Debt Sculpting: a Worked Example

A project's cash flow is rarely flat. A wind farm earns more in windy years, a landfill gas plant's output falls as the site ages, a hydro scheme stops for a turbine overhaul, a contract steps its price up at set dates. A level repayment schedule ignores all of that. It asks for the same instalment in the overhaul year as in the best year, so the loan has to be sized to the weakest period, and the strong periods carry cover the lender did not need.

Sculpting turns the question round. Instead of fixing the instalment and testing the cover, the lender fixes the cover and derives the instalment. The schedule is solved once, at financial close, from the forecast the lenders have accepted, and it is then written into the facility agreement as the repayment profile.

CFADS, cash flow available for debt service, is the forecast cash left after operating costs, tax and maintenance spending. Dividing it by the target debt service cover ratio gives the most each period can pay. Because each period's interest is charged on whatever is still owed, the payments are fixed first and the loan is found from them: its size is the present value of the permitted payments, and each period's principal is what its payment leaves after interest. Where tax depends on the interest deducted, the calculation becomes circular, and models solve it by iteration.

Sculpting decides the shape; sizing decides the amount, and the amount is often the lower of more than one limit. A lender may also cap debt at a share of the project's cost, so the sculpted figure is a ceiling, not a promise. Nor need the target be one number: a schedule can be sculpted to a higher target in years when revenue is uncontracted. And the forecast it is sculpted to is itself a credit choice, a base case or a cautious one.

A run-of-river hydro scheme, constructed for this page like every figure in it, is forecast to generate CFADS of US$6.0m, 6.4m, 4.0m, 6.8m and 7.2m over a five-year loan; year 3 carries a turbine overhaul. The lenders sculpt to a target cover of 1.30 times at an interest rate of 6.5%. A real project loan runs longer; the table is cut to five years so it can be read, and neither the target nor the rate is a market norm.

Set the same US$19.33m on level instalments and the overhaul year fails. Size a level schedule so that the overhaul year clears the target, and the loan shrinks by about a third:

Sculpting lets the scheme borrow US$19.33m against the same forecast that supports US$12.79m on a level schedule, about half as much again. The price is visible the moment the forecast slips. If year 4 produces 10% less than expected, US$6.12m:

The level loan has a year of strong cover to absorb the miss. The sculpted loan has the same thin cushion in year 4 as in year 3, and the miss shows in full in the ratio.

A sculpted loan and the loan life cover ratio are built from the same present value, and at financial close they agree: where every period is sculpted to one target and the cash is discounted at the loan's rate, the LLCR at close equals that target. In the example it is 1.30 times. They separate afterwards. The schedule is fixed, while the LLCR is recalculated on each new forecast, so a weaker outlook for later years shows up in the LLCR before it reaches any single year's cover.

Sculpting also differs from the two straight-line profiles. Level instalments, as in a home loan, hold the payment constant and let cover rise and fall with the cash. Equal principal repayments front-load the payments, because interest is highest early. Sculpting holds the cover constant and lets the payment move.

DEFINED IN ONE PARAGRAPH → · CFADS, WORKED → · LOAN LIFE COVER RATIO →

Because a sculpted loan plans no period with spare cover, the protection has to come from elsewhere. The target ratio is argued first, since it sets the loan's size. Then the forecast: whose case, how cautious, and whether the overhaul or the contract step-down is in the right year. Then the defences around the schedule. A debt service reserve account holds cash against a weak period, and when it is sized to the next instalments it moves with the sculpted profile. A distribution lock-up, often set below the target, stops cash leaving for the owners once cover thins.

The lender also reads the end of the schedule. Sculpting tends to push principal toward the years with the most cash, which are often the later ones, so the tail between final maturity and the end of the contracts decides how much room is left if those years disappoint.

DEBT SERVICE COVER → · AMORTISATION, DEFINED →