An introduction to project finance

documents
https://www.out-law.com/en/topics/financial-services/project-finance/an-
introduction-to-project-finance-documents/

Accessed 27 April 2017

Project finance is a long-term method of financing large infrastructure and

industrial projects based on the projected cash flow of the finished project
rather than the investors' own finances. Project finance structures usually
involve a number of equity investors as well as a syndicate of banks who will
provide loans to the project.

The types of project for which project finance is commonly used include the
following:

infrastructure projects, such as government buildings and transport

systems;
oil and gas exploration projects;
sports stadia; and
liquefied natural gas development projects.

In the UK, most project financings have been carried out under the
Government's private finance initiative (PFI) and are known as Public Private
Partnerships (PPPs). PFI was introduced in the early 1990s and aimed to
introduce private sector skills and finance into the provision of public sector
services. PFI is structured so that the private sector obtains finance - usually
from a bank - to design, build and operate a facility for the benefit of the
public. In return, the public sector grants this private sector partner a long-
term contract to run the facility - usually for 25-30 years. Once the facility has
been built, the public sector pays the private sector a monthly fee over the life
of the project which is used to service the bank loan which financed the project
which is used to service the bank loan which financed the project.

PFI has traditionally been used because:

it is argued that the public sector gets better value for money in the long
term by transferring the risks of building and running the facility over
the life of the project to the private sector. This means that the private
 sector, which is generally perceived as more efficient, manages the risks
of the project; and
since the public sector is essentially purchasing a service rather than
outlaying the significant capital cost of building, for example, a school or
a hospital, it does not need to account for this cost as a liability on its
balance sheet. This means that the public sector does not have to borrow
to finance the capital cost.

Key parties to a project financing

Private sector partner/owner: Usually a corporation or a limited

partnership created for the sole purpose of the particular project. This party is
at the centre of all contracts, borrowings and the construction and operation
of the project. For simplicity, we refer to this party as 'Projectco'.

Project sponsor: The person who takes on the active role in managing the
project. The project sponsor owns Projectco and will receive profit, either as a
result of the ownership of Projectco or via management contracts, if the
project succeeds. The project sponsor often has to cover certain liabilities or
risks of the project by providing guarantees or by entering into management
or service agreements.

Lenders: Commercial banks, investment banks or other institutional

investors who provide the debt portion of the project financing. The sheer
scale of a typical project financing means that most lending cannot be
undertaken by a single lender. Instead, group of lenders form a syndicate.

Agent: one of the lenders will be appointed as the agent and will act on behalf
of the other lenders to administer the loan.

Account bank: a single lender will hold the accounts through which all the
cash generated by the project will pass.

Equity investors: lenders or project sponsors who do not expect to have an

active role in the project. In the case of lenders, they will have a shareholding
in addition to lending by way of debt, as a way of receiving an enhanced return
if the project is successful. In most cases any investment by way of shares is
coupled with an agreement to allow the equity investor to sell its shares to the
project sponsor if the equity investor wishes to exit the project. Similarly, the
project sponsor may have the option to repurchase the shares.
Suppliers, contractors and customers: these include the suppliers of
materials for the project, the contractors responsible for designing and
building the project and the customers of the project.

Construction company: the construction contractor is one of the key

project parties during the construction phase of the project. Typically, a
construction contractor's remit will be based on one of two models:

turnkey model: where the construction company designs, engineers,

procures and constructs the project output, assuming all responsibility
for timely completion; or
EPC model: where the construction contractor engineers, procures and
constructs the project output but does not design it.

Consortia of contractors may be involved in larger projects. As far as liability is

concerned those contractors can be either severally or jointly and severally
liable. Several liability means that each contractor is only liable for its own
contribution to the project, while under joint and several liability any
contractor can be pursued for the whole of the obligation and it will then be
the responsibility of the consortium to sort out the extent of each contractor's
obligations. Lenders prefer the joint and several liability, since the risk of
failure of performance is then the total responsibility of each member of the
consortium.

Multilateral credit agencies: some projects - particularly in developing

countries - are co-financed by the World Bank or its investment bank division,
the International Finance Corporation, or regional development banks such as
the European Bank for Reconstruction and Development or the Asian
Development Banks. Multilateral agencies such as these are able to ensure the
bankability of a project by providing commercial banks with a degree of
protection against political risks, such as the failure of a government to make
agreed payments or provide the necessary regulatory approvals.

