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Don’t look back in anger – operational considerations in a project financing

Don’t look back in anger – operational considerations in a project financing Background Image

A significant amount of work goes into structuring and negotiating a project-financed transaction. Risks are considered from technical, legal, financial, insurance, tax and environmental and social perspectives (among others) and allocated amongst the developers/sponsors, investors, financiers, contractors, suppliers, purchasers, host country and other project parties accordingly. Since financiers do not take completion risk, it is imperative to create a bankable completion risk structure at the outset. Notwithstanding this, it is equally important to ensure that the operational phase is taken into account. Whilst financiers are generally willing to take operating risk (including price risk), they will seek to mitigate any such risks through, among other features, long-term supply and offtake arrangements as well as detailed covenants that limit departure from the ‘base case’ project on which they have conducted their due diligence. In energy projects the balance struck between financier bankability requirements and control and the sponsors’ desire for operational flexibility can influence the long-term economic success and sustainability of a project.

Even with the benefit of experienced sponsors (developers), financiers and advisers and extensive due diligence, it is not always possible to predict the extent to which a project will be exposed to ever-changing market conditions, as the COVID-19 pandemic has shown. Operational flexibility, which imparts the ability to adapt to customer demand and external pressures, is key. In a multi-sourced project financed by a syndicate of financiers, comprised of export credit agencies, development financial institutions, commercial banks, funds, bondholders and/or other financial institutions, even the simplest of waivers can take months to obtain and, in sectors in which competition and customer demand play a significant role, any delay in this regard could directly impact a project’s revenues. There is an inherent tension between the interests of the sponsors, who have a stronger appetite for risk in order to seek a return on their investment, and the interests of the financiers, who are more risk adverse and are seeking to protect the value of their investment. A proper balance must be struck. Focusing on both the completion and operational phases at the outset of a project financing, and developing a fair and appropriate set of covenants and undertakings that provide for operational flexibility, allows a project and its sponsors to take advantage of any competitive technical edge and to respond well to prevailing market conditions.

The tendency for deal teams is to focus on project completion, often without allocating equal consideration to a project’s operations. While mitigating completion risk, and therefore ensuring an operational project, lies at the heart of project finance, we make the case for preserving (and where applicable improving) cash flow reliability if the following points are considered from an operational perspective when structuring a deal.

Lender Approval Process

While an intercreditor agreement is often not given as much attention by a borrower as the other financing documents, this is a key document for a borrower and its sponsors’ interactions with the project’s financiers. In a long-term project financing, it is likely that financier deal teams will change over the life of a project, particularly from the teams in place during the origination and financial close phases where much of the diligence was carried out. The deal teams that consider a request made by the borrower during the operational phase may therefore require considerable background information and supporting materials as part of their decision-making process. Dealing with issues at the outset may reduce man-hours (and consultants’ fees) at a later stage in the project and allow the project workforce to dedicate their time to project execution and operations.

Finance documents customarily contain ‘yank-the-bank’ provisions that allow the borrower to replace non-consenting lenders; however implementing these, satisfying the applicable conditions and finding a replacement lender can take time. A borrower may wish to ensure that matters that require super-majority or unanimous consent truly are crucial decisions; it would be frustrating for a valid and important consent request to be knocked-down simply because of an insignificant but dissenting lender. Likewise, consider whether financiers that are not providing senior loans, such as hedging counterparties or working capital providers, should be given voting rights in certain decisions. Sponsors may be able to insist on a process whereby the financiers are required to respond to requests within certain time periods. This can assist in setting the boundaries and expectations when it comes to the financier voting process. Appropriate timings for decision-making need to be considered and negotiated at the outset; financiers should have sufficient time to consider requests (depending on the nature and extent of the applicable request) as too short a timeframe can result in financiers automatically rejecting the request in order to respond within the required timeframe.

Consider negotiating a wider remit for the intercreditor or facility agents so that administrative tasks and less material decisions can be made without requiring a prolonged financier voting process. Action could be taken when appointing the agents to ensure that they are comfortable and confident to carry out their role in this manner. A more flexible financier approval process, carefully thought out and corresponding to the nature of the requests likely to be made during the life of a project, may help to provide some of the flexibility sponsors require during the operational phase to respond swiftly to changes in market conditions.

Ongoing Compliance with Local Laws and Regulations

A project must comply with applicable laws and regulations; this is a basic undertaking in finance documents as well as a wider requirement of the jurisdiction in which the project is based. The due diligence process includes consideration and analysis of political, legal and regulatory risk but it is not always possible to predict the introduction of new regulations or laws that may require a change in the manner in which a project (or its financing arrangements) are operated. Insofar as possible, borrowers may wish to ensure that what is agreed in the finance documents at financial close is unlikely to inadvertently trigger any breach of a project’s ability to comply with applicable laws at a later stage during the term of the loan. For example, if laws are introduced requiring a project to procure insurance in respect of a certain risk that was not contemplated at financial close, then the borrower should not be restricted by the terms of the finance documents from entering into applicable insurance arrangements and paying the required premium. While a project’s financiers may be reluctant to agree an open-ended pre-approval for this type of scenario, consider negotiating a streamlined approval or consent process to ensure that the project remains in compliance with applicable laws and regulations.

