Risk: Strike a balance between lenders and contractors

As more and more contractors get exposed to project finance negotiations and are asked to provide performance security in the event of their non-performance, the dialogue about the nature of that security is increasing. A delicate balance needs to be struck between lenders and contractors — the security has to satisfy the lenders need for responsiveness in the event of a contractor non-performance event, and at the same time not overly constrain the contractor’s ability to operate its business.

Traditionally, construction contracts have been secured by the following solutions:

Parental Company Guarantees (PCGs) — Often the entity performing the construction work is not the entity with all of the net worth, so the owner (equity) and debt secure their position via a guarantee from the company with the deeper pockets.

Surety Bonds — In North America the traditional performance bond is used to secure contractor performance whereby the contractor has to be in default in the eyes of the surety company. Surety bonds in Canada are often to the value of 50 per cent of the contract value.

Letters of Credit — These instruments are on-demand and provide the equity and debt immediate access to cash and are often in amounts between five and 15 per cent of the contract value.

Cash Reserves — Cash set aside at the start of the project or funded during the execution of the project. The funds can be used to mitigate the losses suffered due to contractor non-performance during construction and into the operations period.

Of late, there has been a movement towards increased use of PCGs and letters of credit. This has been especially true in the public sector asset procurement arena. As the public sector experiments more with delivery models that use the private sectors’ funds, the use of traditional surety bonds has decreased. In order to address migration away from insurance-based performance security solutions, the insurance industry is re-tooling their offerings. The beneficiaries to the policies now get a quicker response to the non-performance of the contractor. Some of the surety offerings, specifically introduced in the later part of 2011, have tremendous potential to reduce or even supplant the letter of credit as a source of performance security.

So why would an owner or lender be interested in trading what appears to be a very liquid instrument for a new solution that offers similar responsiveness, delivered by the insurance industry? Well, there are a number of reasons that these new solutions should be embraced:

1. Responsiveness — These solutions can offer payment with no/or limited insurer scrutiny within five to 30 days.

2. Contractor Friendly — Allow the contractor a greater degree of financial flexibility.

3. Smart Security — Anybody can get a
letter of credit. If I have $10 million in cash I can obtain a $10 million letter of credit. Does this mean I’m a good contractor? Absolutely not, it just means I have cash. Do the insurance offerings have smarts? Absolutely. The smarts from the insurance-based security can benefit owners and lenders in two distinct ways: A) Prequalification — to qualify for these solutions the contractor has to go through a rigorous underwriting of its financial strength and operational practices.
B) Mitigation Knowledge — when a non-performance event occurs some of these solutions come with built-in knowledge of how to get the job back on track.

4. Quantum — the letter of credit is usually in amounts of five to 15 per cent of the contract. Sure the PCG helps, but how responsive will a PCG be if the contractor is defaulting due to insolvency issues? With the suite of performance security offered by the insurance sector, you can get well over 50 per cent of the contract value in place to secure your position.

5. Insurance Capital Base — As the world watches the sovereign risk crisis unfold in Europe, we get more information as to how connected the world’s banking industry is. As these countries are being downgraded, so too are the banks associated with them. This means the credit quality of those institutions are coming into question. Well, the insurance sector is not as directly impacted from these events, and thus, a case could be made that insurance security is more stable then bank originated security.

These are just a few reasons why the project finance community should take a closer look at the new performance security offerings. Educate yourself on these tools as soon as you can. It most definitely could be the difference between winning and losing a job.