Debt Service Reserve Account

What is Debt Service Reserve Account？

Debt Service Reserve Account, also known as DSRA, is a cash reserve account set aside to make debt payments when debt services are not available due to cashflow disruption. Usually, DSRA is a deposit equal to a given number of months’ projected debt service obligations. For lenders who are worried about borrowers defaulting on payments, DSRA is very important since it works as an additional security measure and ensures that the borrowers will always have funds deposited to cover future debt services.

Given that markets can be unpredictable, DARA is one of the most common control accounts in project finance. It is controlled by lenders themselves and is against shortages in cash to pay debt services. The typically required balance on DSRA is an amount equal to the aggregate of the anticipated principal repayments and interest payments over the next six months.

Commonly, DSRA is funded at the end of a construction period once the loan becomes repayable. The initial DSRA funding can be provided either entirely by lenders through a debt service facility, or by lenders and project sponsors in the same proportion. In the latter case, the DSRA funding will reduce the equity valuation and the internal rate of return debt service accounts is generally considered as a part of the financing cost in the project capex. However, it is usually not included in the project fixed assets during the project operations. The DSRA funding, if necessary, can also sometimes happen after the debt service.

The cash from which deposits are made in the DSRA is called cash flow available for debt services (CFADS). The cash can be withdrawn from the DSRA by both lenders and the project company if the project company fails to make debt principal repayment or interest payment. The lenders will withdraw any cash available in DSRA to pay unpaid debt principal in interest payment amounts. The project company may withdraw cash from the DSRA if the cash in the reserve account exceeds the required cash balance. Sometimes, if the loan agreement allows, the project company may present a letter of credit from a reputable bank instead of funding the DSRA.

Figure 1: (Left) The meaning of DSRA. (Right) The simple illustration of the process of DSRA.

More Detail

Structure

DSRA is usually funded up to a dynamic target balance, which includes both the interest and principal repayment amounts. The requirements will be defined in the term sheet and may include certain fees. Typically, the target is 6 to 12 months or can sometimes be a fixed amount.

The funding method for the establishment of DSRA, i.e. the initial funding of DSRA, is usually stated in the term sheet, which could be one of the following:

• Funded in full on the last day of construction
• Partially funded on the last day of construction, then built-up from the project’s cash flows
• Completely built up from the project’s cash flows

DSRA is cash balance owned by the borrower and thus sits on the current asset on the balance sheet.

Purpose

The purpose of DSRA is to provide a cash buffer during periods where CFADS is less than the scheduled payments. This cash buffer allows some breathing space for operational issues to be resolved and/or, in more extreme situations, the debt to be restructured before the borrower defaults on the debt.

Modeling

Established by the company at the Commercial Operations Date (COD), DSRA is normally modeled as a control account, consisting of an opening balance, cash inflows, cash outflows, and a closing balance. These cash movements will usually consist of one row which releases funds from the DSRA when they are needed to pay off senior debt, and one row which tops up the account when it falls below its target level, or releases funds if the account is overfunded.

Example

Table 1: An example of DSRA

An example of DSRA is shown in the table above. In this case, there is insufficient cash to pay the debt service in the second quarter, and funds are drawn from the DSRA to cover the shortfall. This means that the DSRA falls below its target balance but is topped back up again in the third quarter. As the debt service decreases, the target DSRA balance and funds are released from the account in the last two quarters.

The account can be funded in various ways, for instance, it can be built up over time with available cash flow, be funded with a one-off deposit that may be negotiated with the lenders as part of the project costs, or as a combination of the two.

Conclusion

DSRA is an important element in most project finance transactions. It is cash security for the lenders.