3 Structuring the Project

CHAPTER

LEARNING OBJECTIVES
Project finance differs from traditional corporate finance in terms of structure, contractual
bundle, and complex documentation. Before we calculate the value of a project based on
future cash flows, it is important to know whether project documentation is capable of
mitigating the risks that arise to the top line of the project. Why are we doing it now, and not
later on? It is because we believe that if the cash flows do not come, then project valuation
serves no real purpose. This chapter lays down the structure of a project finance deal.
After reading this chapter, you will be able to understand:
◆ key project parties and their roles in a project finance deal
◆ documentation and contractual structures
◆ project documents, financing documents, and key security documents that a project
finance bank loan should use
◆ advantages and disadvantages and key motivations behind using project finance

INTRODUCTION
The challenge before lenders of infrastructure and non-infrastructure projects lies in evaluating the viability
and bankability of a project by following a proper appraisal process. The key to successful project appraisal is
in ensuring that the project has passed through a stringent appraisal process and risk evaluation. This process
requires that a lender understands the importance of a tight structure and documentation (see Section 3.2).
Often, this documentation acts as a second line of defence, when cash flows do not build up.
So, let us embark on this journey.

3.1 KEY PROJECT PARTIES

As a project moves from conceptual and developmental stages to financing and thereafter to implementation/
construction and finally to operations, several project parties get involved with the project. It is therefore
important for the credit officer to identify these parties and the contractual framework binding these parties.
In this section, we will discuss the various key project parties.

3.1.1 Project Sponsors

The project sponsors (also referred to as promoters or developers or group and normally hail from established
business groups) are responsible for converting a concept into a project. They have a role in setting up a
project vehicle [existing corporate or a special-purpose vehicle (SPV)], identifying and recruiting the right
managerial talent to implement and run the project, providing a clear mandate to such a management on their
2 Project Finance

expectations, and finally subscribing to a portion of equity in the project vehicle. Implementation of a project
involves mobilization of various resources by the sponsors, including finance and management, as mentioned
above, and also engineering procurement and construction (EPC) contractors, legal experts, sector domain
experts, etc. The mobilization strength of the sponsors is critical, as the management team put up by them
should have relevant experience in the project area, and the sponsors can also infuse additional equity if the
project gets into cost/time escalation.

3.1.2 Project Vehicle

Infrastructure projects mostly involve an SPV. The SPV is responsible for evolving and delivering a bankable
project, implementing the project, and thereafter operating it in a financially viable manner. It selects and
appoints all the project contractors, negotiates and executes the contracts, raises the financing, supervises
construction and commissioning, and operates the project either directly or through an operations and
maintenance (O&M) contractor. Non-infrastructure projects may involve SPV or could be an extension of
an existing capacity or integration.

3.1.3 Project Lenders

Project lenders provide debt to finance the construction of the project. The lenders could be either banks and
institutions or lenders/investors in securities, such as foreign currency convertible bonds, preference shares,
and bonds. The latter type of lenders/investors is important, as they come in with convertible securities,
long-term mezzanine debt (mezzanine capital is any subordinated debt or preferred equity instrument that
represents a claim on a company’s assets, which is senior only to that of the common shares), and supplement
the equity/loan brought in by the sponsors/promoters for constituting the project margin.
Typically, a consortium of project lenders is led by a ‘lead bank’ that appraises the viability and bankability
of a project based on the project cost and the corresponding means of finance. The lead bank deals with the
project company, disburses debt, and is responsible for monitoring during the construction phase; and on
commissioning, it monitors the performance and operation of the project until all debts are repaid. Bankers
have a claim on project assets and do not normally interfere in the day-to-day operations of the SPV. However,
under conditions of default, the project lenders’ enforcement rights are triggered under the covenants of
events of default. The lenders possess the rights to take recourse to legal action for recalling the dues and
enforcement of security by foreclosure of mortgage, sale of shares pledged, etc.

3.1.4 Substitution Agreement

Lenders normally sign a ‘substitution agreement’ with the sponsors and SPV as a part of the loan documents,
which gives them step-in rights, such as conversion of debt into equity, pledge of sponsors’ equity, appointment
of nominee director/special monitor, and change of management structure. The lenders can then resell the
equity to a third party, which can carry forward the project profitably. The substitution agreement is a specialty
of infrastructure projects that are implemented under a concession agreement, such as roads and ports, and
will require the approval of the party granting the concession, such as National Highways Authority of India
(NHAI) and port authority. In the non-infrastructure sector, change of management has been effected in
some cases under the aegis of the corporate debt restructuring (CDR) forum involving debt restructuring.

