Cutting through the complexity of Project Finance restructures
March 27, 2019
The path to successful restructuring
Private Finance Initiatives (PFI) and Public-Private Partnerships (PPP) came under increased scrutiny in 2018. Projects across the UK are facing similar challenges, especially around underperforming subcontractors; 2017 and 2018 saw an increasing number of highly publicised defaults or terminations and we do not expect this trend to change in 2019.
We have been working with a number of organisations in the PFI sector, taking a lead advisory role for stakeholders affected by these kinds of defaults and disputes. For example, we have recently advised on the consensual termination of a PFI project in the waste sector, the restructuring of a PFI project in the water sector and we’re currently advising a number of clients with contracts in distress, dispute or renegotiation.
While the number of new procurements has slowed recently, PFIs and PPPs are long-term in nature so here to stay. As we move forward, there’s a realistic chance of more failures and disputes due to the underlying environment and nature of the transactions.
With this in mind, our advice for lenders and sponsors is to think ahead. Don’t wait for problems to escalate. Knowing the potential pitfalls and solutions in advance of any major restructuring will put you in a stronger position to successfully resolve issues down the line.
PFI and PPP arrangements are complex, so every situation is unique; there’s no ‘one size fits all’ diagnosis. But, in our experience, five factors often come into play:
1. Falling demand - Is your revenue exposed to demand risk? Capital structures are often put in place assuming a certain level of future demand. But circumstances can change. If forecasts are incorrect, there may be no chance of achieving revenue targets. This can be exacerbated if the project has a high fixed cost base - creating an exposure to demand risk that is much greater than the capacity to bear that risk.
2. Contract specifications - In the past, some public bodies were more willing to accept a degree of non-compliance and flexibility within the contractual framework of a project, as long as the overall purpose of the project was fulfilled. That’s no longer a given. Faced with budget constraints, we’ve seen local authorities taking a harder stance - e.g. on hospital and waste contracts, using non-compliance as leverage to renegotiate or exit contracts.
Alongside that, time can cause problems. As assets get older, unexpected issues can crop up. If contracts are ambiguous, it might not be clear who’s responsible for paying for and fixing the issue, leading to protracted disputes.
3. Technology constraints - Some sectors - e.g. waste treatment - are more technically complex. As demonstrated by some of the issues seen across the waste sector, technical challenges can cause major time and cost overruns. In some cases, these can be well in excess of the liability caps and longstop dates included in contractual protections. In extreme situations, the technology may just prove to be fundamentally incapable of doing the job.
4. Subcontractor failure - The failure of Carillion in early 2018 demonstrated the various issues that this can cause across projects - with the impacts being potentially catastrophic. However, the impact will depend on the nature and status of the project, the profitability of the contracts and the level of contingency planning that has been conducted in advance of the failure.
Let’s take construction projects as an example. Finding a new subcontractor to finish a build can be a problem as the new provider is effectively expected to underwrite the previous provider’s work. If it’s a specialised project that’s running over time or budget, finding a new provider might be impossible. If there are particular guarantees or bonds involved, the failure of a subcontractor might mean losing guarantees from the parent company or access to their technology.
For facilities management, it might be easier to restructure a simple, profitable contract, and it might even give you the chance to renegotiate terms. But many projects initially involved tight margins, which only get squeezed over time. In these cases, new providers could be hard to find - especially if the work involved is particularly onerous.
5. Tariff changes - If tariffs are a major influence on revenue projections, projects may be susceptible to government action. Any change to policy or legislation may mean that revenues are hit very hard. The Spanish renewable energy sector is a prime example of this kind of risk.
Dealing with the fallout
The options available should a project become distressed are varied - from consensual arrangements at one end to non-consensual at the other. Unsurprisingly, consensual solutions often deliver the best value for all financial stakeholders as they avoid potentially lengthy and expensive litigation, but they face a number of challenges:
Often, projects are complex to construct and operate, so alternative subcontractors might be hard to find. Credible providers might also be unwilling to get involved in projects with known problems and the associated liabilities. In light of some of the issues faced in recent cases, a number of well-known contractors are unwilling to take on fixed-price, low-margin contracts.
In some cases, if specialist permits are necessary to operate assets, the SPV / equity / lenders may find themselves operationally hamstrung in terminating a poorly performing subcontractor, as transferring the permits quickly requires cooperation that the underperforming subcontractor is unwilling to provide.
Legal and contractual complexity
PFI projects - and associated documentation and contracts - are often extremely complicated. This can cause ambiguity around performance standards, key metrics and stakeholder positions, leading to disputes. As a result there can often be several areas that need clarification through litigation. This can be costly and take a lot of time - involving referrals to a number of tiers of appeal.
Governance can be a challenge if a party has multiple positions across the structure (e.g. shareholder and operator) as the party is likely to consider their position in the round and use the leverage that the different positions provide in order to optimise their outcome. Directors duties often require careful management.
Invalid contractual protection
The strength of lenders security is generally reliant on the contractual protections provided to them / the SPV, however, it is possible that the nuances of the situation are not contemplated in the documentation, or the provisions are not completely clear. Any lender should look ahead to identify potential structural issues or anomalies early and develop plans to resolve or negotiate around any issues ahead of time.
Public sector constraints
Any public sector counterparty may be limited in terms of what they can and can’t contribute to a situation. How much public money can they be seen to spend? Are they expected to keep the service running? What will be the political and public reactions to any proposal? What is the risk of procurement challenge? Will PFI credits be lost? They might also need Central Government approval, which can cause additional levels of complexity and timing delays.
Two steps to success
When it comes to restructuring PFI and PPP arrangements, the path to resolution can be tricky to navigate.
So how do you succeed? As an advisor, there are two things we always advise our clients to do:
1. Build relationships - Take a conciliatory approach: one where stakeholders take the time to understand each other’s positions and the outcomes they’re looking for. The best approach is one where all sides realise that a pragmatic approach is more likely to see positive results than rigidly sticking to contractual positions.
Our relationships with a broad number of stakeholders have always helped to facilitate a shared plan of action, from governments and local authorities, to private sector providers, investors and the banks.
2. Assess your situation, ahead of time. This is essential to understand potential contractual and structural flaws in the context of the options available to you.
Our experience and technical expertise has shown us that no two situations are the same. Understanding what could go wrong and being prepared in advance are both critical factors in getting to a successful outcome.
If you would like to discuss this topic in further, please get in touch.