Financial Guarantee leverage — what to expect
For mid-market project funding through In3’s Completion Assurance Program™ (CAP), we offer an equity carried interest (the exact percentage negotiated in good faith following our due diligence), based primarily on the unguaranteed portion of the investment, if any, the strength of the issuing bank and somewhat the project’s IRR (for terminology definitions go here).
This means that with either a Standby Letter of Credit (SbLC) or similar, bank-issued instruments (if outside the US, a Bank Guarantee or Performance Guarantee), our partners use the instrument as security that covers part or all of the project’s non-completion risk exposure.
Sovereign Guarantees are a special case, and cannot be leveraged (their market value is less than other instruments), but all types of Financial Guarantees are subject to some discount, decreasing their effective value. Such guarantees, traditionally used for the life of a loan, are used as borrower credit enhancement. With CAP funding, however, the main purpose of an SbLC is client performance and completion assurance — that is, the client takes responsibility for finishing the project’s operating assets no matter what. Every project construction effort runs into issues at some point. The question is how will they get handled? Either the CAP guarantee or a cash deposit assures that they will get handled in a responsible manner.
To a lesser extent, financial guarantees are a short-term form of credit enhancement, because they typically end once the project begins commercial operations (or in the case of a cash deposit, on the last monthly drawdown of funding proceeds), but also because they can be greatly leveraged, as this article outlines.
This is also why it sometimes makes sense to involve a guarantee sponsor or third party backer (individuals or companies with lots of assets but little or no free cash flow) when the developer cannot bring their own guarantee.
Guide to Guarantee Options and how to facilitate and decide
Cash deposits and direct securities (registered and rated bonds, gold with Safe Keeping Records, or MTNs) allow more or less leverage, respectively, as shown in this CAP Security comparison chart:
If your project requires more security (whatever form you prefer) than is available, there are four options:
- Find a sponsor — combine whatever security you have with theirs (they may insist on at least some “skin in the game” from your side)
- Arrange multiple tranches (2 or 3 at most), though each tranche would need to stay “operative” until Commercial Operation Date (COD) has been reached, if an SbLC, then allowed to expire. Cash is handled differently. Keep in mind minimum SbLC face value per tranche ~$18m.
- Decrease the project size (overall budget) for the first phase(s), but be careful not to go below our $25m minimum.
- Secure just the equity funding through CAP, perhaps as little as 10% or as much as 90%, depending on the total ask, then use that commitment to have In3 obtain a Senior Loan for the rest — or do that on your own. More on this CAP-related service.
The remainder of this article applies to bank-issued instruments only, which is mainly as a Standby Letter of Credit (SbLC):
Some leverage can be applied to all financial guarantees, with a minimum coverage of 33% face value for an SbLC, BG / PG / AvPN. The larger the coverage (ideally, 50-75% or thereabouts), the more ownership rights to cashflows will remain for the developer and/or other stakeholders and the faster the draw timing, to a point.
Some developers are fine with offering more ownership to us, with other value streams in mind for themselves. That’s fine, but not required.
For example, with just one third guarantee face value (33.3% guarantee coverage), the developer would be asking to draw down three times the face value of the guarantee in total project capital. Note that the quality of the guarantee, issuing or endorsing (AvPN avalizing) bank, and total budget and timing of draws into the project also influence how we would interpret the possibility of a guarantee being acceptable.
Why is ~2x-3x the maximum leverage? Guarantees are often steeply discounted if the issuer is not a reasonably large bank with a decent rating. Further, larger project budgets make it easier to apply this leverage. Ideally, the face value of a contemplated guarantee should not dip below our minimum of $20-25 million USD. The comparison chart above shows the strict minimum face value for an SbLC as $18m; if at or slightly below that, ask us, we may have a solution.
Examples and Use Cases
For $100 million in total project funding, for example, we would start with the following assumptions:
- If the client or sponsor only provides a 45-55% financial guarantee as completion assurance, that leaves roughly half of the invested capital “exposed” to the risk of non-completion (due to fraud, malfeasance, etc.). For developers to retain more than roughly half the project’s equity, use less guarantee leverage, or no leverage — aim for a guarantee face value of 60-100% of the required capital.
