What Offtake Means to the Capital Stack
The Building Blocks of Blended Finance for FOAK — A Primer
Executive Summary
First-of-a-kind (FOAK) industrial projects have uncertain construction costs and no track record of predictable revenue — both of which are needed to attract traditional infrastructure finance.
Offtake agreements that generate contracted revenue are essential to unlocking lower-cost debt capital, but the cement and concrete market lacks them — creating a structural capital gap.
The quantity and cost of debt in a project's capital stack is driven by cash flow certainty, collateral value, and the creditworthiness of revenue counterparties.
The more contracted and investment-grade the revenue, the more non-dilutive debt can enter the stack — reducing the equity check, boosting returns, and making the project fundable.
First of a kind industrial projects typically have uncertain costs to build and no track record of predictable, low-risk revenue streams, both of which are needed to attract traditional, scaled infrastructure finance capital. That capital, which is more affordable and plentiful than equity capital, is essential to driving down the cost of building new facilities that can produce commodities at scale economically.
Therefore, offtake agreements that generate revenue for and potentially offset green premiums associated with 'first' production facilities for new technologies are essential to unlocking capital investment. Yet the 'Lack of Contracted Offtake' in the cement and concrete market is often cited as a capital gap. But can it be solved?
CTC is often asked by both buyers and suppliers of low emission cement and concrete (LECC):
There is a lot, of course, that goes into a successful offtake agreement and each project is unique. However, to understand and get at those nuances, we find it is first helpful for people unfamiliar with 'first principles' of real asset finance to have a primer that demystifies how capital sources think about financing industrial production facilities, particularly ones that are first, second, or third of a kind projects.
Blended Finance in the Valley of Death
We've all seen that picture of the valley of death — with infinitely scaled volumes of Debt or project finance capital on the right, scarce volumes of Equity capital on the left side, and even scarcer layers of equity, grants, catalytic, and commercial debt covering 'FOAK - THROAK' projects in the middle. But how do those sources actually come together? What dictates how much from each source comes in? Understanding this is key to getting more projects across the valley.
Pulling in Debt
The quantity and terms for debt capital are typically structured into a project based first upon a handful of key drivers:
Capital Deployed into Projects
As discrete from venture, growth equity, or corporate finance/venture debt, project finance is a funding strategy where the use of funds goes exclusively toward the construction or implementation of a project. Where that project can attract non-equity sources of capital, less of the company's equity is required to build the project. The combination of equity dollars and grants or debt from external sources are referred to as a project's capital stack and the combination of all funders in a project are referred to as the 'sources' of funds in the stack.
Free Cash Flow
Debt investment into projects are associated with the expectation by debt funders that the specific project — once completed — will produce revenues that can repay the specific debt capital put into the project, referred to as 'debt service', in a schedule of installments that are agreed upon in advance. Therefore, project finance is very sensitive to cash flow and often focuses on eliminating downside risks.
DSCR
When a project is built and operating, revenues go first toward funding the real-time operations of the project and then toward paying debt-service. The ratio of net operating income to debt service due (over a fixed time period) is known as a debt service coverage ratio or DSCR. A DSCR of 1 means cash available after paying project expenses is exactly equivalent to the debt service due.
Infrastructure debt investors typically 'set' a minimum DSCR for projects correlated to the level of risk associated with cash flow in a project. A higher DSCR assumes a higher degree of risk; and can range from 1.1 to 3. Holding risk around expenses constant, DSCRs will be significantly higher when estimated revenues are coming from 'uncontracted' versus 'contracted' revenue streams as well as for 'noninvestment grade' versus 'investment grade' counterparts.
A revenue contract associated with a project (i.e., the sale of a commodity or service) that is associated with a firm contract to purchase (i.e., a take or pay) at a fixed price would be considered 'contracted' revenue during the period of the contract. If the purchaser of such contract is considered an investment grade entity (i.e., is an entity with a public or private credit rating), the revenues from that contract would be considered investment grade as well as contracted.
Cost of Debt Capital
As lower DSCRs are typically associated with lower interest rates — and noting that investment grades range from low (sub) to high quality — contracted revenues from investment grade counterparts are associated with lower risk and therefore, lower DSCR and cost of capital. Uncontracted revenues or contracted revenues with noninvestment grade counterparts are associated with higher risk and, therefore, higher DSCR thresholds and more expensive capital. Assuming there is free cash flow to pay debt service, higher rates mean higher loan payments, which eat into project profit margin and returns to equity.
