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Client Alert 05 Nov. 2020
The alert is available for download with footnotes here.
In these difficult financial markets, many financial institutions are battening down the hatches and substantially reducing their lending activities. This can be even more tempting in those markets where political and legal risks add to the difficulties faced by lenders.
However, lenders in such jurisdictions, particularly in emerging market jurisdictions, are well used to structuring transactions to mitigate the risks that difficult economic, political and legal environments generate. Such structures typically rely on the cash flows generated by the trading operations of the relevant obligors, and capturing these cash flows can often result in the creation of a lending opportunity where none would otherwise exist.
When lending against cash flows, lenders will typically consider two main categories of risk:
In addition (albeit with varying degrees of diligence depending on the jurisdictions involved in the transaction), lenders will also evaluate:
Of the many techniques that emerging market lenders have developed to mitigate these risks, one of the most enduring, and most popular, is the pre-export finance (“PXF”) structure. Such structures are increasingly being used outside the sphere of traditional “trade finance” with many borrowers seeing such structures as a way to raise additional finance in difficult markets in order to support acquisitions or other event-driven activities.
A typical pre-export finance structure
At its most basic, pre-export finance is simply secured lending to a producer of goods. The loan will be secured by:
This basic PXF structure can be complicated in any number of ways.
If commodity price (or interest rate) protection is required, hedging arrangements can be entered into (and assigned for the benefit of the lenders).
In addition, many PXF structures will involve an SPV-borrower set up for the sole purpose of the financing in order to avoid, for example, existing contractual restrictions that may apply to the relevant producer or to “move” the transaction offshore. Such an SPV will apply the proceeds of the loan made to it in prepayment for goods to be delivered to the SPV (by the relevant producer) under a primary delivery contract. The SPV will then on-sell those goods to final customers pursuant to secondary or final delivery contracts. Such structures are often known as SPV prepayment financings.
In this structure, the security required for the transaction is created by the SPV-borrower, and so could avoid any contractual restrictions on, for example, creation of security by the actual producer and any legal issues that may arise (in relation to the enforcement of security, for example) in the producer’s own jurisdiction.
Prepayment structures can also be entered into on a limited recourse basis to enable, for example, a commodity house to enter into a loan to fund a prepayment of goods to be delivered by a producer. In such a scenario, the commodity house may be unwilling to put its balance sheet at risk and, therefore, will want any borrowings by it to fund the relevant prepayment to be limited recourse to the security provided for the loan (although there will be certain exceptions if, for example, the commodity house has failed to perform its obligations under the relevant purchase contract entered into with the producer).
More commonly, sophisticated producers, particularly those producing commodities, will have their own captive trading entities. In such a scenario the PXF structure has to accommodate several contractual levels. For example, the producer (which will normally be the borrower) may sell goods to another group member (often known as the “trader,” who will, most likely, be incorporated in a tax-friendly jurisdiction). The trader will, in turn, on-sell those goods to other group members incorporated in relevant target markets (“local traders” or “local offtakers”). These entities will finally sell to the ultimate purchasers (final offtakers).
Such “triple-decker” structures, whilst more complex from a contractual perspective, retain the same essential factors and risks as the more basic PXF structure. As a result, for the purposes of this article, we will focus on the more basic structure, referring to more complex structures where required.
Mitigation of risks:
1. Production and delivery risk
In PXF structures, production and delivery levels are central to the trading performance of borrowing companies and, given that the essence of a PXF structure is that lenders are lending against the cash flow generated by that trade, it is clear that if the production and delivery levels fall, the lenders are much less likely to get their money back. As a result, production and delivery risk is fundamental to pre-export financings.
Examples of factors which contribute to production and delivery risk include:
The reliability of offtake arrangements (influenced, for example, by their duration and the level of commitment of the final offtaker) and the final offtaker itself.
How can production and delivery risk be mitigated?
From a structuring perspective, there is relatively little that can be done to mitigate production and delivery risk.
It may be possible for contractual prioritization to be incorporated into relevant delivery contracts so that any goods which are produced by the producer are contractually bound to be delivered under those contracts (as opposed to other competing contracts). This should help mitigate the risk that production levels drop and goods are delivered to another offtaker under a competing (and unsecured) contract.
However, comfort in the face of these risks is mainly provided by the lender’s due diligence (in relation to items such as the borrower’s production record, its reserve profile and reserve replacement record (if applicable) and its historical customer default rates). The involvement of trusted international players, whether as a supplier of necessary materials, operator of production facilities, final offtaker or minority shareholder, and the political or economic imperative (particularly in the context of commodities such as oil) for continued production can all increase the level of comfort that production and delivery will occur as required to repay any financing.
