Project finance

The most common project finance construction contract is the engineering, procurement and construction (EPC) contract. An EPC contract generally provides for the obligation of the contractor to build and deliver the project facilities on a fixed price, turnkey basis, i.e., at a certain pre-determined fixed price, by a certain date, in accordance with certain specifications, and with certain performance warranties. The EPC contract is quite complicated in terms of legal issue, therefore the project company and the EPC contractor need sufficient experience and knowledge of the nature of project to avoid their faults and minimize the risks during contract execution.

The terms EPC contract and turnkey contract are interchangeable. EPC stands for engineering (design), procurement and construction. Turnkey is based on the idea that when the owner takes responsibility for the facility all it will need to do is turn the key and the facility will function as intended. Alternative forms of construction contract are a project management approach and alliance contracting. Basic contents of an EPC contract are:

• Description of the project
• Price
• Payment (typically by milestones)
• Completion date
• Completion guarantee and Liquidated Damages (LDs):
• Performance guarantee and LDs
• Cap under LDs

An operation and maintenance (O&M) agreement is an agreement between the project company and the operator. The project company delegates the operation, maintenance and often performance management of the project to a reputable operator with expertise in the industry under the terms of the O&M agreement. The operator could be one of the sponsors of the project company or third-party operator. In other cases the project company may carry out by itself the operation and maintenance of the project and may eventually arrange for the technical assistance of an experienced company under a technical assistance agreement. Basic contents of an O&M contract are:

• Definition of the service
• Operator responsibility
• Provision regarding the services rendered
• Liquidated damages
• Fee provisions

An agreement between the project company and a public-sector entity (the contracting authority) is called a concession deed. The concession agreement concedes the use of a government asset (such as a plot of land or river crossing) to the project company for a specified period. A concession deed would be found in most projects which involve government such as in infrastructure projects. The concession agreement may be signed by a national/regional government, a municipality, or a special purpose entity set up by the state to grant the concession. Examples of concession agreements include contracts for the following:

• A toll-road or tunnel for which the concession agreement giving a right to collect tolls/fares from the public or where payments are made by the contracting authority based on usage by the public.
• A transportation system (e.g., a railway / metro) for which the public pays fares to a private company)
• Utility projects where payments are made by a municipality or by end-users.
• Ports and airports where payments are usually made by airlines or shipping companies.
• Other public sector projects such as schools, hospitals, government buildings, where payments are made by the contracting authority.

The shareholders agreement (SHA) is an agreement between the project sponsors to form a special purpose company (SPC) in relation to the project development. This is the most basic of structures held by the sponsors in a project finance transaction. This is an agreement between the sponsors and deals with:

• Injection of share capital
• Voting requirements
• Resolution of force one
• Dividend policy
• Management of the SPC
• Disposal and pre-emption rights

An off-take agreement is an agreement between the project company and the offtaker (the party who is buying the product / service that the project produces / delivers). In a project financing the revenue is often contracted (rather than being sold on a merchant basis). The off-take agreement governs mechanism of price and volume which make up revenue. The intention of this agreement is to provide the project company with stable and sufficient revenue to pay its project debt obligation, cover the operating costs and provide certain required return to the sponsors.

The main off-take agreements are:

• Take-or-pay contract: under this contract the off-taker – on an agreed price basis – is obligated to pay for product on a regular basis whether or not the off-taker actually takes the product.
• Power purchase agreement: commonly used in power projects in emerging markets. The purchasing entity is usually a government entity.
• Take-and-pay contract: the off-taker only pays for the product taken on an agreed price basis.
• Long-term sales contract: the off-taker agrees to take agreed-upon quantities of the product from the project. The price is however paid based on market prices at the time of purchase or an agreed market index, subject to certain floor (minimum) price. Commonly used in mining, oil and gas, and petrochemical projects where the project company wants to ensure that its product can easily be sold in international markets, but off-takers not willing to take the price risk
• Hedging contract: found in the commodity markets such as in an oilfield project.
• Contract for Differences: the project company sells its product into the market and not to the off-taker or hedging counterpart. If however the market price is below an agreed level, the offtaker pays the difference to the project company, and vice versa if it is above an agreed level.
• Throughput contract: a user of the pipeline agrees to use it to carry not less than a certain volume of product and to pay a minimum price for this.

A supply agreement is between the project company and the supplier of the required feedstock / fuel.

