May 26, 2003 - Kyiv, Ukraine

Project Financing. Risk Allocation And Security Structure
  by Oleksiy V. Didkovskiy

Project financing in emerging markets has been in use for some time, primarily for financing large new projects without any prior track record or operating history — greenfield projects. Emerging markets are in instant need of project financing as an effective instrument for economic investments. It facilitates attracting new investments by structuring the financing around the project's own operating cash flow and assets, without the additional guarantees of sponsors. The Ukraine continues to pose some investment risks due to political, economic and legislative instability. To date, these risks have made strictly private, long term financing prohibitively expensive or impossible to obtain, leaving quasi-public multilateral financial institutions (such as the European Bank for Reconstruction and Development, the International Finance Corporation, etc.) as the principal sources for Ukrainian project financing. Project financing is commonly described as an exercise in risk allocation and risk mitigation. Indeed, parties to project financing often prepare risk allocation matrixes during the structuring stage of project financing to ensure risks are properly allocated amongst the parties. Specific type of project agreement which forms the basis for project financing (such as a production sharing agreement, concession agreement, power purchase agreement or other form of offtake agreement, etc.) presents unique risks which must be allocated amongst the project lenders, sponsors and project company parties to the project financing. There are two basic types of project financing: limited recourse project financing and nonrecourse project financing. Limited recourse gives the lenders some recourse to the sponsors in the form of the precompletion guarantee or/and other assurances of some form of support for the project. Limited recourse project financing is typical for emerging market projects and projects posing significant risks. Nonrecourse project financing is an arrangement under which lenders do not have any direct recourse to the sponsors. Their security includes various assets of the project company (including the assets being financed) and rely on the operating cash flow generated by the project company. Project financing has two important advantages over traditional corporate financing: increase in the availability of financing and reduction of the overall risks for the project participants, reducing them to an acceptable level. Risk allocation Successful project financing structuring rests on the project itself. Identifying the project's risks and then analyzing, allocating, and mitigating them are the essentials of project financing. The risks unique to project financing in the emerging markets, include, among others: _ commercial risks consisting of (a) risks connected with developing and constructing, operating and maintaining the assets and finding a market for output of the project (the adequate revenues which the project company should be able to generate are a separate component of the commercial risks), and (b) broader economic environment risks related to interest rate changes, inflation, currency risks, international price movements of raw materials and energy inputs; _ noncommercial risks covering (a) local legal and regulatory environment, and (b) political risks. As described in more detail below, parties to the project financing may attempt to allocate and mitigate such risks through, among other things: _ precompletion sponsors undertakings; _ sophisticated intercreditor and security sharing arrangements; _ participation by multilateral and bilateral project lenders; _ political risk coverage provided by specified event carve-outs to sponsors' precompletion guarantees; and _ complex onshore and offshore security structures. A first step in effectively mitigating each risk is to identify the party that is in the best position to manage that risk, or whose actions have a bearing on its outcome. For example, the project sponsors are the ones best able to manage commercial risks. Commercial Risks Lenders involved in limited recourse financing of virtually any type of project, require an assured cash flow for the term of the project debt. While lenders do not require the project company in such transactions to have offtake agreements in place as to production from the relevant fields, they do require that any risks to project revenues be allocated to, and mitigated by, the project company and/or sponsors. For example, to ensure project revenues sufficient to service project debt, lenders should include in the provisions of the project debt documentation a requirement that the sponsors inject the agreed funds into the project company to stabilize cash flow and reserves or top-up the shortfall in precompletion project revenues. Noncommercial Risks In many emerging market project financings, a great deal of time is spent negotiating who will bear the risk of Risk Allocation and Security Structure _ The Ukrainian Journal of Business Law May 2003 _ 9 changes in laws and regulations. Much has been written and said concerning the continuing need for legal and regulatory stabilization, clarity and transparency. In many cases, the change in law risk includes the risk that proposed or required legislation will not be passed. Political Risks The principle political risks faced by projects in many emerging markets, are expropriation and politically motivated violence which affects the project. Sponsors of such projects have sought to mitigate such risks by (a) including in the project lender group one or more multilateral, bilaterals (on the theory that a government is less likely to expropriate or permit political violence to affect a project to which a multilateral or bilateral has lent) or (b) obtaining a political risk insurance policy from a multilateral or bilateral. One of the more attractive features of debt provided by multilaterals or bilaterals for the project financing is political risk protection in the form of "specified event" political risk carve-outs to sponsors' precompletion guarantees. This is a mechanism by which sponsors' obligations under precompletion guarantees are extinguished prior to project completion if certain so-called "specified events" of political violence or expropriatory actions occur. Security structure Project lenders' security interests in project financing can be broken down into two categories: offshore security and onshore security. Typically, offshore security includes: _ an assignment of rights in the project company's offshore bank accounts; _ an assignment by the project company of its rights in respect of its insurances; _ an assignment by the project company of its rights under project agreements; _ a charge over the project company's accounts receivable; _ an assignment by sponsors of their rights in respect of subordinated debt and/or preference shares of the project company; and _ a pledge by the sponsors of their shares in the project company. Onshore security typically includes: _ a pledge of the project company's real estate property; _ a pledge of rights in the project company's onshore bank account contracts; and _ a pledge of the project company's movable property.

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