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National Banking Law Review
February 2014 Volume 33, No. 1
3. Does internal audit have sufficient standing
and authority not only to carry out their responsibilities but also to have their evaluations and recommendations heeded?
of transactions, corporate matters, and regulatory issues.
Koker Christensen is a partner of Fasken
Martineau DuMoulin LLP and Co-chair of the
Firm’s Financial Institutions Group. He advises
financial institutions on a wide range of transactions, corporate matters, and regulatory issues.]
He concluded by saying OSFI will have increased focus on behaviour and risk culture not
just on rules being followed.
[Editor’s note: Robert McDowell is a partner of
Fasken Martineau DuMoulin LLP and Co-chair
of the Firm’s Financial Institutions Group. He
advises financial institutions on a wide range
1
International Institute of Finance, Reform in the financial services industry: Strengthening Practices
for a More Stable System” (2009), 31.
• THE INS AND OUTS OF INTEREST RATE SWAPS IN PROJECT FINANCE •
Simon Williams, Torys LLP
But what do we mean by “project finance”? In
contrast to traditional debt financing where a
lender advances funds against the strength of a
borrower’s historical revenues or asset strength,
in a project financing transaction, the loan is
made against the future cash flows expected to
be generated by the project once it has been
completed.
This article aims to provide a high level primer
on the ins and outs of interest rate swaps as they
are used in project finance deals. We begin with
a general overview of the project finance market
in Canada and a look at how these deals are typically structured, with a focus on the management of interest rate risk. Moving beyond the
commercial aspects of project finance interest
rate swaps, we will then turn to the key principles underpinning the negotiation of an ISDA
Agreement, being the legal instrument of choice
governing the hedge arrangement for the vast
majority of these deals.
The unique structuring of a PF deal is driven by
a unique set of risks inherent in the construction
of a project. Whether it is the construction of a
privately sponsored wind farm or the commissioning of a new hospital by a government
agency, the design and construction of a project
is often an expensive proposition where the
lenders must put their faith in their ability to
effectively mitigate and allocate project-specific
risks to the appropriate transaction participants.
For these reasons, project finance deals are usually characterized by the following hallmarks:
Project Finance Overview
Project finance (PF) is alive and well in Canada.
In 2012, there were 16 published project finance
deals completed in Canada, representing nearly
$9 billion worth of debt financing.1 Through the
first three quarters of 2013, 17 published deals
were completed representing over $5 billion
of financing.2 On a sector-by-sector basis,
80–90 per cent by deal size fell within
the power, oil and gas, and transportation areas.
1. they are highly leveraged with debt-toequity ratios often falling in the 80–90 per
cent range
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February 2014 Volume 33, No. 1
and interest are the revenues generated by the
project (more specifically, by the SPV borrower) pursuant to an offtake or similar agreement.
Thus the amount of the project borrower’s income is effectively fixed per the offtake agreement, meaning that any increase on the expense
side of the ledger will squeeze the amount of
cash available to service the project loans. Loan
principal often reaches the tens or hundreds of
millions in PF deals, so a rise in interest rates by
only a few basis points can easily balloon a project’s expenses.
2. they are financed and developed off the
balance sheet of the sponsor through a special purpose vehicle (the SPV is capitalized
by the sponsor before the loans are made to
the SPV, being the project borrower, and
the SPV is the entity that owns the project
assets and signs the project contracts) because of the large debt liabilities and complex risk management associated with them
3. they involve some manner of revenuegenerating plant or structure being built
4. they are typically structured in two phases:
Consequently, in order for the sponsors or other
equity stakeholders to preserve their expected
return on investment, project expenses (including
interest rate costs) must be managed accordingly.
Typically, the borrower will manage its interest
rate exposure by employing an interest rate swap.
