Utility Contract Buydown and Buyout Prepayment Approaches

Several recommended buydown and buyout approaches exist that allow Federal agencies to leverage prepayments to get the best value from utility energy service contracts (UESCs).

Most UESC projects allow the Federal Government to prepay the funding obligation at any time during the term of the contract in accordance with a pre-established termination schedule. When underwriting a long-term debt obligation, an investor or lender commits assets to an investment that is expected to provide a fixed rate of return over the term of the contract. If the investment is prepaid, the investor or lender must take the prepayment proceeds and reinvest them in another financial instrument that will, hopefully, ensure the same rate of return regardless of current market conditions.

Historically, the Federal finance marketplace has experienced few terminations for convenience or prepayments. Because of this, there should be little, if any, premium paid by Federal agencies for the right to prepay. However, if the Government begins to consistently and systematically prepay and if prepayments are based on lower market interest rates, it is likely that a premium of 25 to 50 basis points would be charged for the prepayment right.

The Federal Government can reduce its costs associated with prepayments (such as the termination liability premium, interest rate premium, or make-whole penalties) by limiting prepayments to actual terminations for convenience.

Minimizing Prepayment Costs

Alternatives to paying a premium rate and having increased monthly payments over the entire term of the financing protect against a possible prepayment shortfall. Customers and borrowers typically use a formula that reflects the current interest rate at the time prepayment is made. This ensures that prepayment is not paid for as an additional assessment to the monthly payment, but rather in the form of the actual cost at the time of the event. Thus, the Government does not pay an increased interest rate for an option that may never be exercised.

The Federal finance marketplace has several other ways to minimize Government costs from prepayments. Some finance companies have substantially reduced the effective risk of prepayment, without charging the Government an interest rate premium or the use of a make-whole formula. This is done by aggregating Federal transactions into portfolios. In this case, the number of projects funded spreads the potential of prepayment and the perceived financial risk over all projects.

Another way that prepayments can be accepted without adding a premium or penalty is by allowing the finance company to reinvest the money for the benefit of the Government and use the accrued interest and principal to shorten the term of the transaction.

Projects for single transactions that aren't funded as part of a larger portfolio may receive a lower interest rate if a make-whole formula is inserted into the contract. Some finance companies offer a lower financing rate if a make-whole clause is used, others do not. The make-whole premium will not compensate the Government for the benefit enjoyed by the finance company should the prepaid funds be reinvested at a higher rate, but will cost the Government money if rates have fallen.

The make-whole clause may limit future flexibility because it does not allow refinancing if rates go down during the contract term. The formula, in contrast with a fixed amortization schedule, is designed to protect an investor should the Government elect to prepay a finance obligation at a time when interest rates (treasuries or swap rates) are lower than when the financing was originally initiated.

The make-whole formula offers investors or lenders protection for yield maintenance. At the same time, it allows the Government to take advantage of a substantially lower interest rate. The impact of the make-whole provision should be evaluated in detail in order to decide which prepayment strategy is the best.

Recommended Prepayment Formula Clause

The following is a draft clause that could establish a mutually agreeable prepayment formula. Insert swap rate terminology if used instead of T-bill references.

This task order provides that if the Government prepays the task order at any time during the term, the Government agrees to give the contractor thirty (30) days prior written notice and to pay a yield maintenance amount plus the un-amortized principal balance of the total funding amount plus accrued interest. The yield maintenance amount shall be equal to the difference, if positive, between (1) the net present value of the payments remaining to be paid through the term of the payment period, and (2) the un-amortized principal balance of the total funding amount. The calculation of the net present value shall assume that each remaining payment is made on the relevant payment due date and shall be discounted to the effective date of the prepayment at an interest rate equal to the sum of (i) the yield-to-maturity of a United States Treasury obligation having a term most closely approximating the average life of the un-amortized principal balance of the total funding amount, and (ii) one-half of one percent (1/2%). Such implied yield shall be determined, if necessary, by (a) converting U.S. Treasury bill quotations to bond-equivalent yields in accordance with accepted financial practice and (b) interpolating linearly between yields reported for various maturities. In the event the Government terminates or cancels the task order for any reason whatsoever after acceptance (including, without limitation, termination pursuant to the clause entitled "Termination for Convenience of the Government"), the Government agrees to pay the sum of (x) the yield maintenance amount calculated as described above and (y) the unamortized principal balance of the total funding amount plus accrued interest. The Government acknowledges and agrees that the payment of such amounts are reasonable and allowable costs with respect to the task order.