3.2 KEY CONTRACTUAL PARTIES

The success of any project finance deal depends on the enforceability and validity of the contractual
structure. In this section, we discuss the details of key project parties and introduce the readers to some of
the critical contracts.
 Structuring the Project 3

3.2.1 EPC Contractor

Typically, the EPC contractor designs the project, procures all the engineering skills and equipment to
construct the project, erects all the project facilities, ensures that test and trial runs are completed, and finally
commissions the project, all on a ‘fixed time, fixed price’ basis. The EPC contractor’s key objective is to deliver
a project as per pre-defined specifications within a certain cost and time frame. It also provides performance
guarantees to the SPV. It may choose to subcontract certain portions of the assignment to other contractors,
but such subcontracting does not relieve it from its sole responsibility of delivering a constructed project to
the SPV. Exhibit 3.1 details the current status of the EPC sector in India.

EXHIBIT 3.1 EPC Sector

According to an Ernst and Young Report, the EPC sector is expected to generate opportunities worth
17.1 trillion during the 12th five-year plan.
Key highlights of the Indian EPC sector
The private sector has taken a leading role in the development of the EPC sector. Indian players have taken
the inorganic route to venture into international markets, as global construction giants are also increasingly
attracted to India’s growth story.
Many EPC contractors now find it attractive to diversify into other businesses or bid for projects themselves.
They have also inked technical partnerships with foreign players. This becomes critical, as power sector and
urban infrastructure and telecommunications are expected to attract major investments in the coming years.
Key challenges faced by the Indian EPC sector
Time and cost overruns pose a major challenge for the majority of infrastructure projects. The EPC sector is also
faced with shortage of manpower, machinery, and material. Fund-raising is another key challenge faced.

3.2.2 O&M Contractor

As the name indicates, the O&M contractor is responsible for operating and maintaining the plant in line
with industry best practices. An O&M contract defines the performance parameters that need to be achieved
during operations. The O&M contractor provides managerial skills and operations experience to achieve the
agreed upon metrics. For example, IRB Infrastructure Developers Limited has the O&M contract for the
Mumbai–Pune Expressway.

3.2.3 Government
The government is a key project party, especially in the case of infrastructure projects implemented under
public–private partnership (PPP). It provides a concession to the SPV to set up the project and ensure
that a proper legislative and regulatory framework exists that allows the concerned SPV to compete on
a level-playing field along with existing, possibly government-owned, entities in the same field. In some
cases, such as the electricity generation sector, the state government counter-guarantees the performance
of off-take obligations of the State Electricity Board (SEB), and in certain cases the central government
counter-guarantees the performance of the state government.

3.2.4 Suppliers
The suppliers are critical in the project development stage. Usually, the EPC contractor ties up with the suppliers of
material before the construction phase. In a power project, suppliers of raw materials for power production are critical.
Equipment suppliers are critical in power projects, and sometimes there is a huge delay in the supply of supercritical
equipment, particularly for power plants. As power plants get delayed (Exhibit 3.2), equipment suppliers are sitting
on overcapacity and a meltdown in their order books. Supply of coal for thermal power plants has to be tied with the
Coal Corporation, and then if the power plant is not located on the pithead, transportation of coal also needs to be
4 Project Finance

arranged. There are examples of many power plants that have faced delays in starting production because supplies of
inputs were not tied on time. As many as six gas-based power plants, including those operated by GMR, Lanco, and
GVK, with a combined capacity of more than 2000 MW in Andhra Pradesh, had stopped operations in 2013 due
to shortage of gas from the Krishna–Godavari basin. Another example of a project affected by the non-availability
of primary fuels was Dabhol, which had to be transformed from a gas-based power plant to one based on naphtha,
which is a costly source of fuel, thus raising the cost per megawatt of power produced. The suppliers would also
include suppliers of equipment and appropriate technology, which is critical in the power sector.

EXHIBIT 3.2 What can the Slowdown in a Sector Do to the Equipment Suppliers?
Toshiba JSW Power Systems India has decided not to expand its power generation equipment manufacturing
capacity in Chennai from 3000 MW to 6000 MW for lack of orders.
Some public sector power generators are ready to increase production because of pressure from the government, but
there is no such pressure on the private sector. This has led to equipment manufacturers sitting on idle capacity. As
per a Business Today ([Link] 6 December 2015) report, of the industry capacity of 36,000 MW,
the bulk of the order (i.e., 20,000 MW) lies with the market leader Bharat Heavy Electricals (BHEL), whose order book
has remained flat for over two years— 101,018 crore in end-FY15 compared with 101,500 crore in end-FY14. For
that matter, even Chinese equipment players such as Shanghai Electric, Dongfang, Harbin, and others are struggling.

3.2.5 Off-takers (Customers)

In the infrastructure sector, there are two types of projects in terms of off-takers. The first type is where off-
takers cannot be defined, such as roads, ports, and telecom, where for demand projections, we have to fall back
on historical traffic/tariff studies. In contrast, there are projects such as power, where the off-taker is the State
Electricity Board [now called distribution companies (Discoms)]. Once the off-takers are defined, we can
have a ‘take-or-pay’ kind of agreement with them, which means a certain predefined payment will be made
(under defined conditions) even if the off-taker is not able to buy the infrastructure output.
In the case of non-infrastructure also, the off-takers cannot be defined (as in the case of a textile unit or a
logistics provider), as the output is generally sold in retail markets and there is heavy competition. In the case
of an automotive component maker, there could be an assured buyback from one or two original equipment
manufacturers, but the character of such an arrangement is not similar to take-or-pay agreement described above.
The project structure described above is summarized graphically in Fig. 3.1.

