Focus on: DUE DILIGENCE IN PROJECT FINANCE
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At a time where the Programa de Recuperação e Resiliência (Recovery and Resilience Program) the nationally applicable program designed by the Government in order to address the reforms and investments aimed at restoring sustained economic growth and supporting the goal of convergence with Europe over the next decade is giving its first steps; at a time where there is a strong purpose of modernizing a number of key infrastructures and at a time where the transition to a greener economy and society offers important opportunities it is even more important to address once again the importance of project finance as a key financing source and of due diligence within the scope of project finance.
Over the next few years Portugal will have to embrace a development strategy that requires intensive capital investments and consequently accessing to important financing sources.
Considering the nature of the of the programmed investments it is only natural to believe that project finance will be a central financing resource in the Portuguese market in the years to come and considering the importance of due diligence in the project finance operations, this will be a trendy subject also in the next few years.
Getting back to basics it is relevant at this stage to try to identify the project finance main characteristics and its importance as a financing resource of long term investments in infrastructure and other significant investments in other areas.
According to many authors project finance operations can be identified by a number of common characteristics, among which we can identify the following ones:
- a long term investment operation, most often in large infrastructures of different nature, such as airports, roads, railway network, energy production, hospitals, water or energy supply, etc., requiring large investments;
- the medium/long term financing is the main financing source and it prevails over equity in ratios that usually vary between 70%/30% to 90%/10%;
- the reimbursement of the financing relies on the cash flows generated by the project;
- the project is developed or carried out by a special purpose vehicle (SPV) incorporated by the project sponsors; this SPV usually has a very limited corporate purpose and a very restricted activity usually limited to the execution of the activities connected to the project;
- all the project is based on a model that is the project’s expected case, determined by using the assumptions that the project team considers are most likely to occur. This model must also consider the evolution of the different variables that may impact the project not only regarding its execution and costs but also regarding its forecasted revenues.
Because project finance largely depends of the income stream of the project for the repayment of financing, the reliability of the project’s model and the determination of the risks to which a given project is subject to are paramount in project finance.
It is also important to bear in mind that project finance implies a web of agreements between different entities – sponsors, lenders, the different agents, Engineering Procurement and Construction (EPC) companies, Operation and Maintenance (O&M) entities, etc. – each one having a specific role in the structure of the project but each one also depending on the fulfillment by the others of their undertakings.
The evaluation of the soundness and reliability of each one of those entities is also essential to the project.
PROJECT RISKS AND DUE DILIGENCE
When analyzing the case in which relies the project finance operation and the entities that will take part in the project, the lenders and other relevant entities conduct a due diligence in order to try to determine, assess, the risks to which the operation is subject as well as to analyze the soundness and reliability of each one of the participants in the project.
These projects’ risks appraisals are, in this context, multidisciplinary evaluations of, among others, technical, legal, financial and environmental aspects of the projects aimed at detecting circumstances or events that may negatively impact the project thus leading to its total, or partial, failure, ultimately meaning, the impossibility of generating the cash flows required in order to reimburse the financing within the forecasted deadlines.
It is therefore easy to understand the key importance of due diligence in any project finance operation.
Having established the importance due diligence plays in project finance operations, we believe it could also be of interest to try to identify which would be the most common risks to which the project finance operations can be exposed to.
Diane Desierto, in her text Due Diligence in World Bank Project Financing, identifies the following risks:
- completion risks;
- operating risks;
- supply risks;
- currency risks; and
- political risks
among the many risks that usually affect international projects.
Like in any other categorization, other authors identify different risks, or use different names for identifying identical risks, or establish different categories of risks.
It is therefore common to come across with risks identified such as market risks, contractual risks, authorizations risks, offtake risks, etc. Despite all the efforts made in order to systematize project finance operations it should be kept in mind that each project has its own characteristics, each project has its own specificities and is, consequently, affected by risks of its own that despite being similar to the risks found in other projects may impact the different projects differently.
As a consequence, the due diligence to be conducted on a project must be a “tailor made” solution for that project. It cannot follow the model “one size fits all”, because it can lead to a situation where specific risks of the project are not identified and other risks may be undervalued or overvalued thus affecting the risk perception of the lenders.
It is also important to bear in mind that times change and issues that a few years ago weren’t perceived as a relevant risk for a given project may acquire a completely different consideration, due to social changes.
Nowadays risks resulting from environmental or social effects of the projects are increasingly gaining ground in projects due diligence.
