Risks and mitigation of pre-billed receivables in project finance

For mid-cap businesses, securing access to project finance is no easy feat. Requiring the transfer of funds prior to contractual delivery, the risks associated with this type of transaction are too great for the majority of lenders operating in the small to mid-cap space. But as Ben Boateng, Senior Director at ExWorks Capital, explains, when executed correctly, this type of financing can be both safe and profitable for all involved.

Due to the size and long-term nature of large projects, project finance is often a much more complex task than the straightforward financing of receivables, where risk mitigation contingency planning starts and ends with avoiding non-repayment. With an ongoing delivery requirement – often punctuated by progress “milestones” – the financier is required to provide debt up-front, meaning any risks affiliated with the project development process are magnified.

Of course, when it comes to projects of £25m or more, securing such financing from banks or investment banks is certainly more achievable. Either possessing in-house infrastructure teams or the resources to appoint an external team of experts, these lenders have easy access to the tools to mitigate the risks that often render these transactions unfeasible for smaller businesses.

While high street banks or alternative, independent lenders would generally provide small to midcap businesses with receivables finance solutions, the aforementioned risks associated with financing projects deter the vast majority of these lenders from participating in this space – particularly when it comes to cross-border transactions.

Yet, that is not to say that these risks are insurmountable. Rather, businesses need to find lenders with both the expertise and the flexibility to understand the way this specialist area of financing works, and why it can be effective for smaller businesses. Certainly, there are measures that can be taken to make sure both the lender and the borrower remain safe in this type of transaction.

Specialist understanding

By carrying out in-depth checks on a company through a due diligence provider that specialises in project finance, a lender is able to verify a company’s track-record before agreeing to any financing. ExWorks tends to look at the previous five to 10 projects carried out by a potential client, enabling us to produce a project curve demonstrating how well it has performed in key areas of project development. For instance, timeliness of delivery and dilution trends, which give an outlook on the potential for any financial issues to arise. By carrying out such thorough checks, lenders are able to ensure that the transaction has a strong foundation, mitigating any serious cause for concern.

But it’s not just the main contractor that poses a risk to project performance. Often, when it comes to cross-border, mid-sized deals, project managers do not have the scale or depth for internal team members to carry out all facets of the project on their own. As such, they must sub-contract local workers – including builders, engineers, electricians and plumbers – to carry out certain parts of the project. As a result, project development is heavily dependent on the competence of such teams and the lender must ensure that they too undergo due diligence examinations in order to assess their ability to deliver on particular areas of the job they have been sub-contracted to carry out.

The contract

With projects spanning extended periods, the loan facility must have a certain level of flexibility to ensure it is able to adapt to the changing needs of the contract where necessary. As such, certain stipulations can be made to protect the borrower.

Generally, large projects are divided into milestones by which a certain amount of the project must be completed. Payments are then made and received according to these. In a construction project, for instance, there will be various phases that will contribute towards the final piece. At each stage, different sub-contractors will be employed to carry out different tasks and are susceptible to varying levels of delay – and this must all be factored into payment timing. As such, the lender will need to make sure that deadlines laid out in the contract are realistic and that an appropriate grace period is set to allow for any setbacks.

Another important provision to make is for liquidated damages – compensation that is deducted from the lending total in the event of a breach, such as failing to meet a payment milestone. This is typically capped at 5-10% of the contract sum and, in the case of late payment, will come into effect once the end of the grace period has been reached. Together with estimations for retention and dilution, such provisions enable the lender to come to an agreement on an accurate advance rate – typically around the 70% mark.

Of course, provided obligations set out in the contract are respected and followed, issues such as non-repayment become very slight – especially given that track-records and reputations are highly important in this type of transaction. However, performance bonds – typically provided by either a bank or an insurance company – provide an important security valve should a borrower either breach or fail to meet the obligations specified in the contract. Often, a similar bond will be extended to suppliers working on the project in order to mitigate the late or non-delivery of goods necessary to project completion.

Once the project has started

The above makes sure that all avenues are covered pre-project. But once the contract has been signed and the work has begun, it is important to carry out regular checks on a project so if something is going awry, it doesn’t escalate. A seasoned lender in this space will put in covenants – safety mechanisms that alert them when things are not going to plan – such as monthly examinations by an independent third party, to make sure that any discrepancies are addressed before reaching the point of invoking liquidated damages. Ultimately, specialised lenders and credit funds will have strong work out teams able to deal with the complex issues that arise in this type of financing: everything must be examined in minute detail, and being able to understand and proactively use this information is vital.

Of course, all of these checks on behalf of the lender require substantial investment. This must be factored into the risk premium that a lender charges and is perhaps the key reason bigger banks are reluctant to lend in this area. With their risk premium frozen at 4%, either the project won’t meet their strict risk criteria or undertaking the deal at a 4% risk premium will just not yield profits to make the transaction worthwhile. Alternatives in this space, however, are able to factor this into their pricing, meaning they are flexible and smaller businesses are able to access a financing product otherwise exclusive to very large transactions – a win-win for both parties.