Host governments/awarding authorities: the government of the

country where the project is based is likely to be involved in issuing consents
and permits both at the start and throughout the life of a project. The
awarding authority is the contracting local authority which enters into the
project agreement with Projectco.

Purchasers: in infrastructure projects, Projectco will normally contract in

advance with a purchaser who will purchase the project's output on a long-
term basis.
Insurers: insurers are vital to a project. If there is a catastrophe affecting the
project, then the sponsors and the lenders will look to the insurers to cover the
losses.

Key documents in a project financing

Project agreement: the principal agreement for any PFI project, the project
agreement governs the relationship, rights and obligations between the public
authority and Projectco throughout the term of the project. It can also be
called a concession agreement.

In early PFI projects, it was common to have separate agreements for different
phases of the project, such as a development agreement for the design and
construction phase and an operating or facilities management agreement for
the operating phase. However, these days it is more common to have a single
project agreement covering all aspects of the project.

Property documents: where the project involves land-based development,

property documentation will be required to reflect the interests of the public
authority and Projectco and the intended ownership position at the end of the
term of the project. Some common structures are:

the public authority grants a licence to Projectco this would occur

where no property interest could be granted or would be needed by
Projectco;
the public authority grants a lease to Projectco with a lease back to the
authority this has occurred in a number of hospital projects where the
interest in land was acquired by Projectco to construct the project but
the authority was to occupy the building throughout the term of the
contract;
the public authority retains the freehold interest and grants a lease to
Projectco with no lease back for the term of the contract; or
Projectco retains the freehold interest and grants a lease to the authority
for the contract term.

The type of structure used will depend on the type of facility comprised in the
project and who will be responsible for its operation once the construction
phase is completed.

Construction contract: Projectco will enter into the construction contract

with the building contractor, under which Projectco's construction obligations
under the project agreement will be passed on to the building contractor.
The building contractor and design team provide warranties in favour of both
the authority and the lenders. The lenders generally have the first right to step
into the construction contract in place of Projectco. Any rights the Authority
has are usually subject to the rights of the lenders.

Service contracts: Projectco enters into service contracts with the service
providers and passes on its service obligations under the project agreement to
those contractors. As above, the service providers provide warranties in favour
of the authority and the authority has step-in rights in certain circumstances
again, subject to the rights of the lenders.

Funding agreements: the facilities agreement is the main document

between the lenders and Projectco and contains the terms of the project
funding. The lenders will also require a security package and guarantees to
protect the funds lent. The loan agreement is discussed in more detail in our
separate OUT-LAW Guide to Key issues for lenders in Project Finance
Agreements.

The lenders' direct agreement: this is a three-way agreement between the

authority, Projectco and the lenders under which the authority agrees to give
the lenders a period of advance notice of the impending termination of the
project arrangement. This agreement will also offer the lenders the
opportunity to step in, either directly or through a nominee or representative,
to remedy the termination event or to find another party acceptable to the
authority to take over the rights and obligations of Projectco under the project
agreement.

Authority collateral agreements: these have emerged as an extension of

the concept underlying the lenders' direct agreement. Authority collateral
agreements are entered into between the authority and the contractors which
contract with Projectco. The intention is that, if Projectco defaults on its
responsibilities under the contract during the construction phase, the
authority can ensure that the project is completed by taking over the relevant
contract from Projectco. In addition, the authority will be able to take over the
operating contract from Projectco if the project is terminated.

Sub-contracts: various sub-contracts are put in place by Projectco to pass

down the risks it undertakes under the project agreement. It is common for
Projectco not to undertake any of the key activities itself but to instead be a
vehicle for forming the suite of contracts associated with the project - hence
the term 'special purpose vehicle'.
Performance bonds: there are two main scenarios Projectco will have to
pay for where performance bonds may be used:

where the authority requires a performance bond to be issued in its

favour by an acceptable surety to cover claims which may arise against
Projectco during the construction phase when, if a default were to occur,
it is likely that Projectco would not be able to meet a claim. The bond
and the cost will ultimately be met by the authority. As a result their use
is not common;
where the lenders require performance bonds to be issued on behalf of a
key contractor because they are not satisfied with the financial strength
of that contractor.

Collateral warranties: the lenders and the authority typically seek

contractual warranties from key contractors and consultants appointed by
Projectco. The value of collateral warranties, to the authority in particular, is
that they protect the position of the authority following termination of the
project where the losses of the authority exceed the value of the built (or
partly-built) project.