Completion Test Flexibility

A project entirely reliant on revenue generation to service its debt obligations can face risk if the project does not meet certain minimum performance requirements. The financiers may insist on a ‘completion’ or ‘reliability’ test under the finance documents, the purpose of which is to demonstrate that the project is capable of achieving the ‘base case’ operating assumptions over a certain period of time. While the importance of mitigating completion risk cannot be overstated, the requirements of any completion test can undermine the flexibility afforded under other project documents, such as under the construction contract(s) or long-term power purchase or offtake contracts in respect of an initial start-up or ramp-up period. During such period, a borrower may be partially or wholly relieved of certain of its performance obligations which reflects the realities of initial operations as a project transitions from construction to operations. If a completion test requires a borrower to perform at a certain capacity or power output or to produce a certain quantity and quality of a product and is intended to be run during this initial ramp-up period, any performance relief afforded to the borrower under the project documents becomes superfluous if the borrower wants to pass the completion test.

Sponsors would therefore be advised to scrutinise the requirements of any completion test and endeavour to strike a balance between performance levels sufficient to service the debt while not being overly onerous or uneconomical at the time the test is run.

Project Improvements

Debottlenecking and increasing the efficiency or capacity of a project is often contemplated in the finance documents. However the extent of the conditions that are imposed by the financiers in order for a project to undertake such work can often mean, in practice, not much is gained at the negotiation phase (except a placeholder and reserving of a sponsor’s position to do this). In LNG projects, the structure of the initial financing agreements will contemplate capacity expansions through, among other things, the separation of the common infrastructure from the other assets of the project so that such common infrastructure can be used for the financing of future trains through a separate group of financiers (without the need to obtain initial financier consent to the same). In sectors in which such structures are not common-place, then if there is a strong likelihood of project enhancements or improvements being required (or desired) during the term of the loan, consider building in an exhaustive list of parameters so that the architecture is reflected in the project’s contractual structure. For example, because transformer capacity can constrain grid capacity in the context of solar and wind power plants, consider whether a mechanism in the finance documents permitting a borrower to procure additional transformers could be worthwhile. In addition to the terms of the finance documents, the sponsors may also seek to ensure that their site lease and land rights arrangements provide them with the flexibility to undertake any such project improvements. If project completion has occurred under the finance documents (including provisional acceptance or mechanical completion under the construction contract(s) and satisfaction of any financiers’ completion test) and where any project enhancements or improvements are funded solely from additional equity, then sponsors may be able to negotiate the flexibility to undertake such project enhancements or improvements where this would not result in material additional liability on the ‘base case’ project. In circumstances in which expansions are being funded from additional financial indebtedness, then it will be more difficult to obtain financier approval since the ability to incur debt will be conditional on meeting the applicable debt:equity ratio, as well as requirements for the additional debt provider to accede to the intercreditor and security trust arrangements on acceptable terms. A balance will need to be struck however, between seeking such flexibility, and demonstrating to the financiers that the initial project scope is appropriate and not deficient in any way.

Financial Indebtedness

It is likely that the project finance documents will contain the customary list of negative covenants, including a restriction on the incurrence of financial indebtedness. A borrower is advised to carefully consider what carve-outs and exceptions are required. Working capital flexibility may be required but it is unlikely that the financiers would agree to an uncapped working capital indebtedness amount in the finance documents. If a project’s working capital needs are important, then a borrower may choose to work closely with its financial adviser to ensure that an appropriate cap is reflected in a manner that is consistent with required financial ratio thresholds, and with its legal advisers to ensure that (if required and customary for projects of that nature) the finance documents contemplate that any provider of a working capital facility benefits from the project security package on a pari passu basis, and that the interest and facility repayments rank alongside the applicable senior debt service in the project accounts waterfall. Alternatively, the finance documents may contemplate a structure whereby the project security package provided to the senior financiers excludes security over working capital (consisting of accounts receivable and inventory) and any working capital providers have access to a separate security package over that working capital only.

A borrower should also consider what operational financial instruments are likely to be required. For example consider whether the borrower may be required to procure letters of credit or other forms of credit support in favour of applicable governmental authorities in respect of its feedstock, tax or utility payments. If possible, the borrower may wish to look to the financing arrangements of competitors and projects of a similar scale and nature to understand what flexibility, and the anticipated levels of additional financial indebtedness, that may be required to ensure that operations run smoothly.

Taking Advantage of Technical Capabilities

Any competitive edge resulting from the development of a state of the art facility with world-class operators may be of little benefit if the finance documents unnecessarily restrict the borrower from taking advantage of such capabilities and expertise. For example, in a petrochemical project where unanticipated market conditions result in a decline in demand for relevant products, either in the short- or long- term, it may make sense to adapt the product slate to mitigate the impact of such market conditions on the project’s revenues. This will need to be considered on a project-by-project basis, but when structuring a project’s financing arrangements, sponsors could consider worst-case scenarios and the likely mitigants that may be employed in such circumstances to preserve (insofar as possible) the project’s cash flow, ensuring that the finance documents would not unduly restrict their ability to do this.