2. Payment risk
Payment risk is, of course, fundamental to all financings, and can appear in a PXF structure in a number of ways, including:
Additionally, foreign exchange regulations (for example, in Russia or Angola) may require that hard currency earnings be repatriated by the producer rather than retained offshore.
How can payment risk be mitigated?
As always, there is no substitute for a thorough credit analysis of the final offtakers. If their credit standing is not thought to be sufficient, appropriate credit enhancement, through the use of letters of credit or bank guarantees, is a common feature of PXF structures. The use of documentary letters of credit also ensures that any disputes in relation to compliance (or otherwise) with the underlying delivery contract supporting the financing (or indeed any other contractual arrangements between the parties) are divorced from the financing arrangements.
We have already mentioned that taking security over receivables and bank accounts is a key feature of PXF structures. Such security should, subject to local insolvency laws, be sufficient to overcome attachment risk.
Hedging is, of course, an obvious way to mitigate against fluctuating commodity prices and interest rates. However, hedging can be expensive and there will be a balance to be struck between the benefits of flooring a commodity price or capping an interest rate payment and the cost of doing so.
Attention should also be paid to the nature of the payment flows under the relevant derivative instrument; ongoing two-way payment flows can lead to a risk of termination by a hedge counterparty for non-payment. If ongoing two-way payments are unavoidable, hedging counterparties may also seek to share in security, which can substantially reduce the value of any security to the lenders.
A feasible alternative is the use (subject to offtaker agreement) of value-based, rather than volume-based, delivery contracts. Such contracts should ensure that sufficient quantities of goods are delivered to repay any underlying financing (provided, of course, the value specified in the delivery contract is sufficiently high to cover any increased interest payments arising from increased interest rates).
3. Political risk
The importance of political, or country, risk will, of course, depend on the jurisdictions involved in the transaction. Again, there is no fail-safe structural solution, although, as already mentioned, lenders will often take comfort from the political or economic imperative of continued production of the relevant goods.
Having said that, governments can, and often do, enter into contractual undertakings in relation to matters of concern to lenders (such as non-interference in production) if the relevant assets are of strategic or political importance. The involvement of multilateral financial institutions or export credit agencies also often provides comfort to lenders (due to their perceived increased political influence).
Political risk insurance (either from an export credit agency or a private insurer) may also be employed to mitigate political risk, although concerns about cost and the perceived difficulty of making successful claims (given general insurance principles such as the duty of utmost good faith) ensure that such insurance remains a relatively rare feature of PXF structures.
Most important, however, in the mitigation of political risk is the use of the PXF structure itself. As we have already seen, payment risk can be moved from the borrower (and its jurisdiction of operations) to the final offtaker, who will usually, if goods are being exported, be located offshore and who will, subject to applicable foreign exchange regulations, be able to pay offshore. As a result, the simple use of a secured offshore collection account is often sufficient to provide the necessary comfort. In particularly problematic jurisdictions, the use of an offshore SPV prepayment financing can also help mitigate against country risk.
4. Legal risk
The level of perceived legal risk will also vary from jurisdiction to jurisdiction. However, the main legal concerns are common to all jurisdictions and include:
How can legal risk be mitigated?
Again, one of the key weapons against legal risk is due diligence. Before a risk can be dealt with, it must be identified and there can be no substitute for thorough knowledge of local laws and their potential practical application. Often the act of taking effective security will be sufficient to mitigate against these risks, although, in some circumstances, it may be necessary to adopt an offshore SPV structure in order to ensure that the risk profile of the deal falls within acceptable boundaries.
Due diligence is also key in understanding any existing contractual restrictions that may impact on the relevant transaction. Once these are identified, they can either be structured around or, if necessary, consents can be sought and obtained.
Finally, the choice of law, and of lawyers, is fundamentally important to the mitigation of legal risk, particularly in emerging market jurisdictions.
Lenders involved in PXF transactions clearly face a number of varied and unpredictable risks, some of which can be mitigated better than others, but none of which can be completely avoided. What is certain, though, is that limiting risk exposure, to the extent possible, to that of production and delivery risk is key, and that well-structured deals are far more likely to survive market fluctuations. Provided that the underlying receivables can be generated, a true PXF structure should be self-liquidating (if other appropriate structural features are included) and that could turn out to be a key selling point in today’s markets.
Attorney advertising. The material contained in this Client Alert is only a general review of the subjects covered and does not constitute legal advice. No legal or business decision should be based on its contents.
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