Project delivery and construction arbitration – A playbook for infrastructure PE funds

With greater private equity participation in infrastructure projects, a clear approach to construction contracts and project governance is essential.

"The global economy is on the cusp of an infrastructure revolution."

Larry Fink, CEO, BlackRock (The Economist, Why BlackRock is betting billions on infrastructure)

The last decade has seen a global surge in private equity (PE) investment in infrastructure assets. According to IJInvestor's Fund & Investors Report Full Year 2023, PE funds have raised nearly US$635 billion in infrastructure capital since 2019, with US$108.7 billion raised in 2023 alone. Infrastructure funds are also growing in size. While overall funding slowed in 2023, the cumulative target size of infrastructure funds in capital-raising mode jumped in 2023 to US$172.9 billion, compared to USD$136.8 billion in 2022. Among the many factors behind this growth, The Economist magazine highlights three prominent trends:

• Decarbonisation: Achieving the world's climate goals requires vast investment. The Economist magazine estimates US$8 trillion is needed over the remainder of this decade in renewable energy and associated infrastructure such as battery storage technology and transmission lines. As reported by IJInvestor, 14% of capital raised by infrastructure funds in the past five years was for renewables projects, highlighting the interest of the PE industry in supporting the energy transition.
• Digitalisation: Governments and industries are racing to unleash the potential of digitalisation, such as artificial intelligence (AI) and the Internet of Things (IoT) to raise productivity. The World Economic Forum predicts that, by 2025, the AI and IoT markets will reach US$4.5 trillion and US$15 trillion respectively. Digitalisation requires significant physical infrastructure to support it, from subsea fibre optic cables to data centres, creating further investment opportunities.
• Diversification: The economic impacts of global events such as the Covid-19 pandemic, the Russia-Ukraine war and the conflict in the Middle East, have reinforced the need for many industries to diversify their supply chains, leading to rising demand for the construction of capital-intensive projects such as factories and transport infrastructure.

All infrastructure projects face the possibility of claims, especially during and after the design, construction and commissioning phases. Where claims cannot be addressed amicably, arbitration is the most common forum for formal dispute resolution. The last few years have seen a steady increase in the number of construction disputes involving PE funds, particularly in complex energy transition projects. In this article, we assess common pitfalls during the project delivery phase which can hamper progress and result in claims, as well as some unique features emerging from construction arbitrations involving PE funds.

Project delivery phase risks

Delivering complex and large-scale infrastructure projects on time, on budget and to required standards requires a robust approach to due diligence, procurement and contracting. Although there are myriad challenges to achieving this on any project, there are some key difficulties that can arise, particularly on PE-sponsored projects.

Incomplete contractual pass through of project risks

While extensive due diligence and scrutiny of data form the basis of financial models on which investment decisions are made, the same level of care may not always be exercised in relation to the legal review of contracts dealing with design, procurement, construction and commissioning risks.

Most infrastructure projects will involve key project agreements between the project company and third parties, which provide for a revenue stream and related infrastructure, such as power purchase agreements and grid connection agreements. These contain obligations and liabilities that need to be reflected in the 'downstream' agreements for design, construction and commissioning. Where those obligations and liabilities are not made 'back-to-back', material gaps can arise in allocating risk. This can mean a project company’s ability to recover losses due to contractor/supplier default can be limited, which may also have implications for the (continued) insurability of the project.

This is especially relevant to projects procured on a multi-contract basis where there is no 'EPC wrap' (ie, no contractor with single point responsibility). In this scenario, the project company needs to ensure any material obligations and liabilities it owes under upstream project agreements, particularly in relation to design and performance as well as associated liquidated damages, are fully reflected across all the key construction/supply contracts it awards. There should also be full alignment across these construction/supply contracts in matters such as the design/performance criteria and the definition of, and remedies for, defects. Otherwise, where defects or performance failures arise, the project company may encounter practical difficulties in rectifying defects (eg, due to gaps in warranties between the relevant construction/supply contracts) and may have limited contractual recourse against individual contractors or suppliers to recover losses incurred under upstream project agreements.

Such 'risk gaps' can be mitigated to a certain extent on greenfield projects, where PE funds are invested from an earlier stage when construction and supply contracts are yet to be finalised and opportunities remain to influence or even dictate contractual terms. That is not normally the case for brownfield projects, where PE funds are investing in projects in which construction and supply contracts have already been awarded. In these circumstances, detailed due diligence is essential to ensure the full extent of the project company’s obligations and liabilities are understood and effectively priced in. The insurance strategy for the project will also be an important part of mitigating project delivery risks, in particular, to address delay to start-up and business interruption once a project has been delivered.

This risk is not theoretical. We have seen many project companies (and by extension their sponsors) unable to recover losses from contractors and suppliers due to such risk gaps, leading to unanticipated liabilities that ultimately impact PE funds' returns.

Internal management challenges

Structural issues on PE-sponsored projects can also impact project progress and obstruct effective dispute management. This is particularly the case where PE funds have assumed development risk by entering the project at an earlier stage, requiring them to make prompt decisions in matters such as extension of time and additional cost claims by contractors, defects and calling on project security.

