Vendor finance can be a valuable tool for meeting capital needs of a project and enhancing returns for vendors. Some of the issues encountered in structuring and negotiating vendor finance originate from the interplay between vendor finance and other project components, as well as the (actual or perceived) conflict of roles occupied by the vendor-financer. These may have an impact on the risk allocation under the construction or supply contract and give rise to concern over the vendor's rights in its capacity as project financier. Early identification and resolution of these issues during project development is advisable to minimize subsequent delay and complication.
Vendor finance – the rationale
Vendor finance is increasingly common as an alternative source of financing in large-scale projects. In this context, the "vendor" could be an engineering, procurement and construction (EPC) contractor, an equipment seller or a service supplier of a project. For the purpose of this article, we will assume the vendor is a contractor under a construction contract.
This type of finance can offer a number of advantages for both project sponsors and vendors. For project sponsors, a vendor financing arrangement will typically have the benefit of getting a project "off the ground," plugging a hole in the financing plan and commencing construction earlier than may otherwise be the case (for instance, to meet a deadline under the project concession or offtake agreement). Further, having a vendor with more at stake in the project helps align the objectives of the sponsors and the vendor. However, this will typically have the downside of reducing the economic returns for the sponsors, which is why sponsors typically have mixed feelings about it.
From the vendor's perspective, it allows the vendor to differentiate itself from its competitors, enhances customer engagement and retention, and provides an additional revenue source by tapping into more than one stage of the project value chain.
Vendor financing models
Vendor finance can take the form of equity or debt financing. In the case of debt financing, it may be senior or subordinated to the senior lenders. In most cases, it is done on a balance-sheet basis with sponsor guarantees thrown in to reduce risk and pricing, although we have also seen vendor financing structured on a limited recourse basis. It may cover the majority of the funding needs of the project, or only a small portion of them as part of a larger financing package. It may be used to plug a pre-financing funding gap or form part of the long-term financing solution. In some cases, vendor financing may be used as part of a cost overrun mitigation strategy after construction has started and where the vendor tacitly accepts some fault, or where the lenders and project sponsors are not able to raise additional financing to fund the cost overrun.
The model adopted for a specific project depends on the circumstances and requirements of the project, such as the overall financing strategy and structure, project economics, party dynamics, and risk appetite of the vendor.
Issues arising from structuring vendor finance
Incorporating vendor finance in the financing structure of a project often gives rise to a number of issues beyond those present in a typical project finance transaction. These issues arise from the interplay between the vendor-financing component and other project components, as well as the sensitivity around the dual roles occupied by the vendor-financer. Any such issues should ideally be identified as early as possible during the project development phase, to minimize delay or complication down the line. We highlight below some of these issues we’ve encountered.
Due diligence and disclosure of project information
Like any project investor or financier, a vendor financier will expect to be able to conduct due diligence of the project so as to understand the additional project risks it will take on by providing financing, and satisfy itself that such risks are properly allocated and mitigated.
However, the sponsors may be unwilling to share with the vendor certain sensitive commercial or financial information such as the commercial terms of the operation and management (O&M), offtake arrangements and other project contracts or the overall project costs for fear of compromising the sponsors' bargaining position in negotiating the terms of the construction contract.
To manage this dilemma, the parties may seek to agree on pricing and other principal commercial terms of the construction contract before allowing the vendor to conduct in-depth project due diligence and finalizing the terms of the vendor finance. The downside of this approach is that issues encountered in the vendor-financing negotiation may in turn re-open some of the terms that are thought to have been agreed for the construction contract, turning the negotiation into an iterative process.
Dual roles as vendor and financier
The vendor's role as financier will inevitably give it certain influence over the exercise of decisions and discretions by the project company under the construction contract. Care should be taken as to whether the presence or exercise of such influence may impact on the vendor's ability to claim compensation or time extension due to any change of specifications, project delay, site condition under the construction contract.
The duality of roles of the vendor may also challenge the traditional risk allocation between the various stakeholders in a project. For example, where vendor finance is structured as debt, the sponsors and the other lenders may require the vendor to be disenfranchised from lenders' voting and decision-making on all matters related to the construction contract, such as the exercise of reserved discretions and the enforcement on vendor-related events of default under the finance documents.
The sponsors may be concerned that application of any proceeds of liquidated damages payable under the construction contract towards debt prepayment should not unduly benefit the vendor in default. The sponsors may also be unwilling to pay the vendor any finance cost incurred during the claim process under the construction contract. By contrast, the vendor may be concerned that any restriction on its right to apply proceeds of the liquidated damages toward prepayment may have the effect of increasing its overall exposure to the project beyond the agreed liability cap under the construction contract.
Another area of challenge is the impact of termination of the construction contract due to a vendor default on the vendor financing transaction. On such termination, it may make little commercial sense for the vendor to maintain its financing commitment. The sponsors, however, may find it hard to accept that the vendor should be allowed to extract itself fully from a project in distress caused by the vendor, leaving the sponsors to sort out the remaining construction and financing arrangements. A possible solution may involve giving the project company a period of time within which to complete the project with a replacement contractor, and postponing the repayment of the vendor-finance debt until after project completion.
There is no standard template which will address all these issues. Experience suggests that they will need to be analyzed, and potential solutions tested, on a scenario-by-scenario basis to ensure that all parties are fully aware of and comfortable with the positions and implications in each scenario.
Sell-down restrictions against vendor financiers are likely to be less strict than those applicable to the sponsors, although there may be restrictions as to the type of investor that the vendor financiers may sell to.
Certain project contracts such as concession agreements and government support agreements may contain requirements as to how the project's finance should be structured, which will need to be considered in deciding whether vendor finance is suitable and, if so, what form it should take.