Lecture 4 Security Arrangements in International Project Finance

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Lecture 4:

“Security Arrangements in case of
        Project Finance”

                                     Cristian PĂUN
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              International Project Finance Risks
• In a project finance, lenders require to the sponsors to provide assurance
             – The project will completed even if construction costs will
               exceed those originally projected;
             – After its completion, the project will generate enough cash to
               meet all its debt service obligations;
             – If or any reason (including force majeure) the project’s
               operations are interrupted, suspended or terminated, the
               project will continue to service (until fully repayment as
               scheduled) its debt obligations.
• This credit strength offered by assurances mentioned above is often
  supplemented by a set of security arrangements between the sponsors
  and other creditworthy parties of the project.

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               Purpose of Security Arrangements
• Arranging sufficient credit support for the project is a necessary
  precondition for project debt financing;
• The contractual security arrangements will ensure a lower risk for the
  project financing;
• The security arrangements ensure provide a legal recourse of the creditor
  on different third parties involved in the project (the purchasers of the
  project’s outputs, providers of raw materials);
• The nature and dimension of these security arrangements will depend on
  the type and the magnitude of the total project risk, the profitability of the
  project and the financial strength of the parties.
• The adequacy of such security arrangements depends on the
  creditworthiness of the parties so obligated.

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             Security arrangements covering completion
•      The security arrangements covering completion typically involve an
       obligation to bring the project to completion or else repay all project
•      Lenders require that the sponsor or other creditworthy parties to
       provide an unconditional undertaking to furnish any funds needed to
       complete the project in accordance with the design specifications and
       place it into service by a specific date;
•      Completion of the project will occurs when:
                    1. The sponsor of the project have accepted the work
                        performed under the construction contract and agreed
                        to make the payments;
                    2. The project has sustained a certain specified level of
                        operations over a specified period of time mentioned
                        in the completion agreement.
•      A completion undertaking requires that the sponsor stand by to
       provide whatever additional funds are needed to complete the project
       when additional costs occur.

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                                   Stingray Pipelines Company                    New Zeeland                        Colonial Pipelines
                                                                              Aluminum Smelters                         Company
Project Description

                                   - Stingray Pipeline Company was           - New Zeeland Aluminum            - Colonial Pipeline Company was
                                   formed to construct and operate, in the   Smelter Limited was organized     organized to construct and operate
                                   Gulf of Mexico, a pipeline network        to construct, own and operate a   a common carrier pipeline with an
                                   that would gather and transport natural   70.000 tons per year aluminum     initial capacity of 800.000 barrels
                                   gas from Louisiana to specific            smelter on the South Island of    per day. The pipeline would
                                   destinations from USA.                    New Zeeland.                      transport petroleum products from
                                                                                                               Houston (Texas) to Linden (New
                                   - Trunkline and Natural will              - Each sponsor will               - Colonial agrees to use its best
Completion security arrangements

                                   individually and collectively use their   contribute NZAS its pro rata      efforts to complete the
                                   best efforts to ensure that Stingray      share of the funds necessary      construction of the pipelines by no
                                   completes the pipeline network before     to enable NZAS to complete        later than November 30, 1964;
                                   December 31, 1976. In case Stingray       the construction of the           - In the event that the funds
                                   does not have sufficient funds            aluminum plant which must         Colonial rises through the issuing
                                   available to cover the full cost of       have an annual capacity of not    of stocks are not sufficient to
                                   constructing and completing facilities,   less than 70.000 tons of          enable Colonial to complete the
                                   Trunkline and Natural will make cash      aluminum.                         pipeline, each stockholder is
                                   advances or otherwise arranges to                                           obligated to contribute to
                                   provide Stingray with funds sufficient                                      complete the pipeline. The
                                   to complete construction. The                                               sponsors may contribute such
                                   sponsors may contribute such funds in                                       funds in the form of subscriptions
                                   the form of equity subscriptions or                                         for additional shares of common
                                   subordinated loans.                                                         stock or subordinated loans.
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             Security arrangements covering debt service
•      After the project completion, contracts for the purchase and sale of the
       project’s outputs (goods or services) represents the principal security
       arrangements for the project’s debt service.
•      These security arrangements are intended to ensure that the project
       will receive revenues that are sufficient to cover operating costs (incl.
       project’s debt service).
•      Lenders typically require that creditworthy parties either directly
       guarantee the project debt or else provide assurances contractually that
       the debt will be fully serviced out of project revenues;
•      The factors that determine the most appropriate security arrangements
                   1. The type of facilities involved;
                   2. The nature of the purchase contracts;
                   3. The parties to the contract;
                   4. The project’s inherent risks.

