Project finance, as a special form of financing, grew in popularity in Hungary after the change of regime, in parallel with the improvement of the money and capital markets and after the necessary legal background had been put in place. Favourable macroeconomic indicators in the nineties contributed to the uptake of this financing tool. Although the economic decline of recent years has had an effect on the general propensity to invest, project finance remains relatively popular as it offers tried and tested facilities that are much appreciated, especially in the area of corporate investment financing. In addition, after demonstrating the benefits of involving private capital in state and municipal investments, public-private partnership (PPP) transactions have come to figure ever more highly in the investment landscape over the past decade.

The first transactions to be financed through project financing schemes were implemented at the beginning of the nineties, mostly in relation to motorway construction as part of the overall improvements made in the country's road infrastructure. Later, in the second half of the nineties, project finance was typically used for investments aimed at the expansion and modernisation of fixed-line telephony and mobile phone networks and alternative telecommunication and data transmission systems. However, these days the highest-volume transactions are in the energy industry in relation to the development of power stations, mostly those using renewable resources (wind or sun, for example) and in connection with oil and natural gas investments. Apart from in these areas, project finance is playing an important role in the real estate industry, particularly with regard to the construction of hotels, shopping malls and industrial parks.

Sources

High-value investments are usually implemented with the help of external sources – typically loans provided by domestic commercial banks. Hungarian commercial banks have now added project financing to their roster of lending products, which are mostly very similar due to the intensity and transparency of the competition. In addition, there are also some private equity funds operating in Hungary, though their role in project finance is not yet significant. By contrast, the national development bank (the Hungarian Investment and Development Bank) plays an important role, especially with regard to the implementation of domestic regional investments.

Apart from this, and perhaps not surprisingly in view of the high proportion of foreign investors in Hungary, it is also typical for loans to be taken up from foreign banks or from development institutions operating in other countries.

Finally, Hungarian investment loans from the European Bank for Reconstruction and Development can also be taken up, and subsidies from the IFC and sources from the structural funds of the EU are also available to investors.

Foreign investors are welcome

In the nineties, the most important priority, in light of the emphasis placed on economic recovery, was to promote the inflow of foreign capital and to establish the legal background and economic conditions necessary for this. Recently, investments of the largest volume have been implemented by project companies registered in Hungary and at least partially-owned by foreign investors, or by foreign project companies (with these together accounting for nearly 50% of all investments in Hungary and 60% for larger investments). Hungary still has the highest concentration of foreign direct-investment capital of all the countries in the CEE region.

The legal background assures that foreign investors are treated on a par with any Hungarian national, and it especially ensures protection against state expropriation and other such measures. It also provides for the free movement of any invested or removed assets, without restriction. Beyond respecting the principle of equal treatment, the government adopts incentives measures from time to time. These measures include various tax breaks, such as a corporate tax allowance for investments above a certain investment value and tax allowances for developments in disadvantaged regions.

Wind projects: shortcomings

The legal background developed in the interests of protecting and encouraging investments still needs improvement, however. Certain shortcomings in the regulatory system have recently come to light in several areas, including project finance.

Inconsistencies that have emerged in relation to wind turbine projects in the energy industry are typical examples, as the law as it now stands obstructs rather than encourages new developments in this field.

Official authorisation procedures are, of course, necessary for oversight purposes, even if they are overly cumbersome at present. However, the fact that several investors – after initiating the relevant authorisation procedures and taking up loans of considerable size – were unable to start generating electricity because the Hungarian state had committed to taking up just 330 MW of electricity generated from wind power, with this total being spread too thinly among the various producers, did not exactly engender a favourable response. After all, the wind farms have been built, and large sums of money spent, only for the future marketability of any electricity generated above 330 MW to appear decidedly doubtful.

