IGF Guarantee Safety and Security

Non-traditional use of assets as short-term security leverages private capital to generate liquidity and long-term benefits

Asset owners often ask us “is this safe?” In practice, using assets in this innovative structure, there will be no reason to call any guarantee. The asset owner can be held harmless, and to do otherwise would be a moral hazard, in our view, as the security brought by IGF is arm’s length to the project’s funding, and cannot be used for any other reason than project completion assurance, their singular purpose.

By contract, the third-party guarantor will have zero responsibility for the project developer’s behavior, so even in extreme cases of project developer fraud (if they abandon their duties, leave town, etc.), the guarantor would be able to exercise granted step-in rights within a new ownership structure.

No developer has ever done this, of course; why would they give up on their own project having come that far? This discussion is about potential risk exposure, however, and not evaluating the actual risk of any undertaking, which is left to the involved parties once duly informed.

This investment model (called “Completion Assurance Program” or CAP) has been proven over several decades to solve multiple issues with mid-market project finance, and thus delivers advantages for all stakeholders. In fact, the role of a guarantor is extremely low risk, and generally worthwhile with a diverse array of motivations and upside benefits.

Understanding the IGF Structure

The security deposit structure is perhaps closest to the practice of asset “hypothecation” with no transfer of title, possession, or ownership rights, nor to the income generated by the asset. Hypothecation is a security arrangement. In this case, IGF asset owners provide short-term security, what we call Completion Assurance. The

point is that assets are not providing traditional hypothecation nor a traditional guarantee. Hypothecation functions as a form of internal credit enhancement, with In3’s funding bank, because:

• It reduces loss given default (LGD)
• It reduces funding risk exposure, enabling better terms and holding the involve parties accountable
• It improves expected recovery rates.

If the unspeakable were to happen (default by the project developer), it then provides asset-backed recovery value in the form of the project itself, enabling another team to step in to finish and deliver the project, or other measures. Even this highly unlikely scenario does not put the hypothecated asset at risk. Other solutions are available. This “securitized” position is also why the security is not equivalent to a guarantee.

Hypothecation has certain characteristics in common with “credit enhancement” (the funding leverages lines of commercial credit and holdings), in this structure, more internal credit enhancement (with the funding bank) and is somewhat similar to insurance, such as completion bonding, but also with important differences within the IGF structure including

• much shorter timeframes
• the fact that there is no loan or credit involved (our partner’s investment upside is based on long-term cash flows, not from time-based interest income), and
• there is no insurance company’s “product” or insurance underwriting involved.

Additionally, there are several other mitigants to the risk of default in this structure, such as

• The availability of the project’s physical assets (typically unencumbered by any liens)
• Monitored monthly draws of capital into the SPV bank account to build and commission projects
• A powerful counterincentive to letting any breach or issue go unresolved, putting the developer’s own investment of resources (capital, reputation, and their own equity “skin”) in serious jeopardy ….

This last point provides accountability that has resulted in successful, operating project assets generating cash flows and other upside for the beneficial owners not to mention the positive impacts of job creation, improved ecosystemic functions, etc.

This approach is also dissimilar to insurance because the security is a financial instrument, involving banks and customary methods like Brussels SWIFT or a custodial account for cash, and thus not an insurance product at all. (Insurance has its place, sometimes to hold EPC/GC firms accountable to their agreements (bonding), or “performance wraps” for product quality and quantity once operational, for example.)

We handle and allocate risks differently. Instead of transferring the risk of non-completion to an insurance company, for example, we hold the guarantor harmless while the funded company works out issues that arise with their project team (EPCs, General Contractors, vendors or land lease providers), serving as a form of accountability to deliver the operating project. Other forms of insurance are often used for ensuring operational performance — producing adequate quality and quantity in value per pro forma financial projections — but a CAP funding security deposit is going to be released before the project begins commercial operation, so the sponsor (asset owner) will be safe and secure, able to move on to the next transaction, or with underlying assets returned, no matter what.

What does “hypothecate” usually mean?

Hypothecation is normally about using specific assets as security — a structure where an asset is used for a period of time, again, without giving up title, possession, or ownership rights, such as the income generated by the asset. The underlying assets can be either movable or immovable, which affords diverse types to constitute value (as perceived by our bank for their demand guarantee or “standby” LC, or as part of a syndicated debt pool), from rated bonds and buildings to public equities and many more assets of value, as may be preferred by IGF participants.

Hypothecation is subtly different from pledging an asset in the sense that, with hypothecated assets, its possession stays with the owner, while a “pledge” is more typical for movable assets like jewelry, artwork, or gold, and when used as a loan’s collateral, for example, the borrower physically transfers the asset to the lender. That’s not happening here with non-cash assets.

How does that compare to “credit enhancement”?

Credit enhancement is a broader concept that includes various techniques (including collateralization, such as via a lien, or a loan guarantee) to improve creditworthiness. But in the IGF structure, the asset’s hypothecation generates additional liquidity for its owner, used shorter-term, limited to the period ahead of construction completion, typically just prior to the start of project operations, and thus sharply different from a mortgage, lien, or assignment (ref) of an asset.

