The Project Finance Law Review: Commercial Lenders
I Commercial lending in project financings
Commercial lending has formed the bedrock of financing sources for large-scale project financings ever since their emergence, with the product being refined in financings for the UK North Sea oil field in the 1970s onwards, and becoming increasingly internationalised during the 1990s and beyond.
While the commercial lenders' share of the market has reduced over time, largely driven by changes in the appetite of commercial banks to provide long-term financing, commercial lenders continue to be the primary funding source for project financings. The IJ Global Infrastructure and Project Finance League Table Report for 2020 reports commercial lending of US$ 221.42 billion to project finance transactions, which comprises over half of the total value of funds sourced from commercial lenders, export credit agencies (ECAs), development banks, bonds and equity. This was even higher than the amount of commercial lending provided in 2019, demonstrating that the commercial lending market (as well as the project financing market as a whole) has continued to lend in spite of the uncertainties that covid-19 brought to the global economy during much of 2020.
The key source of commercial lending has been and continues to be commercial banks, although in recent years and in some markets there has been an increase in non-bank loans by pension funds, insurance companies and investment funds, which had previously tended to be involved in project financings through project bonds and other products.
Very broadly, the commercial bank market is comprised of international and local banks. This is not necessarily an easy distinction, but the typical hallmark of an international commercial bank is that it performs the majority of its lending outside its home jurisdiction, whereas local banks (also called domestic banks) would do the majority of their business in their home jurisdiction, have a full domestic banking licence and be able to lend in local currency. International commercial banks (such as leading European and Japanese commercial banks) are prominent in most regions globally. By contrast, local commercial banks feature more prominently in their respective countries of origin or region (for example various South African banks are particularly active in sub-Saharan Africa and Saudi Arabian commercial banks in the Middle East).
On a global scale, the commercial lending market for project financings is dominated by the large European, Japanese and Chinese commercial banks, comprising together 16 of the top 20 commercial lenders (with three Japanese commercial banks occupying three of the top four spots). However, this varies between regions and between countries within the same region. For example, according to the IJ Global Infrastructure and Project Finance League Table Report for 2020, 19 of the top 20 commercial lenders in Europe are European and Japanese commercial banks. In contrast, in the US, US banks feature more prominently (although two Japanese commercial banks occupy the top two spots). In Asia-Pacific as a whole, three Japanese commercial banks hold the top three spots, although in specific markets this varies, and so for example in China, Chinese banks dominate. In Latin America, aside from the European banks (three of whom are Spanish) and Japanese commercial banks, commercial banks from Latin America and North America (three from each) are more active. Similarly, in the MENA region, eight of the top 20 are from the Middle East (five of which are from Saudi Arabia), while in sub-Saharan Africa, there is a range of banks from South Africa adding to the mix of international commercial banks.
ii Holding versus originating loans
During much of the past century, commercial banks would anticipate remaining the lender of record for the full term of a financing, which in the case of project financings could be well over a decade, possibly two decades. This expectation was reflected on the project company and sponsor side, with large corporates expecting its banks to stay involved in the relationship long-term. This model can be described as an 'originate-hold' approach, and was typical for bilateral loans between the borrower and one commercial bank (often a domestic commercial bank), and when one commercial bank could not hold the full amount of debt on its balance sheet a number of commercial banks formed 'clubs' in order to meet the funding requirements of larger projects.
At the beginning of the century a shift to an 'originate-to-distribute' model occurred, in which certain international commercial banks would use their experience to structure bankable projects, finance them and then sell down their participation (to the extent they were involved in primary syndication) in the secondary market. In this model, the commercial banks with specialised teams could take on more of a structuring role, bring projects to other financial institutions (that did not have the expertise, resources or desire to conduct the complex risk analysis required at the origination stage), and free up capital to be involved in future projects.
After the 2008 global financial crisis, some commercial lenders became reluctant to be involved in transactions where the structuring banks were not, or did not intend to be, lending a meaningful amount of the debt ensuring aligned interests and risk. Commercial banks that were able to lend in a meaningful way used this ability to leverage more of the roles and accompanying fees, leading for example to Japanese banks taking on many more of the multiple roles discussed in Section I.iii. Commercial lenders also discovered that as markets move they cannot necessarily rely on there being a willing buyer of project debt.