- Other solutions to this include bringing the guarantee in two tranches or negotiating for an equity split that uses a waterfall structure
- Why is significant leverage (a guarantee below 60% coverage) being contemplated? If it is about the fees a bank would charge, try a different bank? If the fees remain similarly prohibitive, and the requestor is creditworthy, consider asking them what they would charge for an “Aval” on our simple Promissory Note instead. See Option 2 here.
SIDEBAR on non-completion risk: In practice, any or all issues that arise are worked out in a cooperative manner with the involved parties. We all want projects to succeed, and so we request the guarantee as completion security, or assurance, that the parties will honor their commitments. Bankers sometimes assume we have a different purpose or intention in mind, especially when they are more familiar with trade finance-related Documentary Letters of Credit (LCs), which is not at all how this project completion BG/SbLC works. In fact, completion assurance or “standby” LCs and documentary LCs are opposites, where the underlying cash-backed collateral, if any, cannot be called, or drawn, except in the event of breach of the governing Investment Agreement. That really must not happen and never has in our entire history. The various parties would be asked to work out the issues to get the project back on track. More on this topic via our Frequently Asked Questions (see #2 and 6) or “Communicating with Bankers”.
Further examples of guarantee leverage: If the developer provides, say, 60% BG/AvPN coverage, then we might begin a negotiation for the capital partner’s proportion of carried interest at around 40%. This is always case-by-case, but note that although there is no additional equity anti-dilution benefit to more than 75-80% guarantee coverage. There may be other benefits or advantages, namely the speed at which funds can be drawn into the SPV’s bank account, but the equity stake we will bargain for does also depend on the size/rating of the issuing bank, instrument strength, and anticipated IRR of the project, among other factors. Greater leverage (or multiple tranches) slows down the permissible rate of initial monthly capital draws.
The inverse of this is also true. When a guarantee is highly leveraged (in the range of just 30%, let’s say), the speed of draws into the SPV account would be much longer — perhaps as long as 36 months — to avoid us taking on undue completion risk.
This is a notoriously complex topic, with numerous moving parts. The above points become clear when specific proposals are made to us, as we together seek to pre-qualify the contemplated arrangement. See pre-qualification steps 1-4 here.
Conclusions:
- It is best to assume 65-80% coverage (LTV, a metaphor for loan-to-value, or just face value of the guarantee relative to total funding, ) of the project budget for a completion assurance guarantee (Bank Guarantee/Standby Letter of Credit, or Avalized Promissory Note or AvPN) and you will be able to secure financing at more generous and flexible terms.
- Using substantial leverage or a partial guarantee may slow down the amount of funds that can be drawn during the initial months and increases our Family Office partner’s aspiration for an equity stake.
- The less coverage, below roughly 70-75%, the greater the equity carried interest, typically. There are other consequences of leveraging more than 2x (2:1, or 50% LTV); see below.
- Some amount of leverage can be used without serious downsides, so long as guarantee coverage is at least 70% or 80% LTV from a reasonably strong bank. Financial Guarantees delivered through stronger banks (top ~500) can be leveraged more than guarantees from smaller/weaker banks. Larger projects and those with higher IRR (more at glossary).
Why leverage at all?
Leverage often decreases bank fees and frees up collateral (assets pledged to the issuing bank for a bank-issued SbLC) until the project reaches commercial operation date. Those assets may be needed elsewhere. The exact assets that can be used is between you and your bank, however here is a complete list. Cash is not the only form of collateral used for such guarantees (and if you had cash, you could use that as a deposit instead of a guarantee, as it is more valuable per a given US$ or Euro amount), which are technically “cash backed” but that can include nearly a dozen different asset forms, including many that are illiquid, from gold or silver, to buildings or other projects you own, or other holdings, your balance sheet (no asset pledged as collateral), untapped lines of credit, appraised artwork, etc. See the list, pick something, then ask your bank or the sponsor’s bank.