It is not uncommon that lenders, particularly multilateral institutions but also banks and other financial institutions, put an increased care in assessing the environmental, social and governance of the projects, thus trying to identify, mitigate or avoid the heavy negative burden this issues currently have and are perceived by local communities and the general public, as well.
It is not uncommon that due diligence includes the assessment of environmental aspects such as the environmental impacts of the projects to local communities, the impacts to the protection, conservation or restauration of natural habitats, or the protection to existing ecosystems. At a time where Portugal is at the starting line of the lithium exploration and that lithium exploitation will most certainly involver project finance operations, these concerns and risks will become even more present in projects’ due diligence.
Along with the environmental aspects of the projects, and as already stated, the social aspects of the projects are also becoming more frequently under assessment by means of the due diligence.
Lenders are becoming more concerned about the effects of the projects on local communities, the way projects impact the existing way of life, the local economic structure, local businesses and economic activities, the way it affect the well-being of the impacted communities and the well-being of the projects’ employees.
These types of risks are not easy to assess and usually involve long consultations with authorities, with civil society organizations and even with the affected communities. This consultations are time and cost consuming thus converting the due diligence process in a lengthy, complex and expensive process.
When these types of risks have been identified and resourcing once again to Diane Desierto in the above mentioned text, she establishes a mitigation hierarchy when adverse environmental and social impacts are found in projects financed by the World Bank. Said hierarchy is as follows:
- Anticipate and avoid risks and impacts;
- Where avoidance is not possible, minimize or reduce risks and impacts to acceptable levels;
- Once risks and impacts have been minimized or reduced, mitigate (which may include measures to assist affected parties to improve or at least restore their livelihoods as relevant in the particular project setting); and
- Where significant residual impacts remain, compensate for or offset them, where technically and financially feasible.
It is our opinion that this hierarchy can be adopted regarding any project, not just the ones financed by the World Bank, and also regarding any type of risk, not only regarding environmental and social risks.
In fact these are the mitigation strategies to be adopted in any project when the due diligence results confront sponsors, lenders and other relevant parties, with the projects’’ risks namely the ones that may affect different stakeholders, especially the local communities.
From a legal perspective the due diligence also allows lenders and other parties to identify the material aspects and especially the material agreements to the project, meaning, those aspects or agreements that may have an impact on the design of the project, on the construction of the project, on the performance of the project, on the maintenance of the project, on the revenues of the project, etc., and that cannot be easily and timely replaced by other agreements under similar and comparable terms.
As it’s easy to imagine, material agreements are subject to stricter conditions and usually require the intervention of the lender (or lenders) as a party to those agreements thus allowing lenders, for example, to step-in in case the project comes into difficulty.
This right of the lender to interfere with contract relations of the project is an important tool to revitalize off routed or stalled projects and can only be correctly anticipated and regulated if the situations allowing triggering it are properly identified in the due diligence conducted to the project.
This requires that drafts of the material agreements are also subject to analysis in the due diligence, particularly in the case of non-operating projects. Having the opportunity to previously analyze the drafts of the material agreements will allow the lender to have an intervention in the negotiation of those agreements and consequently mitigate any of the eventual risks that may have been identified in the due diligence.
In the case of operating projects, or projects close to the operation phase, the possibilities of having any intervention in the negotiation of the material agreements drafts are reduced or even non-existing. This will require a different modus operandi by the lender that must secure its rights under the project via other agreements, namely the financial agreements that in this situation will have an even more important role, regarding the mitigation of the project’s risks.
Despite all the time and efforts put into the due diligence and the experience of the involved parties- legal, financial and technical teams – it may well be true that not all risks are identified, or are identifiable, by the due diligence.
It is not difficult to imagine that circumstances such as the COVID-19 pandemic or the ongoing war in Ukraine, were not foreseeable five or ten years ago and they can seriously affect either operating or under development projects.
And please don’t consider that this is just a problem for the lenders. Shareholders are also interested in properly identifying the risks of the project, lenders and shareholders’ interests are (or should be) aligned, because the goal is to have an operating project, performing according to the base model (or exceeding the results of the base model), thus freeing the resources required in order to repay the financing and the resources necessary to remunerate the equity.
However sponsors are usually more willing to accept risks in order to maximize the return on their investment and lenders usually have a more conservative approach, when dealing with risks’ acceptance, because they are more interested in the repayment of the financing and in the payment of interests and fees, without any disturbances or unexpected events that may impair the achievement of those purposes.