Current market practice is that even bilateral project finance loans are typically drafted such that multiple lenders are possible in the future, often with a relatively consent-free right for lenders to transfer. Given this, project companies and sponsors must ensure that documentation appropriately protects their positions, as they no longer have the comfort that they can rely on their relationships with specific lenders to resolve issues that arise in the future.
iii Impact of global financial crisis
The global financial crisis had a significant impact on commercial bank loan liquidity post-2008, as commercial banks sought to reduce their risk exposure to long-term debt by selling down their existing liabilities and refraining from financing new projects. The introduction of new regulatory requirements, such as Basel III, following the global financial crisis resulted in more stringent capital reserve requirements for banks, which further reduced commercial bank loan liquidity (in the primary and secondary market) and increased the cost of funding. In particular, the additional requirements imposed by Basel III attribute a higher risk weighting to long-term debt such that financing longer-term projects became more costly. These events culminated in the commercial banks (particularly banks from the US and Europe) finding it much more difficult to provide longer-tenor debt; tenors exceeding 10–15 years are now challenging for commercial banks and are often only to be seen for the 'big ticket' multi-sourced projects. There is also a divide of banks on a regional basis, with US banks having a 'maximum' tenor typically in the region of seven to 10 years, whereas certain Asian commercial banks (Japanese and Chinese ones) have been able to provide loans for appropriate projects with 15–18 year tenors.
iv Multi-sourced project financings
While ECAs and development banks have been active for decades, the lack of commercial bank loan liquidity for longer tenors has forced sponsors to finance projects using multiple sources.
At the same time, the availability of commercial debt for a project financing increases where that ECAs and development banks are involved. This is due to several reasons, including that 'covered lenders' lending with an ECA insurance policy can reduce or eliminate their exposure to political and commercial risks, the involvement of ECAs and development banks give comfort to commercial banks that environmental, social and governance (ESG) considerations will have been fully vetted and will mitigate their risk of reputational damage, and the perception that local governments will be less likely to interfere with projects that involve ECAs and development banks.
In these multi-sourced financings, the number of commercial banks involved may be comparatively higher than in prior years due to their restraints on liquidity, and the make-up of the commercial lender group has changed, with Japanese and Chinese commercial banks and, in certain regions, local or regional banks taking on more and larger participations.
II Features of commercial banks in project financings
Commercial banks that have extensive involvement in project finance transactions are able to analyse, due diligence and understand how the various project risks are being allocated and how to ensure that a particular project is 'bankable'. The leading international commercial banks in particular tend to have large teams, focused on different sectors and regions, allowing them to be involved in a diverse range of projects globally. This puts them in a unique position of building up a wealth of knowledge and experience that they can utilise for future projects. In some cases, commercial banks may employ their own industry experts in order to heighten their expertise in particular sectors.
The commercial banks' project finance experience can be contrasted with certain other funding sources that may either not be set up to have specialist experience or may be in the process of growing their expertise. In multi-sourced project financings, other funding sources will take added comfort from the knowledge that the project risks have been thoroughly due diligenced and regarded as bankable by experienced international commercial banks. This ability to analyse the complex risk allocation also enables them to be able to provide financing during the construction period. This can be contrasted with other sources of funding, such as in the capital markets, where institutional investors prefer lower, or at least consistent, risk investments and have concerns in funding during the construction period when no project revenues are flowing.
ii Multiple roles
As an extension of their corporate relationship banking approach, advisory and other services (e.g., running project accounts) have always been provided by commercial banks in project financings. However, as project financings have increasingly involved more lenders, there has been a disaggregation of the roles and charging of appropriate fees for each role (which allows the margin on the loans to reflect borrowing costs only).
These roles on the 'lender-side' could include, during structuring and initial syndication, roles such as structuring banks, documentation banks and coordinators or arrangers. The terms used can vary, but the role is generally to manage the overall financing process and act as coordinators between the lenders and also between the lender group and sponsor group. During the term of the financing, other mechanical and administrative roles will be important including facility agent, security agent and account bank; in each case there may be multiple, reflecting different facilities, and security and accounts onshore and offshore. More complex project financings may have roles such as insurance bank (along with separate insurance advisors to the borrower and lenders), technical bank (along with separate technical consultant to the lenders), modelling bank, and so on to streamline the due diligence process. Documentation will tend to include provisions such that these roles can change over the life of the financing.
One critical role that has developed as the complexity of project financings has increased is the role of financial adviser to the sponsors or borrower (i.e., 'borrower-side'). In this role, they can utilise their knowledge and experience to advise the sponsors as to how to structure an internationally bankable project, and what the best sources of financing are for the project, which could include any or all of ECAs, development banks, bonds and commercial bank lenders, among other sources. While there may be an implicit understanding that a financial adviser that is a bank will also be lending some amount (the lending team would be screened from the financial adviser side), there are active independent financial advisers in various markets (e.g., the Middle East power market) that do not lend on the projects on which they advise. The more sources of financing under consideration, the more important this role can be, and the potential involvement of ECAs would mean that consideration should be given to procurement processes also by the financial adviser.