The Cost/Benefit of Guarantee Leverage
Ultimately, it is a business decision, where more leverage becomes dilutive to the owner’s carried interest, so probably better to increase the guarantee’s coverage and enjoy more of the cashflows, but that is up to you to decide. If you are using a sponsor, that conversation can include sweeteners to increase their coverage, offering an all-win over the life of the project.
This rest of this article details the reasons all this matters:
- Leverage may make the Standby LC/BG or AvPN more feasible, in the case of a project seeking 100% funding. If a certain amount of funding is required to reach COD (operational status), then leveraging what is available is probably better than waiting or seeking additional sponsorship. However, additional funding sources (such as a loan) can be combined or “paired” with In3CAP equity. Know more
- Leverage helps you obtain optimal size and duration of a SbLC/BG or AvPN instrument whether brought by the developer or from a sponsor (such as the EPC firm or General Contractor hired to build the project’s assets).
- Different types of Security allow different amounts of leverage, which boils down to 1-2x for direct securities, up to 3x for an SbLC/BG or AvPN financial instrument, or up to 4x for cash. Decision-making facilitation guide may help as there are often factors you will want to consider when making such critically important arrangements, such as the fact that you might not need 100% asset coverage — some banks allow you to leverage the available assets.
- Be in action mode asking questions. Learn all you can. Things are never as they seem at first. Also see Tips for Sourcing a CAP Guarantee to save you time/trouble.
Note that some banks will accept partial asset coverage — they do not require 100% asset value to issue a usable BG/SbLC to access our funding. For example, if you are seeking $100 million in funding, combining equity and debt, an experienced banker might accept as little as $40m-$60m in asset value to issue, say, $80 million BG/SbLC (80% LTV) for the $100m project. Best to apply for the BG/SbLC with the bank as you would a loan in order to formally ask the bank officer that knows you or your company (avoids the customary KYC step). But that said, any rated commercial bank could be acceptable, so you are not required to use your “home” bank.
Banks do not require cash on deposit in order to issue a “cash-backed” guarantee instrument. Most will accept stocks or bonds, real property (if appraised), minerals like gold or silver, precious stones (diamonds, etc.), artwork, etc., … or a commercial Line of Credit, or a corporate balance sheet. Again, ask what would be willing to accept, or ask your sponsor (to ask their bank) to do this. More on this topic below.
The preferred instruments will use ISP98 (ICC 590) or URDG 758, but just ask your bank what they require and what they would charge. If you don’t get a reasonable answer, go somewhere else. Individual bankers, branch locations, and the banks themselves very widely on this topic.
How much leverage can be used?
In practice, an instrument that covers at least 45% – 80% of the project’s budget per tranche is a good starting point for the SbLC face value, if both the instrument and issuing bank are of good quality, for project/portfolios under $100 million. For larger projects, as low as 33%-40% can also be used in some cases, delivering adequate security to guarantee the full capital investment (usually 100% of the project budget as new, outside capital, invested from our side), with the goal of only a minority equity stake (carried interest, rights to a proportion of cashflows) provided to In3’s capital partners.
With 75% or 80% or higher LTV, the terms offered will be similar to 100% LTV (where the guarantee is the same as the total investment) — a minority stake will be requested, subject to negotiation of the exact terms, upon completion of due diligence. Below 60-70% LTV may decrease the equity the developer or ultimate owner retains. Below 35-40% may require giving up a majority financial stake. We do not ask for a controlling interest — majority voting rights. Beware of those who do.
For example, with 50% LTV, plan to offer 50% carried interest to our partners. With 60% LTV, you may need to offer 40%, and so on.
Very few alternative sources of funding will be open to providing 100% of a project budget, but even fewer (or perhaps none besides us) will accept just a minority equity kicker if they’re to provide all the capital.
Equally as rare, for an offer of a modest (minority) carried interest, we are also willing to fund further development steps, until the project is entirely ready to turn dirt, with adequate BG/SbLC coverage. We can finance both development costs and construction/commissioning CapEx via mezzanine or subordinated debt at or below market rates.
A SbLC until Commercial Operation Date (COD), or cash deposit until the last draw, is all that is required, preceded by a simple Authorization to Verify (ATV) letter to verify the account status with the involved banker, as the bank’s statement of intent to later deliver the guarantee or deposit. After initial screening for sector, type, and commercial risk, this guarantee until COD makes the project’s funding feasible.