• Absence of project company legal team: Project companies do not always have dedicated in-house legal teams to manage the project in the collective interests of all project sponsors. Each sponsor will typically have its own in-house legal team and may (but not necessarily) second its members into the project company. The absence of an independent legal function within the project company which can give instructions to external lawyers that represent the aligned position of all sponsors can create an unnecessary obstacle to important commercial and legal decisions being made. Further difficulties can arise if sponsors have different corporate cultures or where certain sponsors are also involved in other parts of the project chain (and therefore have different interests).
• Competing interests among sponsors: Different sponsors often have conflicting financial and commercial goals. While the involvement of PE funds will typically be limited to a fixed and relatively short period compared to more traditional long-term asset owners, other types of sponsors may play multiple and more long-term roles in a project (eg. as the offtaker or the operation and maintenance contractor) and as a result have a different risk profile and attitude towards delays or defects. Misaligned sponsor interests can affect productive contract negotiations and, once contracts are awarded and the works are underway, the project company's approach towards contractor claims, including the timing and quantum of settlement offers made or accepted. For example, a sponsor who is also a project's main offtaker may be incentivised to resist a contractor's claim for an extension to the project completion date if this delays the project's commercial operations and the sponsor's ability to fulfil downstream supply contracts under which it may be exposed to liquidated damages.

Such inter-sponsor dynamics can, of course, be effectively managed. Key measures include setting out clear reporting lines and procedures for approvals between sponsors and addressing in the joint venture or shareholders' agreement for the project company matters such as how to deal with conflicts of interest and deadlocks in decision making. It is, nevertheless, not uncommon to see inter-sponsor disputes arise where these risks are not effectively managed.

Construction arbitration risks

An effective system for managing claims and a cohesive strategy for dealing with formal disputes are important for project success. However, structural features of PE-funded projects can present unique challenges in how claims are managed and arbitrations conducted.

Security for claim/costs

The lifespan of a large, complex construction arbitration can extend beyond the end of a traditional PE investment horizon. This can give rise to concerns about a project company’s ability to meet a contractor's claims and/or the costs of the arbitration, in the event the contractor is successful.

Consequently, this can expose a project company to applications by its counterparty for orders that it provide security for the contractor's claims and/or its legal costs, known as security for claim and security for costs, respectively.

The need for security for claim may arise if, for example, enforcing an arbitral award would be impossible as the project company lacks assets against which the award can be enforced. Security for costs may be needed to ensure that a party - usually the respondent to a claim/counterclaim - can secure an amount representing its costs of defending claims/counterclaims against it.

Although arbitral tribunals can only grant such orders against arbitral parties, the arbitral legislation of many jurisdictions – such as the Singapore International Arbitration Act and users of the UNCITRAL Model Law – allow, in principle, parties to request domestic courts for security for claim/costs from non-parties, such as PE sponsors. That said, in our experience, it would be rare (but not impossible) for such orders to be granted directly against sponsors.

Managing payment schedules

PE fund investors do not generally inject their entire investment capital into a project at the outset. Rather, capital injections are made over time, generally subject to prior discussion with an investment committee. Completing this process requires time, which must be factored into payment schedules for disputes such as the payment of fees for legal counsel, experts, arbitrators and institutions.

Where projects are also debt funded on a non-recourse basis (eg, through traditional project finance structures), project financing agreements usually contain specific notification obligations and restrictions in relation to disputes and related funding. This means that a project company may also need to carefully communicate with and obtain consents from lenders as well as from their own investors.

In practice, such disclosures can attract lengthy enquiries by lenders before the lenders arrive at an aligned decision. As with the communications with investment committees, these lead times must also be factored into a project company's dispute management strategy. Also, a project company should take care not to accidentally trigger events of default under financing agreements due to non-notification of disputes – and related funding issues – to lenders.

Disclosure risks for sponsors

A common feature of arbitrations is disclosure or 'document production', which is the process by which a party seeks to obtain documents that are relevant and material to the dispute from the other party. In the context of construction arbitrations, contractors/suppliers may seek disclosure of the internal discussions among sponsors on the issue in dispute.

Sponsors may try to avoid production by arguing that such documents at the individual sponsor level are not within the 'control' of the project company, to which international arbitral practice typically limits document production. However, depending on the seat of arbitration such as England and Wales, Singapore and Hong Kong, it is possible for a sponsor’s personnel to be separately subpoenaed to produce documents for use in the arbitration, in particular, where that sponsor had a material involvement in the disputed issue.

Sponsors, therefore, should carefully consider the ways in which project information is shared and decisions recorded. Details of discussions on legal matters, particularly potential claims and disputes, should be shared on a need-to-know basis and routed through in-house or external counsel to ensure communications are protected by privilege where possible.

Conclusion

The increasing involvement of PE funds in infrastructure projects is set to continue. With this comes increased and unique challenges for the management of construction claims and arbitrations. One of the most difficult challenges we see is effectively reconciling the diverse interests of sponsors, lenders and the project company, as well as the practical complexities these give rise to.

However, these challenges can be managed. Risks in project delivery can be mitigated by well-drafted joint venture agreements, clear reporting and approval procedures at the project company level and risks passed down the supply chain appropriately. Dispute management risks can also be addressed through early consideration of internal processes for decision making and funding, limiting communication chains – especially on legal issues – and carefully managing external stakeholders, such as lenders.

This article was originally published in our INSIDE ARBITRATION publication (Issue 17, March 2024). To read the full publication, please click here. To watch Dan Waldek's introductory video please click here. 

For more information, please contact Dan Waldek, Noe Minamikata, Tse Wei Lim or your usual Herbert Smith Freehills contact.