LECTURE 2

SOURCES OF PROJECT FINANCE
EQUITY
DEBT CAPITAL
• Syndicated bank
• Loans
• Project
• Bonds
• Export Credit Agencies and Multilateral agencies (ECA & MLAS)
• Subordinated debts
• Credit Enhancement

SOURCES OF FINANCE

2.1. INTRODUCTION

When parties form a consortium for the purpose of exploitation of oil, among the major concerns of the party is the sourcing of the finance for the project. The structuring of project finance can be between equity and debt capital. The determining factors of the financing depend highly on the amount, the degree of risks, and the allocation of the risks.

2.2. EQUITY

The structuring of project finance into equity and debt is because both the participants in equity and the lenders may want to ensure that there is sufficient finance for the project. Equity capital is the internally generated resources that the sponsor raised by exchanging its share of ownership in the project to the financier.

In equity financing, the project does not incur debt and does not have to repay any amount in the future. In the context of exploitation of oil, which depended partly on equity participation of the project sponsor, there are various ways that the project sponsor may raise the equity to fulfill its obligation. For instance, participants like contractors and equipment suppliers may contribute to the equity base.

However, because of the huge amount of capital investment needed to finance the exploitation of hydrocarbons, the most viable equity contribution may be the concession, or license to exploit the oil in situ. However, since oil in situ belongs to the state in many jurisdictions, transfer of license through SPV may be restricted.

Nevertheless, the sponsors’ contributions may take the form of share capital or subordinated loans raised amongst the shareholders in the SPV by entering into an equity subscription agreement directly with the lenders.

Among its advantages is that there is no recurring interest payment, and the equity investors can assist to uplift the project in the event of difficulties. However, the disadvantage of equity capital is that it may be more expensive and may take longer time to obtain than debt capital.

2.3. DEBT CAPITAL

Debt capital is a loan obtained by a company to finance its business and repaid to the lender at a future date with interest. The advantage of debt capital is that it will be easier and faster to raise debt capital comparatively to equity capital; however, it depends on the bankability of the project. Moreover, the lender may necessarily prefer to finance projects that have lowest risk and secure the debt with assets of the company, which will literally make the debt capital to be cheaper than equity capital.

However, among the disadvantages of using debt capital to finance a project is that the liability that extends beyond the non-business asset of the company towards the guarantors could be a complex process. While there are various means to raise debt capital, in order to be concise, it is expedient to evaluate the most common means, namely: (i) Syndicated bank loans; (ii) Project bonds; (iii) Export Credit Agencies and Multilateral agencies (ECA & MLAs); (iv) Subordinated debts; and (v) Credit enhancement.

• 2.3.1. Syndicated Bank Loans Bank loans from commercial banks are the most common means to finance a project depending on the size of the project. For instance, in a large exploitation of oil projects, various commercial banks may syndicate loans through other lenders that will make-up the bulk of the amount required for the project. However, the problem is whether commercial banks will sustain the long-term tenor of up to 25-years lifespan of the project. The risks associated with the duration of the tenor is that, interest rates may change because of market pressure, as well as political risks that may arise in a particular jurisdiction.

In contrast, project bonds allow fixed interest rates, but the commercial bank operates based on floating interest rates to accommodate changing interest rate indices in the financial market. However, a hedging agreement between the project sponsors and the commercial banks to cap the interest rates can mitigate the risk of floating interest rates. There are also limits for which syndicated loans will achieve in project finance. For example, it is true that commercial banks will cover commercial risk but will not engage in project finance for projects within the jurisdictions where there is either geographical risk or geopolitical risk which is not recoverable under insurance. To mitigate the risk, the commercial bank may work in conjunction with Export Credit Agencies (ECA) to insure the political risks aspect to the project.

• 2.3.2. Project Bond Project bond is a form of financing of a project by raising finance on the capital markets. Bonds could be either publicly issued, or privately issued to the domestic or international capital markets over the assets of the project company. The advantage of raising finance in the capital markets is that there is no intermediary between the borrower and the wholesale money markets unlike in the bank funding.

