By Matt Lucas, PhD; NER’s Managing Director, Business Development

 

I’m a huge fan of the US Park Service’s Fat Bear Week, which features some huge bears. The bears have been fattening up all summer and fall for their long winter hibernation. This is the opposite of fat shaming—fatter is better. But truth be told, if they get too fat it’s harder for them to do, well, bear things.

You may not have jumped to the same analog as me, but hear me out: Debt is to project finance as fat is to bears. When you’re building a new facility, as many of New Energy Risk’s clients are, you’ll want some debt. Quite a lot in fact. But too much debt makes the project unwieldy. An over-leveraged project won’t be nearly as healthy looking to your cap table as the fattest of the fat bears.

We know that raising money is hard. Raising equity is especially challenging: equity is in the most junior position to receive cash flows, and equity fundraising is a more linear, incremental process than raising debt. In contrast, raising debt via a public bond offering can raise vastly more capital with similar effort.  And maybe most importantly, debt has a lower cost of capital! It’s no wonder that project developers try to minimize the equity they have to raise in order to accelerate their execution timeline and improve financial returns for their existing equity investors. However, this approach can lead to projects that have too much debt instead. So how do you know what’s the right amount of debt? (You want a fat bear, not a fat bear that can’t climb!) The answer is in your loan life coverage ratio.

 

What’s a Loan Life Coverage Ratio (LLCR)?

An LLCR is a metric that relates available cash to debt service to the cost of the debt service. A higher number is more favorable and means your project can get fatter on debt without drawbacks, reducing the amount of equity otherwise required. A handy equation:

LLCR = [ (net present value of cash available for debt services over the life of the debt) + reserves] divided by (present value of debt)

• Cash available for debt service (CFADS) is your revenue minus operating expenses (including taxes but not including depreciation).
• The denominator of the LLCR is the present value of your debt.
• The interest rate of your debt is the discount rate used for calculating the net present value in the numerator.

A project with a LLCR equal to 1.0 is break-even: all its free cash pays its debt service. A ratio higher than 1.0 means there’s more than enough free cash flow to meet debt service.

You might have heard about a related metric, the debt service coverage ratio (DSCR). The DSCR is similar to the LLCR but is calculated on a quarterly or annual basis, so it’s a snapshot in time. In contrast, the LLCR is an average over the lifetime of the debt. For projects with lumpy free cash flows due to seasonality or infrequent-but-expensive maintenance costs, the LLCR is a more generous metric because it smooths out the cash flows.

 

Why the LLCR Matters

Debt lenders will use the LLCR to gauge the riskiness of your project. Of course, merely breaking even is not a compelling financial result, so the LLCR needs to significantly exceed 1.0.  Below are some typical minimum LLCRs used by lenders for different projects in various industries:

Example of Debt Lending Situation	Typical Minimum LLCR
Infrastructure backed by investment-grade rated government entity	1.25
Power plant whose offtake buyer is creditworthy	1.4
Oil & gas industry	1.4
Metal & mining industry	1.4
Infrastructure with merchant risk	1.75
Power plant selling on merchant market	2.0
New Energy Risk’s experience of projects that get funded and reach financial close	1.7

The table makes it clear that projects with merchant risk—those that lack contracts to sell their production to a creditworthy entity—require significantly higher LLCRs.

At New Energy Risk, our experience is that deals with LLCRs of at least 1.7 are those that get investment. That higher ratio gives the debt lender confidence that even if the project technologically under-performs, or the value of the production decreases, the project will still be able to pay its debt service and make it through the long winter (whether hibernating or not).

 

What Can I Do If My Project’s LLCR Is Too Low?

Uh oh, your bear of a project got too fat on debt! What can you do to restore your photogenic and investment-worthy proportions?

1. Consider New Energy Risk: We can help! New Energy Risk’s insurance products can enable debt funding where it was not previously possible or reduce the cost of debt. In both cases, NER’s help with coverage reduces your cost of debt and increases your LLCR.
2. Reduce your cost of debt by financing in a major currency: Debt is typically cheaper when it’s denominated in major currencies, so if your project is capitalized in a minor currency, you could try denominating your project’s feedstock and production in a major currency instead.
3. Reduce your cost of debt with government assistance: In the US, the federal government will provide loan guarantees for certain types of innovative capital projects. At New Energy Risk, we have worked with projects pursuing such guarantees from the US Department of Energy and US Department of Agriculture.
4. Adjust your cap table to increase the relative percentage of equity: If the total project cost remains fixed, then reducing the portion of the cost capitalized as debt will reduce your debt service and increase your LLCR.
5. Reduce project capital costs: If you can simplify your project to reduce its capital cost without reducing revenue, that will raise your LLCR. For example, you might find that a captive, on-site system for over-the-fence procurement can shift costs from capital to operating expenses and save money on a levelized basis.
6. Reduce operating expenses: If you can reduce operating expenses while holding revenues constant, that will increase free cash flow and increase your LLCR. Maybe the project can be situated in a lower-cost location. Maybe automation can reduce on-site labor costs. You might also try to contract your feedstock costs for a fixed or capped price to reduce the risk of escalating operating expenses.
7. Contract your revenues: Lenders will discount your revenue if they feel it’s uncertain. Selling your production to an investment-grade entity for a fixed price or on a take-or-pay basis will help assure you get more fully credited for all your revenues.

 

So fatten your bear of a project with debt, but not too much; keep the LLCR in mind! Have questions about your own LLCR or project finance? Reach out to us at [email protected]. We’re here and happy to help. (Although we don’t accept salmon for payment, sorry.)