Project Structure

Suppliers EPC

Government Project SPV Sponsors

Off takers Lenders
O&M

Successful project structure entails a win-win situa"on for all

FIG. 3.1 Project Structure

The roles of the lenders and the contractual arrangements have been discussed in Chapter 5.
 Structuring the Project 5

3.3 KEY TRANSACTION DOCUMENTS AND CONTRACTS

The project structure defined in the previous section is unusual in the sense that it is set up to undertake a
single project. From the perspective of a banker, documentation will be the primary evidence in case of any
dispute with the borrower. Documentation will be useful to prove the bank’s claims/charge against legal
representatives, liquidators, official receivers, etc. Correct documentation may also lay the bank’s prior charge
against the government, other creditors, etc. In case of disputes referred to a court of law, documentation may
help in proving the bank’s case against the defaulter. Since a party to a project will agree to assume risk at a
reasonable price only if it understands that risk clearly, project finance is appropriate only for infrastructure
projects such as power stations, roads, railway lines, airports, and telecom networks that involve established
technologies.
Even in the case of non-infrastructure projects, such as textiles, chemicals, steel, and cement, the project
lender is in a similar position. Correct documentation at the development stage helps in monitoring the
project during the construction and operational stages, as it makes terms and conditions for operational
performance legally binding. However, project finance may not be suitable for projects that involve complex
or unproven technologies.
There are two categories of documents in any infrastructure or non-infrastructure projects: project
documents and financing documents.
In the following sections, we will discuss key project documents and financing documents in detail.

3.4 KEY PROJECT DOCUMENTS

The project documents play a major role in establishing the contractual bundle for the project vehicle. These
documents also act as comfort for the lenders. The key documents are as follows.

3.4.1 Concession/Licence Agreement (Infrastructure Projects)

In the case of infrastructure projects such as road, port, and airport, this is the first agreement that the project
SPV signs through bidding or a tender system. It is an agreement with the government, granting the right
to the project vehicle to develop the project. It is called concession agreement in road projects, licensing
agreement in telecom projects (where licences to particular circles are bid by the telecom service providers),
operations, maintenance and development agreement in case of airport privatization, and memorandum of
understanding (MOU) in case of power projects.
The concession agreement delivers the project site to the private developer. Usually, in the concession
agreement, the government/public body agrees to meet the rehabilitation and resettlement expenses, if
any. The concession agreement specifies the term of the agreement (such as 12 years in the case of six-
laning projects in the road sector) and also the termination rights in case of end of concession period or
force majeure closure in the event of political/non-political disturbance. (Force majeure is a common clause
in contracts that essentially frees both parties from liability or obligation when an extraordinary event or
circumstance beyond the control of the parties happens.) It lays down technical specifications and terms
and conditions for any direct agreement of the state with the SPV called the state support agreement (SSA),
which mitigates political risk to a large extent. Concession agreements also clearly list down the procedure for
land handover, substitution agreement and termination benefits.

3.4.2 Shareholders’ Agreement

Shareholders’ agreement (SHA) is the agreement between all the shareholders of the SPV, including
project sponsors/promoters, which establishes the shareholding pattern, the shareholders’ representation
in management, terms of conversion of PE investors’ debt into equity, exit route for PE investors, and
6 Project Finance

minority protection rights, if any. It arises when there are other equity partners, such as PE investors, apart
from sponsors/promoters, and it has relevance to both infrastructure and non-infrastructure projects. It
clearly establishes the decision-making process in reserved matters. From the banker’s point of view, SHA
clearly defines the cash calls and remedies available against funding defaults by a shareholder. In the case
of disputes, the agreement defines a shareholder’s exit process and right of first refusal (ROFR) to other
shareholders. ROFR is exercised when one of the sponsors wants to sell its equity stake to outsiders. To
ensure that the winning bidder’s corporate structure does not completely change (thus leading to violation
of bidding terms), the ROFR ensures that the other partner gets the first right to buy the equity stake.
The SHA is critical, as it ensures that equity funding is fully tied up and available to the SPV as per its
financing requirements. It attempts to ensure a smooth functioning of the SPV and that certain decisions
are made with the concurrence of all shareholders, as opposed to a simple majority of the SPV’s board. It
lays down a simple process by which a shareholder can monetize its shareholding and the rights of other
shareholders in such an event. This helps the banker in clearly resolving disputes between shareholders once
the SPV starts getting profits. It also prevents the project from suffering losses because of shareholder apathy,
as it defines the rights and responsibilities clearly.

