While project financing is sometimes called the “haute couture of the lending business”, portfolio project financing requires even greater skills from the tailor. Portfolio project financing is used particularly where several smaller projects in the renewable energy sector are included in the same documentation.
A. Nature and advantages of portfolio project financing
An essential feature of project financing is the financing of a self-supporting economic entity – meaning an economic unit that supports itself from generated cash flow. Such an economic entity is usually a special purpose vehicle that runs the project on which the financing focuses. By contrast, portfolio project financing consolidates separate individual projects within a single financing structure. The typical basic constellation – and premise of this article – is the financing of a portfolio made up of individual projects that are operated by different special purpose vehicles.
At the sponsor level, portfolio project financing makes it possible for sponsors to be engaged in individual projects within the investment structure. The necessary precondition and sub-goal of portfolio project financing is to make individual projects marketable. Given the considerable time and expense involved in the drafting of individual contract documents, the use of a single, cross-project set of contractual documentation will lead to substantial cost benefits. This also makes it easier to add or exchange projects. The relative reduction of transaction costs described here can ultimately be attributed to the utilisation of economies of scale. Financing-specific cost benefits also result from a diversification of risks. The interlinking of individual projects leads to a diversification that is usually reflected in the financing costs. Where alternative energy resources are financed, risks relating to geography and climate, for example, can thus be diversified. The diversification aspect can go so far that isolated financing of a high-risk project is not possible, but portfolio project financing – together with low-risk projects – is a viable option. It is evident that this can lead to a conflict between the sponsor’s interests and the lender’s interests.
B. Specific risks involved in portfolio project finance
As well as the advantages described above, portfolio project financing naturally also has disadvantages. These relate in particular to the complex structure. The financing of a single project already requires a complex legal structure, and there are many more requirements for financing a portfolio of projects. At an economic level, there are advanced requirements for calculation of the financing because such a calculation must take a much greater number of variables and cash flows into account. At a legal level, one of the major risks is that should an event of default or any other breach of duty occur within one project, this might have negative effects on the entire portfolio. In this context, relevant contract documents include explicit portfolio or cross-default clauses.
Both the borrower and any possible sponsor will, however, be interested in preventing isolated negative developments from affecting the entire portfolio. The question thus arises as to how project-specific risks can be separated to the greatest possible extent when under the umbrella of a single portfolio project financing. Merely eliminating any existing portfolio or cross-default clause is not sufficient. Interfaces and interdependencies between individual projects are to be found in many places in portfolio project documentation, which is made up of multiple contracts – such as security and intercreditor agreements. In the following, the focus will be on individual aspects in need of structuring based on examples selected from the many possible interfaces.
- Contract structure for the purpose of minimising portfolio risks
Portfolio project financing is usually based on a fundamental framework agreement concluded between the borrowers – the special purpose vehicles operating the individual projects – the financing parties and sponsors. This agreement forms the contractual basis for the conclusion of loan agreements and provision of loans for the individual projects. If the intention is to achieve the greatest possible separation, it must be provided for in the structure that the borrower for a project is only the respective special purpose vehicle, and not all of the special purpose vehicles combined, and also not an intermediate holding company that only provides sub-loans to the special purpose vehicle. If, on the other hand, the intention is to bundle the risks, exactly the opposite structure should be chosen. This fundamental course should be reflected throughout the entire documentation. The interests of sponsors, borrowers, security providers and lenders must be reconciled in many places in the documentation. In the following, examples are used to illustrate what needs to be considered during the drafting process when the intention is to make it possible for individual projects to be alienable.
First of all, it is advisable to include an explicit clause signifying that the obligations of the individual special purpose vehicles are independent of each other and do not establish any joint and several liability. It must also be emphasised that events occurring within one project – particularly a default – do not have any effect on other projects or that effects such as an event of default are restricted to the specific project.
The above-described clause needs to be reflected in the rest of the contractual documentation. Each individual reference to the “borrower” and the consequences that arise from this must be examined critically with respect to possible portfoliowide effects. This applies especially to representations, warranties, guarantees and default clauses. Representations and warranties have to be provided by each individual special purpose vehicle and restricted to their respective projects. Clauses that ostensibly do not have any collective effect, such as termination options in the event of a change in legal framework, should also be reviewed critically. If amendments to statutory law are limited to definable projects, this must already be taken into account in the contractual documents in the form of a limitation of possible consequences.
The documentation for portfolio project financing typically comprises a number of contracts. Reference has already been made to security and intercreditor agreements. These agreements must also reflect the above-described separation of the projects. This leads to fewer difficulties in individual loan agreements that are concluded on the basis of the framework agreement with the individual special purpose vehicles, because the project is then already individualised. This does not necessarily apply to security agreements, however. The definition of the secured claims, in particular, involves the risk that the individual projects might be combined, and it must thus be subjected to close scrutiny.
In all of this, it is important not to lose track of the interests of the financing parties in securing their position. These interests can, however, be counterbalanced by means of the distribution of surpluses from the individual projects. It is conceivable, for example, that current surpluses from all of the projects are initially – i.e. before being paid out to shareholders or sponsors – directed to a central account. In the event of an appropriate need (to be defined), weaker projects could be “cross-subsidised” from this account. In this context, an individually negotiated cash waterfall is suitable for taking the different interests of the parties into account.
Portfolio project financing offers time and financial advantages. At the same time, however, there is a substantial risk that negative developments in one project might infect the entire portfolio. It is already apparent from this brief description of individual aspects for consideration that there is no “one-size-fits-all” solution and that individual structuring of contractual documents is necessary in order to reconcile the interests of sponsors and lenders.