INTRODUCTION TO CREDIT ENHANCEMENT IN PROJECT FINANCINGS

In theory, a project financing can be structured in which there are no risks and the lenders are content to rely solely upon the revenue-producing project contracts to service debt. In reality, of course, the discussion of project finance risks described in Chapters 2, 3, and 4 evidences that mere reliance on those contracts is insufficient to protect the lender from equity risk. Credit support, or enhancement of credit as it is sometimes referred to, from a creditworthy source is necessary.

The purpose of credit enhancement is to improve the most severe equity and lender risks in a triage of project financing risks identified. Depending on myriad factors, the requisite support can take the form of direct guarantees by the project sponsor or the project participants, guarantees by third parties not directly participating in the project, and in some cases contingent guarantees and so-called moral obligations of the project participants.

The most obvious type of commercial risk in a project financing is the risk of nonpayment of the project debt. Commercial risks must generally be covered by credit support of the project sponsor or a responsible third party. Although the project sponsor is conceptually the fundamental risk taker, the nonrecourse nature of a project financing limits the ability to allocate risks to the sponsor. While a sponsor may be asked to accept directly some risks, it most likely will also be asked to provide additional equity contributions upon certain specified events, and to provide credit enhancement in the form of insurance, third-party guarantees, or letters of credit in others.