How lenders can cut risks in project finance

Author(s): Robert S. Rendell

Source: Business Law Today, Vol. 3, No. 6 (JULY/AUGUST 1994), pp. 30-31
Published by: American Bar Association
Stable URL: http://www.jstor.org/stable/23288504
Accessed: 23-06-2016 02:54 UTC

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
http://about.jstor.org/terms

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted
digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about
JSTOR, please contact support@jstor.org.

American Bar Association is collaborating with JSTOR to digitize, preserve and extend access to Business
Law Today

This content downloaded from 132.236.27.217 on Thu, 23 Jun 2016 02:54:57 UTC
All use subject to http://about.jstor.org/terms
 AGLOBAL
A GLOBAL VIEW
VIE W International practice
International practice
How lenders can
cut risks in
project finance
Robert S. Rendell
International project finance is a
special type of corporate finance.
While it is more complex than a
typical Eurodollar loan or a com
mercial loan, project finance offers
rewards for both lenders and pro
ject sponsors. Consequently, the
popularity of project finance has
been rising in many markets
around the world, especially in the
rapidly growing Southeast Asia re
gion.
What is project finance? Simply
put, it is lending to a project, rather
than lending for a project. For ex
ample, a loan to a major interna
tional oil company to allow it to
build a pipeline would not be pro
ject finance. The lenders would be
looking to the company's financial
strength, not necessarily to the
pipeline revenues, as the basis for
repayment of the loan.
On the other hand, if the oil
company establishes a separate sub
sidiary to construct and operate the
pipeline, loans to the newly formed
subsidiary would be considered
project finance since the lenders
would be looking to the income
from the pipeline for payback.
Therefore, project finance is a self
liquidating form of finance in the
sense that the project is the source
of repayment and must succeed for
the lenders to be paid principal
Rendell, a partner at Vial, Hamilton,
Koch &■ Knox in Dallas, is a current
member and past chair of the Busi
ness Law Section's International Busi
ness Law Committee.
This content downloaded from 132.236.27.217 on Thu, 23 Jun 2016 02:54:57 UTC
and interest.
Project finance appears to be a
riskier type of finance than a con
ventional corporate loan. However,
a well-structured project finance
can significantly reduce the risks
inherent in lending to a project. In
any event, lenders are compensated
for these additional risks by receiv
ing higher fees and interest rates
than in ordinary corporate lending,
with interest rate margins on an in
ternational project financing rang
ing from 100 to 150 basis points.
What are the risks that apply to in
ternational project finance?
There are three basic risks: con
struction, operational and political.
The construction risk is the risk
that the project will not be con
structed on time or within budget.
Most international project financ
ings involve complex facilities such
as power stations, oil refineries or
transportation systems, and a delay
or cost overrun will result in seri
ous complications for the repay
ment schedule. The Eurotunnel
project is an unfortunate illustra
tion of the consequences of major
cost overruns. By the time the Eu
rotunnel finally opened on May 6,
cost overruns and delays had more
than doubled the original project
cost from 4.7 billion pounds (about
$7 billion) to more than 10.5 billion
pounds (nearly $16 billion).
The operational risk is the risk
that the project will not be oper
ated in a way that will produce
sufficient revenue to service the
debt. The key to all project lending
is for the project to produce a se
cure and predictable source of reve
nue. Two examples are a through
put agreement for an oil pipeline or
an electricity supply contract for a
power station. In the case of an in
ternational project, where most of
the lenders will be international
banks or financial institutions, the
BUSINESS LAW TODAY July/August 1994
30
All use subject to http://about.jstor.org/terms
project revenue should be denomi
nated in a hard currency such as
U.S. dollars, Japanese yen or
pounds sterling.
The political risk is the risk that
the host government will national
ize or expropriate the project or
block the free transferability of for
eign exchange that is needed to ser
vice the project debt. Within this
category of risk is political violence
such as civil war. Because many in
ternational project financings occur
The key is a
predictable
source of
revenue.
in developing countries, political
risk is an important factor in the
lenders' consideration as to
whether to participate. The absence
of political risk is a significant fac
tor that distinguishes project fi
nancings in the United States from
those in many other countries.
How do lenders go about manag
ing the risks they face?
Over the years lenders have de
veloped a number of risk-reducing
