Vendor finance has become a requisite for a sale within several industries
April 2018 | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE
Financier Worldwide Magazine
April 2018 Issue
Vendor financing is certainly not novel; almost all production companies offering energy performance certificate (EPC) terms or supplying major parts to standalone projects have, at some point, engaged in vendor financing. However, there is a clear trend toward more vendor financing, and in some cases vendor financing has become a requisite for a sale. It thus becomes more important that vendors consider which models they want to offer their customers, which models add the most value and ensure sufficient liquidity and an exit in order to be able to continue to offer vendor models to their customers.
Almost all production companies offering EPC terms or supplying major parts to standalone projects, whether to wind parks, biomass plants, cement, oil & gas, mining, terminals, airports, toll roads, bridges and so on, have either regularly, or from time-to-time, engaged in vendor financing, whether as equity participants or as typically subordinated financiers. In the following, we generally do not distinguish between vendor debt and equity models, but merely refer to vendor finance models.
It also becomes more important for vendors to understand their customers’ motivation and the equity economics behind it, how they can optimise their own position and how their offer interplays with the senior project financing of the financed projects.
Why do we see a trend toward more vendor financing?
In most cases, vendor financing is a reaction to a buy-side push, either due to increased competition in the specific market or, as is often seen when private equity funds are involved on the buy-side, due to the buy-side push to optimise the equity return on a project.
In a low-yield regime, as is currently seen, the push for equity optimisation increases further, as investors that are not able to take development risks face tough competition for good post-development stage projects and thus have to search for the ‘hidden’ additional yield through equity optimisation.
However, it is not all bad. Some vendors have learned to use vendor financing as an effective sales tool, which helps not only to turn the focus away from a pure price discussion, but also ensures higher profit margins, additional sales, longer cash flows through service contracts (bundled with the vendor finance offer) and customer retention.
Whether it makes sense, from a risk and return perspective, to frequently use vendor financing proactively depends on whether the vendor is able to increase its sales through vendor financing, whether the vendor can ensure some level of influence on the operations (possibly through service contracts) and whether the credit risk is acceptable.
Vendor finance models used
A large number of vendor finance varieties are available. Models span from early to late stage equity, and various forms of debt financing, including almost any possible variation, from equity and mezzanine to senior financing. However, the most frequently used models are early stage (development to immediate pre-construction) equity and subordinated financing.
Around the turn of the century, Danish company NEG Micon gained a strong position in a number of new markets by investing smaller equity stakes in local developers and development projects, which ensured that they would become the equipment supplier as and when the projects developed. In recent years, DEME Concessions seem to have used a similar model within offshore wind to ensure the turbine installation and service contracts for their offshore installation vessels.
In the Danish market, we have seen, among others, BWSC taking equity stakes in several of its projects. BWSC thus holds equity stakes, together with Copenhagen Infrastructure Partners, in some of the UK-based biomass fired power plants, which they have built in recent years.
Further, on the debt side, we have seen considerable activity from the financial arms of both General Electric and Siemens for a number of years, which have extended various forms of debt financing to support projects buying equipment from the other group companies.
What is your risk profile – and where are the risks best placed?
There are many risks that must be taken into consideration when evaluating the risk of a specific project. However, some of the key risks are development, political, market and operational risk.
Development risks. These risks are, to a very large extent, dependent on the development stage at which the vendor decides to enter the project and which obligates the vendor at the different stages in the development of the project. A tendency seems to exist toward vendor involvement at earlier stages in the project development in order to guide the development of the project and secure the later equipment order if the project matures as expected.
Political risks. A vendor taking on any kind of project risk will always have an indirect political risk, as a materialising political risk is likely to affect the project’s chance of ever succeeding, or – if the political event happens at a later stage – the project’s ability to generate future cash flows – or trigger a senior loan enforcement, senior cash sweep, a cash lock-up or other restrictive actions higher up in the cash waterfall. The political risk related to a project typically drops significantly as the project develops, permits, rights and contracts are secured, protests and claims are handled or settled, the construction is being completed and the project becomes operational.
Market risks. These risks are outside of the control of any of the parties involved in the project and may obviously have a negative impact on the cash-generating ability of the project. However, senior financiers typically require that such risks are mitigated. Such mitigation of market risks is typically handled through long term and fixed price agreements or a full or part hedge of the risk, if such hedge cover is available in the market.
Operational risks. Operational risks are typically the risks which the vendor is best-placed to deal with, as they often relate to the operation of the equipment delivered by the vendor. If the vendor at the same time is able to ensure some level of operational control, either through a service agreement, governing rights or undertakings, the vendor is likely to price this specific risk lower than the project company or sponsor – and may thus, from an economic perspective, be the best risk taker.
Developmental and political risks dilute as the project develops. Consequently, the vendor should carefully consider at which stage of the development to enter a project.
You need to consider possible project finance restrictions
As a significant number of the projects in which vendor financing is relevant are likely to be project financed, the vendor not only needs to understand the project and the project-related risks, but also the project finance structure and the restrictions and obligations therein; in order to ensure that the vendor finance structure considered does not contradict the project finance terms.
A project finance structure is always adapted to the specific project, as the senior lenders will seek to customise the terms to reflect both the specific project risks, risks related to the relevant external environment and the risks related to ownership, governance and operational structures. Thus, it will not be possible to apply a ‘one-size-fits-all’ vendor finance model. The vendor will have to understand the terms and restrictions set out in the project finance structure in order to understand which vendor finance model is (or is not) possible and in order to understand the risks related to the project and the vendor finance model contemplated.
How to deal with capital restraints to ensure liquidity release
Few companies have unlimited liquidity resources to tie up in vendor finance structures. Some vendors may be part of large conglomerates with deep pockets or have access to government support, as has been seen over the years with, for example, General Electric, Siemens and a number of Chinese vendors, but to the rest exit models or liquidity release models are critical in order for them to be able to offer vendor financing to their customers.
The models used are many and vary from those structured around a specific sale to more general investment vehicles which can be used within a set of agreed criteria – or subject to the investor’s prior approval to each project being included in the structure. When choosing the right model, there are a number of general considerations to be made by the vendor, such as volume, risk share, timing and stage of development.
Will the trend continue?
There are no signs of the trend toward more vendor financing slowing down. Expect instead a further push for vendor financing in the coming years – and consequently an increased need for vendors to optimise the models used and to ensure sufficient liquidity in order to be able to continue to offer such models to their customers.
On the other hand, there is an appetite from financial investors toward alternative investments, including partnership models such as the liquidity release or co-investment models described above.
Jens Blomgren-Hansen is a partner at Kromann Reumert. He can be contacted on +45 38 77 43 09 or by email: firstname.lastname@example.org.
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