Pedro Felipe Eraso
US International Development Finance Corporation, Chicago

The increased size and complexity of infrastructure projects create demands for funding that cannot always be met with traditional arrangements such as loans or equity contributions. Developers are increasingly using convertible notes to cover this gap, particularly at the early stages of projects. However, convertible notes remain relatively unknown to market participants and advisers. This article intends to explain the most salient features of convertible notes to enable a better understanding of when and how they can be used effectively.

Convertible notes are hybrid financial instruments that allow an initial investment in the form of a loan, giving the lender the option to convert the outstanding balance of the loan into the borrower’s equity upon certain triggering events. This early capital can be used in tandem with contributions from sponsors or equity holders.

Convertible notes can be a valuable tool for infrastructure projects, as they can be used to raise capital in the early stages of the project, when revenue is limited or non-existent. In standard loan financing, lenders analyse a borrower’s history, emphasising revenue and collateral to secure the loan. However, new infrastructure projects require an initial investment that will translate into revenue only after the commercial operation date is achieved. This early-stage financing is usually provided as equity by sponsors or shareholders. Equity gives equity holders a percentage of profits, but it also implies subordination vis-à-vis lenders in the capital structure.

A convertible note gives lenders flexibility to remain at the top of the capital structure or obtain security over certain assets while preserving the option to become an equity holder if the prospect of future earnings is sufficiently attractive. Thus, convertible note financing gives flexibility to a lender, depending on the circumstances of the project.

This early investment can serve as catalytic financing, anchoring financing for the project to ramp-up financing discussions with other lenders and attract more competitive equity capital from long-term infrastructure investors.

Structuring

Convertible note financing can be structured in many ways, and it is up to the parties and their counsel to agree on its terms. A critical consideration for the lender is the amount of risk assumed and the remedies available in the event of a borrower’s default. Investing early in a construction project is challenging because sources of revenue and collateral are often limited or non-existent.

If no collateral is available, convertible note lenders typically require treatment on at least equal footing (pari passu) with any other creditors of the borrower. The lender should be comfortable with how the loan proceeds will be used and the timing for repayment. Thus, it is important for a lender to clearly define the use of proceeds in the documentation and include robust reporting requirements to monitor construction progress, use of funds and the borrower’s overall financial health. Negative covenants can also be critical, and may include restrictions on the incurrence of senior or pari passu debt, changes to business plans, material asset sales, prohibited affiliate transactions and material changes to project contracts, such as supply contracts.

If collateral, such as equipment, land or intangible property, is available, convertible note lenders should consider perfecting a security interest over such collateral. Such a security interest can be subject to resolutory conditions, such as the borrower achieving financial close for traditional financing or the note converting into equity.

All such covenants should be tied to events of default and related remedies affording the lender the ability to accelerate repayment of the loan.

Notes can be structured so that the borrower can use the proceeds for critical early-stage investment for the project, such as equipment acquisition, development costs, or land acquisition or leasing. For significant investment, such as the purchase of equipment or land, escrow agreements can be used so that the proceeds are directed to the seller. In such scenarios, it is also important for lenders to secure assignability rights with the seller.

Amortisation

Because a convertible note is typically issued before the borrower can generate consistent revenue, amortisation for these notes tends not to involve the usual periodic payment of principal and interest during the term of the loan. Instead, the amortisation of a convertible note can be structured so that the lender receives periodic payment-in-kind interest instead of cash interest. Payment-in-kind interest means that unpaid interest is added to the principal balance of the note, which may later be converted into equity, rather than being paid in cash. If the borrower has some sources of revenue, it is possible to structure the note to provide for cash payments of interest only, while deferring the principal payment as a lump-sum payment, known as a bullet or balloon payment, at the end of the term.

Triggering events

A note can convert into equity at different stages, such as when the project secures long-term financing, achieves the operational phase or starts producing revenue, or when the borrower issues shares. These can be optional or mandatory conversion events for the lender.

Convertible note documentation should include clear mechanisms to calculate the number of shares that the lender will receive based on the outstanding balance of the note. Remedies for failure to convert may include acceleration of the note, specific performance, or injunctive relief to prevent acts or transactions that would impair or diminish the noteholder’s rights.

Finally, it is important to consider the securities law regulations that may apply to convertible note financing. These regulations vary depending on the jurisdiction. For non-public borrowers, such regulations may include limitations on public solicitation or advertising, or restrictions on the offering of notes to certain accredited investors, such as investors with a certain minimum net worth or income, or other special qualifications. For public borrowers, securities laws may require extensive disclosure, filing and notice requirements, market pricing requirements and shareholder approval.

This article was prepared by an employee of the US International Development Finance Corporation (DFC). The views and opinions expressed are those of the author and do not necessarily reflect the official position, policies, or views of DFC, the US government, or any other agency thereof. References to specific companies, projects, products, or services are for informational purposes only and do not constitute an endorsement or recommendation by DFC or the US government.

Pedro Felipe Eraso is Assistant General Counsel at the US International Development Finance Corporation. He is based in Chicago.