Where a PPP is project financed, a ‘special purpose vehicle’ (SPV) Project Company will be created to deliver the project, which will have an asset and liability profile specific to that project. Under such arrangements, lenders typically have no recourse against the Project Company's equity investors or parent company, and they must look to the project's revenues to repay loans. This is a central feature of the project finance arrangements typically used for major PPP projects, and should shield the project from the insolvency of equity investors that own the Project Company.
The focal point of project finance is therefore to match cash flows generated by the project to the Project Company’s debt service obligations over the long term and allowing for an appropriate return on investment for the equity investors.
The result of this arrangement is that any disruption to the project performance and revenue streams (e.g. if a toll road experienced traffic volumes significantly below what was forecast) has the potential to threaten the Project Company’s ability to make its loan repayments and remain solvent.
A typical project-financed Project Company will also have high levels of debt and tight cash flow models. Lenders are therefore incentivised to maintain a high degree of control, including when negotiating the risk allocation of a PPP contract. Lenders often require security against the PPP contract and the Project Company’s cash flow, restrictive covenants, project monitoring and step-in rights to intervene and prevent termination of the PPP contract, as well as additional safeguards typically in place, contractors’ security packages, insurance, hedging arrangements and project reserve accounts are all examples of safeguards designed to minimise the risk of financial distress and insolvency of the Project Company.
As well as being exposed to the project risks, the construction contractor and the operations contractor are typically exposed to additional risks outside of the project, and it is more common for either to become insolvent during the relevant phase of a PPP project than for the Project Company itself.
Lender step-in
Where a PPP is project financed, the lenders may require some right to take over the project where the Project Company has failed to fulfil its obligations under the PPP contract. This can include in circumstances of insolvency as well as other serious breaches of the PPP contract. In this context, ‘step-in’ refers to the ability of the lenders, or a third party nominee of the lenders, to step into the role of the Project Company to give it the opportunity to rectify the issues.
These interventions are designed to give the lenders a chance to remedy the relevant breach of the PPP contract before it is terminated. In such cases, the Procuring Authority agrees under a direct agreement that it will not terminate the PPP contract until the lenders have had a chance to cure the breach.
Lender step-in therefore typically refers to the lenders exercising their rights under a direct agreement between the Procuring Authority, the lenders and the Project Company.
Another method by which lenders may exercise a similar right is embedded into the applicable insolvency laws of certain common law jurisdictions, allowing the lenders to appoint a receiver to take over the project. This has a similar effect to exercising a step-in right under a direct agreement.
Lender step-in events are not common in practice, and the study has not found any example of substitution in the sample of 250 projects globally. However, lenders played an important role in a number of Australian transport projects, most of which reached financial close prior to the sample period.
Examples – Australian transport project insolvencies
The Project Company on the Sydney Cross City Tunnel project in Australia became insolvent in 2006 and the lenders exercised their step-in rights. A receiver appointed by the lenders was able to sell the project assets to new equity investors, which enabled the lenders to be repaid and allowed a partial return of equity to the original equity investors. This was successful from the point of view of the Procuring Authority, as no additional funding was required from the government and tolls were not increased. Similar outcomes have been achieved on other PPPs in Australia that have experienced financial distress, such as the Lane Cove Tunnel project, the AustralAsia (Adelaide-Darwin) Railway project and the Airport Link Tunnel project (though not all lenders involved were repaid in full).
Lenders are not typically in the business of operating live projects, and they may also have concerns that by exercising too much control they may take on direct responsibility for the project’s problems (e.g. environmental liabilities).
Although the granting of lender step-in rights for PPPs is quite common in the global context, there are several jurisdictions where it is not common, or where the underlying legal system (particularly in civil law jurisdictions) does not allow it.
Civil law jurisdictions face some different challenges from those faced in common law jurisdictions. For example, if the concept of ‘economic equilibrium’ exists in the jurisdiction’s underlying legal system and an event materially alters the financial position of one of the parties, then a court might intervene to address the imbalance even though there was no contractual right for that to occur. This situation can affect the lenders’ decision on whether to intervene with additional support in the time leading up to a potential insolvency.
Key contractor insolvency
It is more common for either the construction or the operations contractor to become insolvent during the relevant phase of a PPP project than for the Project Company itself to become insolvent. While the insolvency of a key contractor is primarily a Project Company risk, the Procuring Authority still needs to monitor the situation both during the lead up to and following the insolvency, because of the increased risk to the project. Termination of a key contractor is detailed in Chapter 7 (Default and termination).
The Project Company typically manages the risk of contractor insolvency by seeking to recover the replacements costs from the insolvent contractor’s security package (e.g. performance bonds and parent company guarantees). The security package is designed to cover the cost of replacing the insolvent contractor, including any premium the new contractor will charge to take on partially completed works.