There has been an attempt to rectify this situation through a recent amendment to the relevant law, which provides that the amount of electricity produced from wind energy and falling within the limit of the take-over commitment is to be distributed based on tenders. This should help ensure greater equality of opportunity for investors. Problems resulting from the disproportionately low take-over amount, however, remain unresolved, despite the fact that under Hungary's obligations towards the EU the proportion of electricity produced from renewable resources must be increased to 10% of the total by 2020.

Another drawback as far as investors are concerned is that the amount of electricity produced from wind energy must be projected by the producers in advance, on a daily basis. If there is a difference between the pre-set and the actual amount of electricity generated – although, of course, it is impossible to predict whether the wind will blow or not – the producer has to pay a penalty to the relevant authority.

Given these and other unacceptable risks, investments are seen as being unreasonably exposed, while these risks also indirectly affect the chances of repaying the related loans. If the investment is implemented through a form of project finance, the above legal difficulties are highly disadvantageous, as timely repayment is directly related to the profitability of the venture.

Real estate projects: anomalies

Regulatory anomalies are also discernible in the real estate industry. As mentioned above, project companies are often established specifically for the purpose of implementing a particular investment, and it is frequently in connection with real estate project financing that, following the realisation of the project, when loans should be repaid to the lender, the project company terminates or simply disappears. In this situation, lenders have no choice but to enforce the collaterals under the loan agreement to satisfy their claim. However, enforcement of the collaterals means that the owners who bought the apartments built in the course of the project are left defenceless, as creditors are entitled by law to sell the property. In such circumstances the owners are unable to enforce their own claims, as by then the project company that sold them the apartment has long since vanished.

The above case is mainly typical of the construction industry. It occasionally happens that a project company registered in a different country takes up loans of a substantial value in Hungary and after that establishes a contractor company here. The project company transfers a certain amount of the loan to the contractor company, takes the remaining amount abroad and then disappears. The funds that were given to the contractor company are generally not sufficient for completing the project, so it is generally clear from the outset that no one will be able to pay the loans back to the lenders. In addition, by then a considerable outlay has often been made, not just by the general contractor but by the various subcontractors under it, with any collapse at the top placing smaller contractors in a hopeless situation. These latter contractors have no chance of enforcing their claims. Ultimately, it is the smaller contractors and the consumers who suffer, while the foreign investors make enormous illicit profits that are usually taken out of the country.

The problem outlined above has prompted a change in practice at the banks, who intend to place increasing controls on investors. The introduction of these control methods is also a result of the banks' concern for consumer protection, as the lending banks of investors are often significant lenders to the retail industry.

Characteristics of loan conditions

In Hungary there is no prescribed threshold above which a loan is regarded as a project finance loan. Some banks, depending on the project, recommend a project financing facility above an investment value of Ft200 million ($1.2 million) to Ft500 million, while other banks choose to go down the project finance route only for deals above Ft1 billion. Typically, the investment value of domestic projects falls somewhere in the Ft2 billion to Ft10 billion range, though projects of Ft10 billion to Ft60 billion are not uncommon.

For the purpose of securing the loan, all banks require a certain contribution of own resources, or a down payment, from the debtor. The relative size of the down payment depends on the characteristics of the project and on the collateral system applied, but the required minimum is usually between 20% and 40%.

The term of the loans usually ranges from three to 15 years, with a grace period of between one and four years depending on the nature of the project. The term tends to differ only in the case of real estate financing, where it is shorter, usually one to three years.

The currency of the loan may correspond to the currency in which the investment-related and other expenses will arise, or to the currency of the future revenues from the project, or else is determined based on the method of indexation. Most loans are euro or Swiss franc-based, but loans based in other foreign currencies can also be taken up, and multi-currency loans are becoming increasingly popular.

The interest and premium conditions vary depending on the risk of the project. In the riskier periods of an investment, these tend to be higher than in the payback period when the project is generating income and hopefully turning a profit. For a single bank, the rate of the interest premium – which, despite the risks of such projects, makes participating in them an attractive proposition for the banks – varies from between 0.7% and 2%.

