Underlying terms and conditions refer to financial covenants, but also to cash-trap or lock-up periods, equity pre-funding requirements, additional administrative, legal and technical burdens to meet funding criteria, and fiscal impacts from rigid transaction structures.
To illustrate, in the past five years major project finance banks such as Japan’s MUFC, Spain-based Banco Santander and France’s Natixis, among many others, and capital markets, have increasingly offered long-term traditional non-recourse financing.
This array of optionality allows developers to obtain more efficient financing in both cost and tenor terms. However, the macroeconomic shocks from the global pandemic have taken their toll. Banks across the globe are forced to once again walk the tightrope of lending cheaply in order to stimulate economies without over compromising their limited capital, and as pricing is essentially taken out of banks’ hands, their focus has shifted to things they can still control: underlying terms and conditions.
Faced with this predicament, banks are attempting to control their risk exposure as much as possible, and how a bank goes about attempting to control said risks is the difference between a lender that is simply willing and a lender that understands a project.
In the Chilean renewables sector, project debt headline terms (rate, leverage and tenor) and overall appetite have not drastically deteriorated, but banks’ risk committees are attempting to further reduce their risk exposure. In Chile, this has translated into stricter underlying terms and conditions with many implications at the project and HoldCo levels.
In these Covid-19 times, we have seen firsthand where project loans’ underlying conditions and their resulting operational issues have as great an impact on a portfolio’s profitability as does the nominal cost of the debt.
Because of their nature, it is highly complex to compare terms and conditions (not least because of confidentiality issues), but project sponsors need to be mindful that a lender should not only be willing to finance the project (which is essential), but also understand their project’s specific risks and particularities so that the loan reflects (as best as possible) the reality on the ground.
When a project finance mandate is executed, a substantial amount of time should be dedicated to sourcing and speaking with potential lenders. This stage can (and should) be highly hands-on and time intensive, but it is time well spent because this is where we can gauge a potential lender’s level of understanding. Their overall level of comfort will ultimately be reflected in the loan’s underlying conditions, which will in turn greatly affect a project’s long-term profitability.
One possible lesson from recent experiences is that the cost of debt should become slightly less important to a project sponsor, especially since interest rates are pushed lower and lower by central banks across the globe.
Interest rate margins are once again tightening, and yield curves are flattening. Benchmark rates are being lowered, as are spreads, to incentivize investment in the midst of the global Covid-induced recession.
One conclusion is that the most expensive project debt will not be vastly more expensive than the least expensive project debt. The other is that sponsors should instead be increasingly focused on anticipating the operational aspects of a loan’s underlying terms and conditions.
Firstly, banks are taking steps to further minimize their exposure to construction risk. This is done by enforcing stricter conditions in the security package before a project can be considered eligible for funding (more milestones must be accomplished by the sponsor), increased pre-funding equity amounts, increased conservatism in revenue and cost projections, greater oversight into the EPC and insurance companies and, in some cases, the involvement of credit agencies to assess counter-party risks.
These measures increase the amount of cash required from the sponsor at this stage, in addition to raising the overall cost. As a developer, your most precious tangible asset is cash, and its finite nature means it has a high opportunity cost associated to it.
Increased cash requirements per project means that other projects (opportunities) are being passed on or delayed. In development, the opportunity cost of development equity is a sort of Golden Rule, and raising the cash amount a sponsor needs to commit to a single project for it to reach COD has profound implications on their business.
During the operational phase, there are several measures Chilean lenders are opting to put in place to further control risks. For example, forcing a certain organizational structure (DevCo, BuyCo, HoldCo*, etc.) on the sponsor could have tax implications and administrative inefficiencies that will need to be borne at the corporate level.
It is not new for a lender to isolate the financing structure as much as possible, but we have seen additional layers or burdens put in place. Also, additional reserve accounts of an increased magnitude mean that less of the raised funds will be available to the sponsor. Along these lines, increased limitations (time and operative) on when a project can declare dividends means that a sponsor will need to wait longer before beginning to recoup its equity.
Of the previously mentioned points, this last topic particularly has a direct and significant impact on a project’s Internal Rate of Return (IRR). That being said, one way that can generate additional value for the invested equity is by raising subordinated debt tranches. By negotiating rates and tenors that behave like the project’s senior debt, the subordinated debt or junior debt can help boost equity returns.
In closing, in today’s macroeconomic environment, a project sponsor should consider reformulating their focus when analyzing potential lenders. Instead of targeting the cheapest lenders and asking, “at what rate?”, going forward maybe it should be replaced by “do you understand my project?” and “how will you lend?”
- * DevCo: Development company, an entity created for the purpose of holding projects during their development phase.
- BuyCo: a separate entity created in parallel to the DevCo, to “purchase” the projects from the DevCo once they are fully permitted or have begun construction or are operational.
- HoldCo: Holding company, same function as a BuyCo, but different in terms of project finance. The HoldCo is the entity that is the borrower and will receive the funds from the bank. Only projects that are eligible and typically operational can be on the books of the HoldCo. While the projects are not yet eligible (still under development), they are held by a DevCo
About the author
Carlos Marron is Managing Partner of Latin America for Finergreen, an international financial advisory boutique specialized in the renewable energy sector (Solar, Wind, Hydro, Biomass and Storage). The company has completed €2.1 billion of transactions representing more than 6 GW of assets. With a team of 50+ people based in Paris, Madrid, Budapest, Dubai, Singapore, Mexico, Abidjan and Nairobi, the company operates through three main segments: Mergers & Acquisitions, Project Finance and Strategic Advisory. Based in Mexico City, Carlos and his team cover Central and South America, including the Caribbean. Carlos has over 10 years of M&A experience in Mexico and LatAm, and holds Bachelor's degrees in Finance and in Economics from Southern Methodist University.
The views and opinions expressed in this article are the author’s own, and do not necessarily reflect those held by pv magazine.
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