3.4.3 EPC Contract

The agreement between the SPV and the EPC contractor establishes the EPC contractor’s sole responsibility
in designing, procuring, constructing, testing, and finally commissioning the plant/facility according to
specifications laid down in the contract within a specified date and a certain cost. It lays down guaranteed and
minimum performance parameters that the EPC contractor will need to achieve. It also fixes the responsibility
of the contractor to rectify the plant if it fails to meet guaranteed performance parameters and penalties/
liquidated damages if the plant fails to meet performance parameters. Liquidated damages are also used
against time overruns, if any, by the EPC contractor. Typically, liquidated damages are capped at 20% of the
EPC contract value. Once the project is executed and if any defect in design of rod/plant is found in the post-
commercialization period, the EPC contractor is liable to pay a defects liability. (The defects liability period
is the period of time within which the contractor is contractually obliged to return to the construction site to
repair defects that have appeared in the contractor’s works.)
A well-laid-out EPC contract protects the project against time and cost escalations, particularly if it is a
fixed-time fixed-price contract. However, a limited cost overrun support is sought by the bankers from the
sponsors. The selection of EPC contractor is critical; in the power sector, it becomes mandatory to select a
qualified EPC contractor through an international bidding route. However, in the road sector, it is often
seen that the SPV awards the EPC contract back to one of the sponsors, as many sponsors of SPVs in road
projects are construction contractors themselves. In certain power plants now, EPC contracts are not awarded
at all, as the plants are developed on a boiler turbine generator basis, as the sponsor of the SPV procures the
most critical parts on individual contract basis called the balance of plant contracts. This happens only when
the sponsor has an extremely strong track record in the sector. In addition, by seeking warranties from the
contractor, the SPV ensures that, for an adequate defects liability period, spare parts are available and repairs
are carried out by experienced personnel at zero or low cost.

3.4.4 O&M Contract

The agreement between the SPV and the O&M contractor establishes the responsibility of the O&M contractor
to operate the plant/facility to ensure the availability of project/facility. It clearly defines maintenance obligations
that will ensure that the project/facility is maintained as per the industry best practices. It also specifies bonus
payments to the O&M contractor, for exceeding predetermined performance parameters and penalties for
underachievement. The O&M contract ensures a certain level of mitigation of operating and performance risks.
 Structuring the Project 7

3.4.5 Power Purchase Agreement (In the Case of Power Projects)

This is the most important document, which is directly related to the sale of electricity and cash-flow
generation. This establishes the power-sale obligations between the project company and the utility.
There are several types of power purchase agreements (PPAs). ‘Take-or-pay’ type contract is the best
choice if bulk power is sold to a public sector utility. The take-or-pay contract means that there is a
contractual obligation to make periodic payments in future for an agreed off-take of power at a set
price, and the purchaser must make specified payments even if it does not require the power at a
particular time, and the agreement can be cancelled only by mutual consent. Some other provisions of
PPA that define each party’s responsibilities and penalties in case of non-performance under agreed
terms are (a) nature of the plant, (b) base load or peaking plant, (c) tenure, (d) conditions for the
PPA to come into effect, (e) interconnection facilities, (f ) deemed commissioning clause, (g) tariff
determination, (h) security conditions, (i) force majeure clauses, and (j) termination payments. Initially,
when new independent power producers (IPPs) were set up, PPA was the preferred route for the sale
of power.
An example of this is in a PPA, a capacity contract, which has three key revenue components:

Charge Pricing Basis Covers

Capacity /MW/month Debt service, taxes, profit, amortization of development costs
(fixed maintenance)

Energy /kWh Fuel costs (usually a pass-through, no-profit basis)

O&M /kWh or /period Variable maintenance (sometimes with the fixed maintenance)

In contrast, for an open-market (no PPA) sale, the pricing may be only a variable ‘all-in’ price.
Subsequently, IPPs have chosen to sell a limited portion of power through PPA and the rest through
merchant sales (open access). PPA provided comfort to project lenders in respect of assured off-take and
payment and certain pass-through expenses. However, the IPPs felt that opportunities should not be missed
for enhanced earnings through sale of at least part of the power to public sector and private power trading/
distributing companies, such as Power Trading Corporation, Tata Power, and Reliance Power. Merchant
trading definitely gives higher revenue to the borrower or producer; however, recovery of fixed charges is not
assured in the case of merchant sale.
Until now, independent IPPs used to approach banks for financial assistance after entering into a long-
term PPA with the state utilities/intending purchasers. This helped in assessing the revenue flows from the
project and establishing the financial viability of the project. Keeping in view the state utilities’ present policy
of entering into PPA based on competitive bidding only, banks are being approached for financing of power
projects even when the sale tie-up has not been entered into. Promoters now have to bid for supply of power
and then enter into PPA with the intending buyers. In view of this, a realistic assessment of revenue flow is
difficult to ascertain; hence, it has to be assessed on the basis of the tariff structure prevailing at the time of
appraisal of the project—determined through the competitive bidding route. Therefore, a pre-disbursement
condition for entering into PPA for part capacity (so as to have a debt servicing of minimum 1.10) is being
stipulated. As the Electricity Act, 2003, allows trading in power and provides for further deregulation, power-
trading companies are being established to trade in power. Promoters are also entering into PPA with PTC
India Ltd for sale of power on a long-term basis. The PTC, in turn, enters into back-to-back PPAs with the
state utilities.
8 Project Finance

