Lending Focus - February 2023 – 4 / 6 观点
As inflation and interest rates continue to increase in both magnitude and volatility, it is more important than ever for borrowers and lenders in the development financing market to ensure that their arrangements for dealing with cost overruns operate as they expect and meet their commercial needs.
We have seen lenders increasingly look for entities of substance within sponsor groups to provide guarantees to cover cost overruns on developments (up to a certain amount) and for these guarantees to resize upon the occurrence of certain events rather than remaining fixed throughout the life of a loan. We explore some issues generated by these approaches here.
Given the considerable increases in the costs of raw materials, equipment and labour in recent years, we see lenders seeking cost overrun guarantees more often and looking for higher limits to coverage. This gives them comfort that sufficient equity will be injected to keep the project fully funded in the event of costs continuing to increase ahead of projections included in financial models.
Other than the questions of whether financing costs are to be included and whether a resizing mechanism is necessary, which are explored below, the primary driver of guarantee sizing, as a percentage of the loan advanced, is the extent of cost certainty. Recent experience of unforeseen cost increases, and the persistence of inflationary pressure in the economy as a whole, has led to a general upwards trend in guarantee size.
What factors are relevant to sizing the guarantee?
On an individual project basis, factors likely to lead to larger guarantees being required include:
use of procurement methods and timing which reduce cost certainty at the point the guarantee is entered into, for example 'construction management' rather than 'design and build' contracting, or entering into the loan when the main building contract is not yet agreed
novel construction methods
sponsors with less development experience.
Current market dynamics are likely to make developments with too many of these features increasingly challenging to finance at all.
What about financing costs?
A key point in relation to most cost overrun guarantee arrangements is how to deal with any overruns on financing costs (fees and interest). These costs are generally capitalised during the development phase of a project due to lack of income to service them, so increases above initially projected amounts would lead to a shortfall in available financial resources to complete the development.
One way of dealing with this (on a 100% hedged loan) is to size the projected interest on the strike rate of any interest rate cap. This does however result in the borrower paying commitment fees on a higher amount of total debt and/or reducing the proportion of construction costs that can be funded from debt at a given projected LTV.
An approach we more commonly see in the market is to project future interest costs using a 'normal' method and then seek to cover any gap between the projected costs and any cap (if relevant) or a more pessimistic projection with a guarantee. The interaction between this type of guarantee and a conventional cost overrun guarantee needs attention.
Given that financing costs are frequently included within 'budgeted costs' and 'projected costs' as defined in the loan agreement, overruns could count against both the cost overrun and interest shortfall elements of the guarantee, with equity injections from the guarantor therefore counting against maximum exposures under both limbs.
If this issue arises, it can be drafted around either in the guarantee or the loan agreement, ensuring that the concepts remain separate where required (and together for considering whether the project is being kept fully funded).
Resizing event – how to resize the guarantee and when
Developers are increasingly seeking financing, to cover the full development phase to and beyond practical completion, at a point when cost certainty is lower than in the past. A common example of this (over and above an environment where costs are just less certain than previously) is the main construction contract not having been entered into when the loan is first drawn. Reduced cost certainty (as noted above) leads lenders to require higher liability caps, which ties up the guarantor's capital. Sponsors are understandably concerned to avoid having their capital (drawn or not) committed to projects for longer than necessary, so look to agree to the guarantee changing in size to account for changes in the risks being covered.
How to resize?
Options for resizing a guarantee when risks have reduced or cost certainty has increased include:
dropping certain limbs of the guarantee which are no longer required
re-running the calculations used to size the original guarantee with the new information available
reducing the amount of 'risk premium' baked into the sizing metrics.
These are generally tied to key moments in the procurement or progression of the project when risk is reduced or cost certainty increases. Potential triggers we have seen recently include the following:
where the main building contract, or any key contract in a 'construction management' procurement process, has not been entered into at the time the guarantee is signed, the time at which this is resolved (and there is therefore greater certainty on construction costs)
where the guaranteed liabilities include financing costs, but the hedging has not been priced when the guarantee is entered into, at the point of any change to the modelled costs used to size the initial guarantee
at practical completion of the development or other significant milestones in the development where risk lowers
upon the property meeting certain 'letting-up' thresholds, for example when the property will be generating sufficient rental income to service the finance costs, and they are as a result no longer required to be capitalised.
Approach resizing triggers with care!
All parties should exercise caution in setting resizing triggers.
Lenders should take care not to allow guarantees to be reduced in circumstances where the risk profile remains elevated. They should also be cautious when tying the reductions to specific milestones in the development. The borrower may be able to complete specific items ahead of schedule, meaning the guarantee reduction triggered may not be justified by progress with the project as a whole.
Borrowers/sponsors should be wary of agreeing to resize too often, especially at points when projected costs may actually have increased rather than decreased (either through construction inflation or unexpected issues relating to the project). This risks a sponsor being required to keep increasing its exposure above what it envisaged at the outset, which can strain relationships with investors.
From a lender perspective, it is vital that any guarantor is, and remains throughout the project, an entity of substance which can be relied upon to be able to fund its obligations under the guarantee. In order to ensure this, lenders usually insist on the guarantor continuing to satisfy certain financial covenants and for reporting to be provided to evidence this.
Where the guarantor is highly creditworthy, has a public credit rating or otherwise has public-facing financials, this can be straightforward, but in other circumstances, this is frequently sensitive.
Sponsors are often reluctant to commit to maintaining amounts of drawn commitments exclusively allocated to a project (as this depresses IRR within fund structures) and can see financial transparency at sponsor level as providing the lenders with undesirable insight into their other investments.
Lenders on the other hand are generally unwilling to count funds that are not allocated to a project or the sponsor does not (at a minimum) have an unconditional right to draw from its investors towards covenants and want more evidence of continuing compliance than a bare assertion from the borrower in a compliance certificate.
Getting to a mutually acceptable position here frequently requires bespoke solutions and considerable negotiation. Potential methods of achieving this include:
accepting certificates of compliance (without detailed calculations) from reputable third-party fund/investment managers as an alternative to financial reporting being provided to the lenders
adopting concepts from the sponsor's constitutional documents (assuming these are disclosable to lenders and/or lender counsel) to define which investors are in good standing and therefore able to have their undrawn commitments counting towards the net assets of the sponsor.
The financial and market conditions of the last year or so have greatly increased the complexities of agreeing cost overrun guarantees. No longer merely insurance against changes to the design or something going awry, they are now something any lender should expect to be relevant (in many cases soon after the loan is signed and regularly throughout the project). Given this, the efforts parties (and their lawyers) devote to negotiating them have increased, a change unlikely to reverse and likely to intensify as cost uncertainty persists.
To discuss the issues raised in this article in more detail, please contact a member of our Banking and Finance team.