Considering that a project finance operation is developed or carried out by the special purpose vehicle (SPV) incorporated by the project sponsors; and that this SPV usually has a very limited and very restricted activity usually limited to the execution of the activities connected to the project, it is quintessential for the project to achieve a correct allocation of the risks.
The main purpose of risk allocation in a project should be to allocate a certain risk to the party more suited (because of its experience, technical capacities, etc.) to deal with that risk leaving for the special purpose vehicle only very limited or residual risks.
From the lenders’ perspective this risk allocation strategy is essential, because risks which fall on the special purpose vehicle are, in the final analysis, risks which will fall on the lenders.
Regarding the construction and completion risks, in general terms, lenders will require that the cost of construction, the completion of the project and the performance of the project are guaranteed.
Regarding the operation risks, in general terms, lenders will seek that the financial model (namely in what concerns the revenues) is met and that they are protected against adverse changes in the operation costs that may negatively impact the forecasted revenues; which are the main resource (if not the only one) for the repayment of the financing.
Political and regulatory risks are frequently and obstacle in operations in developing countries. These risks can somehow be mitigated in projects involving governmental authorities with the direct intervention of the governments in the relevant agreements in order to provide adequate and sufficient guarantees to the lenders as to the occurrence of material changes in the law. In other projects multilateral institutions or commercial insurers will be open to share part of the risks and to “secure” the lenders’ interests. However some countries involve such a high risk that developing any project finance in those jurisdictions is virtually impossible because no lender will accept to be exposed to such levels of risk.
In what concerns force majeure and change in law, lenders usually will defend that the repayment of the debt shall maintain even when force majeure events occur or when there is a change in law. As we are all aware off the concept of force majeure is that a party shall not be liable for any default if the breach results from a circumstances beyond that party’s control. Because the project is subject to a web of different contracts, of different nature, involving different parties, many times of different nationalities, subject to the laws of different jurisdictions, it is important to safeguard that force majeure provisions are consistent in the different agreements of the project, thus avoiding situations where force majeure will apply to one agreement but not, or at least not to the same extent, to other agreements related to that agreement.
As already mentioned in previous paragraphs, political risks are subject to commercial insurance. However these are not the only risks of the project that must be insured. We dare to state that an extensive insurance coverage that includes not only most of the traditional risks, such as for example fire, floods, earthquakes, storms and any similar risks; but also other risks of the specific project is essential to any project. A characteristic common to most of the projects, if not to all of the projects, is that lenders will require the insurance indemnities to be paid to project bank accounts controlled by the lenders, thus assuring that those proceeds shall result to the benefit of the project and not to the benefit of specific parties to the project.
As already addressed in this text, the environmental and social impact of the projects is becoming a core aspect of concern to financial institutions. In this regard expert reports identifying the existing (or the non-existence) of social and environmental impacts of the project will be required and when existing specific undertakings regarding the mitigation of those effects will be imposed on the sponsors.
Lenders will also want to address and guarantee that equity contributions will be timely made and that the level of those contributions will be adequate, namely, to the risks perceived by the lenders in the project. This risk perception will definitely impact the debt to equity ratio of the project.
Especially in situations where new technologies are used, lenders will want to have guarantees from the relevant parties (technology suppliers, shareholders, etc.) against any delays, underperformance or cost increased associated to the use of a new technology. These guarantees are usually paired with demanding completion tests to be conducted before completion guarantees are released.
These are just some examples of the risks usually present and addressed in project finance operations. There are many other risks we could highlight. Many of those issues could be common to several types of projects but, as already stated, each project has its own specificities and each one must have a specific and detailed risk assessment.
The sophisticated and demanding process of assembling a project finance operation is considered by several authors as a slow, complex and expensive method of financing, namely when comparing it with corporate finance.
To the contrary, other authors consider that credit appraisal of an individual project is sometimes more favorable than a credit appraisal of the project sponsor or sponsors and a more attractive risk profile will normally result in more favorable interest rates other credit related costs.
A detailed due diligence and risk assessment conducted by experimented legal, financial and technical advisors, conducted at the early stages of the project is an essential feature of project finance operations. We would dare to state this is a view shared by everyone.
Not participating in any project without a careful risk assessment by means of a due diligence is essential for lenders and sponsors, but also to each and every other party involved in the project.
Project finance is the result of a combination of different interests bound by a common interest – the success of the project’s case model and due diligence has an important role in the achievement of this goal.
Contributors: Projects and Project finance department of Raposo Bernardo