The Need For Construction Liquidity

A public-private partnership (P3) model typically transfers the risks related to the designing, building, financing, and/or operating of a large-scale infrastructure asset from the public sector to the private sector. During the construction phase of a P3 project, the private-sector partner usually passes on the design-build risks to a construction contractor on a back-to-back basis. This so-called "drop down" of the construction risks to a contractor exposes the project to the solvency of the contractor. This is an important risk to manage because a large number of construction companies are not investment grade. In addition, a typical P3 project involves up to five years of construction or more, which is a relatively long time to manage an ongoing risk.

P3s usually have construction completion risk. That is, there may be unexpected delays beyond the substantial completion date or the contractor may fail to perform or file for bankruptcy and need to be replaced. A delay in completion caused by the contractor can derail the project's ability to meet its debt service obligations, which usually begin soon after the scheduled completion date. To mitigate this risk, it is typical for a P3 to require the contractor to provide a liquidity security package that ensures the project will have sufficient liquidity to meet any unavoidable costs (including debt service obligations) until construction is complete and it starts to generate revenue.

Beyond covering any delays in construction, projects will often use the liquidity support to cover costs if the construction contractor is replaced due to non-performance or bankruptcy. Typical contractor replacement costs include search and re-contracting costs, fixed costs to cover delays in securing a replacement, an allowance for subcontractor's fees, and a likely higher margin on the new contract. Importantly, some of these costs are immediate liquidity needs, such as for recontracting, whereas others, such as a replacement premium, can be spread over the remaining construction period (for more info, refer to paragraphs 44-48 of our construction and operations counterparty methodology). Of note, if S&P Global Ratings assesses the construction contractor's credit quality to be higher than its rating on the P3 project, we don't require it to provide replacement liquidity. (For example, if we rate a project 'BBB' on a stand-alone basis and assess the contractor's credit profile as 'BBB+', we would assume the contractor has the credit strength to complete the work and stand by its obligations. On the other hand, if we assess the contractor's credit profile as 'BB', we would require it to provide replacement liquidity in addition to delay liquidity.) We refer to the liquidity provided for delays or the replacement of the construction contractor as a security package.

The Evolution Of Construction Liquidity Sources

Traditionally, contractors provide construction liquidity either through cash retainage (when a portion of the payments that are due to the construction contractor are withheld by the project until construction is complete) or with letters of credit (LOCs) provided by banks that we rate higher than our rating on the project. Retainage is used to supplement and, in rarer cases, entirely replace the LOCs during the construction phase. Both the LOCs and retainage are immediately available to the project if there are delays caused by the construction contractor or if the contractor needs to be replaced. Furthermore, the obligations of a LOC provider to the beneficiary are unconditional and irrevocable. Because retainage is designed to build in accordance with the construction schedule, relying on retainage as part of the security package requires making assumptions on when it will be needed and how much will actually be retained. For this reason, LOCs are seen as the safest form of security. It is also why retainage-only security packages are uncommon (because, by itself, retainage may not be acceptable to most lenders).

Lately, however, we've seen some modest growth in the use of innovative surety bonds as a substitute for traditional sources of construction liquidity. These include a variety of bonds developed by the surety industry with tailored language that try to mimic the on-demand features of a conventional P3 construction liquidity package.

In this FAQ, we discuss our view of the use of these surety products as construction liquidity.

Frequently Asked Questions:

What specific terms does S&P look for in surety products to give them credit as construction liquidity?

The project's ability to access the liquid security and the timeliness of payments by the security provider are extremely important for the project to meet its obligations in the event of construction delays or contractor replacement. Therefore, for S&P Global Ratings to consider a surety bond to be eligible as a P3 construction security, the following conditions should be met:

• The surety's obligation to pay under the bond should be unconditional and irrevocable;
• The timeliness of the payments should be well defined, which means that the surety should pay the obligations on a predictable due date and should not try to seek relief or assert any defense that the construction contractor is not at fault, and the surety's obligation to pay should not be subject to the resolution of any disputes (except in the case of expedited dispute resolution bonds); and
• The debtholders should be the beneficiaries of the surety policy.