3.4.6 Fuel Supply Agreement and Fuel Transportation Agreement

A reliable and confirmed fuel supply agreement (FSA), the terms of which match with the terms of PPA, is
an integral part of the security package. The FSA contains evidence of the existence and dedication of fuel
reserves sufficient to meet the project requirements for the duration of the agreement. Some key provisions of
this agreement are (a) period—which should be at least for the currency of the term loans, (b) conditions, (c)
precedents, (d) commitment advance, (e) earnest money, (f ) obligation to sell and purchase coal, (g) quantity
and delivery of coal, (h) loading and delivery, (i) quality of the coal, (j) liquidated damages, (k) purchase price
for fuel, (l) payment terms, (m) force majeure, and (n) settlement of disputes.
Clearances/Consents/Approvals Table 3.1 gives a list of clearances required for a power project.

Table 3.1: Clearances Required for Power Projects

Item Agency
(a) Statutory Clearances
Water availability Water Resources Department,
State Government

Section 18A clearance State Government

(State government concurrence), registrar of companies
Pollution clearance, forest State Pollution Control Board

Environment & forest clearance, rehabilitation & Ministry of Environment & Forests, Government
resettlement of India

(b) Non-statutory Clearances

Land availability State Government

Fuel linkage Standing Linkage Committee

Department of Coal
Transportation of coal Ministry of Railways

(c) Other Clearances

Foreign investment promotion board clearance Foreign Investment Promotion Board

ECB clearance RBI

Forex permission for foreign equity RBI

For each project, both infrastructure and non-infrastructure, the set of approvals required needs to be
identified with the help of the sponsor/promoter, reference to similar projects financed in the past, lenders’
counsel, external experts, etc. The primary responsibility for identifying the set of approvals required should
be pinned on the sponsor/promoter.

3.5 FINANCING DOCUMENTS

Documents that govern the financing of the project as agreements between SPV and project lenders are
referred to as financing documents. These include the following.
 Structuring the Project 9

3.5.1 Loan Agreement

The first of these financing agreements is a loan agreement, which, depending on the bank and structure
being used, may be called common loan agreement, facility agreement, rupee facility agreement, senior
loan agreement, etc. It defines the amount and purpose of the loan and the terms of the loan or repayment
schedule. Normally, the repayment schedule of infrastructure loans is a balloon kind or step-up repayment
schedule with a defined moratorium period based on the gestation period, expected timeframe for
stabilization of commercial production, debt service coverage ratio trend, etc. A similar repayment schedule
is common in the case of non-infrastructure projects. Seasonality is also built in—toll collection in a road
project during monsoon months, non-crushing period in a sugar project, to site two examples. The loan
agreements specify the interest rates, which, because of the long tenure of the project, are generally floating
interest rates pegged to a benchmark, such as base rate of the lead bank or average base rate of the top 4/5
lenders to the project.
No external benchmark, such as GoI securities, has emerged in India for linking the rate of interest of
long-term project loans. In the case of foreign currency loans, London InterBank Call Money Rate is used.
Generally, the interest rates come with a reset clause. This clause provides a hedge to the project lenders. It is
also customary these days for the sponsor/promoter to include a clause for prepayment/refinance at the time
of date of commencement of commercial operations or interest rate reset. The loan agreement defines the pre-
commitment and pre-disbursement conditions, which are discussed in detail in Chapter 6. The drawdown
schedule or disbursement schedule is prepared in consultation with all lenders, and it is stated separately or
in the loan agreement. The loan agreement clearly states the debt fees/service, representation, and warranties,
and the conditions that may be deemed as events of default and the dispute resolution procedure to be
followed in case of default.