Note that some guarantors will have sufficient financial depth that no specific collateral will be needed. This is best determined in practice, as part of contractual arrangements, by asking our bankers for their specific feedback on an IGF client’s financial statement or similar method.

Further, with IGF and In3 Capital (CAP) funding, there is no senior lender, nor would our funder (via a Joint Venture equity partnership) or our bank need to seize the asset if the terms of the investment agreement are not met.  Such “uncured” default (breach of investment contract) would be solved some other way. This is part of an innovative structure where the fundamental mechanisms are subtly different and deserve full understanding.

Security Deposits (not Downpayments): Duration key to CAP’s difference

The vast majority of the time, the guarantee backed by the asset(s) will have been released by the time the project is operational. Given that the Standby Letter of Credit (SbLC) and other bank instruments are usually annual instruments, renewed until the Commercial Operation Date (COD) milestone has been reached, they are then allowed to expire on their maturity date. Rarely, there could be a few months of overlap — the project begins operations quickly while the SbLC had months left before expiration.

But that detail aside, the underlying purpose is the same with an SbLC as with other instruments: all stakeholders are incentivized to work together to finish the project’s construction and commissioning to begin commercial operations, at which time the guarantee is allowed to expire and is released/returned.

How is this safe to the sponsor/guarantor, exactly?

Why would we or the bank not seize the underlying assets if the project developer failed or faltered in their role as developer? Because, history shows, we would solve any breach of the funding contract some other way. We have a strong counterincentive to doing so:

• We have never had to call such an instrument in our entire history, and do not want to start now, ruining our hard-won reputation
• Calling an instrument would be a negative reflection on us, in the eyes of our bankers.
• There’s simply no reason to … even with blatant failure or fraud by the developer, their default would result in asset preservation as they were replaced.

Even in this unlikely event that project developer breach did occur, following a lengthy cure period, the developer would have effectively opted out of their project’s ownership rights, leaving room for a different party to finish and/or co-own the project(s).

If the project could not be completed, for some reason, after all explored avenues had proven dead ends, the guarantee would be assigned to a different project — one that could be finished.

Although the legal right to “call” the guarantee must exist (otherwise it does not offer the required security for our funder’s contract with their bank), there are no situations where the guarantee would need to be called. Any third-party guarantor that did not cause the developer’s default (presuming the asset owner did not interfere with reaching Commercial Operation Date) must be held harmless in any case, thus step-in rights would be offered, and exercised, to make them whole.

In any worst-case scenarios, such as a developer who simply gives up on their project (as unlikely as that is), “opting out” would mean that the project developer deliberately abandoned their own project, and being unavailable or disinterested (or both), could be replaced through equity ownership restructuring. Our funding partner holds the project’s equity in escrow during the construction, as that is cleaner with one owner, then converts to the proportionate and agreed-upon SPV equity split upon completion. This means we can enforce the rights of the parties that remain involved.

Other Scenarios to resolve contractual breach by the project’s developer

• If the contract was breached before funding began to flow, the transaction would simply be unwound, and the underlying guarantee returned or released.  We cannot think of any reason why anyone would do that, having come that far, with signed and notarized funding contracts in place, but this discussion is about safety to the guarantor, legal rights and obligations, not business logic.
• If funding had been disbursed, at least in part, then the guarantor would be invited to exercise step-in rights, and the new team would finish the project or reassign the hypothecated asset to a project that could be finished and commissioned to start operations. Thanks to a closely monitored monthly draw schedule, typically only one or two months of draws would be at risk, an exposure that would not affect the guarantor.

All of the above is extremely pessimistic and extremely unlikely to occur.  These disclosures are part of IGF’s policy of being up-front and In3’s core value of transparency about how things would unfold if such unforeseen downsides did occur. We do our absolute best to filter out any fraud and have had no issues with fraudulent developers or parties that refuse to meet their contractual obligations.

Because of that, to repeat, we have never had to call any guarantee in all of In3 Capital Partner’s operating history, plus we happen to have a strong counterincentive — the parties would end up in court, which would cause irreparable harm to our banking relationships, thus in practice there are always alternative solutions making it entirely unnecessary to call or cash any instrument.

How do non-cash assets compare to the use of a cash deposit?

Are there any other options besides this “Completion Assurance” Guarantee and a hypothecated instrument or direct transfer of an asset? Yes, a more leveraged Cash Deposit (compare), returned upon project delivery, slightly shorter-term Security compared to a bank-involved guarantee, but also not used as a down payment or as owner equity (cash contribution) to the project’s funding.

Cash is easier to manage, thus faster to arrange, without the additional steps of bank-involved instruments, more leveraged (~33% cash is roughly equal to 50% SbLC coverage) and with other advantages of being able to use sources of private debt or lines of credit from various institutions. We can cover the interest payments as required, in some cases, added to the total capital required. Their short-term nature typically have nominal material effect on the project’s upside (measured as unlevered IRR) as even 10-15% APR interest can be amortized over the life of the project’s ownership and becomes 1-2% per year of the total funding, less than the cost of most insurance.

The only downsides of cash surety deposits are that some people are just not comfortable with moving cash, though the contractual arrangements make it quite safe, while others do not have sufficient resources to tie up cash, making non-cash assets the better choice.