Due to the high risk of these investments and the large value of the loans involved, syndicated lending – where several banks participate in the financing and share the associated risks, with one bank as lead manager – is also popular. In fact, due to the strict lending limits on individual banks and to prudential requirements prescribed by law, syndicated loans are often the only option. Where the value of the project is Ft2 billion to Ft10 billion, there are usually between one and three banks involved. If the value exceeds Ft10 billion, the number of banks is usually anywhere from four to 20.

There is also a particular form of multi-party financing where the participating lenders do not contribute to the financing at the same time but chip in at different stages of the project. This is typically the case in real estate investments. First the real estate company develops the property using the cash provided by a bank and, once the construction phase is over, during the operation period, a leasing company finances the project. Thus the construction and the operation phases are clearly separate in terms of both the form of financing and the financiers.

Collateral

Although owners of project companies and their subsidiaries are treated as separate entities under the law (the owners are not liable for the obligations of their subsidiaries), it is a common means of securing the agreement that the owner company undertakes an owner's guarantee towards the bank, typically in case the project's pre-determined cost limits are breached. In addition, it is also usual for the payment of profits from the project to the owners of the project company to be made available only after a certain period has passed and to be made contingent upon the achievement of certain financial performance targets.

The other forms of security required by various banks and other providers of funds are usually fairly similar. Typical collaterals include the assignment of future revenues and certain contractual rights to the lender, transferring the revenues to blocked accounts, a pledge on assets (floating charge), a collection authorisation with respect to the accounts of the project, as well as placing a charge on the project company's shares or quotas and, in the case of real estate investments, a mortgage on the property that is to be developed through the project. In the case of real estate leasing, a typical form of security is that the lessor company reserves the right – in the event that the debtor fails to pay – to sell the real estate in order to satisfy its claim.

PPP projects

Hungary has recently become the CEE region leader in the use of the PPP financing structure. The government is increasingly favouring this type of financing for its development projects, as set forth in its infrastructure modernisation and urban development programmes.

An inter-departmental committee was set up in 2003 to deal with matters related to the preparation and implementation of PPP projects. The most important tasks of the committee are to deliver expert opinions on PPP project plans and to monitor and evaluate the implementation of PPP projects.

Despite the fact that in Hungary there are no specific legal instruments in effect for directly governing PPP projects, the legal background for PPP financing is in place and fully harmonised with EU law. The procedural rules set forth by law regarding the realisation of projects may be examined from two angles, namely: (i) the preparation process; and (ii) the procedure for implementation.

As any PPP project represents a long-term commitment, the formal approval of the government is required by law, and for projects in excess of an aggregate value of Ft50 billion, the approval of parliament is required. The submitted project plans are ranked by the government based on a list of long-term priorities. The committee must then give its opinion on project plans that rank at the top of the priority list.

With regard to the preparation of contracts necessary for project implementation, the provisions of the Act on Concessions or the Act on Public Procurement apply, depending on the nature of the project.

In the case of investments related to mandatory concession activities – usually the utilisation of exclusively-owned state property – tender procedures are governed by the provisions of the Act on Concessions, which are more flexible than those of the Act on Public Procurement. However, if the value of the investment related to mandatory concession activities exceeds the value limits of public procurement, the procedural rules of the Act on Public Procurement also apply.

Most PPP projects are implemented in the framework of a public procurement procedure. In Hungary, a public procurement procedure is mandatory if the aggregate value of the project exceeds the threshold value set by law. There are essentially three types of procedure – procedures applicable to projects of a value equal to or exceeding: (i) the Community thresholds; (ii) the national thresholds; or (iii) the simple thresholds. Hungarian PPP projects are generally implemented under procedures applicable to Community thresholds and such projects are normally implemented by the usual awarding authorities (public entities and municipalities in a broad context and organisations that have received aid from either the state or the EU).

