What is a Debt Service Reserve Account (DSRA) ?

There are three core concepts of project finance.

One, it is all about long term promises of cash flow. The project is worth something as long as it is operating and generating a cash flow.

Two, risk sharing is allocated in contracts to capable parties best able to deal with that risk.

Three, it is non-recourse to the project sponsors. If a project does not go to plan and there is not enough money to repay the lenders, the lenders only have recourse to the project cash flows. They cannot go back to the sponsors. Any protection available for the lenders needs to be at the project level.

If the project cannot pay its debt in any given year, it is in default, in this situation, the lender could allow themselves some breathing room, by setting an amount of spare cash in the project that can be used to cover the shortfall and as we have this spare, or reserve of cash, to pay this shortfall in debt service, the project does not go into default. This cash, or reserve of cash, is called a Debt Service Reserve Account, (DSRA).

So, what is a DSRA?

It is a cash reserve account that retains money for when cash available for debt service (CADS) is too low to service debt.

This account provides cash security for the lenders, as it ensures the borrower always have funds deposited for the next x months of debt service The DSRA needs to maintain enough cash in it to pay for debt service whenever CADS is too low, and this amount it needs to retain is called a target balance.

The DSRA is a safety measure that gives the borrower time to deal with a lack of cash flow available to service debt and prevents them from defaulting.

Modeling a DSRA

The DSRA and funding method are important to consider when creating a financial model for a project. The funding of the DSRA, will affect cash inflows and outflows and modelling the DSRA involves cash inflows and cash outflows.

The DSRA is in fact a pretty complex part of a project finance model, and there are four elements we need to understand.

1. we need to be able to calculate the DSRA target balance.
2. if the DSRA balance is below the target balance, we will fund it from any cash that we have available for funding.
3. if there is not enough cash available to pay debt service, then the DSRA will release money to pay that debt service shortfall. This is the core purpose of the DSRA.
4. if the DSRA balance is greater than the target balance that we need, the extra money in the DSRA account can be released into the waterfall.

Now, remember, lenders will always want to check if the DSRA is in compliance with the facility agreement and you generally find the funding method stated in the project term sheet. As a result, when modeling a DSRA you need to put checks in place to determine whether the project is in breach of any of the contracted covenants.

Target Balance of a DSRA

This is amount of cash the DSRA needs to retain.

The DSRA is typically funded before Substantial Completion, and the target balance is the amount of the scheduled debt service over the next six to 12 months, typically The target balance could alternatively be sized based on the maximum scheduled debt service over any two consecutive periods throughout the loan life. Funding of the DSRA is also a conditioned precedent to Substantial Completion.

DSRA within The Cash Waterfall

In terms of positioning in the cash flow waterfall the DSRA is after scheduled debt service, but takes precedence over any payments to equity, thus providing additional security for the lenders.

From a lender’s perspective, they want to be paid the actual or scheduled debt service first. before they set aside some spare cash, to pay themselves if things do not go as planned. The DSRA is set aside before equity gets paid. This means that the payments to equity are delayed, but equity does not have much of a choice here. DSRAs are standard in project finance and for good reason.

Remember lenders only have recourse, to the project cash flow and the whole purpose of the DSRA in the first place is to set aside money to repay debt if CADS is lower than debt service.

The DSRA helps avoid default. The cash is used to pay debt service if CADS is too low. But when the DSRA is used to pay debt service, we go into lock-up and Equity cannot distribute, and the project will remain in lock-up until the DSRA is fully funded again. Equity gets no cash until the issue causing lock-up is resolved. The DSRA is cash collateral for the lenders. It needs to be fully funded. A DSRA is simply there to provide breathing room. There are bound to be surprises over the life of the project, and allowing lenders to draw the DSRA, by going into lock-up, is certainly better than defaulting.

If you would like to learn more about the requirements of a DSRA  please check out Pivotal180’s free video  DSRA requirements  or if you would like to learn more about financial modeling including learning how to model  a DSRA check out Pivotal180’s  Financial Modeling Courses.

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