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               Type of purchase and sale contracts
Type of Contract      Degree of Credit Support Provided

“Take-it-Offered      The contract forces the purchaser of the project’s
Contract”             outputs or services to take delivery and pay for it
                      only if the project is able to deliver them. No
                      payments are required unless the project is able to
                      make deliveries.

“Take-or-Pay        The contract forces the purchaser of the project’s
Contract”           outputs or services to pay for the output or services
                    that will be delivered in the future. This is a cash in
                    advance agreement that offers a credit to the project
“Hell-or-High Water The purchaser must pay in all events, even if no
Contract”           outputs is delivered because of adverse
                    circumstances beyond the control of the purchaser.
                    It this case, the purchaser will take on him some
                    operational risks.

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             Type of purchase and sale contracts (cont.)
Type of Contract      Degree of Credit Support Provided

“Throughput           During a specified period of time, the shippers (oil
Agreement”            companies, gas producers) will ship through
                      pipelines enough product to provide the project’s
                      company with sufficient cash revenues to pay all of
                      its operating expenses and meet all of its debt
                      service obligations. The shippers advance funds to
                      the project company if, for any reason, there are not
                      sufficient funds to cover the operational obligations.
“Cost-of-Service      The contract requires each purchaser (obligator) to
Contract”             pay its proportionate share of project costs, in return
                      for a contracted share of the project’s outputs or
                      services. A limited form of this contract is the
                      contract that cover only fixed costs or only the
                      variable costs of the project.
“Tolling              The project company is taking tolling charges for
Agreement”            processing a raw material that is usually owned and
                      delivered by the project sponsors.
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             Security arrangements covering supply
• Raw materials supply agreements obligate the providers of the project’s
  inputs to lend credit support to the project company;
• A “supply – or – pay” contract forces the supplier to furnish the
  necessary raw materials for the project or else make payments to the
  project entity that are sufficient to pay the debt service.

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              Additional Security Arrangements
• Depending on the structure and the complexity of the project, it may be
  necessary to provide supplemental credit support through additional
  security arrangements;
• These arrangements will operate in the event the completion
  arrangements or the purchase and sale contracts fail to provide enough
  cash to cover debt service;
• Additional Security Arrangements may include:
                  Financial Support Agreement;
                  Cash Deficiency Agreement;
                  Capital Subscription Agreement;
                  Escrow Fund;
                  Insurance.

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                A. Financial Support Agreement
• Can take the form of a letter of credit or similar guarantees provided by
  the project sponsors to cover the obligations of the project company;
• Such forms of credit support are frequently used in connection with
  commercial paper financings (bill of exchange).

                 B. Cash Deficiency Agreement
• A cash deficiency agreement is designed to cover any cash shortfalls that
  would affect the project’s capacity to meet its debt service;
• The obligor makes the cash payments sufficient to cover the cash

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               C. Capital Subscription Agreement
• Capital Subscription Agreement forces one ore more creditworthy parties
  to purchase for cash securities issued by the project company, in order to
  cover the cash shortfall.

                           D. Escrow Fund
• Lender may require to the project company to create an escrow fund that
  usually cover a period between 12 and 18 month’ debt service;
• A specified trustee can draw money from the escrow fund when the cash
  flow from operation proves to be insufficient to cover the project’s debt

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                          E. Insurance Policies
• Lenders typically require that insurance be taken to protect against certain
  risks of force majeure;
• The project sponsors normally purchase commercial insurance to cover the
  cost of damage caused by natural disasters;
• Country risk, political risk, transfer risk and sovereign risks can be insured
  to specific insurance companies (COFACE, MITI);
• They may also secure business interruption insurance to cover certain other
  risks (water level of the river in case of a hydropower plant).

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• Security Arrangements are designed to increase the credit strength of the
• Security Arrangements increase the proportion of a project’s construction
  and operation costs that can be funded with project borrowings;
• Security Arrangements can be divided in two distinctive categories:
             • Those that ensure project’s completion;
             • Those that ensure the debt service (purchase and sale agreements
               and additional agreements).
• The security arrangements depends on the complexity of the project, the
  characteristics and risk – return preferences of the participants;
• The security arrangements are undertakings that share the risk and
  financial returns between the participants.

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