Supply and Purchase Arrangements

Pre-financial close negotiations will focus on a project’s sales, marketing and offtake structure. Lenders require comfort that the revenue stream will be sufficient to support debt service until final maturity of their loans and require a financial model that demonstrates robust coverage ratios. A sponsor may wish to spend time with its marketing experts to ensure that the marketing and offtake undertakings, and any requirements as to a project’s purchase and sales arrangements, provide sufficient flexibility to adapt to market conditions on a long-term basis. What is customary in sales contracts at a certain point in time may unintentionally cause a project to become uncompetitive a few years later. For example, when negotiating power or electricity purchase arrangements developers and investors are likely to focus on any price escalator or downwards adjustment within those contracts, including consideration of any flexibility required to account for (among other things) inflation-related cost increases, changes in the grid prices and/or efficiency decreases as the facility becomes older. A borrower may also wish to seek conforming flexibility in its financing arrangements to ensure that it can take full advantage of any such price mechanism, subject to any collar or fixed pricing element required from a bankability perspective to support the project’s economics. In distributed generation or portfolio deals or other projects with a range of potential purchasers, consider whether a buffer is required in respect of any required minimum credit ratings for key purchasers or whether flexibility is required in respect of any letter of credit or other credit support procured on behalf of, or any trade financing arrangements required by, purchasers that do not meet the minimum credit rating requirements. Similarly, if a competitor offers more favourable payment terms then a sponsor might consider whether the project economics could support a corresponding adjustment to the payment terms offered by the project to mitigate the risk of valuable consumers purchasing products elsewhere. The ability to adapt to market forces to ensure that a project can sell its output or products on reasonable commercial terms, albeit in a manner that still adheres to the key bankability principles, is essential.

Local Bank Ratings

Local banks and financial institutions are likely to play a role in a project, whether in the form of providing loans, acting as local account bank or providing letters of credit or similar credit support in respect of supply, offtake and bank account support obligations. The credit ratings of domestic banks are likely to be limited by the credit rating of the host country. Consider whether and in what circumstances the borrowers should be relieved of the consequences of a failure to maintain the finance document credit rating requirements (for example, uncontrollable market conditions that cause a certain threshold down-grade of a key local account bank) and whether it is possible to negotiate such a mechanism in the finance documents.


Detailed legal analysis is required during the negotiation of a project financing to ensure that, insofar as possible, the financiers benefit from a complete security package in respect of a project. It will work in a borrower’s favour to negotiate a security regime that works from a practical perspective. For example, if local law does not recognise the concept of a floating charge (or equivalent) then a borrower may want to ensure that the security requirements for work-in-progress and stock etc. are not unnecessarily onerous and do not require a regular and impractical security document update process. Any decision to amend the security provisions within the finance documents is likely to require unanimous financier consent, so it may be preferable for a borrower to look ahead and address the impracticalities of any prescriptive security covenants at the outset.


The financing arrangements entered into at financial close will customarily set out requirements for the operational phase insurances. However, the insurance and reinsurance market can be extremely volatile and it may be the case that in the intervening period the insurance markets have changed in terms of what is available and market capacities. Therefore, consider negotiating a mechanism in the finance documents whereby deviations from the finance document requirements are permitted to the extent that the required insurances are not available on reasonable commercial terms (including pricing).

Consideration should also be given to the ability to smoothly transition from the construction phase insurances to the operational phase insurances. A borrower is often required to procure operational phase insurances by the time the commercial operations date or provisional acceptance is achieved under the construction contract(s). While the conditions to achieving the commercial operations date or provisional acceptance would usually be sufficient for the purpose of an operational insurer assessing the readiness to attach an operational insurance policy, the realities of project completion and the requirements of the finance documents for implementing the switch may mean the two do not necessarily align. If an operational insurer can be convinced that a facility is acceptable from a testing and commissioning perspective, a borrower may want to ensure that it is not restricted under the finance documents from transferring to the operational phase insurances prior to commercial operations or provisional acceptance. The alternative is to obtain extensions to the construction phase insurances until the relevant performance test is satisfied; this can be incredibly difficult (and expensive) in circumstances where no construction work remains to be performed.


There are many issues to be considered and addressed in structuring and agreeing the fundamental parameters of a project financing in a manner that strikes an appropriate balance between the requirements of a project’s sponsors and equity investors and the bankability requirements of a project’s financiers. It is no surprise that the focus of those negotiations is often on addressing completion risk and ensuring that the contractual structure of the project provides sufficient comfort to the financiers in respect of the repayment of their debt. However, giving equal consideration to the long-term operational requirements of a project (insofar as possible) and reflecting appropriate mechanisms within the finance documents to account for such requirements, can mitigate key project risks (including completion risk) and increase the likelihood of a project meeting its financial commitments during the operational phase. Nevertheless, the ability of the parties to incorporate operational flexibility into the finance documents will ultimately be driven by the project financing timeline, the risk appetite of the financier group and the parties’ respective bargaining power.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.