Credit enhancement
Sometimes credit enhancement is referred to form a creditworthy source is necessary. The purpose of this enhancement is to improve the most severe equity and lender risks in a triage of project financing risks identified. Depending on myriads of factors, the requisite support can take the form of direct guarantees by the project sponsor or the project participants, guarantees by third parties not directly participating in the project, and in some cases contingent guarantees and so-called moral obligations of the project participants.
The most obvious type of commercial risk in a project financing is the risk of nonpayment of the project debt. Commercial risks must generally be covered by credit support of the project sponsor or a responsible third party. Although the project sponsor is conceptually the fundamental risk taker, the non-recourse nature of a project financing limits the ability to allocate risks to the sponsor. At the same time a sponsor may be asked to accept straightforwardly some risks, and will also be asked to provide equity contributions additionally upon certain particular events, and to provide credit enhancement in the form of insurance, third party guarantees, or letters of credit in others.
In evaluating the use of a particular form of credit enhancement, the utility of each type of this enhancement device must be considered in relation to several factors, including the term of the device selected, the cost, and the difficulty of, and time necessary for, enforcement. For instance, in determining whether to use insurance or a third party guarantee to enhance the risk of a superior force to the project, the premium price, short policy term, and length of time necessary for enforcement of insurance claims must be compared to the cost, term, and enforcement issues of a guarantee.
Thus, the objective of risk allocation in a project financing is to combine these enhancement mechanisms to distribute the risks among the participants. This combination must produce a bankable project without burdening any single participant to the point that the project financing is converted into a recourse financing.
These enhancements are not limited to the realm of third part guarantees, although such guarantees are an important component of many financings. Other enhancement mechanisms include deficiency, implied, indirect, and limited guarantees, comfort undertakings, letters of credit, insurance, surety obligations, take or pay, liquidated damages, put or pay contracts, through-put, indemnification obligations, as well as additional equity commitments. This list need not be exhaustive; the types of these enhancements are limited only by the creativity and imagination of those structuring the deals.
Each and every type of credit enhancement is usually embodied in a separate agreement and it should be included in the finance structure. Thus, to the extent this enhancement is a necessary component of a deal, it will be a condition precedent to the loan closing that the enhancement documentation be in place. It will also be a loan default if it is no longer in place. Finally, these enhancements will need to be collaterally assigned to the project lender and the enforceable by it.
The type of credit enhancement necessary to satisfy a lender or equity investor that is risk is covered varies based on the financial community's perception of risks at any given point in time. A risk covered by a guarantee on one occasion might not be required several years later, as in the case of a technology that has developed a record of reliable performance. One not required in the past might suddenly be necessary because of changes to the political environment underlying the project, as in the case of a change in the host country's political attitude.
Like other credit enhancement devices, a guarantee shifts risks to entities that prefer little direct involvement in the operation of a project. A guarantee is also a mechanism that permits entities to invest capital without becoming directly involved in the operation of a project.
The value of a guarantee to the project is dependent upon the creditworthiness of the guarantor. It is also influenced by the guarantee language. Unless the guarantee provides a waiver of defenses and an absolute and unconditional obligation, the guarantee may not provide the credit enhancement necessary to comfort a lender that a credit worthy support is in place.
There are essentially two types of guarantors in a project financing. They are third party guarantors and sponsor guarantors. Sponsor guarantor is the most common guarantor in the project financing. Typically, the sponsor establishes a special purpose subsidiary to operate, own and construct the project. The subsidiary, however, lacks sufficient capital or credit rating to support risks associated with the underlying loan obligation. To reach a loan closing, the project sponsor must arrange some form of these enhancements to cover the identified risks. Often the requisite credit enhancement is provided in the form of a guarantee by the project sponsor of the obligations of the project company.
The sponsor guarantee can be framed in various forms to satisfy the objectives of the sponsor and the enhancement needs of the project. For instance, a completion agreement is sometimes used in which the project sponsor is required to complete construction of the project. Once the project is completed to agreed-upon performance levels, the agreement terminates. On termination, the liability of the project sponsor is also extinguished. As a result, its balance sheet is freed to similarly guarantee other projects.
To conclude, if the sponsor guarantee is insufficient, in terms or credit, to support the risks identified, however, credit enhancement by a third party is needed. Each project finance participant is a potential third party guarantor because each participant has an economic stake in the success of the project's development. The various project participants that may provide project finance guarantees include suppliers that have an interest in the fulfillment of purchase orders contingent on financing or that recognize that a project sponsor cannot compete in the marketplace without financial assistance. Other potential providers are output purchasers where supply of the output is of particular importance, and contractors that are interested in constructing the project and realizing construction profit.
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