Example. A plant expects to receive $30 in annual revenue for 10 years, 50% from a firm offtake contract and 50% from buyers in a spot market.
a DSCR of 1.2 is applied to contracted and a DSCR of 3 applied to non-contracted revenues. If this project had operating expenses of $9M/year, applying the avg DSCR to NOI, suggests the project can service a maximum of 10M of debt annually
Let's assume this scenario attracts a lender offering a loan at a rate of 10% over 10 years; at those terms the cash available to pay debt service could support up to $60M in financing. However, if ALL $30M were uncontracted and discounted at the higher DSCR, that would only leave $7 million available to service debt and a lender would likely require a higher rate given the risk of no firm revenue - say 18%
At that rate, CFADS in this scenario could support a lower amount of debt capital, closer to $30M or half of the first scenario. This simple example is meant to show the importance of the DSCR in the financial analysis and does not take into account myriad other important risk and accounting factors.
Collateral
Project finance capital must also be secured, meaning in an event of non-payment, the outstanding balance of the loan may still be repaid. Collateral describes the security for debt capital, which typically may minimally include the project assets (i.e. buildings, equipment, land) as well as all revenue contracts. Additional collateral could come in the form of a guarantor, contractor bond, etc.
The full (discounted) value of the offtake contract plus the real market value (i.e. the appraised or liquidated 'tear down' value of the project's physical assets) could constitute primary collateral pledged against the debt capital. Given the unique equipment configurations deployed in FOAK projects and small universe of operators that could 'step in' to run a FOAK plant to ensure an active offtake contract is paid out, collateral value is likely to be highly discounted.
Therefore, even in the scenario with the bigger potential loan size (based on expected revenue), the actual loan offered may be smaller, due to the lender's 'downside' recovery value analysis on the collateral. For example, a financier who underwrote a potential debt sizing of $60M, may determine the discounted value of the plant & revenue contracts are valued at no more than $80M. If that financier wished to limit its exposure to no more than 50% of this discounted collateral value, debt offered may not exceed $40M.
Debt Sizing
As we have seen, the interplay between DSCR, collateral, and relative cost of capital is a primary driver in determining the quantity of debt capital — often called 'debt sizing' — that could go into a project (just based upon these first principles). Actual funding decisions are based upon myriad other factors that introduce project risk — such as technology readiness, site control, and team execution capabilities to name a few. However, a final critical driver — which is the flip side of 'debt-sizing' in the capital stack — is the minimum equity requirement for the rest of the capital needed to complete the FOAK project.
"The more contracted and investment-grade the revenue, the more non-dilutive debt can come in — reducing the equity check, boosting returns, and making the project fundable."
All Important Equity
Now that we've estimated a maximum amount of debt that could come into our sample FOAK project, we have a better sense of how much equity is required. The company building the FOAK plant (or their equity partners and sponsors) must also consider its own return on equity hurdle and appetite to lever the project.
Adding debt to a project, described as 'leverage' or 'levered', can increase ROE for a project owner since they are utilizing less of their own capital. It also can help the equity investors to be less diluted, through reducing the amount of 'top-co' equity that would have otherwise been raised to fund the hard costs of the FOAK project. This can be critically important for the company's valuation and ability to attract future equity rounds.
Finally, it can establish a credit track record for the company, supporting its ability to raise future, more cost-effective rounds of debt capital into next projects.
On the downside, the cost of debt — through interest rates, fees, and additional collateral requirements or terms — may create undesired 'drag' on an early company's operating capabilities through reducing the nominal cash left for the project owner.
Wrap Up
Raising equity capital is hard and assumes evaluating potential for major future upside that can be difficult to ascertain at the stage of a FOAK project, particularly one that is entering into a commodity market. Given the real excess costs associated with constructing FOAK projects that increase equity raise targets (e.g. caused by investors' requirements for project EPC wraps or GMP contracts, contingency reserves, operating reserves, etc.), reducing the overall equity raise required can be critical toward advancing a FOAK project.
We've seen that the higher the contracted revenues are and the more creditworthy the revenue counterpart, the more non-dilutive, 'debt-like' capital can come in. The more that capital comes in, the less equity is required. The smaller the equity check, the higher the return on equity if all goes well, and the easier it is to reach that equity raise target.
Next time — we'll talk about that all important revenue piece and break it down.
The funding gap defines the challenge. Next, explore how commodity credibility and carbon revenue together build FOAK bankability.