Risks That Will Be Triggered During Hard Economic Times
The hard situation in the market affecting market demand
Projects, which are ideal for project financing, are those with predictable and stable cash flow patterns. Highway projects, power generation plants and high-speed rail fall into this category. The nature of the projects ensures a certain hold on the market for the product or service offered. The driver who does not wish to pay the toll for a highway may have the option of travelling along the old trunk road; but the savings in time and convenience offered by the highway will cause him to use the highway for long distance travel. An internal rate of return sufficiently attractive to attract project sponsors and lenders is invariably worked into the concession granted by the relevant government authority. With good government support and natural monopoly afforded by the nature of the project, the returns to the equity contributors and lenders are assured. Another way which projects can be insulated from movements in the market price of its products or services is to enter into a long-term contract with potential output purchasers.
Currency risks may be hedged in a number of ways. Currency futures contracts enable the entity at risk to fix in advance the conversion rate between currencies for a stipulated date. Another hedging device is the currency swap. In a currency swap, one party expecting a cash flow denominated in a particular currency (say Singapore $) enters into a binding contract to exchange it for a stipulated amount of another currency (say US$). This enables the party owing debt obligations in US dollars to secure the cash inflow in US Dollars even though its receipts and revenues are in Singapore dollars. A third hedging device is a multi-currency loan. If a loan consists of a basket of currencies, the fluctuation amongst the different currencies may offset against one another. However, hedging the currency in which the revenue is denominated against the basket of currencies is also a much more complicated affair. There are others ways to ensure flexibility in contracts by adding some clauses.
Right to claim adjustment clause
Two parties to create legal obligations generally form contracts. These legal obligations are the essence of the contracts. In other words, it is counter parties' obligation that makes the other party to be in a contractual relation. Therefore, when a project sponsors form a contract, they expect some certain obligations to be fulfilled from counter party. However, the value of this obligation can be different in the time of performance from the time of undertaking. In other words, the value of performance could be changed by some unforeseeable events. These unforeseeable events mostly happen during hard economic times. When the value of the performance changes negatively then it might damage project sponsor really badly. In order to prevent this happening project sponsors should put a clause of right to claim adjustment in their contractual arrangement. This is a great way to protect the sensitive balance between the performances of the parties and keeps the contract flexible.
Project sponsors have some certain obligation under project finance contracts. In order to ensure flexibility in its contractual arrangement, it is a good idea to put a clause of suspension under certain circumstances. This is because economic downturns can affect the profitability of the project.
Right of freezing of the value of performance according to value before the crisis clause
As it is stated above, two parties to create mutual legal obligations form contracts. Accordingly, there is balance between parties' performances. The value of the performances may be affected negatively because of the economic downturns. In that point, project sponsors can put a clause to the contract, which grants a right to freeze the value of the performance according to value before the economic downturn.
Because of the hard-economic situation, parties may not fulfil their obligations under the contract. In order to prevent this situation, or having some sort of safe harbor, project sponsors should have a guarantee that the counter party will fulfil its obligation under the contract in time or pay compensation if they fail to do so.
Force majeure clause
Project-financed transactions are distinguishable from corporate finance or structured finance assets because of their potential vulnerability to force majeure risks. The legal doctrine of force majeure excuses performance by parties when they are confronted by unexpected events. Careful analysis of force majeure events is critical in a project financing because such events, if not properly recompensed, can severely disrupt the allocation of risk on which the project financing depends. Natural disasters or changes of law can disrupt a project's operations and devastate its cash flow. In addition, catastrophic mechanical failure, owing to either human error or material failure can be a form of force majeure that may excuse a project from its contract obligations. Despite excusing a project from its supply obligations, the force majeure event may still lead to a default depending on the severity of the accident. Projects are usually not able to cope with force majeure events as well as large corporations with diversified asset portfolios. Force majeure risk may be precisely the sort of risk that the sponsor does not wish to accept. As a result, the risk of force majeure events, if unallocated away from the project, will limit most projects to the "BBB" category or below. Occasionally, some types of project can achieve ratings less affected by force majeure risk, because of the improbability of a force majeure event materially disrupting the project's operations. Therefore, pipeline and road projects can more easily return to operations, compared with a mechanically complex, site-concentrated project. If a project can mitigate force majeure risk with business interruption and property casualty insurance, some rating elevation may be possible. Unfortunately, many insurance policies will either exclude many of the force majeure events that would affect the project rating or are prohibitively expensive. Force majeure risk can easily affect the debt rating which is really an important aspect for project finance. Without any doubt, an economic downturn is not a force majeure but if an event considered force majeure happens then it will have really bad economic affects unless some precautions are taken. Therefore, force majeure risk has to be allocated between the parties by contract or sponsors should make an insurance policy that covers project finance risk.
Right to terminate the contract based on fair cause
Project sponsors enter into the contractual relationship with a party just because they want to benefit from counter party's experience, workforce sometimes just the prestige. When this reason what makes project sponsors make the deal becomes useless, this would be a fair cause for project sponsors to terminate the contract.
Right to terminate the contract based on extraordinary cases
In most of the contractual arrangement that Project sponsors enter into, there is a certain transaction basis. This is the 'cause' of the contract. This is the primary reason why project sponsors make this deal. However, because of some uncertain reason, this contract may not be profitable anymore but can start to damage the sponsors. By putting a clause of right to terminate the contract based on extraordinary cases, project sponsors can ensure some flexibility in their contractual arrangement and terminate the contract after that extraordinary case.
Project finance is mostly non-recourse but sometimes a limited recourse financing structure. In a nonrecourse project financing, Project finance lenders base the credit valuing on the projected revenues from the operation of the project, rather than the general assets or the credit of the sponsor company. Any distemper to the project would result in less revenue or more expenditure than it is expected. Therefore, in project financing there is not any place for uncertainty. However, it does not mean that there will not be any risk. It is risk that makes Project finance more profitable and economic risks are the most significant ones. In order to mitigate economic risks, Project sponsors need flexibility in their contractual arrangements. This flexibility could be achieved in different ways depend on the contract and the relationship between the project sponsors and the counter party. This flexibility could be reached by having some sort of guarantee bonds, which guarantees the obligator will fulfil the performance or pay compensation. This guarantee may cover the full- and on-time performance of the obligation. Another way to achieve flexibility would be the making a flexible loan contract with the lender.