If a project company has an off-take contract, the supply contract is usually structured to match the general terms of the off-take contract such as the length of the contract, force majeure provisions, etc. The volume of input supplies required by the project company is usually linked to the project’s output. Example under a PPA the power purchaser who does not require power can ask the project to shut down the power plant and continue to pay the capacity payment – in such case the project company needs to ensure its obligations to buy fuel can be reduced in parallel. The degree of commitment by the supplier can vary.

The main supply agreements are:

1. Fixed or variable supply: the supplier agrees to provide a fixed quantity of supplies to the project company on an agreed schedule, or a variable supply between an agreed maximum and minimum. The supply may be under a take-or-pay or take-and-pay.

2.Output / reserve dedication: the supplier dedicates the entire output from a specific source, e.g., a coal mine, its own plant. However, the supplier may have no obligation to produce any output unless agreed otherwise. The supply can also be under a take-or-pay or take-and-pay

3.Interruptible supply: some supplies such as gas are offered on a lower-cost interruptible basis – often via a pipeline also supplying other users.

4.Tolling contract: the supplier has no commitment to supply at all, and may choose not to do so if the supplies can be used more profitably elsewhere. However, the availability charge must be paid to the project company.

A loan agreement is made between the project company (borrower) and the lenders. Loan agreement governs relationship between the lenders and the borrowers. It determines the basis on which the loan can be drawn and repaid, and contains the usual provisions found in a corporate loan agreement. It also contains the additional clauses to cover specific requirements of the project and project documents.

Basic terms of a loan agreement include the following provisions.

• General conditions precedent
• Conditions precedent to each drawdown
• Availability period, during which the borrower is obliged to pay a commitment fee
• Drawdown mechanics
• An interest clause, charged at a margin over base rate
• A repayment clause
• Financial covenants - calculation of key project metrics / ratios and covenants
• Dividend restrictions
• Representations and warranties
• The illegality clause

Intercreditor agreement is agreed between the main creditors of the project company. This is the agreement between the main creditors in connection with the project financing. The main creditors often enter into the Intercreditor Agreement to govern the common terms and relationships among the lenders in respect of the borrower’s obligations.

Intercreditor agreement will specify provisions including the following.

• Common terms
• Order of drawdown
• Cashflow waterfall
• Limitation on ability of creditors to vary their rights
• Voting rights
• Notification of defaults
• Order of applying the proceeds of debt recovery
• If there is a mezzanine funding component, the terms of subordination and other principles to apply as between the senior debt providers and the mezzanine debt providers.

The financiers will usually require that a direct relationship between itself and the counterparty to that contract be established which is achieved through the use of a tripartite deed (sometimes called a consent deed, direct agreement or side agreement). The tripartite deed sets out the circumstances in which the financiers may “step in” under the project contracts in order to remedy any default.

A tripartite deed would normally contain the following provision.

• Acknowledgement of security: confirmation by the contractor or relevant party that it consents to the financier taking security over the relevant project contracts.
• Notice of default: obligation on the relevant project counterparty to notify the lenders directly of defaults by the project company under the relevant contract.
• Step-in rights and extended periods: to ensure that the lenders will have sufficient notice /period to enable it to remedy any breach by the borrower.
• Receivership: acknowledgement by the relevant party regarding the appointment of a receiver by the lenders under the relevant contract and that the receiver may continue the borrower’s performance under the contract
• Sale of asset: terms and conditions upon which the lenders may transfer the borrower’s entitlements under the relevant contract.

Tripartite deed can give rise to difficult issues for negotiation but is a critical document in project financing.

An agreement between the financing parties and the project company which sets out the terms that are common to all the financing instruments and the relationship between them (including definitions, conditions, order of drawdowns, project accounts, voting powers for waivers and amendments). A common terms agreement greatly clarifies and simplifies the multi-sourcing of finance for a project and ensures that the parties have a common understanding of key definitions and critical events.

Agreement between the borrower and the lender for the cost, provision and repayment of debt. The term sheet outlines the key terms and conditions of the financing. The term sheet provides the basis for the lead arrangers to complete the credit approval to underwrite the debt, usually by signing the agreed term sheet. Generally the final term sheet is attached to the mandate letter and is used by the lead arrangers to syndicate the debt. The commitment by the lenders is usually subject to further detailed due diligence and negotiation of project agreements and finance documents including the security documents. The next phase in the financing is the negotiation of finance documents and the term sheet will eventually be replaced by the definitive finance documents when the project reaches financial close.