Nuno Serrão Faria
PLMJ Advogados, Lisbon
nuno.serraofaria@plmj.pt

What is it all about?

Forward funding is generally labelled as an Anglo-Saxon-inspired financing model, predominantly used in real estate transactions (eg, residential, retail, hotels and offices), based on a contractual structure of some complexity. While still gaining popularity in the Portuguese market, there is an increasing trend towards implementation by importing more mature legal products from neighbouring European jurisdictions.

Forward funding^[1] has been seen as a useful tool to overcome a certain shortage in the Portuguese market of income-generating assets, given the growing appetite of institutional investors and pension funds. These players are now looking at products still under development, which work as an interesting door into these sectors, leading to attractive yields for investors in exchange for taking on additional construction risk. At the same time, this financing scheme allows promoters to ensure the certainty and stability of the project's financing and, therefore, the necessary cashflow to cover the costs (development finance) from an early stage in the development, as well as certainty at exit through sale at a pre-fixed price, hence mitigating exposure to high levels of debt capital.

Regarding such a structure, developers commit to: develop, construct and market the properties with funds made available by investors; and deliver them to investors once the development is completed. Investors commit to fund  the project development costs, while gradually acquiring property ownership as construction progresses.

Partnerships in this context are typically framed under contractual packages involving a complex set-up and negotiation. In the absence of the specific legal regulation of these contractual tools in Portugal, parties are said to enjoy wide flexibility in designing the structure and allocating the underlying risks. The identified gaps in Portuguese contractual practice have often been filled by importing mechanisms already tested in the jurisdictions^[2] of foreign sponsors or investors seeking real estate projects in the country. Therefore, the lack of sufficiently well-developed legal products in the Portuguese market has led to a context where parties draw up a tailored package in accordance with the different features of the project and their own risk profile.

How are they processed?

Transactions in a forward format are commonly set up through a mixture of property (special purpose vehicle or SPV) transfer agreements (a sale and purchase agreement), credit facility which covers the funding of the development costs (a facility agreement) and the forward funding agreement itself^[3]. Under this contractual scheme, the real estate developer and forward funder will agree on the progressive sale and financing of an early stage real estate development project with a view to selling it entirely at completion, provided that all the conditions set out ab initio are met and against the final payment of a pre-fixed consideration, at which point the final transfer of property (SPV) to the investors is set to occur.

The forward deal may create just the right incentives for the parties, since one should see at the core of the economic arrangement a balanced sharing of future project profit after completion (the development profit): developers get more affordable financing for all the construction costs (compared to other typical sources), which are fully borne by the investor, plus a rate (internal rate of return or IRR) to incentivise project delivery on time and on budget; investors are in turn guaranteed a rate of return on their investment which is usually higher than traditional development financing. Thus, forward funding seems to offer a great solution to parties seeking attractive returns in the context of real estate project development, albeit with a potential increase in risk which is typically shared between the parties. Another key advantage for investors is flexibility, in that the model is set to allow them to shape their investment and control the development of the invested product from an earlier stage compared to more traditional forms of investment.

Main features

Forward funding schemes are based on a phased sale and purchase and financing according to the several milestones of project development until completion (commercial operation date or COD), at which moment the definitive share purchase agreement (SPA) to transfer the remaining share of project (company) ownership will be executed. Until then, the project is agreed to be developed in a collaborative, partnership or joint venture manner, based necessarily on a shareholders’ or investment agreement with a strong financing component. Therefore, this model revolves around the contractual regulation of the purchase and sale and investment, included in a package with a set of principles on risk allocation, governance mechanics, step-in and exit rights, which are essential to the economy of the agreement. Although the acquisition will usually take the form of a share deal, the contractual structure tends to differ in several aspects from a typical M&A transaction.

Due diligence

Due diligence is an absolutely crucial stage in the process (as in a pure M&A transaction) in view of establishing the basic principles of the agreement and defining the perimeter of risks, which both parties will allocate among themselves during project development. It is generally carried out prior to the signing of agreements. Due diligence will focus on land rights, urban planning and construction permits, and the solvency of the developer, complemented by a confirmatory and usually a simplified/abridged audit (with site visit) prior to final closing, aimed at certifying that the developed project complies with the agreed construction schedule and conditions.

Conditions

At initial acquisition, an investor will usually expect land rights to be secured and some steps in project licensing already completed or initiated, whereas the final acquisition/completion (COD) will typically be conditional upon the project’s provisional acceptance, lease execution and issuance of the final licences/permissions. Non-verification of the final conditions will usually entitle the investor–buyer to withdraw from the project and terminate the executed contract (step out).

It will not always be the case that developers manage to transfer all the construction risk (including delay-related liquidated damages) to the contractor (pass through), in which event they will be taking on part of that risk. Nevertheless, developers will seek to align the completion phase of the work under the construction contract (engineering, procurement and construction or EPC), with project acceptance by the investors at final closing.

