By David Tournier
, General Manager & Corporate Secretary, IFFCO Canada Enterprise
Bankability, or the ability to obtain banks' funding, can be a life or death sentence for any transaction requiring borrowed funds. Because financing industrial projects tends to require leverage by debt, their promoters must arrange various blocks so that the resulting construction is bankable. The blocks they work with are made of paper and ink: studies on the one hand (engineering, environmental, marketing, financial modeling), and contracts on the other hand (procurement of feedstock, work for the Engineering, Procurement and Construction
- EPC of the project, sale of the future production or services, operation and maintenance of the projected infrastructureâ€¦).
When the cost of the venture is high or its achievement complex, one generally resorts to the well-oiled technique of project finance
. Bankability in project financing depends less on the creditworthiness of the sponsors or on the value of the assets offered as collateral than it rests on the anticipated ability to generate enough revenue to repay the debt and remunerate the invested capital at a rate which is consistent with the associated risk. Of course, lenders will look at the track record of the sponsors and their ability to mobilize additional funds to cover costs overruns. But these sponsors will in turn seek to limit their own risk to the amount of equity they are willing to invest. Their equity investment is thus generally made into a specific purpose vehicle (SPV)
incorporated so as to isolate the sponsors' assets from creditors' remedies. The SPV's assets are offered as collateral, but these pipes, turbines and other machinery are of limited value until the project is completed. This is why lenders and financial investors must rely on the SPV's ability to repay them out of its future revenue. Depending on the degree by which the SPV's shareholders are protected from the lenders' remedies, one then refers to a non-recourse
or limited recourse project financing
Because the usual guarantees do not play a central role in that context, it is essential for the project to be structured so as to secure a sufficient volume of cash flow to cover the project's operating cost and the repayment of the debt incurred by the SPV over the agreed tenure. This translates into very practical constraints that must be addressed by the executive team in charge of assembling a sound contractual structure. Overcoming these constraints can be facilitated by the nature of the project, such as energy plants benefitting from a long-term power purchase agreement entered into with a sovereign entity. This article tends to focus on more challenging industrial projects and aims to illustrate their constraints along three core components: (i) procurement of the feedstock, (ii) engineering, procurement and construction (EPC) of the infrastructure, and (iii) offtake of the production.
Getting those components right will reduce the guarantees sponsors would otherwise have to provide and increase the amount of debt they will be able to raise. A satisfactory assessment of those core elements should thus be a prerequisite to any commitment to an industrial project, be it as a lender, a shareholder, or a contractor.
First Milestone: Feed the Beast
Feedstock, the raw material or fuel required for a given industrial process, is a determinant factor in the decision to undertake a specific project at a given location, resulting in regional clusters
for some industries. Being able to procure hydrocarbons at low cost and in large volumes, be it due to the proximity of important reserves close to the construction site or to an efficient transportation infrastructure up to such site, is for example a prerequisite of any petrochemical project. Similarly, aluminum plants tend to be located where electric power is affordable and available with the lowest possible risk of shortages because a stable supply is required for the refinement process. Most of the bankability issues associated with feedstock thus revolve around its affordability and availability, including through efficient means of transportation.
In a non-recourse financing, where the lenders can only act against the SPV to obtain repayment of their loan, the project's bankability demands that feedstock be purchased at a foreseeable price that will be low enough to provide the profit margin expected from operations. A hedging strategy therefore tends to be required so as to isolate that price from market fluctuations. Several options are available that cannot be reviewed in details here. Simply put, the two main options are a physical or financial hedge.
Physical hedging is obtained by the SPV fixing or capping the price at which it purchases its feedstock within the agreement entered into with the supplier of the relevant product. One can also allow the price of the feedstock to fluctuate in correlation with the price at which the future production will be sold. The spread between those two prices must then be structured so as to generate at all times a sufficient volume of cash flow to repay the debt and operate the facilities.
Financial hedging is obtained through a financial institution, to lock the price of the feedstock via a derivative agreement. Such hedging agreements have an inflationary or deflationary impact on the price of the feedstock over the life of the project, which impact depends upon market price at the time of contracting the hedge agreement and on the general consensus prevailing then on future trends. Said otherwise, the risk of market price fluctuation is shared between the SPV and its counterpart under that hedge by agreeing in advance to compensate each other as needed from time to time to ensure that both pay or receive the agreed upon fixed price. The period of such agreements generally match the tenure of the SPV's debt.
