Is Innovation Challenging the Traditional Principles?
The Spanish project finance market has become increasingly active and sophisticated during the last few years. While many transactions have become commoditized (for example, wind farms, toll roads) and closely follow the traditional principles of project finance, a number of projects evidence a high degree of innovation that occasionally challenges what were thought to be principles set in stone. Innovation has been fostered by strong competition between banks, the sophistication of the players involved -banks, sponsors and their advisers-, the size and bargaining power of Spanish sponsors and, until recently, the almost irrational liquidity of the markets. Another interesting development in the Spanish market is that it has become truly international. Spanish companies have invested heavily in infrastructure and energy projects in Latin America, Portugal, the UK, Italy and Poland, among other countries. Spanish banks have been wise enough to follow their clients' lead and now have exposure to projects in many jurisdictions.
Whether this trend will continue following the recent liquidity crisis that began last spring, remains to be seen. It is worth, however, reflecting on some of the traditional principles of project finance that seem to have been challenged in recent years. These are some examples.
Construction risk must be transferred at financial close. In ordinary projects, on or before financial closing, the borrower will sign an EPC contract with an experienced and creditworthy contractor who will construct the facility at a fixed or maximum price within a clear timeframe and subject to certain technical specifications. Otherwise, at a minimum, the lenders will require a project completion guarantee. However, the Spanish market has seen at least two projects where the borrower was not required to sign a construction contract at financial close and, therefore, did not effectively transfer the construction risks (cost overruns, delay and technological risks) to a predetermined contractor. In both projects the borrower agreed to sign, within a defined period, specified project contracts (in lieu of a single EPC contract) meeting certain requirements, such as execution with a contractor from a list agreed with the banks, substantial adherence to pre-agreed general conditions, compliance with certain critical milestones instead of a detailed construction schedule, compliance with minimum technical specifications and a maximum price per contract, that could be exceeded with the savings obtained in the price of other project contracts. This allowed the borrower, whose shareholders were experienced in the construction of similar facilities, to have great flexibility and significantly reduce the project costs.
The project must be defined at closing. In a large wind-farm project which involved construction activities in more than ten different sites in the same region, the banks authorized the borrower to change, without their prior consent, the location of some wind farms, subject to certain minimum requirements. This allowed the borrower to complete any part of the project on a different site if the original site faced unexpected permitting problems or wind tests, which were not complete on financial close, revealed a shortfall with the base case.
Only new assets are financed. Project finance structures have been used to finance the purchase of existing operating assets through SPVs with limited recourse to the sponsor. The line which separates these deals from an acquisition financing is not clear. However, the term, the covenants and the supervision of technical advisors throughout the life of the facility make these financings look and feel like project financings.
Completion guarantees. The Spanish practice used to require broad completion guarantees in all kinds of projects, even in the absence of significant technological or regulatory risks. However, the recent market trend is to reduce this requirement to a select few cases, such as projects developed outside Spain, particularly in Latin America.
Project finance lenders are the only financial creditors of a project. In some large projects the borrowers have required flexibility to contract additional debt. Permitted indebtedness has included a range of unsecured or junior facilities that could be incurred with other lenders outside the syndicate without the need to execute an intercreditor agreement. This structure will allow, for example, a borrower to expand its facilities.
The borrower must be a special purpose vehicle. In the case of two projects involving concessions of public services -a waste project and a water project- the borrower was an operation company. In one, the concession agreement -which dated back to the early 1990s- was amended to include additional services requiring expanded facilities. The existing facilities had been financed by the EIB and commercial banks. A new non-recourse financing was set up to refinance the existing debt and to fund the expansion. Such structure offered the advantage that the existing business could cover a large part of the debt service incurred as a result of the new investment. With respect to the other project, a new independent concession was awarded to an operating company which held other concessions and had different creditors. A complex ring-fencing structure had to be created and the claims of each lender to certain assets had to be limited.
It is fair to question whether some of these deals were truly project financings or some other type of financing. But one can also wonder whether innovation is changing some of the traditional principles of project finance. The current liquidity crisis has significantly reduced the leverage of borrowers in negotiations and has made banks more cautious. The future will tell if some of the trends that we have outlined will remain with us.