In summary, the surety's policies should meet the principles of S&P Global Rating's guarantee criteria (please refer to our guarantee criteria for further details).

It is important that the payments under the surety policy be made on or prior to the event of default (EOD) under the project's financing documents. For example, if an EOD is triggered under a project's financing documents when a debt service payment is not made within three days of the due date, we would expect that the terms of the surety bond ensure that the payments are made within no more than three days of being called upon to avoid a default under the project financing documents.

Are there any specific trigger mechanisms that S&P looks for in the policy or construction contract to give credit to these surety products?

While the terms of payment in the surety policy are important, the triggers for accessing the liquidity offered under the policy are equally significant. Typically, liquid securities are callable in case of an EOD by the construction contractor as per the construction contract. Hence, S&P Global Ratings looks at the trigger mechanisms in the construction contract when assessing these products. We consider the following two triggers to be most important:

• The project should be able to call upon the surety bond irrespective of a good faith dispute (pay now, dispute later). This is to ensure that the surety is not able to dispute any claims from the project; and
• The liquidated damages (LDs) under the construction contract should be payable immediately without any cure period. This means that the project is able to call upon the surety policy immediately without waiting for a cure or grace period to end.

How does S&P address the capacity and willingness of the insurer to meet the obligations?

Apart from the payment terms in the policy and trigger mechanisms in the construction contract, we assess the creditworthiness of the surety provider to determine the insurer's capacity and willingness to meet its financial commitments.

We use a Financial Enhancement Rating (FER) when an insurer supports a transaction through an insurance policy or other commitment that is predominantly used as credit enhancement or a financial guarantee because the FER addresses the capacity and willingness of the insurer to meet its financial commitments in accordance with the terms of the obligation (for more info, please see our previous FAQ on relevant measures of insurer creditworthiness).

What surety products has S&P given credit to in some of its recent transactions?

S&P Global Ratings does not give credit to the traditional performance bonds issued by surety companies for North American project financings and P3s because the language in those bonds allows the surety to dispute payment. Therefore, we don't view them as unconditional or necessarily timely (there can be a lag as insurers determine the validity of a claim; claim adjudication can also be lengthy and the timing is uncertain). The surety may also reject a claim due to fraud or negligence on the part of the insured or a third party. Performance bonds also typically require a proof of breach by the construction contractor whereas true demand instruments, like LOCs, do not.

Some of the surety products we have seen and given credit to in transactions that we have rated recently include:

• Demand bonds;
• Cash riders; and
• Expedited dispute resolution (EDR) bonds.

A demand bond (which was used in the recent Mobilinx Hurontario General Partnership transaction) is the newest instrument that we have seen in our recent transactions. With a demand bond, the surety has an unconditional obligation to make payments in the timeframe stipulated once the beneficiary demands payment. The surety cannot assert any defense or try to seek relief for its obligations. Thus, these bonds are more like LOCs issued by banks and meet the conditions we look for from insurance companies that provide credit enhancement.

A cash rider is part of a performance bond that stipulates the claim has to be paid (to the extent of the cash rider amount) within a specific timeframe defined in the rider. Similar to a demand bond, this portion of the performance bond is paid first and disputed later.

While we do not give credit to traditional performance bonds, we consider EDR bonds to be generally acceptable because they adequately address any timeliness and conditionality concerns with a well-defined timeline for dispute resolution (e.g., about 90 days). We look for two conditions to consider an EDR bond as a source of liquidity:

• Other forms of liquidity (cash or cash-like) must be present to bridge the EDR dispute resolution period; and
• Under our construction criteria, we view EDR bonds as a liquidity support for up to 10% of the total funding for a project (for more info, see our most recent full analysis on Plenary Walsh Keystone Partners LLC).