Pricing

The definition in advance of the closing price is a key feature of a forward type of funding agreement. It is usually pre-defined based on certain assumptions, by incorporating both the estimated margin of the promoter (profit) and a certain project profitability assured to the investor (yield), that is the split of the project profit, which is strictly dependent on the remuneration established in the lease contract (rent) from which the cashflow or return to investor after the project starts operating will stem.

The goal here is to reach a final remuneration that is as fixed as possible so as to limit parties’ exposure to the risk of abnormal variations between the initial purchase and closing. From another angle, by committing to a fixed final price, the promoter will run the risk of potential fluctuations in the project's development costs, which the investor will commit to finance only up to a certain threshold. While certain investors will want to receive a coupon linked to the project’s ongoing financing, promoters typically receive their profit share only after and subject to completion, and such a share may be impacted (reduced) in the case of completion delays or overruns. The high yield guaranteed to the investor from the outset and the generally lower return for the promoter is also a result of the element of risk taken by the investor as the financier of the project costs, while also assuming part of the risk from construction delays and the promoter's own insolvency.

Risk allocation

The mechanics of risk allocation also tend to differ from a traditional M&A structure. Given the phased and upfront nature of both the payment and financing of project development, the parties are led to agree on a risk allocation process throughout the construction phase. This is a critical aspect, especially for investors, who will be exposing themselves to the risk of underperformance or insolvency of the developer–seller.

The risks underlying the correct and timely completion of projects are fundamentally covered in the form of standard representations and warranties provided by the seller for the benefit of the buyer; these will usually have different meanings at each stage of the project acquisition: at initial acquisition the promoter will be declaring that the project is held by the SPV, has certain technical features, and meets a set of legal and regulatory requirements (true representations), whereas statements agreed for the final acquisition phase tend to consist, in essence, of warranties  as to the future occurrence of certain events, of which the main one is delivery of the project according to agreed characteristics, without overruns or encumbrances of any sort. Underlying these warranties is the pure objective allocation of risk between the parties, who decide to place on the developer–seller the risk of non-verification of the agreed assumptions regarding the project’s final configuration

Guarantees

In a forward funding structure where the partial transfer of SPV ownership has already taken place, the investor becomes exposed to both the construction and promoter’s insolvency risks, which leads to the need to agree on a set of guarantees in order to mitigate those risks. For this reason, investors will sometimes wish to negotiate the provision of additional guarantees to cover the risk of delays in the project development or concerning the promoter's own insolvency. Typically, promoters will seek to transfer such risks to the contractor under the EPC contract (pass through), which is not always possible in its entirety.

Control/reserved matters

This is one of the most delicate and intensively negotiated issues in the contractual package, given the challenge to finding a balance between safeguarding the developer's autonomy in the project development and the need for the investor's intervention at key moments/decisions. Since the risk of the construction and developer's insolvency is borne by the investor, the investor will be encouraged to monitor the developer's behaviour and anticipate/control any cost overruns throughout the entire development stage and will, therefore, seek to ensure their active participation in the decision-making, which may impact the course of the construction.

Although management is primarily allocated to the shareholder–promoter, who are responsible for selecting the company's main counterparties in the project development, the investor is commonly called upon to opine on and validate that selection, and the terms and conditions of the construction contracts and leases, in order to ensure that the remuneration, schedule of works and guarantees/collateral provided are in line with the business plan and budget, and are duly reflected in the final price.

The agreement will generally be based on a business plan and budget that will set out the financial milestones of the project and the conditions for successive drawdowns, with the investor committing to inject the funds required for the construction on a recurrent and scheduled basis (capital calls). The agreement will necessarily include a maximum investment amount (funding threshold) to which the investor will commit itself and which defines the limit of its exposure to the risk of cost overruns. Financing by the investor will typically bear interest, usually higher than bank debt, but lower than mezzanine finance.

Step-in or participation rights and exit rights

Mechanisms are commonly foreseen to allow investors to replace the promoter in the management of the project in the case of underperformance (eg, schedule or budget slippage) or the risk of insolvency in order to prevent the project from not being completed. In the event of cost overruns, or contractor or tenant default, the investor will want to be assured of step-in rights under the construction contracts in case the developer or vehicle company defaults.

Final remarks

Forward funding, as a transactional financing structure, has significant potential to be seen as a viable alternative investment solution to typical debt structures and traditional sources of finance. The financing model of these so-called pre-let development projects tends to offer the appropriate incentives to the promoter–seller and investor–buyer alike. While based on more complex contractual structures and tending to be riskier, the trade-off is generally seen as rewarding, promoters accept a lower upside return in exchange for cashflow certainty and stability for the project's development; investors are required to have a higher level of expertise and involvement in the course of the project development in a collaborative way, closely monitoring the promoter's actions and given the risk of slippages or delays or promoter insolvency, generally ensuring higher returns compared to traditional investments.

Forward deals are increasingly seen in Portugal as a robust resource and a viable and profitable alternative, both by developers and institutional investors. The growing sophistication of the associated contractual packages and the maturity of the market itself are set to boost this transactional market in Portugal.