Core Financing - Legal Strategies

This paper hopes to identify some core legal and financial strategies to core financing of Infrastructure projects like power, telecom, ports, airports and expressways. Necessarily, for one thing, such projects do, often involve huge outlay of funds that may not be available with the government. Second the funds are required for a long tenure  - say 10 to 20 years since the projects have long construction periods or overruns and need to be continued for a very long time in order to recover a decent return on investment.

In the Indian financial sector, i.e. the banks and financial institutions are legally and financially equipped to raise funds for five to seven years only. Hence, they would be hesitant to deploy such funds for a longer period and face problems at the time of paying their own liabilities. Further, a lot of these projects would be run on a commercial basis for the first time. There are several legal and financial risks at each level - construction, operation, revenue collection, etc. Due to these peculiar problems, legal appraisal and assessment of infrastructure projects require special skills and structures in Contract law with an accent on project financing.

Over the last six to seven years financial institutions have evolved strategies in the dynamics of infrastructure financing. They have managed to identify most of the risks at each stage of these projects, and they have looked at evolving adequate legal and financial safeguards to alleviate these risks.

While the lenders have sharpened their loan structuring skills, the borrowers have not. The lenders have also evolved several concepts which provide more security to lenders and are expected to invest more funds into the sector. Let us understand some of these concepts.

The major concepts are cash flow financing, usage of government guarantees to induce private financing, concept of escrow mechanism to insure that lenders get first charge on project's cash flows and new concepts like Take-out financing and Subordinate debt financing. The next part of this paper is devoted to understanding these concepts.

In Cash Flow Financing, the lender estimates the cash flows of a project over its life time to see what kind of debt burdens it can support and at what rates. Then, the amount of debt, financing rate and the way of repayments can be tailored to fit the cash flows of the project, This helps both the lender and the project promoter to arrive at a financial closure promptly. At this stage important legal documentation and a very clear cut understanding of building contracts is involved. There is an accent on understanding the logistics of banking and financial laws.

The next concept is Escrow. The escrow mechanism in the context of Independent Power Projects (IPP) has been built by private parties out of private funds for supply of electricity to the State Electricity Boards (SEB). Essentially, it ensures that out of revenues of the SEB, the debt obligations of the financial institutions will be paid first of all.

This is done by having some identified revenues being passed through a separate account called the Escrow Account to which the lenders have a right to appropriate  the funds in case the SEB defaults in making payments. By having the power to be assigned those funds in case of default gives an added comfort to the lender and allows the power project to raise financial assistance. However, inappropriately documented Escrows results in premature closure. Consequentially, your IPP client may not have much assured revenue flows for meeting its other operational expenses.

As already pointed out, one of the major problems of financing infrastructure projects is that while requirements are for long periods, Indian banks and financial Institutions can traditionally lend funds only for say five to seven years.

‘Take out finance' is of assistance here. This financing allows banks to finance 15 year projects through five to seven-year money. In India , asset reconstruction companies (ARCīs) offer this facility to banks and Institutions. It offers to take out the loan from the bank's books after an initial period of say five years. The interest rates have to be monitored carefully. Proper legal documentation has to be done to re-schedule the loan and ensure that the transferee entity books the correct amounts in terms of principle and capital amounts borrowed. The transition can be tricky and legal strategy is called for at this stage. The ARC, keeps the loan in its books, or lend it to another bank, for say another five years. While the project promoter has got the loan for 15 years, through this mechanism, banks can participate in loans on a part-to-part basis where they could not have done so earlier.

In another variant, the take out financier could offer refinance facility to the original lender at the end of five years instead of taking out the loan from its books. This means that the take out financier will infuse funds in the bank in case the bank faces any liquidity problems at the end of five years and earn interest. Such assurances have to be obtained in writing and appropriately documented as otherwise the account would become a non performing asset in the books of the institution. Once, it becomes an NPA the account will be frozen and all credit facilities will get withdrawn.

Institutions have also talked about funding infrastructure projects through quasi-equity instruments called Subordinated Debt Financing which may have flexible maturity and payment terms. In this case the borrower gets money which have a longer tenure, and has the comfort of paying it after he has met the secured debt obligations. The payment terms can also be made flexible. Such loans can even be converted to equity at a later date, if desired. Since the interest rates would be, normally, high these loans will be more expensive than others. The ratio of debt to equity and timing of such conversion etc. have to be legally documented so as to at  ensure that a project starts up in time.