The Attitude Of Lenders To A Project Finance Proposal; Banks In Perspective -By Oyetola Muyiwa Atoyebi

The failure of sponsors to understand the bank’s ‘risk-reward’ judgment in concluding is a major area of concern in project finance.

 Project finance is limited recourse, thus when it goes bad, banks stand to lose their principal and interest. It is a project with the lowest possible risk. If the project scales, they will receive their money as well as any accrued interest, resulting in a relatively small gain.

 As a result, sponsors must approach these institutions, with a package that indicates a grasp of their anticipated concerns, and strive to resolve these concerns practically. That is, you must demonstrate that the project will be able to discharge its debts, with a sufficient margin of safety, in a variety of scenarios.

INTRODUCTION

Sponsors[1], investors, lenders[2], insurers, operators, suppliers, host governments, off-takers, experts/professionals, and lawyers are just a few of the parties involved in project finance. The role of lenders in project finance, particularly banks, and their approach to project financing are the subject of this article. Project finance is defined as the financing of a project, asset, or activity that is repaid primarily through the cash flow created by the project or asset being funded. As a result, lenders often have no access to the project sponsor(s)’ other assets or cash flows, earning the terms “limited/non-recourse financing” or “off-balance-sheet financing.” This also means that lenders will be more discerning when evaluating applications for such projects. Why do businesses use this concept, in a nutshell?

On the surface, there are a few reasons:

• isolating the project in this manner allows the sponsor to ‘hide’ the debt on its balance sheet;
•  where the project is a success, it increases the return on equity invested in the project;
•  it is attractive for projects involving more than one sponsor where a joint structure is preferred;
•  where capital is limited and must be allocated across projects, it increases the debt element of a project’s funding;
•   the sponsors may want to insulate themselves from both the project debt and the risk of any failure of the project;
•  Legislation in particular jurisdictions may indirectly force the sponsors to follow the project finance route (e. g. where a locally incorporated vehicle must be set up to own the project’s assets)[3] and lastly, but not exhaustively;
• it may be the only source of finance available for some sponsors. This is not an exhaustive list, but one or more of these reasons will likely feature in the minds of sponsors who have elected to finance a project on limited recourse terms.

BANK’S GENERAL CONSIDERATIONS

The parties who will have a role (however tiny) in the project, whether at its start, during building, or throughout the operation, must be examined before a decision to financially support or lend to it is made. In addition, it usually entails the examination of the following:

1. The creditworthiness of the parties and, in particular, whether they have sufficient financial resources to meet their obligations under the relevant project documents.
2. The capacity of the parties to deliver and perform according to the specific provisions of the project documents.
3. Independence of the project parties in light of the political considerations of the project jurisdiction.
4. The continuity of the project, and whether the early parties would be involved throughout the project, or would be looking to transfer their interest at a future date.
5. The expertise of the parties providing professional advice on the project and whether they have obtained indemnity for negligent advice.
6. The lenders will be concerned to ensure that each party that contracts with the project company, is duly authorised to enter into contracts with the project company, and that its obligations under these contracts constitute its legal, valid, binding and enforceable obligations[4].

These are some of the factors that lenders assess before selecting whether or not to lend to a particular party. It is worth noting that these worries are similar to those expressed by sponsors. As a result, a thorough understanding and assessment of these problems are beneficial not only in approaching banks with an effective proposal, but also throughout the project’s success.

Having laid the foregoing foundations, let us now examine the bank’s attitude when presented with a capital-intensive project financing opportunity. The bank usually asks three questions to wit:

1. Is the project scalable/bankable?
2. What are the risks inherent to the project? Are they acceptable or can they at least be mitigated?
3. Is answering the first two questions worth the effort to warrant an acceptable deal structure?

SJ Mills and Melissa Taylor[5]  approached these questions backwards because they believed they were crucial, particularly for smaller renewable energy entrepreneurs seeking project financing for the first time.

Many times, banks have told sponsors that the technical risk is too high, that the expected return is unrealistic, or that the sponsor is too tiny for a project of that size. In practice, if a sponsor presents its proposal in a way that provokes these or similar reactions, the proposal or its delivery has failed. The sponsor may believe that the lender did not pay close attention to the project proposal, or that the lender did not grasp the scope and nuance of the project from the proposal, or that the lender did not even consider ways to eliminate or, at the very least, mitigate the risks posed, and they may be correct.

However, at that time, it is fruitless to do so because the chance may have passed you by. Before beginning a full review of the proposed project, the sponsor has to know the lender’s initial attitude.

To begin, the sponsor must be able to keep up with the situation of the global banking market, as well as the bank’s financial capacity and health at the time. Many banks have suffered losses as a result of events such as the third-world debt crisis, troubles in the US secondary banking market, the effects of recessions on their customers, the 2008 financial crisis, and, most recently, Covid-19 and its ramifications. Project finance is a specialized, high-risk, capital-intensive branch of banking that few banks are willing to embark on. As a result, sponsors should conduct their due diligence and approach those banks that have the credit capacity to fund such capital-intensive projects. There are banks (and other financial organizations), that have set aside funding for high-intensity projects particularly. Sponsors can also attempt to leverage existing ties, since banks are more likely than not to support current clients during moments of capital restraint.

