Project Finance

Introduction

Origins of project financing

With the explosion of project financing in the late 1980s and 1990s, both in Europe and around the rest of the world, there is a temptation to think that the financing of projects on limited or non-recourse terms is a relatively novel concept, and one for which the ingenious lawyers and bankers of the 1980s can take most of the credit. This is, however, far from being true. Indeed, there is early evidence of project financing techniques being actively used during Roman times and earlier still. According to the historians, sea voyages on the Mediterranean ocean were extremely dangerous adventures in Greek and Roman times, mostly on account of the dual perils of storms and pirates. As a result of these nautical perils, some risk averse merchants would take out a fenus nauticum (sea loan) with a local lender in order to share with that lender the risk of a particular voyage. The fenus nauticum worked on the basis that the loan was advanced to the merchant for the purpose of purchasing goods on the outward voyage, which loan would be repayable out of the proceeds of the sale of these goods (or more likely other goods bought overseas with these proceeds). If the ship did not arrive safely at the home port with the cargo in question on board, then according to the terms of the fenus nauticum, the loan was not repayable. At the time, this was viewed essentially as a form of marine insurance, but it can just as easily be classified as an early form of limited recourse lending, with the lender assuming the risk of the high seas and the perils that accompanied her. History also recounts that, in order to protect their interests, these brave lenders would often send one of their slaves on the voyage to ensure that the merchant was not tempted to cheat on the lender (an early ancestor of the security trustee perhaps!).

In modern times too there is plenty of evidence of project financing techniques being used by lenders to finance projects around the world. In the 19th century, lenders in the City of London were financing numerous railway and other projects in South America and India and investing in other overseas ventures that had many features of modern-day limited recourse lending. In most cases these loans were not specifically structured as limited recourse loans as we know them today, but the commercial reality was that this is exactly what they were.

However, limited recourse lending in the UK really took off in the early 1970s when lenders in the UK started making project finance available for the development of some of the early oil and gas fields in the UK continental shelf. The early projects that were financed on this basis were relatively few and far between as there was a relatively small pool of lenders prepared to finance projects on this basis. It would also be true to say that the treasurers of many of the companies operating in the UK continental shelf at this time took some time to appreciate the advantages of financing projects in this way. The first major financing in the North Sea was in the early 1970s. This was British Petroleum’s Forties Field, which raised about £1 billion by way of a forward purchase agreement (see section 4.7 for a description of this structure). Shortly after this transaction two loans were raised by licence holders in the Piper Field (Occidental Petroleum Corporation and the International Thompson Organisation). Other financings of North Sea hydrocarbon assets followed and by the late 1970s and early 1980s what had started as a modest number of transactions had turned into a significant volume of project financings related to oil and gas fields, first in the UK continental shelf and then in the Danish and Norwegian continental shelves.

Much of the documentation and many of the techniques for these early oil and gas transactions were borrowed from practice in the US where adventurous bankers had been lending against oil and gas assets for many years. The significant difference in the context of the North Sea, however, was that bankers were in reality taking significantly more risks in lending against oil and gas assets in the North Sea. Not only were these brave bankers lending against offshore oil and gas assets where the risks were considerably greater (especially in the early days, given the new technology being developed and utilised), but they were also, in some cases, assuming all or part of the development/completion risk. Traditionally, in the early days of project financing in the US, loans were agreed against producing onshore assets, which carried a far lesser degree of risk. The North Sea was, however, an altogether more hostile and hazardous environment.

The 1980s in the UK saw perhaps the greatest growth spurt in project financing, with power projects, infrastructure projects, transportation projects and, at the end of that decade, telecommunications projects leading the way. This was continued throughout the 1990s until the more recent global financial crisis, which saw a huge growth in project financing, not only in Europe and the US but also throughout Southeast Asia and further afield.

Definition of project finance

There is no universally accepted definition of project finance. A typical definition of project financing might be: “The financing of the development or exploitation of a right, natural resource or other asset where the bulk of the financing is to be provided by way of debt and is to be repaid principally out of the assets being financed and their revenues.”

Other more sophisticated definitions are used for special purposes; set out at Fig. 1 is an example of a definition used in a corporate bond issue. This illustrates the aims of the bondholders, on the one hand, to exclude from the definition any borrowings having a recourse element (since the purpose of the definition was to exclude project finance borrowings from the bond’s cross-default and negative pledge) whilst, on the other hand, the aim of the issuer to catch as wide a range of project-related borrowings.

Extent of recourse

The expressions “non-recourse finance” and “limited recourse finance” are often used interchangeably with the term “project finance”. In strict terms, non-recourse finance is extremely rare and in most project finance transactions there is some (limited) recourse back to the borrower/sponsor beyond the assets that are being financed. As will be seen in section 6, this security may amount to full or partial completion guarantees, undertakings to cover cost overruns or other degrees of support (or comfort) made available by the sponsors/shareholders or others to the lenders.