3.5.2 Inter-creditor Agreement

Where the quantum of project loan is large, as in the case of infrastructure projects in general and non-
infrastructure projects such as steel and cement, the project loan is arranged by the process of debt syndication.
Since in syndication, the number of participating lenders for a large project is high, an agreement is put in
place among the lenders; this is critical and facilitates coordinated action and harmony of terms and covenants
of all the lenders. It also prevents action by any single lender. This agreement preserves the right of each
individual lender against the borrowers by writing a procedure for the same in the agreement. The agreement
specifies lenders of facility agents if appointed, and the rights and responsibilities are clearly spelt out. This is
discussed in detail in Chapter 9 (on loan syndication).
The project documents and financing documents, along with the key contracts listed earlier, are called the
transaction documents of the project.
Figure 3.2 depicts the concept of contractual linkages. At the centre are the SPV and the concerned
government department/authority that is bound by a concession agreement. Lenders are contractually
obligated to give funding, and borrowers (SPV) are contractually obligated to protect the interests of the
lenders. SHA plays a key role in the constitution of the SPV. It works as a credit enhancer for lenders, and
lenders use the provisions of SHAs as financial covenants. Lenders and SPV give payments to the EPC
consortium with a contract to build, and the O&M consortium is linked to the EPC consortium for handing
over and taking over of the project sites. O&M contractor has the contract to maintain, operate, and collect
the revenues.
The strength of the transaction documents forms the basis of project appraisal by the bankers. If all the
project parties are bound by iron-clad contracts at this stage and all risks plugged in, then there is little chance
of a project not being successful.
10 Project Finance

Lenders
SPV & Lenders
Co
Cre ven
Payments dit an
Lenders En ts
Funding Protec!on ha
nce
me
nt
Cons!tu!on
Concession Agreement of SPV
Construc!on Shareholders
Contract SPV & concerned
authority Agreement

SPV & EPC

consor!um
Contract Contract to maintain,
to build operate and collect
toll/tariff
Linkage of handing
over & taking over
O & M Contract
SPV & O&M
contractor

FIG. 3.2 Contractual Linkages

3.6 CAPTURING CASH FLOWS

While negotiating the terms of a loan, it is also pertinent to factor in a repayment profile such that
it matches with the inflow profile. The repayment profiles could be equal, front-ended, back-ended,
ballooning, bullet, or equated. The borrowed funds can be unsecured loans/deposits and subordinate debt,
which can be considered as quasi-equity. Subordinated debt represents finance with repayment priority
over equity capital, but not over commercial bank loans or senior debt in the event of default or bankruptcy.
Such a debt is usually provided for by the sponsors and has a schedule for payment that is subordinate to
the principal debt. The timing of infusing owned/borrowed funds depends on the phase of development
of the project. Equity is infused in the early stages of development, while debt financing follows—after
financial closing. It is critical to determine the extent of profitability of the project and its sufficiency
in relation to the repayment obligations pertaining to debt assistance and servicing of sponsor interests.
Entire transactions of the project are routed through trust and retention account (TRA), where payments/
disbursements are done during operations as per agreed pattern. A waterfall mechanism is shown in Fig.
3.3, wherein sub-accounts and specific charges are created on the main account, implying that revenues
of the project must meet operating expenses, administration costs, then debt payments, then debt service
reserve account wherein two or three quarters of instalments are kept as cushion against default, and then,
finally, sponsors can get profits. Unless the previous bucket is full, the money will not go into the next one.
It is necessary for the bank to stipulate TRA mechanism in infrastructure projects such as roads and
ports and debt restructured under CDR framework in both infrastructure and non-infrastructure projects.
A typical TRA with waterfall mechanism is shown in Fig. 3.3.

3.7 SECURITY DOCUMENTS

Security documents are an important part of financing documents. They protect the lenders in the event of
default by the borrower. The documents define the claim of senior lenders over the subordinate ones. In times
of crisis, it allows lenders to assume control over the project assets. The assets that are available for security
are land, building, plant, and equipment of the SPV or project assets besides receivables and book debt and
 Structuring the Project 11

The cash
Waterfall

Opera!ng Expenses
Fuel costs
Approved O&M Costs
Approved Administra!ve Costs Debt Service
Payment on
Senior Debt

Payment on
Subordinated
Debt

Debt Service
Reserve Account
Equity
Distribu!ons
Maintenance
Reserve Account

FIG. 3.3 TRA With Waterfall Mechanism

other contractual rights and intangible assets. Uniquely, the asset created out of project financing may not
be available to the lenders. Roads/ports are relevant examples. The security documents generally involved in
infrastructure projects are as follows:

(i) Toll receipts under TRA/escrow mechanism

(ii) Right of substitution under which the lenders can replace the developers, subject to the provisions of
the concession agreement
(iii) SSA for enlisting state assistance in acquiring land, right of way, and so on
(iv) NHAI owns responsibility to acquire land and handover to the developer
(v) Any other collateral available to the lenders

In the case of the telecom sector, the fixed assets created are in the form of network, software, last mile
connectivity, etc. These expenses are capitalized and amortized over a period of time as per accounting
standards/tax rules. Here too, the main security is TRA/escrow of revenue.