The economic result of the interest rate swap is to
convert the floating rate of interest payable by the
borrower to the project lenders into a fixed rate
payable to the swap providers (usually the derivatives branch of the same banks providing the
project loan).
a. a construction period where loan funds
are needed to pay the builder but no
revenues are being generated
b. an operating period beginning once the
project has been built where no further
advances are needed and revenues
should be available to repay principal
and interest on the project loan
5. the related project loan agreements are
covenant heavy such that the Borrower
lives and breathes to complete the project,
generate revenues, and repay the loans with
interest
To illustrate, consider a hypothetical example of
a $100 million solar project that will take one
year to build and will be financed with $10 million in equity (contributed by the sponsor at
closing), with the balance of $90 million funded
by the project lenders over the construction period. A borrower looking to secure long-term
project financing such as this would be highly
motivated to lock-in a fixed rate, especially in
today’s low-interest-rate environment. Once the
solar plant is operational and revenue positive,
the loan converts from a construction loan to a
term loan with a maturity of ten years from the
completion date. During the operating period of
the project, the borrower will be required to
make quarterly payments of both principal and
Interest Rate Risk
Broadly speaking, the project-specific risks referred to above may be characterized as commercial risks (encompassing completion risk,
operating risk, revenue risk, and environmental
risk, to name a few) or financial risks. For a project that is both developed and funded within
Canada (the most likely scenario), the most significant financial risk is interest rate risk. That is
the focus of this article.
Interest rate risk is a major consideration in project finance deals because the only source of
funds available to repay the lenders’ principal
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February 2014 Volume 33, No. 1
interest on the term loan based on an 18-year
amortization schedule (resulting in a residual
principal balance at maturity that must be repaid
or refinanced).
rate (prime) from the swap dealer, which the
borrower effectively flows through as an interest payment on the term loan to the project
lender. A key element of a swap arrangement is
that the fixed and floating rates are netted, resulting in only one cash payment payable by the
party obligated to pay whichever happens to be
the higher of the two rates at the time. That is,
so long as the prime rate is lower than 4.5 per
cent, the borrower will owe a quarterly net
payment to the hedge provider. If prime moves
above 4.5 per cent, the borrower will receive the
difference from the hedge provider.
In these circumstances, a project borrower with
a reputable sponsor standing behind it might be
able to secure loan financing from a bank at the
bank’s prime rate plus a credit spread of 2 per
cent per annum. Assuming the prime rate is currently 3 per cent per annum, the all-in interest
rate payable by the borrower would be 5 per
cent per annum. Because the prime rate is a
floating rate and therefore subject to change
with the macroeconomic environment over time,
the all-in interest rate would fluctuate commensurately with the movements in the prime rate.
Given that interest rates are near historical longterm lows, the market interest rate is likely more
liable to rise than fall over the ten-year life of
the term loan. Rather than risk what could become an interest rate of 7 or 8 per cent in five or
six years from now, the borrower decides to fix
its debt service costs by entering into an interest
rate swap under which the borrower pays a
fixed rate of 4.5 per cent to the hedge provider
for a ten-year period (matching the term of the
underlying loan). In order to sync up the loan
and swap cash flows on each quarterly payment
date, the swap must also match the size of the
loan. Accordingly, the notional amount of the
hedge will initially be $90 million (the starting
balance of the term loan upon conversion from
the construction loan) and, from there, will
ratchet down quarterly in line with the amortization schedule of the term loan.
From a risk mitigation perspective, by entering
into an interest rate swap the borrower is trading
short-term upside for long-term certainty: the
borrower will pay 4.5 per cent per annum regardless of how much interest rates rise or fall
over the ten-year life of the loan, but the price
for that financial insurance is the premium
baked into the 4.5 per cent fixed rate offered by
the hedge provider (being higher than the prevailing prime rate at the time the swap is struck
at closing, or 3 per cent in our example).
In terms of credit risk profile, both the lenders
and the hedge providers rank equally in respect
of collateral security and priority of payments:
each sharing ratably as a first lien creditor with
loan payments (principal and interest) and swap
payments (net scheduled payments and applicable breakage costs) having equal status in terms
of payment priority (both as to timing and
amount). A key distinction between the relative
rights of the lenders and hedge providers,
The cash flows under the swap and loan are illustrated in the figure below. The Borrower
pays a fixed rate (4.5 per cent) to the hedge provider (a swap-dealer affiliate of the project
lender), and the borrower receives a floating
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however, is that all voting decisions (including
whether or not to waive or enforce a default) lie
solely with the lenders.
ISDA Agreement contains a much sparser suite
of reps, covenants, and events of default by virtue of the form being designed to be of generic
application and, in the context of interest rate
swaps, governing a purely financial arrangement (the exchange of fixed and floating
payments). To contrast the two documents by
numbers, the 2002 ISDA Master agreement is
less than 30 pages long, whereas it is not uncommon for a project loan agreement to reach
130 pages.
