What it means
Many financial plans depend on a forecast. A toll road expects traffic revenue, a landlord expects rent, and a fund expects to sell an asset at a certain price.
If the real figure comes in lower, there is a shortfall, and someone has to fill it. Shortfall cover is the promise that someone will.
It can come from a parent company, a bank, a government body or an insurer, and it is written into the contract in advance. The provider agrees to pay up to a stated limit, usually under conditions that define when the cover can be called on.
Lenders like it because it lowers their risk. A bank financing a new power plant may require the sponsor to provide cover for any cost overrun or shortage of debt repayment cash, which makes the loan safer and the interest rate lower.
In effect, the cover moves the risk from the lender to the party best able to bear it. The cover has a price and conditions.
A guarantee fee or insurance premium is paid, the amount is capped, and the provider may have rights to recover what it paid from future profits. Readers of a contract should check what exactly triggers the cover and how quickly the money arrives.
Shortfall cover differs from a reserve account, which is cash set aside in advance, because the money is only paid if a gap appears. Many deals use both: a reserve for small, predictable gaps and shortfall cover for larger, rarer ones.
Testing both against a downside forecast shows whether the structure is strong enough. In accounting terms, the provider of the cover may need to record a liability or disclose the commitment in its notes to the accounts.
Beneficiaries should also check whether the cover is counted as an asset or simply noted as a contingent source of cash. Auditors usually ask to see the contract and a recent assessment of the provider's ability to pay.
In practice
Real-world examples.
Example
A company building a solar farm borrows $40,000,000 from a bank. The bank requires the sponsor to promise shortfall cover for any gap in loan repayments during the first two years of operation. This reassures the bank while the farm is still ramping up.
Example
A shopping centre owner has a tenant who guarantees minimum rent. If sales are weak and rent falls below $2,000,000 a year, the guarantor pays the difference. The owner uses the guarantee to secure a lower interest rate on its mortgage.
Example
A trade credit insurer agrees to pay a manufacturer for unpaid customer invoices above an agreed excess. When a large customer fails, the insurer covers the shortfall in collections. The manufacturer avoids a cash crunch that would have delayed its payroll.
Formula
Calculation
Shortfall = amount required - amount available
Cover ratio = cover available / expected shortfall
Suppose a project must pay $500,000 of loan instalments this quarter but only has $380,000 of cash available. The shortfall is 500,000 - 380,000 = $120,000. If the sponsor has agreed to provide shortfall cover of up to $150,000, the cover ratio is 150,000 / 120,000 = 1.25 times. The cover pays the full $120,000, leaving $30,000 of the facility unused.Case study
Seen in the real world.
Calderwood Infrastructure is an illustrative, fictional company that built a small hospital car park on the promise of steady parking income. Its lender agreed to finance $12,000,000 on the condition that the parent company provided shortfall cover for the first three years.
In year two, a new bus route cut the number of cars, and revenue fell $350,000 short of the amount needed for loan payments. The parent company paid the gap from its cover limit of $1,000,000, which kept the loan in good standing.
By year four traffic had recovered and the car park covered its own payments. The parent had paid out $350,000 in total, and the illustrative lesson is that shortfall cover gave the lender confidence early and gave the project time to mature, at a known cost to the sponsor.
Watch out
Common mistakes.
- Assuming shortfall cover pays out automatically, when it normally has conditions that must be met before it can be called on.
- Ignoring the cap, so a large shortfall exceeds the amount the cover provider has agreed to pay.
- Counting on the cover without checking the financial strength of the provider, who may not be able to pay when needed.
Questions
People also ask.
Who usually provides shortfall cover?
A sponsor or parent company, a bank, an insurer or a government body, depending on the deal and who is best placed to take the risk.
Is shortfall cover the same as a guarantee?
A guarantee is one common form of it, while insurance and standby loans are other forms that achieve the same result.
Does the provider ever get its money back?
Often yes, because many arrangements let the provider recover its payments from later profits or from a subordinated claim on the project.
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