3.7.1 Mortgage Document, Deed of Hypothecation

In respect of some infrastructure projects, as most of the assets that are available to be offered as securities are
project assets, and the project assets are under the concession agreement with a government department, there
is little by way of tangible security that is created in projects such as road, port, and airport development. In
the case of a power project, security in the form of mortgage of land and building, and plant and machinery
is available. In telecom projects, project finance creates tangible assets only for part of the amount disbursed.
12 Project Finance

Other assets that are available for security are equipment, bank accounts (TRA), receivables of project assets,
and pledge of sponsors’/promoters’ shareholding, fully or partly. Assignment of licence, brand, key contracts,
and so on should be explored and negotiated. Lenders also derive rights under the concession agreement such
as substitution. The final call should be taken as per delegated authority.
In the case of non-infrastructure projects, tangible security of project assets (i.e., land and building, and
plant and machinery) will be available, especially manufacturing projects. In the case of services projects,
creation of tangible project assets may not happen to the full extent of the project loans disbursed like ITES.
Collaterals such as pledge of sponsor/promoter shareholding and personal guarantee/corporate guarantee
should be explored. The final call should be taken as per delegated authority.

Share pledge agreement by the sponsors/negative lien

Normally, the bank insists on pledging of equity of sponsors in the project SPV; however, in certain cases, the
bank may accept negative lien, which is not exactly a charge, as per delegated authority.

Assignment of key contracts

Concession agreement, licensing agreement, insurance contracts, off-take agreements, construction contracts,
and so on are assigned to the banker (Fig. 3.4). In the light of lack of tangible security, the assignment assumes
importance in certain types of infrastructure projects. Various guarantees are sought for mitigating risks such as (a)
from sponsors/promoters completion guarantee, (b) from concessioning authority termination payments, (c) force
majeure guarantees from insurance company, (d) construction guarantee from project contractor, (e) performance
guarantee from supplier, etc. The deed of assignment of contracts will attract ad valorem stamp duty; assignments
are included as part of English mortgage. Stamping authorities have not levied additional stamp duties.

Risk/Security Package
Comple!on Poli!cal risk, physical damages,
guarantee loss of profit protec!on

Sponsors Ins!tu!onal
Investors Insurance co.
Concessioning
authority Project Co. Lenders
Termina!on
payment,
force majeure
Project O&M User/ Equipment
contractor contractor consumer Supplier

Construc!on Performance Cost infla!on & Performance

guarantee guarantee FE risk protec!on guarantee

FIG. 3.4 Risk/Security Package

3.7.2 Security Structure

Mitigation of the payment risk by SEBs/off-takers is critical for ensuring the viability of the power projects.
In addition to direct payment, security package, in the form of letter of credit (LC) and escrow agreement,
serves as a temporary measure for enhancement of creditworthiness of SEBs/off-takers. State government
guarantees may also be explored, although currently most state governments do not extend guarantees.
 Structuring the Project 13

Although the security structure has been envisaged for payment dues, SEBs/off-takers in the normal
course are expected to make direct payments within a stipulated period from the date of presentation of
the invoice. The money in the escrow account is ‘flow-in’ and ‘flow-out’, and the cash in the account will be
trapped only in the event of default.
Direct payment The project company would raise the invoices on a monthly basis, that is, after generating
and supplying the power to SEBs/off-takers for a period of one month. SEBs/off-takers would have two
options of making the payments according to the specification: (a) number of days (say 5–10) from the
presentation of the bills and avail of the discount; or (b) time (say 30 days) from the presentation of invoice
to avail of a lower discount (say 1 per cent).
Letter of credit The SEB/off-taker shall also maintain an irrevocable, standby, unconditional LC issued by
an acceptable creditworthy bank in favour of the project company. The LC will be opened in favour of the
project company for an amount prescribed in the PPA (e.g., equivalent to one month’s billing) from the date
when the project company starts selling power. In the event of default in payment, the LC equivalent to one
month’s billing will be invoked.
Escrow account Escrow account is a part of the mechanism intended to capture the revenues of the purchaser
in case of default in making payments to the project company. Escrow account is a designated account opened
with a commercial bank—the main banker to the purchaser of power—supported by a structure designed
to ensure that receivables of the purchaser are deposited to the credit of the said account only. The FIs/
banks have developed a model EA (MEA) that is more suited to vertically integrated SEBs in pre-reform
era. In the unbundled scenario, that is, when the SEBs are split into transmission company (Transcom),
distribution company (Discom), and generation company (Gencom), the MEA would need to be modified
to accommodate the two-tier escrow structure. Under the two-tier escrow mechanism, Level I escrow would
be positioned between the consumers and Discom, and Level II escrow is envisaged to be positioned between
Discom and Transcom. On default by Discom, Level I escrow is triggered and receivables are paid directly
into the Level II escrow. On default by both Discom and Transcom, both Level I and II escrows are triggered
so that the receivables are directly paid to the power producers by the consumers. The principles of escrow
would, however, remain the same under both the scenarios.
State government guarantees The state governments have been providing guarantees with a view to
attracting investment into their respective states. This has been the practice and over a period of time, the state
government guarantee was recognized by lenders and sponsors as a part of the security package. However,
lately, state governments have not been extending their guarantees, and most of the power projects are being
funded without their guarantees. This is because of the keener interest shown by promoters in setting up
power projects and also because the lenders now feel that securing the receivables of the power project is a
better security than the state government guarantee.
Trust and retention account The project company opens and maintains a TRA and deposits all the cash
flows of the company into the said account, and, the proceeds shall be utilized in the manner and according
to the priority decided by the lenders. A TRA attempts to discipline the utilization of the cash flows entering
a project company. The TRA can be at two stages.
Implementation stage This TRA structure requires that during the implementation stage, all project funds
(equity/debt) be placed into it. The main account is designated as the proceeds account, which captures all the
revenues. Based on the implementation schedule, during the implementation phase, funds from this account
are transferred to the construction account (sub-account) for meeting construction expenses, and to the interest
service account (sub-account) for meeting the interest payments during construction expenses. Withdrawals
from this account are permitted on the basis of an approved project implementation plan that is permitted by
14 Project Finance