It is important to note that hedging requirements have diverse impacts on the financing of projects. Financial hedge providers indeed tend to rank pari passu
with senior creditors. This increases the amount of claims secured by the same collateral, resulting in higher risks for the lenders and a possibly more expensive financing. Also, the hedge provider (which can be the feedstock supplier itself) might require important financial guarantees against the risk of the SPV failing to make payments under the hedging agreement or to purchase the agreed volume of feedstock (for example, due to delays in the construction of the plant). It is therefore important for the sponsors of a project to make an early assessment of the financial weight that hedging and associated guarantees will add to their funding requirements.
When procuring feedstock, sponsors will often be required to enter into a long-term agreement with a counterparty holding reserves which are large enough to feed their project at least until the incurred debt is repaid. Because it would be responsible for any shortage over the term of that agreement, lenders and investors would also require that the supplier be solvent enough to cover the cost of procuring feedstock from another and potentially more expensive source, should its own reserves dry out or become unavailable for any reason (such as a technical break, for example). The larger the provider's reserves are, and the more financially solvent it appears, the better it fares for the project's bankability.
Entering into a long-term agreement might not be mandatory however, provided the SPV can procure feedstock on the spot market from an accessible hub that is liquid enough to ensure availability for purchase on any day. Storage capacity at the chosen hub then becomes essential information to be verified by the project's sponsors and investorsâ€¦ just like transportation capacity between the point of supply and the project's site.
Industrial projects cannot always be undertaken in the vicinity of their feedstock's point of supply, such as a mine or a natural gas play. Transportation up to the plant then becomes an important consideration for bankability purposes. Sponsors must design a solution that maintains the project's profitability while finding a location that offers the best possible combination of connectivity and proximity (both to the feedstock's point of supply and to the ultimate market for the plant's production).
Important issues can arise absent a sufficient transportation infrastructure, be it roads, railways, pipelines or power lines. Having to construct new infrastructure or even upgrade an existing one to be able to feed the project can seriously hinder the raising of financing. First, because even when the SPV is not required to bear the cost of such construction or upgrades, it can be asked to provide important financial guarantees against the risk of the project never being completed while the transporter undertakes large investments to improve its transportation network. Those financial guarantees can sometimes amount to the formidable cost of the required works on the transportation network, and add to the project's funding requirements. The sponsors and investors should thus verify existing transportation capacity prior to confirming the location of the future plant's site. If upgrades are required, they should obtain all information available on the complexity of the necessary works and on the anticipated amount of any financial guarantee requirements (which is sometimes capped by applicable regulations).
Second, transportation issues can affect a project's bankability because it creates a delivery risk. Delays in completing these works can indeed result in the financed plant being completed while feedstock cannot yet be transported up to it. In such a situation, the SPV would have no means of generating revenues to start repaying the debt incurred. Lenders and investors will generally be reluctant to assume that important risk. They might require financial guarantees from the SPV or its sponsors, and tend not to allow disbursement of the project's financing before all regulatory approvals for the construction or upgrading works are obtained (for example, approvals of regulatory authorities such as the Federal Energy Regulatory Commission
in the U.S.A and the National Energy Board
in Canada). Depending on the importance of the works required on the transportation infrastructure, these regulatory approvals might imply an additional permitting process altogether in parallel of the one required for the projected plant, including an assessment of social and environmental acceptability.
Local social and governmental support, as well as an efficient regulatory environment providing a foreseeable and timely approval process, then become essential to the project's success.
Arranging feedstock in a manner that secures a project's cash-flow should bring its sponsors closer to the finish line. Of course, many other pieces must be arranged strategically for an industrial project to reach financial close. In the second part of this article
, we will therefore examine the considerations that should determine the arranging of a project's EPC and the offtake of its productions.
- Project finance in theory and in practice, by Stefano Gatti 2nd edition, Academic Press
- Principles of Project Finance, by 2nd edition, E.R. Yescombe, Elsevier Science & Technology Books;