that the whole of the claim for the construction price is secured and not only parts hereof. There are instances of considerations (including administrative and liquidity constraints) that caused entities to secure less than the aggregate value of the construction price. These should be addressed as soon as possible.
A quality relationship with the Contractor is essential to the successful implementation. Where an ongoing relationship is maintained a contract can be renegotiated to deal with the challenges requiring resolution. For example, the parties may need to deal with force majeure events. It would be prudent to insert a force majeure clause in the contract which allows for extension of time and/or price adjustment and, if the negotiation fails, the dispute resolution mechanism may need to be invoked.
Emerging Trends in Project Finance Law
The future trends in project finance law are poised to be shaped significantly by the rapid pace of digital transformation and an increasing emphasis on developing sustainable projects. The technological advancements in recent years such as blockchain, artificial intelligence, and sophisticated data analytics will all inevitably impact the structure and delivery of legal services and, more specifically, project financing transactions. The use of blockchain technology has the potential to revolutionize not only project finance but the entire lending business. Digitization can significantly reduce traditional paper and waste in the closing process while improving the reliability of the transaction data contained within documents.
Another significant focus of the coming years will be on more sustainable and responsible investing . There is growing recognition by lenders, borrowers, and bond investors of the need to consider the environmental and sustainability impacts of a project and the desire now to align their investments with their values. This is becoming more prevalent with investors aligning their portfolios with ESG values, with many funds incorporating ESG factors into risk analysis for investment decisions. In particular, the effect on the environment is becoming a more important consideration by project financiers.
Project finance law is also likely to be impacted by increasing efforts towards connecting new projects with necessary social and physical infrastructure. The World Economic Forum has recommended projects undergo an assessment process that includes social impacts. There is also a shift away from mega-projects to smaller projects that can occur in incremental phases to help manage risk. Additionally, lenders increasingly want to know whether projects financed do support the UN Sustainable Development Goals.
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