Additionally, commercial banks may (1) provide bridge financing loans (until the full project financing becomes available) on a corporate financing basis, often based on key relationships between the commercial banks and the main sponsors developing the project; (2) provide working capital facilities during the term of the financing to assist the borrower in managing its day to day cash flows (which may or may not be secured at the same level as the project financing); (3) act as providers of any necessary credit support, such as letters of credit; and (4) perform the key role of hedging banks where necessary (discussed further in Section II.iv).
As a final note, international commercial banks tend to be well placed to perform advisory and service roles in project financings, whereas various sources of financing such as bond investors, ECAs and development banks tend to not perform these roles (at least in multi-sourced financings), and lenders of 'alternative financing' such as insurance companies also tend to prefer to be 'passive' lenders in project financings.
Commercial banks that are able to participate in the more complex project financings, particularly in roles such as a coordinator, tend to be able to offer considerable flexibility to the borrower and sponsors. This is partly as their interest is, at least traditionally, purely commercial and ensuring that the overall transaction is 'profitable'. This differs to some other financiers, such as government-owned ECAs or development banks, whose involvement may be subject to policy-based eligibility criteria, such as promotion of a country's exports, support for a particular industry (e.g., renewable projects) or other considerations. As such, while commercial banks may have their own internal policies and business strategies that will inevitably influence their product offerings and decision making, ultimately if it makes commercial sense, then they can exercise a greater degree of latitude in considering whether or not to be involved in any given project (having said that, patterns have begun to emerge where internal policies of, and external pressures on, commercial banks are having a greater level of influence on their decision making than in the past, as discussed in further detail in Section III). For example, while it may be common to see Japanese commercial banks financing projects involving major Japanese trading houses, the existence of a Japanese trading company in the project is not in itself a mandatory requirement (whereas the involvement of JBIC or NEXI as the Japanese ECAs would necessitate some Japanese content or benefit to Japan for a project to be supported).
This flexibility manifests itself in many ways which may be of varying value on different projects, such as:
- funding flexibility, whereby commercial lenders are more likely to be able to allow drawdowns over the construction period that align with payment milestones (as compared, for example, to bonds that tend to be single drawdown or limited flexibility);
- repayment flexibility, whereby commercial lenders may be able to offer amortisation profiles that are tailored to the specifics of a particular project, which can be more challenging for other financings sources such as bonds and ECAs (many of which are limited by the OECD Arrangement restrictions in this regard);
- currency flexibility, whereby commercial lenders may be able to offer local currencies as part of the financing package if construction and ongoing costs may be in local currency, and also provide for a natural hedge where all or a portion of revenue will be denominated in local currency; and
- consent/waiver flexibility, whereby commercial lenders tend to be able to manage consent or waiver requests that may arise in a project's day-to-day running (as compared to consent processes with bondholders being more difficult to manage, and institutions such as ECAs and development banks often having more formal processes that may make the process more lengthy).
iv Interest rates, tenor and hedging
Commercial banks typically provide floating rate facilities linked to an interbank offer rate (IBOR), such as LIBOR (or its successor SONIA), given how they in turn fund themselves, whereas some other financing sources (e.g., ECAs, project bonds) can provide fixed-rate loans. Hedging can, and often is, used to remove or mitigate the risk of interest rate fluctuations from the project company, and lenders often require this. This hedging is often also provided by commercial banks, but while lenders and hedging banks together form part of the overall financing structure, their interests are not entirely aligned, and so intercreditor arrangements must be carefully managed (hedging banks will almost always be a secured party and will share in any proceeds on enforcement, but hedging banks tend not to have much control over day-to-day decision-making). During 2020, hedging has become a considerable discussion point on many project financings as the ongoing transition away from LIBOR has raised questions as to how to ensure that the replacement screen rate used under both the loan documentation and the hedging documentation is sufficiently consistent. In practice, having the same commercial banks taking on roles as both lender and hedging bank is generally perceived to be advantageous, as a commercial bank is likely to take a more holistic approach if involved in both (even if these are separate desks and risks internally), and controls on avoiding 'orphan swaps' in cases of transfers of debt post-closing are often put in place.
As mentioned earlier, one critical challenge in the context of commercial banks on project financings relates to their ability to offer long tenors, with the market finding ways to manage this through increased use of multi-sourced financings as described above, or through the use of mini-perms as discussed in Section III.
v Representations, covenants and events of default package
The package of representations, covenants and events of default that are contained in the finance documentation are very important to the commercial banks, and will be reviewed in detail to ensure the commercial banks (1) receive the appropriate level of information in order to monitor the progress and performance of the project; (2) have the appropriate level of control to consider issues as and when they arise; and (3) appropriate protections and remedies in the event that the project goes into default. However, given that multi-sourced financings are now becoming the norm, the requirements of the commercial banks in relation to this package are very much aligned with the requirements of other funding sources, such as ECAs and development banks. While the package tends to more restrictive than the package applying to a project bond, commercial lenders tend to be able to react more quickly to amendment and waiver requests.
vi Host country risk
While commercial banks are keen to support the activities of their key customers wherever these may be carried out, the location of a project can have a significant impact on how the commercial banks view the overall risk profile of that project. Ideally, the political and regulatory landscape would be stable, established and reliable because the commercial banks are looking to the long-term success of the project, and so sudden changes in political policies or regulations can have a materially detrimental impact on the viability or economics of a project. Although this can never be guaranteed, there a certain regions and jurisdictions that will be viewed as in the higher risk category insofar as these matters are concerned (such as sub-Saharan Africa, South East Asia and Latin America).