Negotiation of the ISDA Agreement
As noted earlier, interest rate hedges for project
finance deals are customarily documented
under an ISDA Master Agreement. At its core,
the ISDA Agreement creates a framework for
fixed and floating payments to be netted and
made between the two hedge counterparties. It
sets out the rules governing how and when those
payments are to be made, whether collateral
must be posted by one or both parties, and how
breakage costs are to be calculated in the event
the swap is terminated (by a party defaulting or
otherwise) before the scheduled maturity date.
Ancillary to that, the ISDA Agreement contains
many of the same contractual elements one
would expect to find in a traditional loan
agreement, such as reps and warranties, positive
and negative covenants, and events of default.
In negotiating the loan agreement with the lenders and the ISDA Agreement with the hedge
provider, the borrower will want to ensure that
it is not subject to two parallel but differing contractual regimes. For example, the borrower
may have negotiated a cure period right with the
lenders in the loan agreement in respect of
the borrower’s performance under an operation
and services agreement. The ISDA Master
Agreement, however, contains a cross-default
provision that might otherwise be triggered immediately upon a default by the borrower under
a third-party contract.
A borrower arranging project financing with an
accompanying interest rate hedge will be required to enter into two principal finance documents: the loan agreement pursuant to which the
project finance loan is made and the ISDA
Agreement pursuant to which the borrower
hedges the interest rate risk deriving from the
underling project loan.
The solution to the potential inconsistency between the loan and ISDA agreements is relatively simple: (1) the events of default under the
ISDA agreement should be disapplied as they
relate to the borrower and (2) the events of default under the loan agreement should be incorporated by reference into the ISDA agreement.
This prevents the “tail wagging the dog” so to
speak, by effectively neutering the hedge banks’
enforcement fights under the ISDA Agreement,
with the hedge banks ceding all enforcement
decisions to the project lenders. It is for this reason that the project lender and swap provider are
usually the same entity or an affiliate, as the
hedge desk will be relying upon its lending counterpart to make decisions that reflect a holistic
Given the risk profile of a project financing and
its highly structured nature, project finance loan
agreements are often very long and highly negotiated documents. Lenders will often impose a
comprehensive regime of conditions precedent,
reps and warranties, covenants, and events of
default on the borrower. Many of these provisions will need to be specifically tailored to reflect the nature of the particular project being
developed. By contrast, the standard form of
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February 2014 Volume 33, No. 1
consideration of the financial institution’s interests, both as a lender and hedge counterparty.
operational phase, whether the sale involves a
minority or controlling interest, and whether the
creditworthiness and experience of the proposed
assignee are acceptable.
In a similar vein, legal counsel will want
to ensure that the ISDA Agreement dovetails
with the provisions of the loan agreement in
other respects as well. A case in point is the assignment provisions of the loan agreement
relative to the transfer rights under the ISDA
Agreement. Given that the fixed rate payments
under the hedge are modeled on the corresponding principal amount of the project loan outstanding at a particular time, generally speaking,
assignments of the loan will be accompanied by
corresponding transfers of the interest rate swap.
In terms of substantive legal rights, the default
provisions of the ISDA Master Agreement permit either swap counterparty to transfer its leg
of the swap with the consent of the other party.
In contrast, the assignment provisions under a
project loan agreement are often highly negotiated, particularly in respect of the borrower’s
right to assign its interests in the loan and project. For example, the conditions under which a
project borrower is permitted to assign the loan
will often be driven by such considerations
as whether the project is in construction or
To summarize, negotiating a project finance
deal requires careful attention by counsel to ensure that the respective rights and obligations
of the borrower, the lenders, and the hedge
providers are carefully considered and appropriately reflected in both the loan agreement and
the ISDA Agreement to ensure consistency between the two documents.
[Editor’s note: Simon Williams’s practice focuses on corporate and structured finance law.
Simon has experience representing banks, hedge
funds, institutional investors and other market
participants with various debt offerings, and
structured finance and derivatives transactions.]
1
2
18
Thomson Reuters, Project Finance Review: Full Year
2012, <http://dmi.thomsonreuters.com/Content/
Files/Q42012_Project_Finance_Review.pdf>.
Thomson Reuters, Global Project Finance Review:
Managing Underwriters, First Nine Months 2012,
<http://dmi.thomsonreuters.com/Content/Files/3Q201
3_Global_Project_Finance_Review.pdf>.