What it means
Lenders to a new project face a basic problem: the project has no track record, and its cash flow may not appear until it is built. To make the loan acceptable, the sponsor behind the project agrees to cover any shortfall between the cash the project generates and the debt payments it owes.
This makes the lenders' risk depend partly on the sponsor's strength and not just on the project. The agreement usually sets out when the sponsor must pay, how much and for how long.
It may be limited to a maximum amount, or to a defined period such as the construction phase, or it may continue until the debt is repaid. The wording matters a great deal, as a limited promise gives the lenders less comfort than an unlimited one.
For the sponsor, the agreement is a contingent liability, meaning an obligation that may or may not arise depending on future events. It may need to be disclosed in the financial statements, and it can affect the sponsor's own borrowing capacity.
Rating agencies and lenders look at such commitments when assessing the sponsor's overall debt. Deficiency agreements are related to, but different from, guarantees.
A guarantee usually promises that the debt will be paid if the borrower fails, whereas a deficiency agreement tends to promise funding of a shortfall as it arises. In practice the two can overlap, and the legal documents decide which applies.
The sponsor should model its exposure carefully. A project that underperforms for several years can require repeated top-ups, and the total can far exceed what was expected at the start.
Stress testing the project's cash flow is the best way to understand the downside, including how long a weak period could last. Setting aside a reserve in advance is a sensible way to avoid a sudden call on cash.
Many sponsors also agree a cap and a time limit with the lenders, so that the commitment is clear and can be planned for.
In practice
Real-world examples.
Example
A toll road project in its first two years of operation attracts fewer cars than forecast. The sponsor pays the shortfall on the loan under the deficiency agreement until traffic grows. The lenders are repaid on time throughout, and the sponsor recovers value later when traffic reaches the forecast level.
Example
A utility company builds a power plant through a subsidiary. The parent signs a deficiency agreement so that lenders will provide finance at a lower interest rate.
Example
A hospital group builds a new wing funded by a bond. A foundation agrees to cover any shortfall between patient revenue and bond payments for the first five years. Bond investors take comfort from the foundation's backing, and the interest rate on the bond is lower as a result.
Formula
Calculation
Required top-up = scheduled debt service - cash available from the project
A project has scheduled debt service of $1,500,000 for the year and generates $1,180,000 of cash available for debt service. The shortfall is $1,500,000 - $1,180,000 = $320,000. The sponsor must contribute $320,000 under the agreement. The project's debt service coverage ratio before the top-up is $1,180,000 / $1,500,000 = 0.79, which is below 1.0 and shows why the support was needed.Case study
Seen in the real world.
Northgate Waste Recovery is an illustrative, fictional company building a recycling plant through a new subsidiary. The banks would only lend $30,000,000 if the parent company agreed to cover any shortfall in debt payments for the first three years.
The parent signed a deficiency agreement capped at $4,000,000. In the first year, the plant started slowly and the parent paid $600,000 to meet the debt service.
Northgate is a made-up company, but the story shows the point. The parent's finance team had already included a contingency in its budget, so the payment was absorbed without difficulty, and the plant reached full production in year two. The agreement lapsed after year three without any further payment.
Watch out
Common mistakes.
- Treating a deficiency agreement as a formality, when it can lead to real cash payments by the sponsor.
- Leaving the contingent liability out of the sponsor's own debt capacity and budget planning.
- Assuming it works like a full guarantee, when its scope and limits depend on the exact wording.
Questions
People also ask.
What is the difference between a deficiency agreement and a guarantee?
A guarantee typically promises to pay the whole debt if the borrower defaults, while a deficiency agreement usually promises to fund shortfalls as they arise.
Who usually gives it?
A parent company, project sponsor or government body with a stronger credit standing than the project itself.
Does it appear on the balance sheet?
It is generally treated as a contingent liability and disclosed in the notes unless payment becomes probable.
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