The ability for commercial banks to participate in projects located in these regions will often be enhanced (if not contingent) upon the substantial involvement of one or more ECAs or development banks as part of the financing. The commercial banks will take a significant degree of comfort in their involvement, as these institutions have direct lines of communication into senior representatives of the host country's government, which can be crucial when seeking to address specific political or regulatory concerns that may impact the project.
It is notable that in regions such as Latin America and sub-Saharan Africa, ECA and DFI funding features more prominently as a funding source and commercial lending represents a smaller percentage of the overall sources of project financing in these regions than it does in Europe, North America, the Middle East (especially the GCC) and Asia-Pacific.
III Notable trends
i Energy transition
ESG considerations have been important to commercial banks throughout this century, with the Equator Principles (a risk management framework for determining, assessing and managing environmental and social risks in project finance) being adopted early in the century by many of the most active project finance commercial banks. Nevertheless, the last couple of years and 2020 in particular has seen a huge increase in the stakeholder pressure (shareholder, government and public) on commercial banks to consider 'non-commercial' factors in their lending business, for example to prioritise energy transition and sustainability projects above potentially more profitable financings in less green or sustainable sectors. This pressure to reshape the economy through financings was first felt by development banks as non-commercial policy lenders, then more recently by ECAs, and now commercial banks. This pressure is most critically felt by European and US commercial banks, whereas many local commercial banks in developing countries continue to support bankable projects across all sectors in a more 'neutral' way. The pressure is now spreading globally, with the majority of new banks that have adopted the Equator Principles in the last couple of years being from Asia. There is some mismatch between the domestic pressure that an international commercial bank may face (e.g., for a European bank to not finance oil and gas projects), and what is relatively green in the markets it operates in – for example, gas being a clean alternative to coal in China and India, LNG being critical to Japan's energy security policy, and lack of power being a more critical issue for much of sub-Saharan Africa than source of power.
ii Emergence of non-bank commercial lenders
The commercial lending market is overwhelmingly made up of banks. However in recent years there has been an increase in non-bank loans by institutional investors, such as insurance companies, pension funds and investment funds, sometimes referred to as 'alternative finance'. These types of financiers traditionally prefer government bonds or property as relatively low risk and with predictable returns; however, interest in project financings has increased as return on their traditional products have declined and returns on project financings have increased reflecting liquidity issues in the commercial bank market. By way of example, AXA Group (through its investment arm, AXA Investment Managers) has been active in the infrastructure sector since 2013, when it was provided with €10 billion to invest in infrastructure and Allianz Global Investors established an infrastructure debt platform in 2012.
At this stage, this type of alternative finance has focused on sectors regarded as lower risk and which are in line with their sustainable development policies, such as the social infrastructure and transport sectors in developed markets. These sectors are generally regarded as well developed and stable, and to the extent the projects are structured with long-term revenues linked to inflation (often on an availability basis rather than market risk) then it is an attractive proposition for insurers. Many of the challenges that institutional investors have in project bonds such as construction risk, as described elsewhere in this work in relation to project bonds, remain for loans by institutional investors.
iii Mini-perm structures
In the US and GCC in particular, the challenge of commercial banks being unable to provide long tenors is being addressed in some projects by way of 'mini-perms'. A mini-perm is a relatively short-term loan that relies on a project being refinanced, typically within three to four years after construction, once the project has demonstrated stable operations and the period of highest risk has passed. At this point, the borrower should be able to refinance on more competitive terms, and may be able to attract a broader range of financial providers that have lower risk appetites (such as institutional investors by way of a project bond). Mini-perms can be 'hard' in that they require the project company to refinance the loans by a certain date and failure to do so leading to an event of default, or 'soft' in that after a certain period of time 'punitive' mechanics will increase financing costs, provide for cash-sweeps and stop dividends, or other similar measures, thus incentivising a refinancing. These structures are, however, only bankable in regions where there is a higher degree of confidence in the ability to refinance, such as the US (given its deep liquidity pools) and the United Arab Emirates and other GCC countries (given the track record of successful project financings and refinancings).