Distribution Lock-Up: a Worked Example

In project and infrastructure finance the borrower is usually a single asset, a wind farm, a toll road, a hospital under a long concession, owned through a company with no other business. The owners' return arrives only as distributions. If those continue while cash flow is sliding, value leaves the one place the lender can reach it. A default ratio set close to break-even catches the problem late. A lock-up set above it catches the problem while there is still cash to keep.

The same idea appears in property and corporate lending under other names: a condition that dividends may be paid only while a ratio is met and no default is continuing. The project finance form is the most developed, because there the distributions are the whole of the owners' return and the lender's only early lever.

The ratio is usually measured on each calculation date, often six-monthly, and many agreements test a historic ratio over the past twelve months and a projected one over the next. Cash flow available for debt service is the numerator, not EBITDA. Other triggers sit beside the ratio: a debt service reserve account not fully funded, a default continuing, completion not yet reached. The definition of distribution matters as much as the ratio. It commonly takes in dividends, share buybacks and capital returns, interest and principal on shareholder loans, and fees paid to the owners or their affiliates. Release terms vary: some agreements lift the lock-up and free the trapped cash at the next passed test, some require two passes in a row before anything is paid out, and some send cash that stays locked up for long enough to prepay the loan.

A solar farm selling its output under long-term contracts, constructed for this page like every figure in it, pays US$10m of debt service a year. Its finance documents set a lock-up at 1.20 times and a default at 1.05 times, tested each year on the past twelve months. Both levels are the example's and are not offered as a market norm. Its reserve account is full throughout.

A run of weak irradiance and an inverter failure push cover below 1.20 in year 2. The loan is not in default and the lender takes no action. But the US$1.5m surplus that year, and US$1.0m the next, stay in a blocked account. By the end of year 3 the farm holds US$2.5m it would otherwise have paid away, which is three months of debt service (2.5 ÷ 10 × 12).

The distance to default tells the lender what that cushion is worth. In year 3, cash flow could fall a further US$0.5m, to US$10.5m, before cover reached 1.05 times: less than 5% of the year's cash flow. Without the lock-up, the owners would have taken the US$2.5m and the lender would face that margin with no cash behind it. With it, a bad fourth year could be met from the account before anyone called a default.

The default ratio is the line beside it, and the gap between the two is the point of the structure: wide enough that a lock-up is a warning the borrower can act on, not a step on the way to default a quarter later. The reserve account is the other neighbour. It holds a fixed amount set aside in advance, usually sized as some months of debt service; a lock-up builds an additional cushion only when cover weakens, out of cash that would have left. Where locked cash ends up after a long lock-up is the point at which it meets the cash sweep.

A lock-up is also separate from the law on dividends. In New Zealand a board may authorise a distribution only if satisfied on reasonable grounds that the company will pass the solvency test immediately afterwards; in Australia the Corporations Act sets conditions on paying a dividend, including that it does not materially prejudice the company's ability to pay its creditors; in the UK a company may distribute only out of profits available for the purpose. A borrower can pass its lock-up test and still be barred by these, or pass these and still be locked up.

DEFINED IN ONE PARAGRAPH → · DEBT SERVICE COVERAGE (DSCR) → · THE DEBT SERVICE RESERVE →

The lock-up is argued in the term sheet on four points: the level, whether the projected ratio counts as well as the historic one, what the definition of distribution leaves out, and how long cash may stay trapped before it prepays the loan. Owners push on the last two hardest, because shareholder-loan interest outside the definition would keep flowing in a lock-up, and a short path to prepayment turns a pause into a permanent loss of cash.

Once the loan is running, the lock-up changes behaviour more than balances. Owners facing a lock-up have reason to fix the operating problem, inject equity or agree a refinancing, because each passed test returns their cash. For a lender reading a project's history, a lock-up that lasted one period says something different from one that has lasted three.