Moreover, bonds are on fixed rate instead of floating rate, which is common with bank debt; and provide funding on longer term comparatively to other funding in project finance. These advantages are relevant in project finance relating to exploitation of oil because of its time consuming nature, for which there may be fluctuation of currency that may affect interest rates. The disadvantages in financing projects through initiation by project bond include the fact that bonds are through public offer on a stock exchange or other platform. This will give rise to publicity and liability issues, which are not present in project finance by banks. Moreover, offering documents (i.e Prospectus) of bonds will cover description of the project such as its location, and technical details, which may include confidential data in a typical exploitation of oil project, and may breach the confidentiality agreements the parties to a joint venture entered.

The purpose of Art.5 of Directive 2003/71/EC is to mitigate the risk of disclosure of confidential documents by apportioning liability to the issuers of the bonds. Although project bonds are an efficient way to project finance, the project has to be highly rated to attract purchase in the capital markets which may not be suitable for pre-development during the exploitation of oil projects if rating is a prerequisite in order to get the financing. The need for investment grade rating is because of the differential risk between the construction phase and the operational phase of the project.

The factor that may affect the project rating includes both the geographical location of the project and the geopolitical status of the host country. Hypothetically, the sovereign rating of the host country may have a negative investment prospect if the host country is hostile to foreign investors as a result of its policy. Moreover, while construction risk and operational risk may play crucial roles in the grade rating of any project, the cash flow is also relevant. As per Vinter G, “these elements are designed to absorb losses and also to provide liquidity in particular during the construction phase of a project”. As we shall see in this report, contractual arrangement between the parties can mitigate the identified risks.

• 2.3.3. Export Credit Agencies and Multilateral Agencies (ECA & MLAs) ECA & MLAs are relevant in project finance, especially where the project is in a commercially risky and politically risky environment. The advantage of using ECA and MLAs in project finance is that it can accept projects despite the mentioned risks where commercial banks may assess and accept commercial risk, but may not readily accept to finance projects in a politically risky environment.

The distinction between project finance in political risk and commercial risk environment is relevant where the lending institutions are to assess the insurance policies in its assessment of the risks as means to mitigate the associated risks. The disadvantage of using ECA in project finance of large oil projects is that it has a limit of what it can cover in the placing of orders for large projects. However, depending on the size of the project and in project sponsors’ perspective, the advantage of using ECA & MLAs outweighs its disadvantage since they can fund projects notwithstanding the political risk of the location of the project.

• 2.3.4. Subordinated Debt Subordinated debts are debts incurred from loans taken by project sponsors to bridge any gap between the equity contributions and the senior credit taken in financing of the project. Subordinated loans are required from third party lenders commonly known as ‘mezzanine financiers’. Subordinated debts are useful in large projects like exploitation of oil because of the uncertainties and unpredictability of the project for which construction cost may be over-run and may require additional financing.

Subordinated debt is through mezzanine finance by way of “structural subordination”, which is when a mezzanine financier lends to the company who held the real assets of the project. Literally, it may be argued that subordinated debt operates like a “necessary mechanism” when it serves its purpose of filling the financial gap between the equity contributors and senior creditors. For that reason, the interest rate to mezzanine lenders for the subordinated debt is supposed to be higher than that of the senior creditors.

This could be reasonable in a commercial point of view since the mezzanine lenders will not be able to enforce its subordinated debt in the project without concordance of the senior creditors. In a typical project finance for the exploitation of oil where large equipment and different types of equipment are needed, subordinated debts will play a useful role in the acquisition of certain equipment.

This may occur where the equipment supplier plays part in the financing of the project through selling of their equipment on deferred terms. In that case, the equipment suppliers retain the title of the equipment as security until the entire purchase price and interest are fully paid. It is effective from a tax point of view and from the perspective of the borrower, because the lessor can retain ownership of the equipment, and the borrower benefits from it through deductible tax. However, it will depend on the jurisdiction because certain jurisdictions may not allow such tax incentives. The question that may arise is what will happen if the borrower fails to repay the lease; and the lessor decides to repossess the equipment.

The mitigating approach is that since the project sponsor is highly leveraged, so if it is the lessee of the equipment, it will disadvantage the lessor.

The better alternative for the finance lessor is to lease the equipment to the senior creditor who may guarantee against the lease of the equipment, and the project sponsor indemnifies the senior creditor. As has been stated above, subordinated debt may be a ‘necessary mechanism’ in project finance since senior creditors as commercial banks apply ratio, for example, 20% equity for the project sponsor and 80% debt capital. In a hypothetical large exploitation of oil projects that need huge amounts of finance –say £500 billion, the above illustration may be applicable.

