Payment Security: an overview

In another post I have presented several types of financial securities. In this post I would like to describe more in detail an important subcategory, the Payment Securities.

A Payment Security is usually requested by the seller from the buyer of wind turbines. It is a mechanism to compensate the seller, entirely on partially, if the payments are not completed as per the contractual payment schedule.

Payment securities such as Letters of Credit can have a financial impact – their cost can range from 0.5 to more of 2% of the amount covered, and they usually use lines of credit.

The 2 main types of Payment Securities are:

  • Letter of Credit (full or partial)
  • Parent Company Guarantee (with or without download trigger)

Other 2 possible types of project finance mechanism (without Payment Security) are:

  • Balance Sheet Financing
  • Direct payment from lenders

A Letter of Credit from the point of view of the seller is the strongest alternative. Usually is “unconditional” and “irrevocable”, meaning that it can be used almost as cash: the seller can go to the bank who issued the Letter of Credit and ask for its full amount without explaining what is happening (it is “unconditional”) and at any time (it is “irrevocable”). It is not linked to the contract – that is, the seller does not have to proof that the buyer is defaulting on its obbligations.

A Partial Letter of Credit is simply a Letter of Credit that cover only a percentage of the total contract price (for instance, 30% or 40%).

A Parent Company Guarantee means that the performance of the contractual obligation of the company purchasing the turbines (usually a SPV, a “Special Purpose Vehicle” created only for the project) are guaranteed by a bigger, financially solid parent company owning the SPV.

The Parent Company Guarantee has a Download Trigger if there is a mechanism in place that can force the buyer to replace it with a Letter of Credit. The “download” refers usually to a credit rating downgrade of the parent company or some kind of deterioration of the balance sheet.

The Balance Sheet Financing is not frequent, at least in my experience. It happens when big companies (for instance State utilities) decide to pay for a project “out of their pocket”, without recurring to lenders. As this companies are usually huge, at least in terms of turnover compared to the other players in the business, they can be allowed to buy without providing a Payment Security. Basically they are (or should be) too big to fail.

In the last scenario, Direct Payment from Lenders, the seller doesn’t provide a Payment Security. However, the money flows directly from the lenders (usually a consortium of banks) to the seller, effectively lowering the risk. Obviously the seller will perform a due diligence to check all conditions of the project financing agreement.

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