Another common problem is sponsors’ incapacity to comprehend the bank’s ‘risk-reward’ analysis when coming to a decision. Project finance being a limited recourse, banks risk losing both principal and interest if it goes bad. It’s a project with the lowest possible risk. If the project scales, they will receive their principal as well as any accrued interest, so there is only a minor benefit.

Sponsors must thus, approach these institutions with a package that displays a grasp of their anticipated concerns, and a reasonable attempt to address these issues. That is, you must show that the project will be able to discharge its debts, with a sufficient margin of safety in a variety of circumstances.

Once the sponsor has cleared this hurdle, the next step is Risk Analysis and Allocation, as well as the project’s bankability. These two aren’t explored in detail because they necessitate a more technical approach appropriate for different types of literature. Sponsors should be aware, however, that banks will conduct risk assessments in the areas of sponsor standing, technology risk, completion risk, input/supply risk, operating risk, approvals/environmental risk, and offtake/sales risk.

Finally, in terms of scalability, banks would most likely examine some cover ratios relating to cash flow generated to debt outstanding, as well as compute the loan amount to ensure that minimal cover ratios are maintained throughout the loan’s term.

SECURITY FOR PROJECTS

Security is crucial in project funding, and it frequently determines how a project is constructed. As previously stated, lenders often have no access to either the sponsor’s or the project’s assets, and rely on the project’s cash flow to repay loans secured for the project.

As a result, lenders must ensure that legitimate and effective security interests, in all or portion of the project assets, are taken. If there is a problem with the project, the lenders will be required to enforce their security over the project assets as the only way to get their money back.

If the project company is a special-purpose vehicle, it is likely that the lenders will have taken security over all of its property and assets, and will seek to have control of those assets to the exclusion of other creditors.

If the project firm is not a special purpose organization and has other assets in addition to the project assets, these assets will certainly have been ring-fenced, limiting the lenders’ efforts to exercise their security against the project assets alone. This is one of the key reasons why project finance is done through special-purpose vehicles.

CONCLUSION

When lenders take security over assets they’ve financed, the primary goal is to ensure that the lenders can sell the assets if the security is enforced. In most jurisdictions, this will not cause insurmountable challenges for lenders in the event of movable assets such as ships and aircraft. Similarly, most real estate will find a buyer at a price that is determined by the state of the local real estate market, and the sort of property in question.

The capacity to sell project assets, on the other hand, will not be the primary motive for taking security in the first place for most projects. Instead, they will focus on achieving the lenders’ goals. They consider a thorough security package as a defensive mechanism in this case, meant to prevent other creditors from taking security over the assets they have financed, as well as other creditors from attempting to attach them.

As a result, a project sponsor must understand the varied concerns of banks to produce a robust and personalized proposal, that adequately addresses the bank’s issues.

The failure of sponsors to understand the bank’s ‘risk-reward’ judgment in concluding is a major area of concern in project finance.

 Project finance is limited recourse, thus when it goes bad, banks stand to lose their principal and interest. It is a project with the lowest possible risk. If the project scales, they will receive their money as well as any accrued interest, resulting in a relatively small gain.

 As a result, sponsors must approach these institutions, with a package that indicates a grasp of their anticipated concerns, and strive to resolve these concerns practically. That is, you must demonstrate that the project will be able to discharge its debts, with a sufficient margin of safety, in a variety of scenarios.

AUTHOR PROFILE                                          

AUTHOR: Oyetola Muyiwa Atoyebi, SAN.

Mr. Oyetola Muyiwa Atoyebi, SAN is the Managing Partner of O. M. Atoyebi, S.A.N & Partners (OMAPLEX Law Firm) where he also doubles as the Team Lead of the Firm’s Emerging Areas of Law Practice.

Mr. Atoyebi has expertise in and a vast knowledge of Corporate Law and Commercial Law and this has seen him advise and represent his vast clientele in a myriad of high level transactions.  He holds the honour of being the youngest lawyer in Nigeria’s history to be conferred with the rank of a Senior Advocate of Nigeria.

He can be reached at atoyebi@omaplex.com.ng

CONTRIBUTOR: Ibrahim Wali

Ibrahim is a member of the Project Finance Team at Omaplex Law Firm. He also holds commendable expertise in project management.

He can be reached at ibrahim.wali@omaplex.com.ng

[1] The project sponsors are those companies, agencies or individuals who promote a project, and bring together the various parties and obtain the necessary permits and consents necessary to get the project under way.

[2] Lenders are simply those persons, institutions, cooperatives and other legal entities who provide funds for the development of projects in agreed rations. For this article, we look at banks as a class of lenders, thus bank and lender are used interchangeably.

[3] Dentons, A guide to project finance, 2013.

[4] S J Mills and Melissa Taylor, ‘Project Finance for renewable energy, Renewable Energy’, Vol.5, Part I, pp. 700-708, 1994 Elsevier Science ltd, Great Britain.

[5] Ibid 4