project lenders on the basis of project status reports/certification regarding achievement of various yardsticks
and milestones as agreed upon at the outset. Such a mechanism is considered to be of paramount value to
the project lenders, for ensuring end-use of funds and monitoring project implementation. It can serve as a
useful tool for taking mid-course corrections, especially in the case of long-gestation infrastructure projects.
Operations stage Once the project is fully implemented and starts generating revenues from its operations,
the entire revenues continue to be captured in the trust and retention accounts, while the construction and
interest service accounts opened earlier are no longer required.

CONCLUSION
Project financiers try to bolster the structure with belts- For the lenders, the deal represents a long-term
and-braces security and covenants as much as possible. commitment with many opportunities to go wrong and
That does not prevent a litigation lawyer finding many no easy way out except to book a loss/provision and run.
delaying tactics through the courts. The bankruptcy costs The structure is built as robustly as possible, but when
and agency costs can be very high in a workout as much it comes to litigation, court systems particularly in India
from the delay as from the many professional teams that will inevitably tend to ‘defend’ the borrower from the
may need to be mobilized—such as engineers, lawyers, ‘oppressive’ lender with no one covering the interest bill
and accountants. The margins and payments in a project during these interminable delays.
financing are usually woefully insufficient to fund any
serious workout.

CONCEPT CHECK
So, we ask again. Why do project finance deals work? There are several project parties that share the project
They work because of the tight contractual bundle and risk and may be allocated some of the risk through
the chance it gives to the providers to capture project counterparty contracts. Why do they bear this risk? Of
cash flows. To attract long-term funds, PPP projects course they look forward to get rewarded by project
have a higher risk diversification potential as the risk returns. The trick is to get that optimum risk–return
is shared between government, private investors, and trade-off.
other project parties. The risk is mitigated by writing These contracts are either related to projects or
counterparty contracts. These contracts, agreements, financing. This leads to creation of project documents
and guarantees are written in such a manner that they and financing documents. Together, they are called
elicit the expected behaviour from the counterparty transaction documents, and they form the backbone
and act as a second line of defence, in case the project of the project finance deal.
faces cash flow problems.

CONCEPT REVIEW QUESTIONS

1. What are the key project parties in a typical project finance deal?
2. What are financing documents? Describe them briefly.
3. Clearly explain the difference between a TRA and an escrow account.
4. What is a shareholders’ agreement and why is it written?
5. How can you mitigate fuel supply and equipment risks?

CRITICAL THINKING QUESTION

Try mapping out the matrix
On the y-axis of this matrix are key documents. Put a black dot against as many risks on the risks on the x-axis you
think is the matrix mitigating.
 Supply/ Interest
Market Operating Management Environment Completion Construction Funding Legal
Traffic Rate
Concession

Government
Support

Shareholders’
Agreement

EPC Contract

O&M Contract

Loan
Agreements

Mortgage
Agreements

Trustee
Agreements

Legal Opinion

Traffic Studies
Structuring the Project
15
16 Project Finance

REFERENCES
1. Ernst and Young (2013), Engineering Procurement and Construction: Driving India’s Growth, [Link].
2. Hoffman, S.L. (1998), The Law and Business of Project Finance, Kluwer Law International, The Hague, The Netherlands,
p. 344.
3. Mukerji, A. 2000, ‘Emerging Trends in the Indian Power Sector’ in Project Finance Yearbook 1999/2000, Euromoney
Institutional Investor, pp. 118–123.
4. Nevitt, P.K. and F.J. Fabozzi (1996), ‘Reserves Oriented Financing’, Project Financing, 6th Edition, Euromoney
Publications, London, pp. 295–307.
5. Tinsley, C.R. (1994), ‘Coal Financings: The Good, The Bad, The Ugly’, at Ninth Pacific Rim Coal Conference,
28–30 June, New Delhi, India.
6. Tinsley, C.R. (1996), ‘Structuring and funding’, Practical Introduction to Project Finance, Euromoney Books,
London, p. 8.