When My Base Case Is Your Worst Case

Last week, a friend who is not a credit professional asked me to review a loan agreement. The lender and borrower, who shall remain unnamed, were unknown both to me and each other. Their meeting was brokered via social media.

I obliged my friend, not because I’m nice; but because somewhere, buried in the deal docs, there is always a hidden credit gotcha: an intellectual itch to scratch, a problem to fix, or if it can’t be fixed, a cautionary tale to share.

Summary of Key Terms:

The loan agreement itself was thin, more like a term sheet. The term sheet is the deal’s key terms, in a section of the prospectus that has borders.

Party B, headquartered in the U.S., seeks a loan of $250 MM to build out a new (“greenfield”) energy project with a superior green technology on a site in their state that they consider ideal. The construction phase is expected to take 3 – 3.5 years. Operations should be cashflow-positive by the beginning of Year 6.

Party A, an offshore investor, will commit $250 MM for a ten-year period with interest due annually at 3% with no penalty if Party B prepays. A has the right to convert the bonds to shares at 80% of the sale price if B sells a majority (>50%) to a third party prior to the loan maturity date.

But A stipulates that before disbursing the loan, they and B must pledge collateral agreeable to both, for conveyance to an SPV for the benefit of A until the loan is repaid. If A and B fail to agree on the collateral within 90 days of when the agreement is signed, it will terminate without notice or further obligation. B will pay A $17.5K to front the cost of the SPV registration.

Both sides represent and warrant that they have the authority to transact. Both sides agree to abide by the terms and conditions of the loan agreement or it is an event of default. Governing law is the law of the land where A is headquartered.

Where’s The Gotcha?

These recitals are not massively informative. They contain no substantive details about the project that generate funds to repay the loan. It makes sense to dig in by asking a fundamental question: Where’s the deal?

Since a loan is a credit instrument, and we don’t have many numbers to run here, the intent must be hidden in the little information provided, or in the information withheld. To suss out the intent, I reorganized the disclosures along the lines of the 5 Cs, and found the following:

People have character—projects have feasibility. But to find out if the project is feasible, it makes total sense to look at the transactors’ motivations and capabilities.

First, some obvious capacity challenges: A and B are strangers. They operate 8,000 miles apart, in different countries with different cultural assumptions. Can they see eye-to-eye enough to keep the deal on track?

Does A have prior experience or familiarity with the types of risks the Project Company is likely to face? More troubling, does B have practical experience negotiating and managing Engineering, Procurement and Construction (EPC) contracts for greenfield projects? green energy technology?

The governing law is in effect where A operates. What does B know about A’s laws, which are very different from its own? If the deal fell apart, how would it unwind? Has B even considered finding out whether it is legal for A to lend to B? Plus, the construction site is in the U.S., where B operates, and where property rights are controlled by state and U.S. federal law.

Once we probe the conditions necessary for this deal to work, the potential for jurisdictional conflicts becomes all too obvious. And we have not even begun to probe potential risks coming from the technology, its fundamental feasibility and rollout.

The loan agreement gives short shrift to capacity and conditions but is focused on capital and collateral factors.

This is a non-recourse project financing where A looks to Project value to get repaid and has no rights in B’s existing property. Party A seeks a lien on the Project Collateral because this is a standard project financing, not a corporate loan to B. Otherwise, A could demand recourse to B’s property.

Yet prima facie, the agreement is much more like a corporate loan than a Project Loan. No reference is made to the contracts for the Project Build; and B is not responsible for the Build. B’s capacity to do more than agent the project is not discussed.

As for the capital sum, it is not large as project loans go, but A seems taking it all down, which is a bit unusual for a project financing. There is no way to know if A will syndicating it on the back end.

Even odder, the loan is for 100% of the stated Project face value with no requirement for overcollateralization or Project equity as conditions precedent to funding. In light of these glaring financing and operating risks, the low interest rate quoted (3%) makes no financial sense at all.

It is a strange deal. For both parties. Possibly a non-deal.

Why would A or B waste time and resources on a non-deal? Maybe because there are very few real deals in proportion to the non-deals (dreams) in the world, making the latter a way to make money (schemes) if the inertia is low enough.

Who’s Scheming Who?

To find the answer, follow the money. The Loan Agreement is very specific about one thing. Did you catch it? Let’s replay in reverse order:

B must pay A upfront $17,500 to cover the SPV registration fee. If, within ninety (90) days, A and B fail to agree on the collateral to be pledged, A gets the $17.5K scot free.

That’s the real deal.

$17.5K is a relatively expensive SVP set up cost for a deal that may not happen. Probably, A does not believe in the Project, or B. But if B believes enough in the dream to pay up, A can fail to cooperate and wait 90 days for a payout. Low inertia.

We don’t know—we’ll never know—the final recipient of the $17.5K. Could be A. Or a lender to A. Maybe it’s a Bum-in-the-Middle. It’s not a lot of money—but it’s effort-free, risk-free, and best of all, B just might agree to it.

This is the interpretation I consider most likely because it’s the most straightforward. But there are other scenarios to consider:

Maybe A sees value in the Project, but not in B. The next condition is if B negotiates in earnest for the collateral, then maybe A will too. If A and B reach an agreement, then A will control the collateral. If B fails to perform, then A can seize and monetize it. If A has misjudged B, and the Project Company attracts a majority shareholder before the loan matures, A can exchange the debt for equity with a 25% kicker from Party B (1/0.8).

A’s Worst Scenario Is B’s Base Case

And that means, in substance this is not a loan agreement but a real options trade.

Credit is finance’s only win-win instrument. The base case is meant to be structured for both parties to come out ahead. The only way it does not transpire is when they fail to fulfill the promises to one other. By contrast, options are zero-sum games. Initially they may appear fair to both parties, but the endgame is structured to produce one winner and one loser.

Based on the information available, it is also not clear that real options are at stake here, as we do not know who ultimately would provide the funding and who would deliver the goods.