Distribution lock-up in project finance

A distribution lock-up is a contractual restriction that prevents the project or property company from paying dividends, shareholder loan repayments or other equity distributions when defined tests fail, so that cash remains inside the borrower for senior creditors.

AFME's project finance discussion paper states that distribution covenants imply distributions can be blocked where the debt service cover ratio or other ratios fall below a threshold, retaining cash when cash flows decrease. If DSCR is lower than the lock-up level, excess cash after debt service is trapped in the project company and cannot be distributed to shareholders. S&P Global Ratings defines a distribution test (also known as a lock-up test) as a test that must be passed before cash balances can be used for lower waterfall priorities, and defines a senior lock-up test as a coverage test that, if breached, locks up cash that would otherwise go to subordinated debt or equity.

How a distribution lock-up operates

In project finance and many CRE structures, receipts flow through controlled accounts under an accounts or cash management agreement. AFME describes the waterfall order as operating and supply costs, debt service, funding of debt service and maintenance reserves, then the distribution account. Lock-up sits at the distribution gate. Even if cash has reached a surplus or distribution account, transfer to sponsors is prohibited while lock-up conditions subsist.

Typical lock-up conditions include:

• historical or forward DSCR below the distribution threshold
• loan life or other cover ratios below threshold
• debt service or maintenance reserves not fully funded
• continuing default or potential default
• incomplete reporting, auditor certificates or model updates
• in CRE facilities, occupancy, debt yield or similar portfolio tests where documented

S&P's senior lock-up definition states that locked-up cash flows are typically reserved for the benefit of senior debtholders or ultimately used to repay senior principal if the documents so provide. Lock-up therefore pairs with optional or mandatory sweeps, cash traps and prepayment clauses. EBRD materials list pledges over bank accounts and typical ratio covenants as part of project loan packages, which is the security and covenant environment that makes lock-up effective.

Distribution lock-up versus default and cash sweep

Lock-up is often set above the default DSCR level. A soft breach traps cash without accelerating the loan. A harder covenant breach may create an event of default with acceleration rights. AFME notes that DSCR covenants can also allow security enforcement when needed. Credit papers state both the lock-up ratio and the default ratio, and whether lock-up alone is a default.

A cash sweep applies excess cash to prepay debt. Lock-up may trap cash without prepaying until a further trigger, a time limit, or lender instruction. Some facilities convert long-running lock-up balances into mandatory prepayment after a stated period. The economic effect on sponsors is similar (no distributions); the effect on loan life differs.

OECD Arrangement project finance criteria focus on repayment from project company cash flows and collateral over assets. Distribution restrictions are private contract tools that protect that repayment waterline. They are equally common in CRE cash management regimes where borrower SPVs distribute only after debt yield or DSCR tests.

CRE and PF common ground

In both desks, the borrower is often an SPV with restricted business objects. AFME stresses limitation of borrower activity and restriction of dividend payments as part of cash control. CRE springing cash management and lockboxes pursue the same objective: prevent leakage of rents or project receipts to equity while senior tests are failed. The security package over accounts and assignments of earnings or rents makes the restriction real rather than contractual only.

Reporting frequency determines how quickly lock-up engages. Quarterly DSCR tests create lagged traps; monthly tests engage faster. Forward-looking tests can lock distributions before a historical breach appears. Definitions of CFADS, add-backs and one-off items decide whether a period is distributable. Misalignment between the model and the lock-up definition is a recurring source of false comfort.

What a distribution lock-up review covers

A distribution lock-up review covers:

• each distribution test and its look-back or look-forward window
• relationship to default covenants and events of default
• treatment of subordinated debt and shareholder loans during lock-up
• whether trapped cash may cure reserves, fund capex or must wait
• any automatic sweep of aged trapped balances
• CRE-specific occupancy or debt yield overlays where relevant

Distribution lock-up is therefore a going-concern control on equity leakage. It keeps surplus cash inside the secured perimeter when coverage weakens, giving lenders time and liquidity without immediate enforcement, while leaving scheduled debt service and senior reserve mechanics ahead of any later release to sponsors.

Release from lock-up

Exit from lock-up requires satisfaction of the distribution tests on the relevant test dates, often for one or two consecutive periods, together with absence of default and full reserve funding. Some facilities allow equity cures that inject cash to restore DSCR for distribution purposes; cure recognition rules differ from debt sizing rules and must be read from the definitions.

While locked up, cash may still move for senior purposes: reserve replenishment, mandatory prepayment, or permitted cure of operating shortfalls. AFME's description of trapped cash building a buffer through weaker periods assumes that leakage to equity is blocked while senior-protective uses remain open. The accounts agreement lists those permitted uses explicitly.