techniques; otherwise the credit
committees of banks would never
approve project financings. In to
day's market, lenders will not as
sume the full construction risk.
They expect, and customarily re
ceive, financial support from the
project sponsors in the form of
overrun commitments or comple
tion guarantees. That is why project
finance is frequently referred to as
"limited recourse" finance. The
amount and duration of this sup
port are two of the principal issues
to be negotiated between the lend
ers and the sponsors.
The operational risk is usually
addressed through a comprehensive
security structure, including an as
signment of the proceeds from any
and all contracts covering the out
put from the project.
For example, in a project financ
ing of the construction of an oil re
finery, the lenders will require an
assignment of the offtake agreement
covering the refined products sold
by the refinery company. In addi
tion, the "offtakers" (purchasers]
will be required to consent to the
assignment, usually through a di
rect agreement with the security
agent for the lenders. Finally, the
lenders will expect a first mortgage
on the plant and a further assign
ment of all contracts relating to the
construction and operation of the
project. The project sponsors will
find the lenders' requirements to be
particularly intrusive since they
give the lenders control over every
phase of the project.
These comprehensive security ar
rangements are a principal differ
ence from a conventional corporate
loan. The role of the lawyer is criti
cal in helping the project lenders
design a workable security structure
and in implementing these meas
ures. Difficulties may be encoun
tered in many developing countries
where the legal system does not
recognize some of the more con
ventional types of security, such as
the filing of financing statements
with respect to personal property.
Further, the enforcement of secu
rity may depend on obtaining the
host government's consent to the
sale of the project to a third party,
and there can be no advance assur
ance that the host governemnt will
provide its consent. Of course, the
best protection against operational
risk is a combination of experi
enced and reliable project sponsors
This content downloaded from 132.236.27.217 on Thu, 23 Jun 2016 02:54:57 UTC
and a project whose feasibility has growing in popularity. As many
been thoroughly tested. countries enter new phases of eco
Mitigating political risk can be nomic growth, their needs for infra
more troublesome, due in part to structure and energy sources have
the sensitivities of the host govern outstripped their available re
ment. Insurance is available, but is sources. Not all these needs can be
limited in scope and is very expen financed out of public funds or
sive. Most lenders attempt to deal with government assistance. This is
with political risk through some especially true in Asia, where ma
type of host country assurances — jor project financings have been ar
the value of which is questionable ranged in Indonesia, the Philip
— and by diversifying the national pines, Thailand, Malaysia and now
ity of members of the lending China.
group. If the lending group consists The conclusion of the North
of American, European and Japa American Free Trade Agreement
nese banks, as well as some banks and the continuing deregulation of
located in the host country, it is economies in Latin America offer
less likely that the host country new possibilities for project financ
will interfere with the project. It is ings in countries such as Mexico
also very helpful to involve the and Chile.
World Bank Group, especially the Governments and private spon
International Finance Corp., and sors are looking to project finance
export credit agencies such as the to spin: new developments. Banks
U.S. Export-Import Bank. are willing to take more risks in
well-structured project financings.
Over the past several years, inter This combination augurs well for
national project finance has been this specialized form of finance. ■
Oceana's NAFTA Service Comes Full-Circle with a
Portable Value-Added Desktop Edition
The Practitioner's Deskbook Series: NAFTA
(with corrections as of entry into force Jan. 1, 1994)
final Text, Summary, Legislative History &
Implementation Directory with Bonus Diskette
Edited by James R. Holbein & Donald J. Musch
1994- Soft cover with Diskette ■ ISBN.-0-379-00835-1
■$59.95* • Multiple copies $36.95 each
No Other NAFTA Publication Offers:
^An expert practice oriented article-by-article
analysis and summary
^An Implementation directory which puts you
in touch with authorities who can answer
industry specific questions
^>A Bonus DISKETTE containing the full, final text
of the NAFTA (System Req: IBM PC compatible; 4MB
hard disk space; DOS 3.0 or higher; 484K RAM avail.)
To order or for more information
Call 914-693-8100 or Fax 914-693-0402
"NAFTA looseleaf service subscribers pay only $44.95
Circle 33 on Reader Service Card
ABA SECTION OF BUSINESS LAW
31
All use subject to http://about.jstor.org/terms