September 07, 2017

Contractor Participation in Private Project Financing: A Landscape of Opportunity, Risk and Reward

Luke Hagedorn and Justin R. Watkins

There are two fundamental truths in the large-scale Engineering, Procurement and Construction (EPC) and Balance of Plants (BOP) markets:  1) project owners must raise significant capital to finance their projects, often requiring creative approaches to financing, and 2) the universe of EPC/BOP contractors that can provide critical specialized services is limited, making competition for contracts intense.  In this particularly demanding marketplace, an opportunity is emerging for EPC/BOP contractors to participate in project financing and to stand out among the competition.  Of course, contractor participation in project financing brings inherent risk, and contractors and owners must evaluate a number of factors before considering any such partnership.

Contractor Financing in Action

While not yet a pervasive feature of the construction marketplace, contractor participation in project financing is not unprecedented.  

During the mid-2000s, for example, the ethanol industry used contractor financing when a large number of biofuel facilities were constructed across the United States.  It became common for equipment vendors and BOP/EPC contractors to participate directly in financing the construction of ethanol facilities.  Generally, contractors would either commit an initial investment of funds to the project, or would offer their services at a reduced rate, and in return would receive an equity position in the project entity through issuance of either common or preferred units.  The units allowed the contractor to appoint one or more members of the project entity’s board of directors and would specify a predetermined dividend amount be paid to the contractor by a certain date.  Project owners were rewarded under this financing structure not only by receiving a portion of their capital needs, but also by attaching the reputation and experience of some of the most knowledgeable contractors in the biofuels industry to their projects.    

More recently, in August of 2016, Lion One Metals Limited and Ansteel-CapitalAsia Global Engineering Inc. revealed their agreement to a contractor-financing structure involving substantial contractor investment for the development of a gold processing plant in Fiji.1  Ansteel agreed to perform EPC services for the project, and to finance up to 80% of the anticipated value of the EPC Contract in the form of a deferred payment of up to $44,000,000, with Lion One providing the remaining 20% of the anticipated EPC Contract value.2  The deferred payment would be treated as a senior secured obligation, secured by project assets, and to be repaid in quarterly installments plus 7% annual interest.3  Lion One also issued ownership units to Ansteel equal to approximately 10% of the deferred payment amount that would mature upon the earlier of the final scheduled deferred payment, or 5 years.4

Potential Contractor-Finance Structures

As illustrated in the ethanol industry and with the Lion One project, contractor financing can provide additional flexibility and security to project delivery, and can create a significant investment opportunity for contractors, as itadds an additional layer of financing with characteristics that often resemble a standard construction loan, but that can also deviate from that model in various respects. 

With a standard construction loan, the lender provides a non-recourse loan, secured by assets of the project, and repaid with project revenue.  When contractor financing is modeled after a standard construction loan, the contractor provides a portion of the project capital, either through a direct payment of cash or through deferred payments that would otherwise be owed under the EPC or BOP agreement.   As consideration, the contractor may receive an equity interest in the project or have its deferred compensation paid, plus interest or some other inflationary factor, upon the achievement of a certain project milestone(s).  The contractor’s capital investment may also be repaid over time through distributions or other mechanisms tied to on-going proceeds of the project.

Within this construction loan model, the owner and contractor have freedom to form their relationship to balance the allocation of both risk and reward.  For example, the EPC/BOP contractor could directly obtain an equity interest in the project company, thus establishing a joint-ownership relationship that could be governed by the equivalent of a participation or joint operating agreement.  The joint entity can be established with several tiers of ownership units, some common and some preferred, with distributions for preferred units tied to certain predefined goals or metrics.  The EPC/BOP contractor’s interest can then be granted through an issuance of select ownership units, which in turn dictate the terms and rate of repayment.  The units could be either callable or putable by the unit-holder, allowing the upside and the downside of the potential return to be negotiated and tailored between the parties.