Recent PPP results

According to the committee report for 2008, there are 67 PPP projects underway or operating in Hungary. Of these, the smaller projects include investments based on the investment plan of the Ministry of Education in connection with the enlargement of student dormitories, as well as investments related to the development of gyms, swimming pools and sports halls. For these low-value projects, the project-control ministries prepare project plans for approval in the context of project packages and the projects are analysed, implemented and monitored in accordance with the respective method. Nevertheless, the application of the PPP option is not always recommended for small projects. For example, of recently implemented sports-related investments, only 37 of the projects were realised out of a total of 121 that had been planned because, in light of the low value of the projects and the low degree of competition involved, the PPP option proved relatively expensive and several municipalities refused to conclude the agreements.

Apart from the areas of education and sport, Budapest's new cultural centre, as well as two prison projects and recent highway investments, are also being implemented through PPP projects. Of these, the highway investments are far and away the most significant in terms of investment value. Of the 67 operating PPP projects, the combined investment value of the top seven – which include a number of highway projects – exceeds Ft30 billion.

According to the committee report for 2008, the most significant projects scheduled to be implemented in the very near future are the FEREX (airport railway system) project and the establishment of the electronic payment system related to highway use. Other PPP projects are being planned for dormitory, highway and transportation developments.

The future of PPP

Despite its recent successes, doubts have recently emerged in relation to PPP as a financing option. In the opinion of investors, PPP represents certain political risks, as actual PPP projects and the financial wherewithal for funding such investments are determined by the government in power. Any change in the governing party may result in a reallocation of the sums earmarked for the investments, as well as in a possible revision of the development objectives. In light of these and similar political risks (a possible change in the taxation rules, for example), investors expect the government to undertake certain guarantees to ensure the smooth implementation of such investments. However, these circumstances may make the government's – and, by implication, the investors' – situation more difficult because, as a result of the guarantee, the value of the investment may exceed Ft50 billion, in which case the approval of parliament will also be required.

Apart from this general tendency, the committee has also said that it frequently comes under pressure from lobbyists and other promoters wishing to use the PPP option for projects where such a financing arrangement would be patently unsuited as it would render the project unprofitable. The committee therefore suggests that PPP structures be applied only for projects with a value of more than Ft1 billion – primarily projects related to infrastructure developments. In the case of smaller projects, it strongly recommends that framework agreements be drawn up to help keep costs in check.

The committee also draws attention to the fact that it does not have adequate information on the PPP programmes of the EU (JASPERS, for example) and that it is by no means clear who should represent Hungary in such programmes and who should provide information in relation to them. In the interests of rectifying this, the committee intends to improve communication with the relevant bodies of the EU, which is also important in light of the committee's desire to gain greater access to EU funding sources.

In addition, based on recent experience, the committee aims to review the law on concessions and public procurement in terms of the requirements of the PPP model and to elaborate amendment proposals with regard to these laws for the purpose of enhancing the effectiveness of PPP projects. This review is now underway. The proposal for amendments is expected to be submitted in 2009.

Author biographies

Dr Zoltán Varga Nagy és Trócsányi Ügyvédi Iroda Dr Zoltán Varga is a partner in Nagy és Trócsányi Ügyvédi Iroda. He joined the firm in 2008. Zoltán was general counsel at CIB Bank Ltd from 1997 to 2007. He gained his degree at Miskolc University, Faculty of Law, Hungary in 1990. Zoltán also gained a postgraduate degree in foreign trade law in 1994. His practice includes company law, foreign trade, financing and capital markets. Zoltán is a member of the Arbitration Court of Money and Capital Markets, Hungary and is fluent in Hungarian and English. Dr Tamás Pásztor Nagy és Trócsányi Ügyvédi Iroda Dr Tamás Pásztor is an associate at Nagy és Trócsányi Ügyvédi Iroda. He joined the firm in 2007. Tamás gained his degree at Eötvös Lóránd Science University, Faculty of Law, Hungary in 2007. He is fluent in Hungarian and English.