The senior bank project financier may lend 80%, the shareholders lend 15% subordinated debt and subscribe 5% equity. This may operate as turnover subordination to the senior creditor. » Contrasting Subordinated debt and Equity The advantages of subordinated debt to equity is that a debtor will be entitled to “deduct interest” payable by it from gross profit in calculating its net profits on which the debtor pays tax. Moreover, there could be security over debts while there is no security over equity; it means that a secured creditor of subordinated debt can rank ahead of equity contributors. Nevertheless, the disadvantage of subordinate debt creditor is that the creditor may not have rights to vote but may control management of its covenants as determined by debt instruments. The argument may arise as to what will be the outcome if the senior creditor incurred its debt in reliance upon the subordinated debt. It seems to me that the subordinated creditor may not claim parity with the senior creditor in a distribution from the insolvent.

However, if the senior debt is incurred prior to the subordination or after but without knowledge of the subordination, the senior creditor may not rely on the doctrine of estoppels, if it cannot show reliance on the subordinated debt. Therefore, in a hypothetical exploitation of an oil project, supposing that the project sponsor could not raise sufficient equity to cover the 20%, mezzanine finance may be useful in supplementing the lapse. The mezzanine may benefit from greater interest rates for operating at greater risks

• 2.3.5. Credit Enhancement Credit enhancement is where the project sponsor is required to provide some form of guarantee or pledge, which the lenders may rely upon to mitigate any risk exposed to the SPV. An oil exploitation project that is valued, for instance at £500 Billion, is a huge project that will be characterized with various types of risks.

How the risks are allocated and mitigated is usually a concern to the lender. Although there are various types of credit enhancements, however for the sake of space, it is expedient to discuss some of the credit enhancement, namely: (i) guarantees; (ii) letter of credit, and (iii) Indemnification obligations.

» Guarantees A Guarantee to lenders is a form of credit enhancement to cover certain risks, for example the construction and operational risk of the project. In that case, the third party who is giving the guarantee is part of the project finance notwithstanding the fact that its involvement is minuscule compared to the project sponsors and the senior lenders.

The most important thing is that risk has shifted unto the guarantor. The most essential factor of such guarantee will be whether the guarantor is creditworthy. However, the question that the Court may face to answer is where the project sponsor is also the guarantor of the credit enhancement. This is possible where the sponsor established a subsidiary SPV to handle any part of the construction phase.

The legal effect of that is that the sponsor has indirectly stood as a guarantor for its parent company which amounts to the sponsor re-lending to itself. Such arrangement may create an ineffective guarantee to the detriment of the lender. In such circumstances, it will be more realistic from the point of view of a lender for guarantee by third party guarantors. However, the identification of a third-party guarantor is not exhaustive since participant to project finance in a large project like exploitation of oil, will have its stake in the project; it follows that any of the participant can be a third-party guarantor who will be relevant at the pre-development of the project. The only party who may not qualify at that stage could be the off takers since the exploitation of oil may not have commenced at commercial stage. In general, there will be a credit risk on the side of the lender with any unsecured guaranteed obligation.

» Letter of Credit

A letter of credit is also a form of credit enhancement in project finance. However, because of the effect that letter of credit is “standby”, and putting into consideration a large exploitation of oil projects, standby letter of credit may not serve the intended purpose since such a large project may have a life-span of up to twenty years. Therefore, while a letter of credit may serve as credit enhancement for small projects, it may not be a source of credit enhancement for large project finance.

» Indemnification Obligations Although credit enhancement could be in the form of Insurance, and liquidated damages, particular emphasis laid to the operation of indemnification obligations as a form of credit enhancement is relevant.

Indemnification obligations operate to allocate liability to those who may be liable for a loss. In the context of exploitation of oil, the parties that made up the consortium may insert a Knock-for-Knock clause in the contract with the effect of allowing the sharing of losses among the entities of differing responsibility for a loss. Such a clause may legally favor the lender to the effect that the lenders will ensure that the risk of unexpected financial obligations is minimized.

Click on the Link Below  to Download the PDF Version

LGC Full Course Oil and Gas and Project Finance Brochure LECTURE 2 

Click on the link below to access more resources

02 Lecture 2 OGPF SOURCES OF FINANCE

02 Lecture 2 OGPF SOURCES OF FINANCE