Authored John L. Schuster, JLS Capital Strategies LLC
I have been struck by the substantial number of stalled projects. You see them—literally—driving along the road in certain parts of Africa and Asia. They are evident in available statistics and from the number of parties calling for help.
The trend is unsurprising, given chronically low oil and commodity prices. What is noteworthy is how developers and lenders respond. Things have gone wrong. Various problems have emerged such as loan defaults, project degradation, and permit lapses. Yet project parties press on as before.
Some may characterize this behavior as a form of insanity according to a popular, but misused, definition of doing the same thing repeatedly and expecting a different result. But this behavior is understandable. In my experience, the problems facing most projects are not a result of poor development and financing strategies, but rather weak markets, force majeure, bad luck and similar uncontrollable factors. If this is the case, why change?
However, this behavior is irrational and remarkably similar to that identified in a popular self-help book—the inspiration for the romantic comedy that is a big favorite at my house—He’s Just Not That Into You.
The book, written by Greg Behrendt and Liz Tuccillo, and the movie are directed toward women who, constantly in search of the “spark,” overlook the obvious signs that relationships are going nowhere and instead grasp for a few clues that tell them they are the exceptions to the rule. Following advice from well-meaning parents who tell them that the real reason the little boy who was mean to her was because he liked her, they look for subtle clues to give them hope for a commitment that never materializes. Convincing themselves that they are exceptional, they overlook the obvious facts before them.
Projects are gender-neutral, inanimate concepts that have no feelings and are not “into” anyone. But in this analogy, the project is “the guy.” The advice of this article is directed to those who care, who have become excited about the promise of the project, believing they have found “the spark.” Anyone who has ever seriously pursued a project has done so because he or she believes in the project’s concept economics and believes that the project will achieve success.
While excitement about and commitment to a project are important, the spark is never enough. Just as in the relationship world, impasses can impede project success at almost every turn. But instead of dating, commitment and marriage, it is development, funding and repayment.
When things go wrong, project parties look for clues of hope: they focus on what could have been. In search of “the spark,” they stop focusing on the large realities before them.
The key to breaking the impasse is to assess the practical facts that are in plain view and then pick up the pieces and move on.
If you are out of money, you are out of the project.
Most projects that encounter impasses early on are those with enough capital to get started with the rest “on the way.” The sponsors hope that the initial undertaking will adequately demonstrate to the world that the project is happening and will happen. Most lenders will not (or should not) finance without 100 percent of committed equity supported by an approved credit, in which case the premature start becomes just that—with no debt to continue. Even if lenders do commence financing, they are likely to halt funding in order to avoid uncapped exposure if the equity money does not materialize.
Ultimately, progress stops and everyone is left facing dry-hole risk. Even after years without progress, some borrowers will grasp for signs that the money is on the way. Here are some popular hopeful refrains.
“We had a really productive and positive meeting with the bank.”
The only meeting one needs to have with a bank is punctuated with sentences like this.
Borrower: “We have the equity we need to cover the cost of the delay and ensure completion.”
Lender: “Thank you for meeting our requirements and for committing those funds first. We will be moving forward with our loan approval and funding process now.”
Anything else is just talk.
“We have a promising sale that will be the key to more equity and debt.”
The only sale that will bail out a deal with a cash deficit is a sale with money that looks, smells and acts like equity. There are such sales—condo-sats, for example—that are satellite capacity sales where the buyer pays upfront and agrees to forgo certain security and voting rights that are troublesome to lenders. But most sales are conditioned upon completion of the project, which depends on the ability to secure enough funds, which was the problem in the first place.
If several years have passed, the rest of the money still has not shown up and productive negotiations have long since ceased, there is no reason to think it will all turn around tomorrow.
If you cannot complete phase one, it is not time to plan phases 2 through 10.
Most projects get started with the idea that an initial project is just the starting point. This is especially true for new, inexperienced developers. If the idea is good for one project, it can be used for many projects, right?
That may seem true where sites and permits are easy to obtain, or where sales contracts are standard, as with certain renewable energy projects. So why not keep the spark of the great idea going? While writing this article, I found several websites devoted to showing how small projects can be transformed into additional and potentially larger projects, but alas, the websites show no tangible evidence of success.
There is a reason for that. Projects do not have an inner essence that can be copied like paper. Site conditions, offtaker circumstances, regulations and other factors are subject to change. Even if they were not, seed money cannot be turned into long-term equity any more than straw can be spun into gold. It is best to stick with phase 1.
If lenders and sponsors are not aligned, no one is into anyone.
Most project financing negotiations start (or should start) with an alignment of interests between lenders and sponsors. But market changes, tax consequences or other factors can change incentives, causing the sponsor to lose interest in project success.
When interests diverge, the choice is not whether to adopt a new strategy—a change in direction is a must. Projects with unmotivated sponsors are less likely to work out issues with host governments. They may divert talented personnel to other projects or lose them to other enterprises. They may engage in the less-than-transparent uses of funds, prompting lending and all progress to stop. They may be slow to undertake new developments. On one mining project—let’s call it project X—the sponsor made more money in tax losses by avoiding profitable new developments. Sponsors of petrochemical, satellite and other projects reliant upon ongoing market sales will be less motivated to make these sales if the sales will not generate dividends.