Venturing further from the traditional construction loan model and traditional project roles, the parties can also enter into a purely contractual relationship under a joint development or strategic alliance agreement defining the rights and obligations of the parties, including capital investments.  The terms of the arrangement dictate or limit the type of interest and repayment terms for the overall financing, so a thoughtful approach is required.  With a joint development or strategic alliance agreement in place, a more traditional loan-type investment (as opposed to equity participation in the project company) may make the most sense, as the terms of the repayment will be more dependent on contractual terms, rather than tied to equity participation.  But this structure offers significant additional freedom to allocate risks and benefits through defined management rights, distribution and repayment terms, and exit rights between the parties. 

Careful consideration must be given to the structure underlying any contractor participation in financing.  There are a host of factors and issues that can profoundly impact the overall structure that is proposed, including potentially significant tax ramifications tied to the classification of ownership interests, and of the allocation of income and losses, as well as potential securities, usury or anti-trust issues, all of which must be carefully analyzed.

Unique Benefits and Risks of Contractor-Financing

Contractor financing proposals can offer advantages for both owners and contractors.  The project owner can secure a portion of their overall capital need, with some additional freedom to creatively structure the terms and repayment of the investment to benefit the overall economic viability of the project.  Additionally, by having an EPC/BOP contractor with skin in the project, the owner ensures the contractor is strongly incentivized to help the project succeed.  For the EPC/BOP contractor, there is the opportunity for substantial differentiation from the competition, and to greatly increase the chance of securing the contract.  Contractor-financing also presents a unique opportunity for EPC/BOP contractors to diversify their financial portfolios and revenue streams. 

Contractor-finance proposals also raise unique risks.  Fundamentally, contractor-financing can lead to a blurring of the traditional line between owner and contractor.  As a result, it is vital that the parties carefully consider how participation may impact risk allocation.  As examples, consider the following:

  • Contractor participation in the overall project financing may complicate arbitration or litigation scenarios arising from non-payments, failure to perform specified services, etc.
  • The EPC/BOP contractor might be deemed to possess increased knowledge (constructive or actual) of site conditions, regardless of how thorough a site investigation was actually performed.
  • If the contractor has a right to participate in owner decision-making for the project, it may be bound by owner decisions regarding changes to the project scope, program, and budget, which could otherwise be disputable.
  • Principles of compensable delay and other claim rights that protect the contractor could be altered if the contractor is deemed jointly responsible for project conditions that would otherwise be typically under sole owner control.
  • Equity ownership or contractual partnership that resembles a joint venture may alter the relationship between contractor and subcontractor, potentially impacting subcontractor lien rights, nullifying pay-if-paid provisions, and otherwise altering the anticipated contractual structure.
  • Participating in project financing when the contractor is not involved in design could alter application of the Spearin doctrine and diminish the contractor’s right to rely upon the adequacy of project design.

Though not necessarily material, if these considerations increase the owner’s or EPC/BOP contractor’s overall risk, they should be properly assessed when evaluating the transaction as a whole, and steps can and should be taken when drafting the contract documents to ensure that desired risk allocation is preserved.

A Good Tool for the Right Project

If the circumstances align, a contractor-finance proposal can be an excellent tool to help accomplish goals for both the project owner and the EPC/BOP contractor.  The primary benefit is the significant flexibility available that grants the parties the ability to craft a structure tailor-made for the circumstances of the project, and to meet the goals of both the project owner and contractor.  Of course, that is also its biggest risk, and it is important to fully consider all of the various issues that may arise, both legal and practical, as well as the appropriate allocation of risks and rewards between the parties. 

Endnotes

1. Press Release, Lion One Metals, Lion One Announces MOU for EPC Contract and Vendor Financing with Ansteel-CapitalAsia for Construction of the Tuvatu Gold Project (Aug. 24, 2016).

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Luke Hagedorn

Polsinelli PC, Kansas City, MO

Justin R. Watkins

Polsinelli PC, Kansas City, MO