Although free to developers, and also increasingly scarce, Sovereign Guarantees (SGs) cannot be leveraged as their commercial value always receives a discount, mentioned above. We will finance the full budget of the project nonetheless. If you are working in a country that can still issue an SG, here is more on Sovereign Guarantees. Since COVID, the better practice is to ask a sponsoring government to direct a bank to issue a BG/SbLC or endorse an AvPN in lieu of an SG, which can be difficult to arrange.
How much SbLC leverage is too much?
45-55% coverage (roughly 2-to-1 leverage) is right on the edge of what may result in a request for a majority stake in smaller projects, if that’s a particularly sensitive area, where the goal is for the developer to avoid dilution of their cash flow rights. We usually interpret 45-55% coverage as a request by the owner to retain roughly half or more of the long-term equity participation. If you have something else in mind, let’s discuss.
Note that financial interest and control are separable, so owning 49% financial interest does not mean you would be giving up control (majority voting rights). Board seats are balanced and we do not expect majority vote.
If the guarantee is provided only until commissioning (the instrument would be allowed to expire once the project reaches Commercial Operation Date), a negotiation point is whether or not accelerated repayment would be requested in cases of substantial leverage (50% or more, up to 3:1). The feasibility of this funding depends largely on how much equity you are comfortable offering for 100% financing, the issuing bank’s rating, and instrument quality, total funding requested and project IRR.
More leverage or more time (the guarantee can be brought in ~2 tranches) may also slow down the draw schedule, as mentioned above. It is up to our partners’ funding bank to decide if the timing of draws will be acceptable, as their own policies require them to avoid an initial “whoosh” effect as that is likely to trigger anti-corruption rule (anti-money laundering) compliance alerts. Regular (roughly consistent) or steadily increasing monthly draws are preferred, but real world cashflow requirements to complete construction of the project will be considered.
Our partners’ calculus is that with, for example, just a 35% SbLC/BG or AvPN, their necessary coverage of remaining ~65% of the project’s capital would be unguaranteed (exposed) during construction.
Once operational, unless otherwise arranged, the loaned/invested project capital becomes subject to the same execution/market/operational risks as the developer/owners, an exposure that ought to get us a somewhat larger carried interest (depending on project size, and subject to case-by-case review and negotiation of final terms). A project’s specific SbLC/BG or AvPN scenario can be put forward for pre-qualification feedback.
What if the SbLC/BG or AvPN period could be extended beyond the just the required period, until reaching COD? What would that get you? Potentially greater leverage, enabling the sell-side SPV owners (developers/sponsors) to hold onto the same carried interest, still with 100% funding from us, but a longer debt repayment cycle. That would delay principal repayment for as long as the BG/SbLC or AvPN instrument can be left in place.
And why does that matter, exactly? Except for philanthropic sources, private investors are in it for the same reasons you are — to make money and do good work in the world, over time. We know the value of our capital assets in the hands of the right developers, and ~3% APR fixed for up to 20+ years is concessionary (below market rates), so our rationale should be no surprise, as we strive to …
a) Increase our co-owned asset base over time via investing in many, diverse but profitable and meaningful projects, and
b) To the extent possible, avoiding tying up more capital assets than necessary to take on some of the project’s risks and rewards.
Enter the element of time … often confused with money (hint, they’re just related)
In cases of extreme leverage (less than 50% BG/SbLC or AvPN coverage), consider the possibility of offering a Bank Guarantee or AvPN for more years than is minimally required (which is first draw to COD), by renewing the instrument for additional years. The CAP investment agreement might extend the SbLC renewal period from 2 to, say, 4-10 additional years, enabling interest-only (no principal repayment) during that period.
There’s an “easy out” here worth considering. It is fairly common to have the SbLC get dropped earlier than contractually arranged, but still after COD, for various reasons, to release or reuse the underlying collateralized assets as changing business conditions may require. In case that happens, but not sooner than COD, then the investment contract might agree to ‘claw back’ 5%-10% (to be negotiated and included in the investment agreement up front) of the carried interest to our partners starting in the year the SbLC/BG/AvPN is not renewed, for the duration of the shareholding.