The problem is how to move on. Lenders are loathe to enforce security and change sponsors because the sponsor may be well positioned to make the project a success. Changing sponsors might not re-align interests and may exacerbate problems. However, if interests cannot be re-aligned with the current sponsor or if sponsors have misbehaved, then it is time to change horses.
How to move on
Here are a few tips for discerning how to move on:
On project X, the poorly motivated sponsor X was amazingly transparent about its disregard for the lending group. It failed to share information, piled up costs through expensive mining practices, and refused to adopt new mine plans with demonstrated profitability. When the lenders began exploring options to sell the project, sponsor X openly denigrated its mine, seeking to poison the market for a sale. The lenders failed to pick up on the obvious, grasping at straws about how sponsor X was going to improve, allowing sponsor X to disrupt the sales process. Ultimately, sponsor X acquired the project for cents on the dollar and, within a year, implemented the mine plan it had just refused to adopt.
Lenders are usually quicker to pick up clues. On a different mining deal, an inexperienced sponsor wasted funds on poor mining and imprudent spending, which demonstrated a lack of good faith and commitment, if not outright conspiracy. Fortunately, the deal facilitated an overhaul of sponsor arrangements and a resolution to problems. On a telecom deal, a new entrant agreed to substantial cash sweeps with the intention of making money through less-than-transparent activity. However, the sponsor was corralled early during operations, and new equity ultimately came in to prepay the debt.
If you are serious, follow all the money.
As a rule, project finance lenders—especially multilateral lending or export credit agency lenders—are very good at tracking total equity at risk and understanding how it affects incentives for future action. What gets murkier is following that equity down the rabbit hole to understand the obscure and complicated inner details of the shareholder arrangements, like the incentives of individual partners and dynamics among shareholders and project management. One can understand why these details are overlooked: these realities extinguish “the spark.”
I recall a large US pipeline that overcame a host of logistical, marketing and profitability issues only to be tripped up after less interesting, but (in hindsight) more important tax issues prompted one particularly affected sponsor to drop out. After other parties failed to step in and fill the gap, the deal descended into litigation. On deals where the size of sponsor equity is crucial, no one wants to assess the details that might show that the sponsor in control of the deal may not be the party with real equity risk.
Know your limitations and your counter-party’s strengths.
My aim in this article is the same as Behrendt’s and Tuccillo’s He’s Not That Into You: to provide guidance on “picking up the pieces and moving on.” The key challenge facing parties doing so is to understand realistically one’s circumstances and discern what to do given that reality. That means forgetting about things that developers and sponsors justifiably hold dear, like millions of dollars in equity investments and loan disbursements.
Economics 101 taught us that these are sunk costs that are irrelevant to decision making, but no one should try to tell someone who is out millions of dollars that the money does not matter. It does matter—even to decision making—but in the opposite way most think. Investors and lenders focus on recovering money contributed from the liability side of ledgers (which is indeed irrelevant), leading to unproductive loss-avoidance strategies. The focus should be on the value of assets and a re-orientation of the deal.
Loss avoidance leads us to stay the course and avoid rocking the boat, and to at least three foibles. One sponsor foible is to focus solely on the primary lending option. This gives the lenders 100 percent leverage, and if things falter, a lengthy loan process hurts market perceptions and project value.
A second sponsor foible is to keep saying yes to demands in the hope of appeasing lenders and facilitating loan disbursement. The problem is that desperation confirms negative perceptions. Lenders may also suspect sponsors are not paying attention.
The third sponsor foible is to be patient, stay the course and hope for the best. This is not a strategy, but a prayer. Hail Mary passes are for US football teams and have no place in project finance; even football teams view them as acts of desperation.
To pick up the pieces and move on, one needs to face potentially inconvenient truths and be prepared to re-orient the deal process.
Rather than focusing solely on the primary deal (foible 1), one should turn outward and assess realistic alternatives. Perhaps the value of a sale to another company is less, but that value is better than nothing and, more importantly, is instructive about how far one should go in pursuing the primary deal. Even if concessions are dear, if they result in a deal that is better than alternatives, they create value. The value of alternatives defines when one should stop saying yes to everything (foible 2) and enhance one’s credibility.
At each step, the key is to understand the value of alternatives, and to then use that value as leverage to get the best deal possible within a reasonably expeditious period.
Ironically, no one focuses on the value of alternatives because they may be the obvious signs that no one wants to face. The value of the development in progress (sites, permits, contracts, construction, etcetera) is probably less than the cost of development. If the project is really stuck, then it may be that the best option is to sell the project to another party at a loss. For lenders, if debt funds have been advanced, the lenders’ interests may be best served by taking 50¢ on the dollar rather than losing everything. None of this is what parties want to hear, but understanding options along the way has to be better than waiting until no other options remain.
To maximize the value of their options, parties should include the value of a counterparty’s potential losses as an asset. A lender may be willing to grant concessions if doing so minimizes debt write offs. In other words, a lender may expect a borrower to accept lower returns if that is better than lost investments.
Ultimately, a realistic assessment of the facts about one’s circumstances is always better than reliance on hope and prayer for what one wants (foible 3). Funds are rarely extended for a deal one wants to have, but rather for the deal that actually exists. That is the only way to pick up the pieces and move on.