JLS Capital Strategies, LLC

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Your Project’s Just Not Into You

I have been struck recently by a large 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 isn’t surprising, given chronically low oil and commodity prices, which have just dropped again.  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 want to continue as they were.

Some may characterize this behavior as a form of insanity according to a popular but misused definition of doing the same thing and expecting different result. But this behavior is very understandable.  In my experience, problems facing the majority of projects are not a result of poor development and financing strategies, but rather weak markets, force majeure events, bad luck, etc. And if this is the case, why change?

This behavior, however, 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 towards 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 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 signs or 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’ve found “the spark”.  Anyone who has ever seriously pursued a project has done so because they believe in the project concept, its economics, and that this promise will bring about success.  

While excitement about and commitment to a project is 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’s development, funding, and repayment.  When things do 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’re out of money, You’re out of the Project

Most projects that encounter impasses early on are those with sufficient capital to get started with the rest “on the way”. The hope here is that the initial undertaking will sufficiently demonstrate to the world that the Project IS happening and WILL happen. Most lenders won’t (or shouldn't) finance without 100% of committed equity supported by an approved credit, in which case the premature start becomes just that – with no debt to continue.  But even if lenders do commence financing, they are likely to halt funding in order to avoid uncapped exposure if the equity money doesn’t show up.

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, often with hopeful refrains like this:

“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. (Though, most hopeful sponsors talk anyway)

“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--which are satellite capacity sales whereby 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 sufficient funds, which was the problem in the first place.  

If several years have passed, the rest of the money still hasn’t shown up and productive negotiations have long since ceased, there is no reason to think it will all turn around tomorrow.    We will talk about where to go from here in the concluding section.

If You Can’t Complete Phase I, It Isn’t Time to Plan for Phases 2-10.

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 several projects, right? Such 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? In writing this article I have found several websites and ventures devoted to showing how small projects can be transformed into larger and potentially additional projects– but alas, these websites do not show tangible evidence of success.

There is a reason for that.  Projects do not have an inner essence that can be duplicated as easily as paper. Project site conditions, off-taker circumstances, regulations and everything else is subject to change, and even if they weren’t, seed money can’t be turned into long-term equity money any more than straw can be spun into gold.  Best to stick with Phase 1. 

If Lender and Sponsors interest 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, and the sponsor loses interest in project success. 

When interests do 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 use 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 they don’t generate dividends. 

The problem is how to move on.  Lenders are loath to enforce security and change sponsors, which is not a good idea if the sponsor is well-positioned to make the project a success. Often, changing sponsors fails to re-align interests and only exacerbates the problem.  But, if interests cannot be re-aligned with the current sponsor or if there are genuine problems with the sponsor group, it’s time to “change horses”.  Here are a few tips on how to discern how to move on. 

A Counter-Party is Conspiring Against You is DEFINITELY Not Into You.

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 lender-supported mine plan. 

Lenders are usually not so slow in picking up clues. On a different mining deal, an inexperienced sponsor wasted considerable funds on poor mine planning and imprudent spending—all of which clearly demonstrated a lack of good faith and commitment, if not outright conspiracy.  Fortunately, the project documents facilitated an easy 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 behavior.  Fortunately, the sponsor was “corralled” early during operations– new equity ultimately came in to prepay debt.

Follow the Money – ALL the Money

As a rule, project finance lenders – especially 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 between shareholders and project management—rarely front-line lending issues.  One can understand why these details are overlooked – these realities obscure the thrill of the deal.

I recall a large U.S. 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

 When things go wrong, most parties spend an inordinate amount of time investigating what happened.  While a root cause analysis may be valuable, it is not essential. In most cases no one is to blame. Weak markets, force majeure delays, or detrimental actions of the host government--usually the fault of no one-- don’t reveal anything about the character and ability of the sponsor or how best to fix things. 

The key question is who can fix things.  In a power project in Indonesia--when the government threatened to cancel the project—the sponsor was best suited to do so given its political skills and the fact that lenders are usually poorly placed to run the project. The solution was to reschedule PPA payments, requiring the sponsor to accept higher mandatory debt payments in exchange for reduced cash sweeps.  The sponsor’s willingness to “hang in there” to get its dividends under the restructured financing was key to resolving the issue.

The same is generally true in most market-driven projects, such as satellites, where sponsors have specialized skills to sell to target markets.  Lenders may be able to hire consultants to inform them of such issues, but it’s important to note that they are ultimately in the business of lending, not sales. Getting new parties to come in to sort things out is also difficult.   If possible, and where there are no signs of sponsor conspiracy, lenders’ interests are generally served by restructuring incentives to motivate existing sponsors to make those sales.

To know where to go, Know Where You Are.

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 main challenge facing parties doing so is to understand correctly current circumstances and discern what to do given those circumstances.  That means forgetting about a lot of things that project developers and sponsors justifiably hold dear--like millions of dollars in equity investments and loan disbursements--or more likely, tens or hundreds of millions of dollars. 

Economics 101 taught us all that these are sunk costs that are irrelevant to current decisions, but NO ONE should try to tell someone who is out millions of dollars that it doesn’t matter. The money 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 their ledgers, which is indeed irrelevant. That focus leads to unproductive, loss avoidance strategies.  The focus should be on assets, value, and a very different deal orientation.

Loss avoidance leads us to stay the course and avoid rocking the boat, and to at least three foibles.

#1 - Laser focus on primary lending option - that’sthe best one.

Gives lenders 100% leverage. If it doesn’t work out, a long process hurts market perceptions and value of alternatives.

#2 - Keep saying yes to demands. Lenders will be happy and lend.

Creates perception of desperation and confirms negative perceptions. Lenders may be suspicious sponsors aren’t paying attention.

#3 - Be patient, stay the course, hope for the best

Not a strategy but a prayer.   Hail Mary’s are for Roger Staubach. 

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 having a laser focus on the primary deal (Foible 1), one needs to turn the other way and assess realistic alternatives.   Perhaps the value of a sale to another company or a scavenger fund 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 those concessions are dear, to the extent they result in a deal that is better than alternatives, they create additional value.   The value of alternatives defines when one should stop saying yes to everything (#2), and maybe that helps enhance one’s credibility. 

What matters is the value of one’s investment, and how to use that value as leverage to get the best deal possible.  The focus on the value of alternatives leads to the best deal possible, and ultimately to deal completion.

Ironically, no one focuses on the value of alternatives because they may represent inconvenient truths that no one wants to face. The value of project development (sites, permits, contracts, construction, etc.) is likely less than the cost of development –not what developers want to hear.  If the project is really stuck, it may be that the best option is to sell the project to another party at a loss – which is REALLY not what a developer wants to hear.  For lenders in the case where some debt funds have been advanced, it’s the same.  The lender’s interests may be best served by taking 50 cents on the dollar rather than losing everything – again, not something that lenders want to hear.

In this equation, one party’s value includes a counter-party’s potential loss.   A lender may be willing to grant concessions if it minimizes debt write-offs.  A lender may expect a borrower to accept lower returns if that’s better than lost investments.  This talk of losses is again not what one wishes to hear.

Regardless, a realistic assessment of the facts about one’s circumstances is always better than reliance on hope and prayer for to what one wants – to recapture the spark (#3).  Funds are rarely extended for the deal one wants to have but rather on the deal one actually has.  That is the only way to pick up the pieces and move on.

 

 

 

 

 

 

John SchusterComment