DATE: Thu 26 Apr 2018
BY: Julia Eberdal
A Debt Service Reserve Account (DSRA) is normally required by the lending banks if you are looking for project financing.
A DSRA is a restricted bank account into which funds are set aside in order to cover periods of weak cash flow and ensure that your debt service (interest + principal) still can be made without going into default due to temporary liquidity issues. The commercial terms are negotiated for each deal, but as a rule of thumb its target balance is usually six months’ future worth of debt service.
Equity holders will be delighted to achieve excess returns (above forecast); however, this is of less concern to the lending banks. The banks’ primary concern is whether the debt that has been drawn down can be repaid. They do not benefit from any excess return, which goes to the equity holders; their concern is for their own return – which often is fixed.
Now, as lenders, the banks need to ensure that they get their return on investment. This is no different from the equity holders. The banks; however, are paid a fixed rate of return, whereas roughly speaking, the equity holders are paid any return in excess of this.
The main reason that a DSRA might not be desirable by all (in particular equity holders), is simply that cash is being locked up. Cash is not free, it comes at a cost, and whilst holding cash on your balance sheet generates interest, the interest income rate is typically much lower than the equity rate of return on the project. The same goes for a funded DSRA – if the project company borrows cash to fund the DSRA, the lending rate is generally much higher than the interest income rate it earns on the DSRA. This means that the equity IRR takes a hit and is why settling the DSRA typically involves long-winded negotiations. The consequence is simply that equity holders will want to keep the amount as low as possible, whereas the banks will want it as high as they feel necessary to provide greater certainty of payment.
A DSRA is normally modelled as a control account, consisting of an opening balance, cash inflows, cash outflows and a closing balance. It is established by the company at Commercial Operations Date (COD).
These cash movements will normally consist of one row which releases funds from the DSRA when they are needed to pay off senior debt, and one row which tops up the account when it falls below its target level, or releases funds if the account is overfunded.
*Example of a DSRA
In the above example, there is insufficient cash to pay the debt service in the second quarter, and funds are drawn from the DSRA to cover the shortfall. This means that the DSRA falls below its target balance, but is topped back up again in the third quarter. As the debt service decreases, so does the target DSRA balance and funds are released from the account in the last two quarters.
The account can be funded in various ways, for instance, it can be built up over time with available cash flow, be funded with a one-off deposit that may be negotiated with the lenders as part of the project costs, or as a combination of the two.
When it comes to which cash flow to use, it depends on how your cash flow waterfall is constructed and where the DSRA falls in terms of seniority, which you can read more about in the article on CFADS. If you have a DSRA for your senior debt, the cash inflows and outflows to and from the DSRA should follow your senior debt interest and principal repayments, drawing from a line item which can be clearly labelled as Cash flow available for DSRA.
*Example of the DSRA in the Cash flow waterfall
A common issue that arises when modelling your DSRA is that of circularities. Why does this happen? Often the target balance is agreed at the forecasted six months of debt service, and with the logic being forward-looking, circularity issues can arise. There are various reasons to why this is the case, not simply due to including interest on the DSRA – these will be dealt with in detail at a later occasion. A common solution to get around circularity issues is to have a copy/paste macro, which copies your forward looking target calculations into a pasted row. The dependents which were previously tied to the copied row are moved to the pasted row, which breaks the circularity.
This is a high level summary of the DSRA, and also the second blog in the series of Project Finance Basics. Be sure to keep up to date and follow the coming parts, which will be summarised in a Whitepaper – covering some of the most commonly used terms within Project Finance.
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