Make Lenders Love Your Construction Contract

July 10, 2017 |

By Charles G. Loos, P.E., Special to The Digest

By the time a developer seeks non-recourse financing for a biomass project, the contracts for construction and major equipment procurement have usually been pre-negotiated and are on hold awaiting notice to proceed.   Prospective lenders then scour these contracts for defects, paying particular attention to inconsistencies between the various contracts.  Clean contracts attract the best lenders and the best rates, but inconsistencies can drive lenders away.

This article describes common types of inconsistencies between equipment and construction contracts, and shows developers how to avoid them. The issues are similar whether a project employs a single wraparound turnkey contract, or separate contracts for major equipment (e.g. boilers, gasifiers, turbines), engineering and construction.

Thinly-staffed developers often negotiate the pre-purchase of key plant equipment to lock in cost and a delivery date, based on a preliminary design.     Months may pass before a companion installation and construction contract is negotiated.   Meanwhile the details of environmental permitting, site control, feedstock supply and plant design continue evolving.   Both contracts are often put on hold awaiting financing.   In some cases the construction contractor assumes the equipment contract and provides wraparound guarantees. Absent extreme diligence, contractual holes can develop and multiply throughout the development process.

The Lender’s Perspective

From the lender’s perspective, however, the suite of equipment procurement and construction contracts must seamlessly interlock.   Any inconsistencies introduce potential risk to the lender.   Lenders commonly handle risk by; 1) increasing the interest rate, 2) walking away or, 3) making the developer fix the problem.  In other words, developers with clean contracts get the best financing.

How to ensure contractual consistency? The first step is philosophical in nature and costs nothing to implement. That is to treat the project as a financial product, rather than a physical project, from the first day of development.   The overarching development goal must be crafting a seamless and interlocking contract package that minimize the lender’s risk. This article covers only the equipment and construction contracts, but the concept applies to all contracts including feedstock supply, site lease, product sales, power sales and the like.

Stated simply, financeability must be the primary goal. Engineers, who may be focused on technology, particularly struggle with this concept.   Sorry, but financing trumps technology. Developers, including engineers, must think like lenders.

The Most Common Contract problems

Step two is to understand and guard against the most common contract problems including weak acceptance tests, inconsistent design point guarantees, unfavorable progress payments, and warranty mismatches Each is discussed in detail below.

Lenders need assurance that the completed plant will work as designed, under the full range of conditions, and for the long haul. Toward that end, three separate types of acceptance tests have evolved.

Acceptance Tests

The first is a simple performance test which demonstrates that the system meets output and efficiency guarantees under design-point conditions, usually for a couple of hours.

The second type is a functional test to demonstrate that the plant can handle all operating transients including normal starts, normal stops, emergency stops and changes in load or output.

The third type is an endurance test, often lasting a week or two, during which the plant must run continuously, without tripping or malfunction, under a variety of real-world conditions.   If the plant trips, the is clock re-started.

To minimize their own risk, equipment suppliers and construction contractors tend to minimize the type, duration and rigor of acceptance testing. Often they will include only a brief performance test under Design Point conditions.   This won’t pass muster with lender’s engineers.   Therefore developers must negotiate much more extensive testing that includes all three types of test.

Several practical questions typically arise, including; 1) measurement deadband or instrument test tolerance, 2) instruments calibration protocols, 3) use of testing codes and standards, and 4) payment for feedstock/fuels used during testing.

Acceptance testing negotiations can be both spirited and complex, requiring technical, environmental and contractual depth at the negotiating table.   

Design Point Guarantees

Will the plant meet its performance guarantees? Lender’s engineers will pick apart the equipment and construction contracts to make sure the performance guarantees are consistently defined.   Are the Design Point conditions common to all contracts? Do they all specify the same ambient temperature, feedstock composition and makeup water temperature?   Is blowdown accounted for? Which parasitic loads are included? Is guaranteed production on a net or gross basis? Such are typical of the parameters that must be defined in a Design Point.

Biomass feedstocks, being natural products, are highly variable in moisture content and chemical composition. This adds another layer of uncertainty.   The characteristics of feedstock to be used during testing must be rigorously defined.

Even though the gasifier (for example) contract may have been negotiated months before the construction contract, developers must ensure absolute consistency in the Design Point conditions.   If discrepancies exist, the lender’s diligence team will find them later, potentially threatening financial closing. 

Progress Payments

A classic mistake is to pay equipment suppliers and contractors too much, too early, thus removing incentives for timely performance.   Lenders also insist on good value for every progress payment made, so as to minimize losses in case the project goes bad.   Equipment suppliers, by contrast, want as much money as possible up front, and unless developers push back, they’re likely to be stuck with unfavorable terms.

One developer, seeking to ensure timely equipment delivery, pre-purchased a quarter-billion dollars of boilers, turbines and process equipment with payments tied to calendar dates.   When unrelated factors delayed the project, the developer faced ruinous progress payments or cancellation fees.   Had payments been tied to progress instead of time, this would have been avoided. Ultimately the project was never built, and the developer never recovered.

For major equipment, progress payments should fairly reflect the manufacturers actual costs and progress.   Heavy equipment manufacturers often base progress payments on large subassemblies such as turbine rotors and boiler steam drums, which is perfectly appropriate.   The same applies to the schedule of cancellation charges, which should also be pre-negotiated.

Progress payment and cancellation must be compatatible across all construction and equipment contracts.

Warranty

Beware of gaps in warranty coverage between the equipment contract(s) and the construction contract.   If a Long Term Service Agreement (LTSA) is also in place, the warranty picture gets even more complex. It’s wise to think through several “what if” warranty scenarios to ensure continuous coverage.   Is it clear who to go to in case of warranty claims?   What sorts of claims are covered by the equipment manufacturer, the construction contractor and the LTSA provider?   Are there coverage gaps as the equipment warranty expires and the LTSA takes over?

Action Plan

The common types of contract holes are well known to lenders.   Count on the lender’s engineer and counsel to lay the equipment and construction contracts side by side, brew a pot of coffee, and search for inconsistencies. They know exactly what to look for. Each hole they discover becomes an expensive emergency for the developer to fix.

To create the clean, consistent contract packages that lenders love to finance, start with these three steps.

  • Think like a lender and make clean, consistent contracts a top priority from day one
  • Beware the common types of contract holes discussed herein
  • Fix contractual problems as they arise

Lee Enterprises Consulting will be publishing a full series of articles on renewable fuels and chemicals financing later this year. Be sure to watch for them!

About the Author: Charles Loos is a member of Lee Enterprises Consulting, the world’s premier bioeconomy consulting group, with more than 100 consultants and experts worldwide who collaborate on interdisciplinary projects, including the types discussed in this article.  The opinions expressed herein are those of the author, and do not necessarily express the views of Lee Enterprises Consulting.

 

 

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