The LC-backed equipment facility

A letter of credit is an undertaking given by a bank, at the request of an applicant, to pay a beneficiary against presentation of specified documents. Two features make it different from a guarantee, and both matter structurally.

It is independent. The bank's obligation is to the beneficiary and stands apart from the underlying commercial contract. A dispute between buyer and seller about the equipment does not, of itself, excuse the bank from paying. That independence is the whole product: the beneficiary is relying on the bank rather than on the counterparty.

It is documentary. The bank pays against documents that comply with the credit's terms, not against an assessment of what happened in the world. A presentation that complies is paid; one that does not, is not — regardless of the underlying merits.

Two forms recur in equipment transactions. A commercial or documentary credit is the payment mechanism itself, used where a supplier ships against payment on presentation of shipping and inspection documents. A standby credit is a support instrument, drawn only if the party it supports fails to perform, and it functions economically much like a guarantee while retaining the documentary character above.

In either case, what the structure has done is substitute one credit for another. The beneficiary — a supplier, a lessor or a lender — no longer needs to be comfortable with the applicant. It needs to be comfortable with the issuing bank, with the documents it will have to present, and with the period the undertaking runs for. Everything difficult about an LC-backed facility follows from that last point.

One further mechanism completes the picture: the applicant reimburses the bank if the credit is drawn. The LC is not free capital; it is a contingent obligation of the applicant that converts into a real one the moment it is called. What the applicant has bought is the beneficiary's willingness to transact, and what it has given is a reimbursement obligation, usually secured.

The instrument is used across the stack, but it earns its place on layers 3 and 4, where equipment is being bought and where the equipment's own value is doing less work than a sponsor expects.

The recurring situations:

The buyer's credit will not carry the exposure alone. A newly formed project entity, a sponsor without a long operating record, or a structure whose assets are all pledged elsewhere. The supplier or financier is willing to transact with the assets and the plan, and unwilling to take the entity's own promise to pay.

The supply is cross-border. Where the parties are in different jurisdictions, the seller is exposed to a legal system it does not know and enforcement it cannot price. A bank's undertaking, governed by widely used documentary practice, is a common answer and a large part of why the instrument exists at all.

Payment precedes delivery. Long-lead equipment is paid for in stages before it arrives, which is the exposure described in [equipment finance for turbines and gensets](equipment-finance-for-turbines-and-gensets). A credit can be structured so payment is released against documents evidencing progress or shipment rather than against trust.

The collateral is weak on its own. On compute in particular, recovery is a thin backstop — the equipment moves, sits in someone else's building and loses value quickly, as [collateralizing compute](/compute/collateralizing-compute) sets out. A support instrument moves the analysis away from an asset nobody wants to enforce against.

What the LC does not do is change the underlying transaction's economics. It reallocates who bears non-payment risk, at a cost, and that cost is real: the applicant pays fees and generally provides collateral or cash cover for the bank's contingent exposure. Capital tied up as cover is capital not funding the project, which is the trade-off that decides whether the instrument is worth using.

Introducing a bank into a bilateral transaction moves several risks and leaves others untouched. Reading which is which is the practical work.

This is the structural weakness of the instrument and the thing most often handled badly.

Equipment facilities are sized against an asset's economic life or a contract's term. Letters of credit are issued for a validity period, and that period is usually shorter than either — banks issue contingent exposure for defined windows and review it when it comes up. So the support that made the paper bankable has an end date that does not naturally coincide with the exposure it supports.

The market answers are all imperfect and all worth negotiating explicitly:

Evergreen or auto-renewal provisions. The credit renews automatically for successive periods unless the issuer gives notice that it will not extend. This is the standard response, and it moves the risk rather than removing it: the beneficiary now depends on a bank choosing not to send a notice.

Non-extension drawing rights. The beneficiary may draw the full amount if it receives a non-extension notice, converting the support into cash before it disappears. This is what makes an evergreen credit workable, and its absence turns a renewal decision into an uncovered exposure.

Notice periods that are actually usable. A non-extension notice with a short window leaves no time to arrange a replacement. The period has to be long enough for the applicant to source an alternative and for the beneficiary to draw if it cannot.

Step-downs matched to amortisation. Where the underlying exposure reduces over time, the credit can reduce with it, which lowers the applicant's cover requirement. The mechanics have to be automatic or they will not happen.

Replacement obligations. A covenant requiring the applicant to procure a replacement credit from an acceptable institution by a stated date, with consequences for failing to.

The question that settles the design: on the day the credit expires, what does the beneficiary hold? If the answer is a claim on the applicant, the LC was covering a period rather than the transaction, and everyone should understand that at signing.

Letters of credit fail in well-documented ways. That they are well documented is not much comfort, because they still fail.

• Documentary non-compliance. The dominant failure mode. Presentations are rejected for discrepancies between what the credit requires and what was presented, and the bank is entitled to reject them. The mitigation is unglamorous: agree the required documents when the credit is issued, confirm that every party can actually produce them in the exact form specified, and check a draft presentation before it is needed.
• Soft clauses. Conditions that make a drawing depend on something the applicant controls — a certificate signed by the applicant, an inspection it must arrange, a document only it can issue. A credit that cannot be drawn without the cooperation of the party it protects against is not independent in any way that matters, and this is the single most important thing to read for.
• Expiry, and the notice nobody read. A non-extension notice sent to an address that is no longer monitored, or received with too little time to react. The date passes and the support is gone.
• The issuer is not acceptable to the beneficiary. Beneficiaries maintain their own criteria for which institutions they will take. Where the applicant's own bank does not meet them, a confirmation from an acceptable institution is the usual answer, and it has its own cost and its own availability question.
• Cover consumes the project. Collateral or cash cover posted for the bank's contingent exposure is capital doing nothing else. A structure supported by more credit than it needs has solved a bankability problem by creating a liquidity one.
• A drawing converts into funded debt. The reimbursement obligation is real. Where a credit is called, the applicant owes the bank immediately, generally secured — and that obligation arrives at exactly the moment the applicant is least able to meet it.
• Cross-border and sanctions exposure. Payment under a credit can be affected by the rules applying to the issuing, confirming or advising banks. This is legal territory and belongs to counsel; what matters commercially is that it is asked about early rather than discovered at presentation.

Continuum structures and arranges transactions that use these instruments and coordinates the parties in them. It does not issue, confirm, advise or hold letters of credit, is not a bank, a broker-dealer or a direct lender, and does not hold client funds.