It may even be that the only tangible form of support that a lender receives over and above the project assets is a right to rescind the project loan agreement with the borrower and/or to claim damages for breach of any undertakings, representations or warranties given by the borrower in the project loan agreement. Of course, where the borrower is a special purpose vehicle with no assets other than the project assets being financed by the lenders, then a right to claim damages from the borrower is likely to add little to a claim by the lenders for recovery of the project loan from the borrower. Further, the right to rescind the project loan agreement is likely merely to duplicate the acceleration rights of the lenders following the occurrence of an event of default contained in the project loan agreement. However, in those cases where the borrower does have other assets, or the sponsors are prepared to underwrite any claims by the project lenders for damages against the borrower, then a claim for damages for breach of any undertakings, representations or warranties may afford the lenders some additional recourse.

A claim for damages, however, from a lender’s perspective is not the same under English law (and for that matter most common law based jurisdictions) as a claim for recovery of a debt under, say, a financial guarantee. This is because a claim for damages is subject to certain common law rules; for example:

• The lender must show that the loss was caused by the breach in question
• This loss must have been reasonably foreseeable at the time the undertaking or warranty was given
• The lender is in any event under a duty to mitigate its loss.

In other words, a claim for damages against the borrower is an unliquidated claim as opposed to a claim for a debt, which would be a liquidated claim. All that a lender has to show in the case of a liquidated claim is that the debt was incurred or assumed by the borrower and that it has become due. This is clearly considerably easier than having to satisfy the common law rules and, consequently, lenders and their advisers, wherever possible, will seek to structure arrangements with a view to acquiring liquidated claims against borrowers and others supporting the borrower’s obligations (this is particularly important for lenders in the context of sponsor completion undertakings – see section 6.5).

One of the key differences, therefore, between project financing and corporate financing lies in the recourse that the lender has to the assets of the borrower. As the earlier definitions demonstrate, in project financing this recourse is limited to an identifiable pool of assets, whereas in corporate financing the lender will have recourse to all the assets of the borrower (to the extent that these assets have not been charged to other lenders). Indeed, should the borrower fail to pay a debt when due, then, subject to the terms of the loan documentation, the lender would be entitled to petition to wind up the borrower and prove in the liquidation of the borrower on a pari passu basis with all the other unsecured creditors of the borrower. In the context of a project financing, however, a lender would only be entitled to this ultimate sanction if the project vehicle is a special purpose vehicle set up specially for the project being financed. In those cases where the project vehicle undertook other activities, then it would look to ring fence the assets associated with these activities and in these cases the lender would not ordinarily be entitled to petition to wind up the borrower for non-payment of the project debt. To allow otherwise would be to allow the lender to have recourse to non-project assets, which would defeat the purpose of structuring the loan on limited or non-recourse terms in the first place.

This principle of limited recourse financing was recognised by the English courts as long ago as 1877 (and possibly earlier) in the well-known case of Williams v. Hathaway (1877) 6 CH D 544. In this case, a sum of money (the fund) was paid by way of recompense by a railway company to the vicar of a parish and the incumbent of an ecclesiastical district in accordance with an Act of Parliament which authorised the railway company to take a certain church for its purposes. The Act directed, in effect, that the money be applied by the recipients to provide a new church and parsonage. The recipients of the fund contracted with a builder to build the church and parsonage and the project proceeded. In the event, the cost of the works exceeded the monies in the fund and the builder took legal action to recover the deficiency. Jessel MR, held, inter alia, that it was permissible for a proviso to a covenant to pay to limit the personal liability under the covenant to pay without destroying it. Despite the fact that the contractual arrangements were with the individuals who were for the time being trustees of the fund, it was held that “the object [of the contractual instrument] is to bind the fund” and not the trustees in their personal capacity.

Why choose project finance?

Before examining how projects are structured and financed, it is worth asking why sponsors choose project finance to fund their projects. Project finance is invariably more expensive than raising corporate funding. Also, and importantly, it takes considerably more time to organise and involves a considerable dedication of management time and expertise in implementing, monitoring and administering the loan during the life of the project. There must, therefore, be compelling reasons for sponsors to choose this route for financing a particular project.

The following are some of the more obvious reasons why project finance might be chosen:

• The sponsors may want to insulate themselves from both the project debt and the risk of any failure of the project
• A desire on the part of sponsors not to have to consolidate the project’s debt on to their own balance sheets. This will, of course, depend on the particular accounting and/or legal requirements applicable to each sponsor. However, with the trend these days in many countries for a company’s balance sheet to reflect substance over form, this is likely to become less of a reason for sponsors to select project finance (the implementation in the UK of the recent accounting standard on “Reporting the Substance of Transactions” (FRS 5) is an example of this trend)
• There may be a genuine desire on the part of the sponsors to share some of the risk in a large project with others. It may be that in the case of some smaller companies their balance sheets are simply not strong enough to raise the necessary finance to invest in a project on their own and the only way in which they can raise the necessary finance is on a project financing basis
• A sponsor may be constrained in its ability to borrow the necessary funds for the project, either through financial covenants in its corporate loan documentation or borrowing restrictions in its statutes
• Where a sponsor is investing in a project with others on a joint venture basis, it can be extremely difficult to agree a risk-sharing basis for investment acceptable to all the co-sponsors. In such a case, investing through a special purpose vehicle on a limited recourse basis can have significant attractions