This page addresses theoretical project finance issues associated with debt sculpting in the case where the amount of debt is given along with the minimum DSCR and the maximum debt life. In this situation, where the debt to capital constraint drives debt size and a minimum DSCR is established by a term sheet, the pattern of debt repayment is driven by the average debt life. The manner in which returns are affected by different minimum DSCR, average life and debt to capital constraints with different cash flows is described using different scenarios. If you are negotiating a term sheet, the analysis described on this page will help you understand what terms are important and what terms do not make much of a difference.

## Sculpting Theory and Sample Term Sheet

The sculpting methods in other pages that address sculpting when there is a debt to capital constraint use what I refer to as the LLCR method to sculpt debt. For example, say the minimum DSCR is 1.35 and the maximum debt to capital ratio is 80%. Say also that the debt to capital constraint is in place, meaning that if you sculpted to achieve the minimum DSCR in each period, the debt to capital would exceed 80%. The screen shot below illustrates the point that in a term sheet that is being negotiated, the debt to capital ratio is a maximum constraint and the debt could be lower if the DSCR constraint results in a lower amount of debt.

The LLCR method works by changing the target DSCR in the sculpting equation. This means that if the debt to capital constraint is limiting the debt size and then, you could increase the DSCR so as to achieve the debt to capital constraint. You can do this with the LLCR formula which is nice an elegant, but it generally will not appropriately model the structuring issues. If the DSCR is allowed to fall to the minimum level over the life of the project the DSCR does not have to be constant. If the DSCR is allowed to be higher at the beginning of the debt life and then fall to the minimum level, then the payments in the early part of the life of the project are reduced. This means that a level or flat DSCR over the debt life at a higher level than the LLCR computed flat amount is optimal. This idea is demonstrated in a simple example below with screenshots.

The first screen shot shows various components of a term sheet. Note that the minimum DSCR is specified as well as the maximum debt to capital. In addition, the minimum average debt life is stated as a constraint. In this term sheet, if the DSCR of 1.35 results in a debt to capital ratio of above 80%, then the debt to capital constraint will be in place. The minimum and average DSCR from tailoring the debt are not specified, but it is possible that the minimum DSCR can be 1.35 and the average DSCR can be above 1.35 (like the LLCR). In this case, the average debt life of 10 must be maintained. Note first the language about the DSCR language. The minimum and average cannot be below 1.35. But the minimum could be 1.35 and the average could be above 1.35. This could be the case if the LLCR sculpting is above 1.35 as shown a little bit later:

Note the how the maturity provision works. If you mess around with the DSCR, the average life of the loan must still not exceed 10 years. This means that you could have changing DSCR’s all over the place, but the minimum must still be 1.35.

So, let’s take a case where the DSCR is 1.35, but if you use 1.35 in every year, then the debt to capital will be too high. This applies the rule that the NPV of debt is from the DSCR and CFADS. By constraining the debt, you could come up with the scenario below with where the LLCR is used as the target in sculpting.

1. Sumproduct method: Multiply the period of the debt by the repayment for each period. Then sum the product and finally divide the product by the opening balance of the debt. This demonstrates that the average loan life is indeed the weighted average life of the repayments.

2. Opening Balance method: Sum the opening balance of the debt (it gets smaller as the debt is repaid). Divide the sum of the opening balance by the balance at COD.

In the case without debt constraint (where the debt is sized by the DSCR and not the debt to capital ratio), you can demonstrate the effect of the DSCR and the interest rate on the average loan life. This is demonstrated in a data table below.

A Rule of thumb for max Average loan life is

0.7x of the door-to-door tenor

.7 x 16 = 11.2

.7 x 14.5 = 10.15

Instead, you can design the sculpting so that the minimum DSCR will still be obtained, but that: (1) the total debt will be repaid (NPV of debt service) = debt; and (2) the average loan life is less than a specified loan life in the term sheet or loan agreement.

## Illustrative Case Study of Sculpting, Constraints and Equity IRR

The file and screenshots below are designed to provide an understand the negotiating implications of parameters that affect IRR with advanced sculpting. The sculpting is designed to produce a varying DSCR that is targeted to achieve constraints of both: (1) a target debt life; and, (2) a minimum DSCR.

**Spreadsheet File with Simple Example of Using Goal Seek and Solver for Sculpting with Fixed Debt**

The advanced sculpting is compared to two other cases. The first alternative case is one where there is no curvature in the DSCR. The second is the case where there is not debt to capital constraint and the debt size is driven by the minimum DSCR in each year. An excel model that includes these three cases and is used for the exercises is available for download by pressing the button below.

This section will demonstrate that the average life of a credit facility can have a big effect on the ultimate equity IRR for the investor.

If the average debt life is relatively short, the minimum DSCR in the term sheet may not be obtainable because of the constraint that the debt size is driven by the repayments. On the other hand, if the minimum DSCR is low, a long debt life may allow initial repayments to be reduced and a higher IRR to be obtained.

To illustrate the process, you should understand how the average debt life works. If the repayment occurs at the end of the period which is the standard approach you generally use in analysis and modelling, then the average loan life can be computed in two ways as follows:

1. Sumproduct method: Multiply the period of the debt by the repayment for each period. Then sum the product and finally divide the product by the opening balance of the debt. This demonstrates that the average loan life is indeed the weighted average life of the repayments.

2. Opening Balance method: Sum the opening balance of the debt (it gets smaller as the debt is repaid). Divide the sum of the opening balance by the balance at COD.

In the case without debt constraint (where the debt is sized by the DSCR and not the debt to capital ratio), you can demonstrate the effect of the DSCR and the interest rate on the average loan life. This is demonstrated in a data table below.

(If you don’t know what this means, you need to review the debt to capital versus the DSCR sizing analysis in the advanced structuring section.) As the average life drives the pattern of repayment, this section will demonstrate that the average life of a credit facility can have a big effect on the ultimate equity IRR for the investor.

To illustrate this case, I begin with a case where the debt to capital constraint is in place (because of a high debt life, a long debt tenure or a low interest rate).

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