SJ Mills and Melissa Taylor approached these questions backwards because they believed they were crucial, particularly for smaller renewable energy entrepreneurs, seeking project financing for the first time.
Many times, banks have told sponsors that the technical risk is too high, that the expected return is unrealistic, or that the sponsor is too tiny for a project of that size. In practice, if a sponsor presents its proposal in a way that provokes these or similar reactions, the proposal or its delivery has failed. The sponsor may believe that the lender did not pay close attention to the project proposal, or that the lender did not grasp the scope and nuance of the project from the proposal, or that the lender did not even consider ways to eliminate or, at the very least, mitigate the risks posed, and they may be correct.
However, at that time, it is fruitless to do so because the chance may have passed you by. Before beginning a full review of the proposed project, the sponsor has to know the lender’s initial attitude.
To begin, the sponsor must be able to keep up with the situation of the global banking market, as well as the bank’s financial capacity and health at the time. Many banks have suffered losses as a result of events such as the third-world debt crisis, troubles in the US secondary banking market, the effects of recessions on their customers, the 2008 financial crisis, and, most recently, Covid-19 and its ramifications. Project finance is a specialized, high-risk, capital-intensive branch of banking that few banks are willing to embark on. As a result, sponsors should conduct their due diligence and approach those banks that have the credit capacity to fund such capital-intensive projects. There are banks (and other financial organizations), that have set aside funding for high-intensity projects particularly. Sponsors can also attempt to leverage existing ties, since banks are more likely than not to support current clients during moments of capital restraint.
Another common problem is sponsors’ incapacity to comprehend the bank’s ‘risk-reward’ analysis when coming to a decision. Project finance being a limited recourse, banks risk losing both principal and interest if it goes bad. It’s a project with the lowest possible risk. If the project scales, they will receive their principal as well as any accrued interest, so there is only a minor benefit.
Sponsors must thus, approach these institutions with a package that displays a grasp of their anticipated concerns, and a reasonable attempt to address these issues. That is, you must show that the project will be able to discharge its debts, with a sufficient margin of safety in a variety of circumstances.
Once the sponsor has cleared this hurdle, the next step is Risk Analysis and Allocation, as well as the project’s bankability. These two aren’t explored in detail because they necessitate a more technical approach appropriate for different types of literature. Sponsors should be aware, however, that banks will conduct risk assessments in the areas of sponsor standing, technology risk, completion risk, input/supply risk, operating risk, approvals/environmental risk, and offtake/sales risk.
Finally, in terms of scalability, banks would most likely examine some cover ratios relating to cash flow generated to debt outstanding, as well as compute the loan amount to ensure that minimal cover ratios are maintained throughout the loan’s term.
SECURITY FOR PROJECTS
Security is crucial in project funding, and it frequently determines how a project is constructed. As previously stated, lenders often have no access to either the sponsor’s or the project’s assets, and rely on the project’s cash flow to repay loans secured for the project.
As a result, lenders must ensure that legitimate and effective security interests, in all or portion of the project assets, are taken. If there is a problem with the project, the lenders will be required to enforce their security over the project assets as the only way to get their money back.
If the project company is a special-purpose vehicle, it is likely that the lenders will have taken security over all of its property and assets, and will seek to have control of those assets to the exclusion of other creditors.
If the project firm is not a special purpose organization and has other assets in addition to the project assets, these assets will certainly have been ring-fenced, limiting the lenders’ efforts to exercise their security against the project assets alone. This is one of the key reasons why project finance is done through special-purpose vehicles.
When lenders take security over assets they’ve financed, the primary goal is to ensure that the lenders can sell the assets if the security is enforced. In most jurisdictions, this will not cause insurmountable challenges for lenders in the event of movable assets such as ships and aircraft. Similarly, most real estate will find a buyer at a price that is determined by the state of the local real estate market, and the sort of property in question.
The capacity to sell project assets, on the other hand, will not be the primary motive for taking security in the first place for most projects. Instead, they will focus on achieving the lenders’ goals. They consider a thorough security package as a defensive mechanism, in this case, meant to prevent other creditors from taking security over the assets they have financed, as well as other creditors from attempting to attach them.
As a result, a project sponsor must understand the varied concerns of banks to produce a robust and personalized proposal, that adequately addresses the bank’s issues.