If, however, you reach the full guarantee tenor per the investment agreement (whatever additional time you decided to offer, if any), the proportionate equity ownership remains status quo for the life of the SPV. Other creative solutions are also available. Let’s discuss.
Four illustrative examples, each presuming a hypothetical $100 million project with at least 10-15 years asset useful life:
Example 1: 75% SbLC coverage — so $75M SbLC/BG or Avalized Promissory Note — for 2 years, as required, until the project reaches Commercial Operation Date (COD).
Indicative Terms: Negotiated agreement with our partners for 30% equity interest [just a sample — actual equity interest is negotiated on a case-by-case basis following our rapid due diligence cycle], with 50/50 share of profits until the original investment is repaid, which then dropped to 70/30 thereafter. Note that share buyback will be entertained if that is important to the project developer(s)/owner(s).
Example 2: 50% SbLC coverage — or $50M SbLC/BG or AvPN — for 2 years, as required, until the project reaches Commercial Operation Date (COD).
Indicative Terms: Negotiated agreement with our partners for 40% equity interest (in contrast with 30%, shown above); all other terms remain the same as Example 1.
Example 3: 40% SbLC coverage — or $40M SbLC/BG or AvPN — for 2 years, as required, until the project reaches Commercial Operation Date (COD).
Indicative Terms: Negotiated agreement with our partners for 55% equity carried interest (hypothetical majority participation due to ~3x SbLC/BG leverage), with accelerated return-of-principal (investment repayment) initially from 75% of profits (25% profits stay with original owners). Drawdown of initial funds with consistent amounts each month over at least 20-24 months, typically.
Once the investment is repaid, subsequent cash flows could be split 55/45%, a minor “waterfall” effect. Again, this is just an example; your actual arrangement is subject to good faith negotiation.
SUMMARY: These are obviously hypothetical scenarios, for discussion purposes only. We can get to more precise indicative terms once a developer’s first project(s) come forward with budgetary uses of funds, estimated project IRR, offtake plans, size of issuing bank, etc., plus an offer for SbLC/BG coverage or leverage. This offer is best captured via our RWA letter; request our template if you have not already received it.
What enables even greater leverage? Budgets well above the proposed scenario of a $100 million investment. Ask us.
How to keep more of the owner’s equity
For developers that don’t want to give up rights to their own cashflows, there are several solutions available to avoid such dilution, including
- Bring a larger guarantee, perhaps combining them from more than one source.
- Bring in some “cash” funding from the client’s side, or another source, to offset the total request from us, increasing the relative LTV. That cash can take the form of a bridge loan, senior debt, convertible debt or a Line of Credit.
- Break the guarantee that is provided into phases, or tranches (each tranche must be at least ~$18M or €18M face value), with at most 2-3 tranches to fund the entire project.
- Use a “creative” structures like waterfall, share repurchase, or others proposed and discussed during negotiation of final terms.
- Consider alternative funding options, such as short-term debt (if interest rates are high), or long-term senior debt, separately or in combination with CAP funding, now available to developers that have some cash they can put forward as either a security deposit, debt service coverage reserve, to defray due diligence costs, and/or to obtain a binding offer from our lender network.
We are entrepreneurs, not bankers … we will find a way to make it work.
Generally, see the face value of the guarantee, a % of total funding to be drawn down, as roughly equivalent to the loan size (only interest paid on the amount borrowed) and the rest as equity.
Disclaimer: every situation is actually on a case-by-case basis, when the essential facts are all put on the table. We will confer with our partners once you are certain the EPC or General Contractor’s offer is “real” (the firm has accepted and agreed to it, in principle or in fact) to get a more precise indication of what terms would be acceptable.
Final terms will be reached upon completion of our due diligence, which is typically much faster than other investment firms (usually less than 2-3 weeks for well-prepared files) because our flexible conditions make the file review relatively streamlined. First draw is 30-45 days after closing.
Please revert with questions via +1 831-761-0700 Ext 1.