It is a lenders' market. Finance for large scale infrastructure projects is hard to come by. The credit crunch has seen the syndication market nearly close. Australia's big four banks have dramatically reduced their contribution to debt financing for infrastructure projects and many European banks have exited the Australian market altogether.
In these market conditions, lenders can be more selective about the types of projects and risk profile they are prepared to fund. The challenge for project sponsors and contractors alike is to deliver to lenders 'bankable' contracts in an effort to make financing of the project more attractive, while still maintaining a commercial deal acceptable to each of the contracting parties.
In this article, we examine the meaning of the term 'bankability' and some of the key issues for lenders in considering construction contracts for infrastructure development projects.
What is 'bankability'?
Bankability is a term used to refer to a project's suitability for project financing. A bankable project is basically a project which lenders are prepared to finance (usually with equity from the project sponsors). It is not a term of art but a fluid concept which changes with market conditions.
Until quite recently banks were enthusiastically competing to participate in project financing of infrastructure assets. Lenders were becoming increasingly flexible as to what constitutes a bankable project. Times have changed. There is currently higher demand for debt financing for infrastructure projects than supply, and it is likely that lenders will tighten their requirements and take a more conservative approach.
A number of factors influence whether a project is bankable, including:
- Practice on other similar recent transactions.
- The attitude of the lenders involved – some are more risk adverse than others.
- The reputation and creditworthiness of the project sponsors, and the proposed contractor, operator and offtaker.
- Risk mitigation strategies (including insurance arrangements).
- Risk profile of the project and how these risks are allocated under the key project documents including the supply agreement, construction contract, off- take agreement and operation and maintenance agreement.
Each of the key project documents will be scrutinised by lenders when considering whether to finance a project. However the construction phase commonly represents one of the riskiest phases of a project. It is a period of high capital expenditure, and with little or no revenue generation until completion of construction. As a result, lenders generally invest a significant amount of time in carefully reviewing the construction contract.
Key issues for lenders in construction contracts
While lenders' attitudes will vary on particular issues, the following matters are likely to be of importance to lenders in considering whether a construction contract is bankable.
Who is the contractor?
Careful selection of the contractor is critical from a lending perspective. While the contractor's price for performing the works is important, lenders generally place greater emphasis on the contractor's experience, capability, approach and reputation.
Lenders generally prefer to see one contractor (which may be a consortium or joint venture) taking responsibility for the delivery of the project, including the design, engineering, procurement, construction, commissioning and testing activities. This is commonly achieved via an engineering, procurement and construction contract or an 'EPC' contract. A single point of responsibility, as opposed to separate contractual arrangements for design and construction, makes determining liability somewhat easier and helps to avoid the blame game which is sometimes played where there are separate contractors.
Price and payment
Lenders generally require that the contractor delivers the works for a fixed price, subject to limited provisions for price increases. The contractor generally takes the risk of cost overruns, unless the contract specifically provides a right to claim for additional costs.
Ideally, payment is made for achieving milestones rather than by way of progress payments. The payment profile will be examined and an advance payment guarantee may be required if a large advance payment is to be paid up front to the contractor. Substantial advance payments for material before it is incorporated into the works will also come under heavy scrutiny.
Time and completion
The time given for completion is an extremely important issue for lenders. This is because generation of revenue by the asset (and consequently repayment of the debt) usually commences when completion occurs.
The contractor will be required to deliver the completed asset by a fixed completion date. Often the contract will also specify that the contractor must achieve contract milestones by specified dates. The contract will include an extension of time regime which extends the completion date in specified circumstances. Lenders will usually require that the circumstances under which a time extension can be granted are clearly limited to specified events and are likely to critically review each of the grounds for a time extension.
The contractor will be required to pay liquidated damages for late completion. The adequacy of the rates of those damages is often an area of focus for lenders.
The contractor must deliver the project such that it meets the performance guarantees, including the required output and reliability for the asset. If the contractor fails to achieve the performance guarantees, it will be liable for performance liquidated damages. Again, lenders will focus on the adequacy of performance liquidated damages, both in respect of the short term shortfall in output and loss of revenue and the permanent shortfall in output and associated revenue estimated to be lost over the life of the project.
Where the contract requires the contractor to provide the design of the asset, lenders will seek warranties from the contractor in relation to that design. This could include warranties that the design meets the performance specification, that it is fit for purpose and that if defects are discovered in the design they will be rectified at the contractor's cost.
Limits of liability
Contractors typically seek to limit or cap their liability in construction contracts. The level of the cap varies, but caps at 100% of the contract price are common. Sub-caps may also be agreed in relation to liquidated damaged payments, among other things. An exclusion of consequential losses is also often sought by contractors. Such caps are now common practice in EPC contracts and lenders are usually comfortable having caps on liability, provided the limits are reasonable.
Lenders will require that the contractor provides security in relation to performance of its obligations under the contract. This is normally in the form of bank guarantees. Such security may include:
- An advance payment guarantee for an initial lump sum payment made to the contractor.
- A performance guarantee to secure the proper performance of the contractor's obligations (usually such guarantees are progressively released until a small proportion is held for the duration of the defects liability period).
- An advance payment guarantee to cover payments made to the contractor for materials not yet incorporated into the works.
Although insurance bonds and cash retention are sometimes still used, they are generally not favoured by lenders financing infrastructure projects.
Where the company (or companies) comprising the contractor is not the ultimate holding company, the contractor is required to procure a parent company guarantee, guaranteeing the performance of all of the contractor's obligations under the contract.
Lenders seek to tightly control the circumstances in which a contractor can terminate the construction contract. This means the grounds for termination and the process around termination is an important focus.
Direct agreement with lenders
The contractor and project company will be required to execute a direct agreement with the lenders in the form of a deed. This will provide step-in and cure rights to lenders in specified situations including where the contractor seeks to terminate the contract.
The big picture – relationship between key contracts
The relationship between the contractor, operator and off-taker are critical to the successful delivery of the project. Accordingly, the interface between the key project contracts will be reviewed by lenders who will be looking to see that issues such as commencement and completion, coordination, payment and indemnities are appropriately dealt with in the context of each of the other key project contracts.
Successful construction of the asset being developed is central to the success of any project financed infrastructure development. While the requirements for a bankable construction contract will change over time with different market conditions, it is necessary for project sponsors to understand the issues which are important to lenders if sponsors wish to obtain project finance in the current market. It is also important that contractors have a good understanding of lenders' changing requirements if they want to be involved in project financed developments.
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This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances.