This action might not be possible to undo. Are you sure you want to continue?
This Project Finance is based on public-private partnership (PPP) projects with a broad understanding of the process around project financing. Although the responsibility for arranging project financing lies with the private sector participant(s), all stake- holders must understand the process when evaluating the value for money conditions set out in the Treasury Regulations on PPP projects. Understanding the process will also assist depart- mental managers to manage transaction advisors and in negotiating with private sector par-ties. Finally, it is important to understand that the processes and structures used in the financing of projects are dynamic and continue to evolve. All stakeholders will therefore need to be flexible. PPPs are often funded through the department’s budget, but may also be partially or completely funded by the users of the service (e.g. a toll road or port). PPP projects vary significantly in term and in structure. Every project requires a certain level of financing, but this Project Finance primarily addresses the financing of longer-term PPP projects in which the private sector provider is required to raise funds for capital investment. Most of these PPPs pro- vide social services to the public. The objective of using project financing to raise capital is to create a structure that is bankable (of interest to investors) and to limit the stakeholders’ risk by diverting some risks to par-ties that can better manage them. In project financing, an independent legal vehicle is created to raise the funds required for the project. Payment of principal, interest, dividends and operating expenses is derived from the project’s revenues and assets. The investors, in both debt and equity, require certain basic legal, regulatory and economic conditions throughout the life of the project. The project’s revenues are obtained from the government and/or fees (tariffs) charged to the users of the service. In some projects, the private sector provider also pays concession fees to the government or to another designated authority, in return for the use of the government’s assets and/or the rights to provide the service, which is often a monopoly. In toll roads and ports projects, for example, the concession fee is based on the use of the service or the net income, giving the government a vested interest in the success of the project. In this case, the government’s interests are comparable to those of an equity investor. 1
Project Finance on public private partnership The rest of these Project Finance addresses the general structure of a project, funding alternatives, investor profiles, and the criteria investors will consider before and during the implementation and operation of the project. This is followed by a discussion of the terms and conditions often required by investors, and of the various financing (equity and debt) strategies to be considered by the sponsors of the project. This manual uses examples of existing PPP projects in South Africa, frequently referring to Trans African Concessions (Pty) Limited (TRAC), which was awarded the 30-year build-operate-transfer (BOT) concession for the N4 toll road between Witbank, South Africa and Maputo, Mozambique. This concession is discussed in more detail in Annexure 1. Annexure 2 outlines the various ratios used in project financing, while Annexure 3 defines the risks inherent to PPP projects.
Project Finance on public private partnership
2. Project finance structures
Project funding can be obtained from various sources. The charts below demonstrate the difference between public, corporate and project funding, using an example of a water treatment project.
For years, many governments, including the South African government, funded projects by using existing surplus funds or issued debt (government bonds) to be repaid over a specific period. However, governments have increasingly found this funding to be less attractive, as it strained their own balance sheets and therefore limited their ability to undertake other projects. This concern has stimulated the search for alternative sources of funding.
Chart 1: Public finance
• A government borrows funds to finance an infrastructure project and gives a sovereign guarantee to lenders to repay all funds. Government may contribute its own equity in addition to the borrowed funds. Lenders analyse Government’s total ability to raise funds through taxation and general public enterprise revenues, including new tariff revenue from the project. The sovereign guarantee shows up as a liability on Government’s list of financial obligations.
Project Finance on public private partnership
The following chart illustrates the structure of a water treatment project in which the private sector participant uses its own credit for raising the funds due to its capacity and the limited size and nature of the project. This option is often used for shorter, less capital-intensive projects that do not warrant outside financing. However, as with government financing, private companies avoid this option, as it strains their balance sheets and capacity, and limits their potential participation in future projects.
Chart 2: Corporate Finance
• A private company borrows funds to construct a new treatment facility and guarantees to repay lenders from its available operating income and its base of assets. The company may choose to contribute its own equity as well. In performing credit analysis, lenders look at the company’s total income from operations, its stock of assets, and its existing liabilities. The loan shows up as a liability on the company’s balance sheet (“Mining the Corporate Balance Sheet”)
• • •
Project Finance on public private partnership
Project financing uses the project’s assets and/or future revenues as the basis for raising funds. Generally, the sponsors create a special purpose, legally independent company in which they are the principal shareholders. The newly created company usually has the minimum equity required to issue debt at a reasonable cost, with equity generally averaging between 10 and 30 per cent of the total capital required for the project. Individual sponsors often hold a sufficiently small share of the new company’s equity, to ensure that it cannot be construed as a subsidiary for legal and accounting purposes. The final legal structure of each independent project is different. The following chart illustrates a simple project finance example. It shows that the legal vehicle (company) frequently has more than one sponsor, generally because: • • • • • The project exceeds the financial or technical capabilities of one sponsor The risks associated with the project have to be shared A larger project achieves economies of scale that several smaller projects will not achieve The sponsors complement each other in terms of capability The process requires or encourages a joint venture with certain interests (e.g. local participation or empowerment) The legal and accounting rules stipulate a maximum equity position by a sponsor, above 5
e. as well as by the credit implications for each participant.Project Finance on public private partnership Chart 2: Project Finance • A team or consortium of private firms establish a new project company to build. These relationships will be governed by additional contracts between the project company and the sponsors. stakeholders should maintain maximum flexibility. The new project company is capitalised with equity contributions from each of the sponsors. The project company borrows funds from lenders. sponsors often have other interests in the project. In other words. Annexure 1 describes the N4 toll road. including the design. construction or management of the project. 6 MGM IBM . this overlap often occurs in practice. The lenders look to the projected future revenue stream generated by the project and the project company’s assets to repay all loans. maintenance and actual ownership). The structure is often dictated by tax and other legal conditions. • • In large projects. construction. Sponsors are not precluded from being lenders. sponsoring firms provide limited guarantees. different legal vehicles may be established to perform specific functions (i. in which more than one Project Company was established and the sponsors’ interests extend beyond their equity investment. for which they will establish independent legal entities. In designing the structure of the project. The host country government does not provide a financial guarantee to lenders. own and operate a specific infrastructure project.
although not secured by specific assets. requiring the lowest returns. or the lessee may be exempt from taxes or expect losses in the early stages of the project. Construction financing. They are listed in order of seniority from the most risky. Preferred equity also represents ownership of the project. When the construction is completed. is used for construction purposes and is usually very flexible with respect to draw downs. usually at the option of the holder. A lessor may be able to depreciate an asset for tax purposes.or long-term and. is senior to equity and pseudo-equity in receiving dividends and repayment of principal. However. Construction financing lenders may require a designated long-term investor to 7 MGM IBM • • • • • . These are best described by their use of funds and carry specific conditions that will meet those requirements. the sponsors have a priority over the common equity holders in receiving dividends and funds in the event of liquidation.Project Finance on public private partnership 3. as the name suggests. Secured debt may also be short or long-term and is secured by specific assets or sources of revenues. although the lessor always retains the rights to the leased assets. one generally replaces it or more of the longer-term securities described above. requiring the highest level of return. The sponsors usually hold a significant portion of the equity in the project. • • Common equity represents ownership of the project. Convertible debt is convertible to equity under certain conditions.Project funding alternative This section outlines the types of long-term securities that a project may issue in raising funds. This debt is generally considered subordinate and senior lenders regard it as pseudo-equity. Lease financing can vary in terms of structure and duration. Tax issues and the strength of the collateral are usually the driving forces behind a lease strategy. The level of security required by the lender will vary. Unsecured debt can be either short. Banks generally offer other short-term funding options. to the least risky.
This form of financing is also generally terminated when longer-term funding is received. usually during inception. Under certain conditions. Because a line of credit will not necessarily be used. As with construction financing. such as options and rights to purchase additional securities (usually equity). • Bridging finance is similar to construction financing but can be used for other purposes. Annexure 1 describes the N4 toll road. It is essential that the terms. A standard short-term interest rate is charged on any amount drawn on the line of credit. It is also not unusual for the lender of the construction financing to also be the long-term investor who will settle the construction financing. Some forms of securities may be independent or attached to the securities listed above. bridge financing may require various levels of security. Line of credit funding is obtained and repaid on a regular basis throughout the life of the project. including a firm commitment on the part of a longterm lender to provide a facility for settling the bridging finance. hybrid securities are constantly being developed to meet investor requirements.Project Finance on public private partnership commit to paying out the construction finance at a predetermined time. conditions and risks be well defined and understood by all participants. in which more than one project company was established and the sponsors’ interests extend beyond their equity investment. Credit lines are used as a cash management tool and are usually set up with various banks. the fee structure is based primarily on a commitment fee – a percentage (usually between 1 and 3 per cent) of the total line of credit committed by the investor. 8 MGM IBM . • Considering the dynamic nature of finance and the uniqueness of each project.g. other vehicles (e. trust funds and guarantees) may be established to reduce the risk to certain investors.
the government. The department is primarily concerned with ensuring the provision of services of sufficient quantity and quality. and on a non-discriminatory basis. For instance. banks. Most funds have an investment mandate or strategy that allows them to invest in certain industries (e. insurance and trade union funds). suppliers. equity funds (unit trusts). non-bank financial institutions (pension. end-users (customers).g. construction. black empowerment). On large projects. Sponsors usually include construction. management and empowerment companies. and even the public. dams and power plants. supply. the management and employees of the project. but also from any project that requires significant capital investment.g. supply or management contracts) from projects such as toll roads. For this reason.Project Finance on public private partnership 4. infrastructure). • The promoter of a project is usually the government department responsible for providing services to the public. southern Africa) or to promote certain social issues (e. other investors may require the sponsors to hold their investment for a minimum period (e. it can submit an unsolicited bid to the relevant government department. They may derive other opportunities (e.g. The functions and mandates of some of these institutions in South Africa are briefly described below. The sponsors of a project (see below) usually participate in promoting a project. These investors are primarily interested in the prospect of earning dividends or appreciation on their investment. as discussed below). Equity funds may include locally registered unit trusts or foreign equity funds. several banks may form a consortium to raise funds 9 MGM IBM • • • . investor profiles vary widely from project to project. Investors include the sponsors. and in achieving their social objectives. geographical locations (e.g. four years or until the shares are floated publicly.Investors Profile As with the financing alternatives. Banks are involved at least as short-term lenders and frequently as long-term lenders and financial arrangers (underwriters).g. when a potential private sector provider recognises the value (value for money) it can add to an existing or potential service.
fully consider any such obligations. take-or10 MGM IBM . This selection is based on the banks’ experience and capacity for raising funds in a certain industry and country. these funds usually invest in the more senior securities to ensure that they obtain the cash flow required for meeting their payout obligations to their clients. • End-user financing can be prepayment for the future delivery of services.financing involvement in the TRAC Consortium. • Government may not necessarily directly finance a project. but it often provides indirect financing through guarantees. Underwriting fees generally vary between 1.5 and 5 per cent of the amount raised. insurance and trade union funds. it should care. in their investment options. it can reassure investors. As the government is usually the end-user in PPP projects. • Non-bank financial institutions include pension. The fees (under. and selling them to the public. The adviser is usually independent of the lenders and underwriters to avoid conflicts of interest (see section 7).writing) paid to the bank for providing a firm commitment are therefore more expensive than for a best efforts arrangement. The equity investors usually select one or more lead banks to manage the consortium or the process of raising funds. Although these institutions often have significant resources. the type of security. by law and/or mandate. depending on the size of the project. As a result. The project may also hire a financial adviser to formulate a financing strategy. but is more often a take-or-pay contract in which the end-user commits to purchasing a minimum amount of services over a period. the risk associated with the project and the level of commitment provided by the bank. The fees for raising equity are generally higher than for raising debt. Although this is not a straightforward form of financing.Project Finance on public private partnership together. Although the bank usually raises debt. with a primary function of investing their assets in medium or long-term securities. Annexure 1 shows the banks’ non. in which the bank will be required to furnish the funds even when it has failed to raise other funds. The banks’ level of commitment in raising funds may be either a “firm commitment” or “best efforts”. they are generally quite limited. it may also raise equity. Stakeholders prefer a firm commitment. South African banks are currently bundling and securitising large project loans.
• Public participation in the financing of a project usually comes at the operating stage. a government department may also be the promoter of a project. The government’s objective is to provide affordable and best value-for-money services to the end-user. as they will ultimately continue as employees of the project.Project Finance on public private partnership pay contracts. This reduces the cost of financing by increasing the potential investor base. The party (or parties) responsible for funding must contact as many potential investors as pos. 11 MGM IBM . The government often requires any employee laid off as a result of a PPP to be given a first opportunity to bid for jobs created by the project. to allow the original equity investors to plan their exit strategy. As noted. The process of listing a company’s equity and/or debt is often included in an understanding between the sponsors. This is more common in a straight privatisation. Annexure 1 lists the equity and debt investors in TRAC. In each case. the N4 toll road concessionaire. • Management and employees may promote or sponsor a PPP.sible early in the process. where the government provides incentives such as subsidised loans. it should fully understand and be in a position to undertake such risk. the government and the lenders. as with the TRAC project described in Annexure 1. sole provider licences and other commitments. Management and employees are usually part of the overall sponsor team that bids for a project.
The sponsors’ feasibility study is usually prepared on a base (expected) best and worst case basis.Investors Criteria The criteria investors set for determining the feasibility of a project. Critical financial ratios are outlined in Annexure 2. as well as sponsors’ experience in the industry and country (this is an important consideration when forming the sponsor team). both quantitative and qualitative. leverage. • The credit of the project participants is critical.ticipant and are less able to reduce their risk. Stakeholders consider the internal capacity and financial position of the sponsors. Although the government often mitigates this criterion by requiring bidders to post a performance bond.g. such as liquidity. but must also earn an acceptable rate of return relative to the risks. its reputation in dealing with other PPP projects.holders. or. include the following: • The strength and experience of the project sponsors and the government department or parasitical currently responsible for the function are usually the most important criteria. and examines various critical ratios. as they must provide services over an extended period. balance sheet and the income and cash flow statements). The sponsors are also interested in the affordability of the services (to the government) to ensure that funds will be available in the future. These important ratios are derived from the projected and eventually actual financial statements (i. especially its technical capability. They will examine the fundamental and economic nature of the project (e. activity and profitability. A PPP project is first compared to the public sector comparator (PSC). whether users pay for the services they receive).Project Finance on public private partnership 5. on a feebased project. other participants rely heavily on the contribution of each par. An important sub criterion is the experience of the sponsor team in working together on projects – a successful joint track record reassures the other stake.e. 12 MGM IBM . whether the service will become obsolete in future. The investors will also assess the strength and reputation of the government department currently responsible for the services. The private sector participant must provide value for money in delivering services. and its history of fee collection • The project fundamentals and economics are both quantitative and qualitative.
The sponsors must also follow the standard procurement policy in bidding on the service. when the services may be provided with fewer constraints. The government must carefully consider all the ramifications of such commitments. The financial covenants included in the various agreements are important not only to the investors but also to all stakeholders. and restrictions on the extent and nature of the services a sponsor may provide. restrictions on the transfer of ownership of the project. Other covenants include a minimum asset maintenance level (e. The prospect of deregulation may discourage investment in a PPP project. for example. The added value that a given sponsor may bring to the project may include synergies and a more efficient or effective method of providing the services. Stakeholders must consider many risks before entering into a project.g. In the N4 TRAC agreements. Synergies will be achieved if the sponsor already provides such services and therefore has the infrastructure necessary for including the government as an additional client. sponsors may not provide services beyond those included in providing the turnkey project. 2 percent of asset value). The 13 MGM IBM • • • • .Project Finance on public private partnership • Contractual arrangements between the parties stipulate who is responsible for what. These risks and the method for managing them are defined in detail in Annexure 3. A proposal or bid in which an experienced company has only a small role is obviously less attractive and more risky than the stakeholders might initially have been led to believe. On toll road projects. the project company may require the assurance that the government will not build an alternative road. as investors may decide to wait until after the deregulation. Many of the potential financial covenants to be included in agreements are discussed in detail in Annexure 3. • Investors may only be interested in investing funds in a project when they are awarded a project that precludes competition. The Mozambican sponsors were ultimately not required to obtain majority shareholder authorisation. or a minimum debt coverage ratio. These non-financial covenants increase the level of comfort of investors and other stakeholders. They may include a minimum equity to debt level. without obtaining authorisation from the majority shareholder. a restriction on the payment of dividends unless certain ratios are met.
and the likelihood that these may be revised in the future. Incentives may include reduced tax rates or tax holidays. but also the level of risk to which they will be exposed and.ing under existing tax. • Sponsors and investors also consider the existing legislative environment. for instance. 14 MGM IBM . Investors will consider all these criteria in determining not only whether to invest. The legislative environment may include the nature and risk of operat. it may already have the latest mainframe capacity needed by a line department.Project Finance on public private partnership sponsor may also have the technology to provide the service more efficiently and effectively. the rate of return they will require. labour and property ownership laws. In certain countries. Departmental managers responsible for analysing and implementing PPP projects should be familiar with the investors’ concerns when promoting the project and when negotiating with the selected private sector providers. A country and government with a history of successful PPP projects and a strong legal foundation will be better placed when negotiating new PPP contracts. the ability of foreign investors to repatriate their initial investment and interest or dividends is also an important consideration. In an information technology PPP. and incentives that may be available. consequently.
• Drawdown conditions stipulate how funds will be transferred from the investors’ account to the project’s account. Although each agreement generally follows a set structure. especially those related to debt. Both fixed and variable interest rates may be negotiated. include many terms and conditions.Project Finance on public private partnership 6. in proportion. The amount to be funded should be sufficient to cover construction and operating costs. Departments can transfer this risk to the private sector by negotiating a turnkey contract in which the cost of constructing. as well as interest and contingency costs incurred during construction. except under unusual economic conditions. The general terms and conditions included in most agreements are outlined below: The amount of funding related to a specific security: this reflects the initial principal to be invested. A fixed interest rate transfers the risk of inflation and high interest rates to the lender. who is ultimately rewarded for taking such risk. Debt investors often require equity drawdowns to be either greater or equal. A variable interest rate structure retains the risk at project level. certain terms and conditions may be unique. • Pricing (interest rate or preferred dividend) is the cost of borrowing the funds. The schedules are based on the project’s cash flow requirements. The repayment schedule sets out how the principal debt will be repaid – on either a “straight line” or a “balloon” basis (when it is repaid at the end of the project). and is based on existing market rates plus an amount for risk. and often includes the underwriting. upgrading or expanding the project facilities is agreed on up front. to the debt drawdowns. Many repayment schedules include grace periods in which no payment is required on principal and may even include an interest accrual period in which interest is 15 MGM IBM • . arranging or success fee paid to the under. Terms and condition of investment agreement All investment agreements. or set certain milestones or conditions for drawdowns. Longer-term securities will require higher interest rates than short-term securities.writer or arranging bank.
15-25 years). 16 MGM IBM • • • . The term or maturity of a debt issuance reflects when the final payment is due.Project Finance on public private partnership added to the principal rather than paid to the investor. but are not limited to the following: • Conditions precedent to closing can include issues such as receiving regulatory approvals. The term is generally based on the projected life of the assets (e. These may include conditions regarding the legal status of the sponsors. projects may also negotiate to have the interest capitalised (added to the principal) during the grace period. long-term assets (property). The purpose of this condition is to preclude related parties from benefiting from contracts that do not reflect market rates. This condition is often negotiated through the construction period. The secured debt holder has the first right to the assigned security in case of liquidation. • A grace period is an opportunity for deferring payments of principal for a pre-established period. Restrictions on related party transactions are virtually always required when the sponsors may be in a position to provide goods and services to the project.g. • The conditions on a funding agreement usually include. Security (collateral) can be provided in the form of specific shortterm assets (accounts receivable or cash). Under this condition. contracts or revenues. or assurances that the construction will meet certain conditions. and also cover affiliates of the related parties. Section 7 addresses the repayment schedule options in detail. Annexure 1 shows that all of TRAC’s long-term debt carries a grace period of 4-10 years. legal opinions or closing of other agreements before finalising the funding agreement. This condition allows the funding process to move forward and allows all agreements to be closed quickly. Representations and warranties by the sponsors of the project are often included in the debt funding agreements. the depreciation or amortisation of the assets will frequently mirror the scheduled repayment of principal (see section 7). Although interest payments are usually due throughout.
Collateral may also be held in a common trust. the quality of the services provided and the ability of the project to provide these services in the future. thereby initiating default procedures. 17 MGM IBM . Events of default include the financial viability of the sponsors.Project Finance on public private partnership • The use of proceeds conditions ensures that funds are used for the purposes specified by the sponsors. if necessary. • In addition to the terms and conditions of the funding agreement. how the security or collateral will be divided and the manner in which remedies will be undertaken. the creditors may enter into inter-creditor and common trust securities agreements that do not include the project company. The terms and conditions for rectifying events of default may require one party to notify the other/s in writing. These agreements may address issues such as who will provide the working capital.
and analyse the opportunities and methods for diverting risk from sponsors while maximising the project’s ability to leverage or maximise its gearing ratio. investment or merchant bank) to design the strategy. The financing strategy is based on the cash flow requirements of the project and includes multiple sources of funds.g. Advisers must have the technical expertise. allowing them to focus their negotiations with potential investors. In conjunction with the sponsors. they explore and contact potential sources of finance. Therefore.and short-term options for funding (described in section 3 above) are used extensively from the inception through the termination of a project. their appetite for investment may vary between the following options: 18 MGM IBM . track record and innovative thinking necessary for planning and implementing complex strategies. Investors aim at maximising their returns while minimising their risk. The long.Project Finance on public private partnership 7. and will usually hire a financial adviser (e. PPP department managers should be fully aware of the various potential investor strategies. Financing strategies The sponsors are responsible for developing the financing strategy. Needs of the investment market Investment strategies are dynamic and can change on a daily or weekly basis. The following issues should be considered in developing a financing strategy: • • • What does the investment market want? What should be the average maturity of the project’s securities? What should be the average maturity of the project’s securities? The sections below address each of these issues in turn. contacts.
g. Debt vs equity – an investor heavily exposed to debt may only be interested in equity or pseudo-equity. Economic expectations – an investor that expects tourism to grow rapidly may be interested in investing in infrastructure with a tourism component. electricity generation may be interested in increasing its holdings in this industry. may be more attractive. 19 MGM IBM . other areas.Project Finance on public private partnership • • Fixed v/s variable rates – an investor whose liabilities and debt are fixed will generally prefer fixed-rate investments. such as the Cape. Demographic expectations – an investor expecting the middle class to grow strongly may be interested in investing in projects that target this market segment. Industry type – an infrastructure fund with a disproportionately low investment in. an investor with longterm liabilities and capital (e. Location – when most of an investor’s holdings are in Gauteng. there. the (real versus accounting) average life of a project’s assets should determine the average life of its capital structure. This is important for two strategic reasons: • The amortisation of project debt should reflect the depreciation pattern of the assets. investors may want to get their “foot in the door”. Long. for instance. Development of a relationship – when aiming at participating in future projects with the same sponsors. for instance.by achieving the proper schedule of depreciation expense to payment of principal.v/s short-term investment – as above. • • • • • • Average maturity of securities As a rule. a pension fund) will prefer long-term loans.
Although earnings may decrease owing to higher interest payments. However. therefore. where ratepayers will benefit from the operations of the asset throughout the project life. It is defined as the earnings before interest. By extending the term of the debt (see chart below). the level at which they decrease is less than the additional earnings available per equity share. 20 MGM IBM . the debt investors in TRAC are comfortable with equity to total capital ratio of 20 %. the unit cost of debt increases as the debt investors take on additional risk. depreciation and amortisation divided by the debt service (the payment of interest and repayment of principal). the cash flow requirements of interest payments and of repaying the principal should be carried equally by ratepayers who benefit at different stages of the project life. allowing the revenue available for debt service to exceed the debt service throughout the project life. This condition is particularly critical in highly capitalised infrastructure projects. the lenders’ risk is increased and. In this scenario. Gearing ratio of the capital structure Sponsors aim at minimising the level of equity in favour of debt. Therefore. the DSCR is increased because shorter-term debt service payments are decreased. The dynamics of the financing strategy are illustrated below to demonstrate how this strategy can affect project viability: The debt service coverage ratio (DSCR) is the most important ratio for debt investors. For example. as the equity level decreases.Project Finance on public private partnership • Matching the life of the project’s capital with that of its assets may reduce the cash flow implications of the repayment of the debt principal. the cost (interest rate) is also higher. The obligation to pay debt service is also extended in the longer term (when revenues will be sufficient). as the required rate of return on debt is less than that on equity. taxes.
The lenders’ risk is increased. the cash flow from revenues becomes sufficient to meet debt service requirements. One form of deferring principals is to make a balloon payment at the end of the term. Again.Project Finance on public private partnership By deferring principal payments (see chart 5). the lender risk is higher and. necessitating a higher interest rate. 21 MGM IBM . The cash flow requirements of the project can also be met by borrowing with a grace period (see chart 6). therefore. so is the cost.
22 MGM IBM .g.Project Finance on public private partnership A guarantee (see chart 7) by a more creditworthy entity (e. thereby reducing the debt service level to below the revenues available for debt service.est for the original life of the loan. government) will lower the inter.
Project Finance on public private partnership Debt structuring can also involve other financing methods. and the parties developing the finance strategy must remain flexible and explore all available options. However. The primary options for enhancing credit or the feasibility of a project are discussed below. The waterfall method of demonstrating fund flows consists of the cash inflows (revenues) and outflows (operational and maintenance costs. 23 MGM IBM . These strategic financial engineering options include the following: Increasing tariffs (see chart 9) is one option for making the project feasible. debt service. The debt structuring options can be used individually or in combination. such as shortterm debt to finance the shortfall in the earlier period. taxes and profits). and can be used independently or in combination. and outflows of cash. and may reflect higher government payments for the provision of services. as illustrated in the “waterfall” example (see chart 8). the value for money condition set out in the Regulations and Guidelines for PPPs may preclude this option. These methods are both operational and financial.
but may also undermine the project if it is already operating efficiently or if such reductions are mismanaged. 24 MGM IBM .Project Finance on public private partnership Decreasing operating and maintenance costs (see chart 10) may improve the efficiency of the project. An increase in equity (see chart 11) will reduce the amount of debt financing required. but may also reduce the return on equity to an unacceptable level. as noted above.
or rents out space within its buildings. it will also distort the 25 MGM IBM . Although this increases revenues. Finding another source of revenues within the project (see chart 13) when the project sells a by-product of its goods and services. In either case. The source of funds for such a reserve account may be the project’s revenue or an independent third party.Project Finance on public private partnership Establishing a reserve account (see chart 12) may satisfy the beneficiaries of the reserve account (usually the debt holders) and reduce the cost of debt. this increases the overall cost of the project as the funds in the reserve account could have been better invested.
A third party guarantee. Some sources of other revenue are logical (selling by-products).Project Finance on public private partnership apparent financial performance of the project. This is a common option because. although the cost of the subordinate debt is greater than that of the senior debt. Subordinate (mezzanine) debt can be created to reduce the cost of senior debt (see chart 15). 26 MGM IBM . This option has a specific cost that the project or government will be required to pay either directly or indirectly. such as by a financial institution (see chart 14). it may create the necessary conditions for the senior debt holder to invest in the project. while others may indicate excess capacity in the project.
Project Finance on public private partnership 27 MGM IBM .
is contracted to provide the construction and maintenance of the toll road. Eight per cent of value warranted for the purchase of equity at original value 2. The TRAC Consortium will own the assets for the life of the BOT. Project finance structure More than one Project Company was established and the sponsors’ interests extend beyond their equity investment. Recognising this. their primary interest is in the earnings they will generate in constructing and maintaining the toll road. Basil Read and Stocks & Stocks together own 40 per cent of the TRAC Consortium and 100 per cent of SBB. South Africa and Maputo. Equity • • • • R331 million to be increased if required (20 per cent of total financing) Sponsors – R132 million (40 per cent of equity) Non-sponsor equity holders – R199 million (60 per cent of equity) R1 324 million (80 per cent of total financing) 1. and the SBB Consortium.transfer (BOT) concession for the N4 toll road between Witbank. Three construction companies. Bouygues. Mozambique.Project Finance on public private partnership Annexure 1: N4 toll road The Trans African Concessions (Pty) Limited (TRAC) was awarded the 30year build-operate. consisting of the primary TRAC Consortium construction companies (sponsors). Although they are equity investors in the project. the other equity and debt investors in the project require these sponsors to maintain their equity position in the TRAC Consortium for a minimum of four years. Draw down in conjunction with additional equity 28 MGM IBM .
Project Finance on public private partnership Non-financing bank participation in issuance of TRAC equity Lead arranger • • Future Bank Corporation Merchant Bank (South Africa Co-arranger in Mozambique Banco Comercial e de Investimentos (Mozambique) Underwriters • • • Investec (South Africa) Banco Comercial e de Investimentos (Mozambique) Future Bank Corporation Merchant Bank (South Africa) Development funding • • Commonwealth Development Corporation (United Kingdom) South African Infrastructure Fund (South Africa) 29 MGM IBM .
the governments also jointly and severally guarantee the TRAC equity.Project Finance on public private partnership Equity and debt investors in TRAC The governments of South Africa and Mozambique jointly and severally guarantee the debt of TRAC. Equity (Sponsors/construction companies) • • • Bouygues (France) Basil Read (South Africa) Stocks & Stocks (South Africa) Equity (Non-sponsors) • • • • • • • South African Infrastructure Fund (South Africa) RMB Asset Management (South Africa) Commonwealth Development Corporation (United Kingdom) South African Mutual Life Assurance (South Africa) Metropolitan Life Limited (South Africa) Sanlam Asset Management (South Africa) SDCM (Mozambique) Debt (excluding equity investors that are also debt investors) • • • • • • ABSA Corporate and Merchant Bank (South Africa) Development Bank of South Africa Limited (South Africa) First National Bank (South Africa) Mine Employees and Officials Pension Funds (South Africa) Nedcor Bank (South Africa) Standard Corporate and Merchant Bank (South Africa) 30 MGM IBM . Under certain conditions.
The ratios may be compared from period to period for a given project. depreciation & amortisation)/Interest charged 31 MGM IBM . including Standard & Poor’s.g. Cash is the most liquid asset.50X).e. this depends on the quality of the data. Dow Jones and Robert Morse Associates. The current ratio shows the ability of a project’s current assets (e.g. Times interest earned = (Earnings before interest. Investors are usually looking for a comfortable margin (e. such as the balance sheet. The acid ratio should exceed 1. A financial analyst will also examine the liquidity of each type of current asset (i.00. cash. inventory) to cover current liabilities (accounts payable. or used to compare the performance of the project with that of other projects in the same industry. as they are interested in earning income on an ongoing basis and in recovering their original investment (principal). Several industry groups and financial institutions publish industry ratios. debt due within one year). the ability to convert it to cash) and allow for any discount that may be required when converting the asset to cash. Most investors (especially debt investors) are primarily concerned with liquidity. 1. Current ratio = Current assets/Current liabilities The quick or acid ratio excludes less liquid assets (inventory) from the current ratio.00. e.g. taxes. Dun & Bradstreet.Project Finance on public private partnership Annexure 2: Financial ratios Financial ratios are drawn from the actual or projected financial statements of a project company. income statement and cash flow statement. The current ratio should comfortably exceed 1. accounts receivable. Quick or acid ratio = (Current assets – Inventory)/Current liabilities The times interest earned ratio allows debt investors to determine the extent to which interest obligations will be covered by revenues or turnover after operating costs. whether these were compiled on the basis of generally accepted (or recognised) accounting practice. Although these ratios can be valuable.
taxes.50X). the higher the level of debt to equity. The significance of each ratio is based on the nature of the business in which it operates. DSCR = (Earnings before interest. Fixed charge coverage = (Earnings before lease charges. Investors are usually looking for a comfortable margin (e.ect. Therefore. depending on the nature of the project. depreciation & amortisation)/ (Interest & principal charged) Leverage (gearing) ratio The last three liquidity ratios mentioned above are largely based on the amount of debt and leases outstanding in the project.ect. for a project that provides services. taxes. 1. depreciation & amortisation)/Interest & leases charged The debt service coverage ratio (DSCR) is probably the most important ratio for lenders to a proj. the less profitable the project. Debt ratio = Total debt/Total assets Activity ratios These ratios are important to the sponsors and management of the project. as the profits must be shared by more equity investment in the project.75X). Investors and lessors are usually looking for a comfortable margin (e. Non-liquidity related leverage ratios include the debt ratio and the related equity and debt to equity ratios.g. The debt ratio is the most common ratio for determining the leverage or gearing of a proj. these ratios are less generic and vary significantly from industry to industry. 1. Generally. The lower the level of debt to equity. the inventory 32 MGM IBM . Debt investors in a project prefer a lower debt ratio and are usually satisfied with between 70 and 90 per cent. interest. For instance.g. the more financially risky the project. as they measure the performance of the company against previous periods and against other companies in the same industry.Project Finance on public private partnership The fixed charge coverage also takes into account any costs associated with leases that may be entered into by the project.
the more efficiently the project is operating. although important to all participants. a utility) will often have a ratio between 1 and 3. Fixed asset turnover = Sales/Net fixed assets The inventory turnover ratio reflects the quality of inventory management of the project. These ratios show the level of profitability that can be expected on their investment and are often used by regulators as the basis for determining rate changes in a regulated project or payments by the government in a government-funded project. This ratio is often compared to that of similar projects. such as the age of the project’s plant. The older the plant (more depreciation). electricity and water).g. but the average collection period ratio will be critical.Project Finance on public private partnership ratio may not be significant. and close to 0 days for a toll road that collects fees at the tolls. Inventory turnover = Sales/Inventory Profitability ratios The profitability ratios. Average collection period = Receivables/Sales per day (where the sales per day is the total revenue or turnover divided by 365) The fixed asset turnover ratio shows whether the fixed assets are being employed properly. The profit margin on sales shows the level of profit (after taxes) against the total sales of the project. such as a change in operating policy. This ratio should be between 30 and 45 days for a utility (e. may be influencing these ratios and compromising their value. the better the ratio appears. are especially important to the sponsors and other equity investors. This ratio is affected by other factors. Profit margin on sales = Net profit after tax/Total sales 33 MGM IBM .g. The average collection period reflects the success of collections on the sale of services. It is often necessary to examine the operations of the project to determine whether circumstances. The value of this ratio may be affected by a change in management’s method for writing off bad receivables. A highly capitalised project (e. The higher the ratio.
The discount rate attaches a time value to the negative and positive cash flows – one rand today is worth more than a rand next year. Return on total assets = Net profit after taxes/Total assets The return on equity ratio differentiates between debt and equity investors. using an appropriate discount rate.out the life of the project. The formula for determining the NPV is given below. Equity includes the total amount invested in equity and any retained earnings (undistributed earnings) through. based on the components described above. The result will show a rand value to the project.mining the value for money criterion for PPP projects. but shows the net income after taxes against the total assets. it is also included in most spreadsheet software and even on some calculators. ∑= Sum R = Cash flow per period (t) N = Project’s expected life k = Discount rate C = Initial investment 34 MGM IBM .Project Finance on public private partnership The return on total assets ratio is similar to the profit margin on sales. This ratio is similar to the internal rate of return (IRR) described below. Various proposals can be compared to each other on a value-for-money basis by determining which project will either yield the government more revenue or less cost. investment and expenses) or positive (e.g. and should be between 10 and 20 per cent after inflation. Return on equity = Net profits after taxes/Total equity The net present value (NPV) shows the value of a series of cash flows. The NPV methodology is also used in deter. Where.g. whether negative (e. revenues or turnover). This ratio does not differentiate between debt and equity investment.
Even within an industry. It shows the annual rate of return on a percentage basis. This rate must substantial. including non-financial ratios.specific ratio. topography and the age of the infrastructure. the IRR will equal the discount rate. Although the significance of these ratios will vary from industry to industry. The formula for IRR is similar to that for NPV with the result equal to 0. The number of customers per employee ratio shows how efficiently a project operates with respect to the number of employees. in which variance may explained by population density. The IRR expected by equity investors in South African infrastructure projects will vary between 10 and 20 per cent after inflation. Operating costs per kilometre = Operating costs/No. Number of customers per employee = No. measure performance and efficiency.Project Finance on public private partnership The internal rate of return (IRR) formula determines the discount rate of the cash flow of a proj. The lower this ratio compared to the industry. If the NPV is 0. customers/No. they are often used as a benchmark in designing and implementing a project. A project with a relatively low or decreasing year-on-year rate is considered to be operating more efficiently. employees The operating cost per kilometre of water pipes or electricity lines is an example of an industry. The IRR required by equity investors depends on the nature and risk of the project. the more efficient the operations. Other ratios Other frequently used ratios. of kilometres of pipe or electricity line Other such ratios may include: • • • • Customers/value of infrastructure Construction cost/kilometre of construction Net income/employee Net income/customer 35 MGM IBM .ect. and stakeholders must be able to appreciate the differences.ly exceed the rate of return on debt. Both the NPV and IRR are used extensively in analysing and comparing projects. and the dependent variable being the k in the above equation. assuming an NPV of 0. these ratios may differ from project to project.
which also includes construction and design risk. to assume the risk. Completion (technical and timing) risk This risk. the objective is to avoid exercising these guarantees. banks and insurance companies) and of per. This risk is borne by the private sector company and contract conditions will penalise the private sector provider should a problem not be rectified in the prescribed time. labour strikes or late delivery of equipment and supplies. It may be attributable to weather.Project Finance on public private partnership Annexure 3: Risks Availability risk This is the risk that the services provided by the private sector party may be less than required under the contract with the public sector.ties to an agreement being unable to meet their contracted obligation. customers or any other party that commits to meeting certain obligations in the future. construction companies.pliers. Other non-engineering or construction completion risks must also be considered and methods for mitigating Counterparty credit risk Counterparty risk is the most obvious and common risk. and is associated with the other par. Although the expense related to the performance bond will be passed on to customers. where required. This risk exists with sup. Although this provides a certain level of comfort. Counterparty risk is generally managed by undertaking a thorough due diligence (review of the credit rating) and.forming the due diligence. obtaining a performance bond.g. the bond enables entities in the business of taking counterparty risk (e. The parties providing the engineering and construction services are often required to post a bond that may be drawn on should certain commitments not be met. A third party may cover the performance bond totally or in part by funds or other liquid assets in a special purpose (escrow) account or by a guarantee. generally results in time and/or cost overruns that will require a substantial increase in capital and/or interest expenses during construction. The third party guarantee is usually 36 MGM IBM .
Country (political) risk Clearly. a part of the construction and operating risk of the project South African PPP laws and regulations require all PPP projects to be denominated in rand. investors maintain a constant watch on the political con. country risk is probably the most difficult risk to manage (apart from force majeure risk). the lower the risk. deferring maintenance or taking steps to repatriate funds.g. Currency risk occurs when the revenue or turnover and the expenses (operating or interest) of a project are in different denominations. restrictions on the repatriation of funds.Project Finance on public private partnership provided by an independent financial institution. nationalisation. In addition. in order to promote exports to the host country. Although the existing PPP laws and guidelines mitigate currency risk. the lower the required rate of return (e. or exchange controls. they will examine the likelihood of other changes within the legal system. war. limiting or freezing any additional capital investment. to a large extent. Currency risk Currency risk is. Although some countries offer limited insurance against these risks. Other methods of mitigating this risk include 37 MGM IBM . tax and environmental issues. in which the project is assured a certain exchange rate. Before such an agreement is concluded. the counter party’s credit rating must be examined to reassure the project of the party’s ability to meet its obligations. This risk is also referred to as legislative or policy risk. In addition.g. Investors will generally review the history and current political conditions of the host country to assess the possibility of expropriation. particularly with respect to labour. Therefore. Foreign investors will generally use their primary operating currency in determining the projected IRR or NPV of a project (see Annexure 2). interest rate).ditions of the host country and make risk-limiting decisions on an ongoing basis (e. the most common method for managing this risk is to enter into a hedge agreement with the supplier and/or a third party financial institution. more stable political conditions and legal systems in a country will stimulate more investor interest in a project. This will automatically shift the risk from the project to the supplier of the product or service. but may also be given by an affiliate of the counterparty to the transaction.
ing the cost of the project.lels rail tracks).Project Finance on public private partnership arranging for a portion of the project’s revenues or turnover to be paid in the relevant foreign currency. water. the input and through.not be controlled by the private sector. It may be affected by factors such as increases in the cost of raw material (e. typhoons. such as earthquakes. residual oil or natural gas in the production of electricity).tract’s pricing formula.ited time or amount of investment. a new road that paral. As with resource risk. power generation and gas pipeline).rences into account when valuing the project and determining the required rate of return. based on inflation.g. in the con. a proper due diligence must be undertaken to ensure that this risk is mitigated. Inflation risk This risk represents the possibility that the actual inflation rate will exceed the risk projected during the development of the feasibility study. which may negatively affect the construction or operations of a project. flooding or war. Force majeure risk This risk reflects the occurrence of unexpected and uncontrollable natural and/or man-made conditions. reduc. These risks are generally taken on by the project promoters and investors for at least a lim. This risk increases when the jurisdictions in which the source. Market (demand) risk Market risk relates to the demand for services to be provided by the project. the public sector may decide to retain the risk. the development of a substitute service (e.g. Inflation risk may be mitigated by including an actual index. throughput and ultimate consumption of the resources are different.put risk is critical. or by entering into long-term supply contracts with predetermined prices (these contracts increase the counterparty credit risk).g. Input and throughput risk For non-extractive projects. To the extent that the risk can. overall economic conditions. governmental 38 MGM IBM . in which the viability of the project depends on the supply of sufficient natural resources (e. Investors will certainly take the possibility of such occur.
or design. in which any changes in pricing are based on historical factors. equity interest in project). long-term fixed price supply contracts that support the pro. developments in the customer industries (e. training. Methods for mitigating operating risk include implementing employee-friendly labour poli. This risk ranges from a com. however. nuclear power plant operations).cerns. 39 MGM IBM . This risk may be directly controlled by management (labour issues). such as water.g.neering or construction faults that adversely affect the project’s eventual operations.opments. and/or take-or-pay conditions. or be due to external conditions (exchange rates on imported resources). Regulatory risk Regulated projects. face the risk that any decrease in costs attributable to changes in glob.g. These problems may prevent the project from meeting the scheduled quantity and/or quality of serv. tourism). and adherence to all environmental laws and regula.plete disallowance to recover costs. exclusive rights to provide the service. To mitigate this risk.jected profit margins.tions (e. These may include automatic rate increases under certain conditions. gas or residual oil for the production of electricity) is one example of such a volatile cost. the investors may request certain conditions in their concession or management agreement. face regulatory risk – being uncertain about the future pricing of services sold to customers.g.ices. Operating risk Operating risk applies to the various resources that are important to the operations of the proj. taxes).ect. inadequate maintenance. Ratepayers also.al economic conditions may not be passed on to them. longterm labour contracts that are acceptable to all parties.Project Finance on public private partnership policy (e. proper insurance. personal advancement. engi. political devel. This risk can be controlled by stipulating in the agreement that increases in the prices of volatile cost factors will automatically be passed on to customers.g. The cost of a natural resource (e.cies (e. and environmental con. to a regulatory lag. Investors will generally rely on the operating experience of the promoters of the project to mitigate this risk.g. electricity generation or toll roads.
these resources are critical in meeting the debt service and return on equity requirements of the project. Technology risk This risk refers to the possibility of changes in technology resulting in services being provided with sub optimal technology. However. Contracts may address this risk and set out a method for rectifying related problems. This risk is difficult to control. Although the ultimate responsibility for managing this risk lies with the promoters and other investors. Allowing for the residual value of the assets to be determined at the end of the project can mitigate this risk. Resource risk Resource risk is the possibility that the natural resources required in the operation of an extractive related project may not be of the proper quantity or quality to make the project feasible. The stakeholders must also plan for dealing with any excess natural resources. Any condition to absolve the private sector provider from this risk should be countered with a minimum maintenance standard. the private sector provider will almost certainly implement such changes. However.viding the services. when better technology decreases the cost of pro. and may include engineering and geological studies. the residual value is dependent on the maintenance of the assets during the operations.Project Finance on public private partnership Residual value risk This risk only applies to the contracts in which a value is attached to the assets when they are transferred back to the public sector at the end of the contract. due diligence efforts must be sufficient to satisfy all stakeholders. For some projects. 40 MGM IBM . such as the development of natural resources and energy.
Nevertheless. private investors (both domestic and international) have shown interest in countries that are at least moving toward these structural prerequisites. • A developing domestic debt market. as well as the foregone economic opportunities of simply not investing in infrastructure. a stable playing field) that lessen a country’s susceptibility to economic and financial contagions and create an orderly legal and regulatory environment in which to invest and operate. This allows us to distinguish certain countries. private-sector participation requires some structural prerequisites (i. The traditional alternatives to infrastructure finance in most countries are central government deficits and debt and multilateral bank lending. However. as more ripe for private-sector investment than others. both passively as institutional and retail investors in infrastructure bonds and actively through companies that sponsor projects as contractors.e. Unfortunately. bankruptcy and lender remedies. contract enforcement. Chile and Poland. a quick perusal of these investor prerequisites reveals how few countries fit all of these categories. A greater capacity of infrastructure investment is present in the developed countries due to the participation of the private sector.Project Finance on public private partnership Findings & Suggestions Prerequisites for a Receptive PPP Debt Market • A relatively stable macroeconomic environment. • A relatively stable regulatory framework that recognizes the lifecycle needs of the project. operators or equity investors.. Korea. such as Mexico. 41 MGM IBM . • A developing legal framework for concessions.
and most are susceptible to the contagion effect of a financial and economic crisis. the ongoing practice of diluting.Project Finance on public private partnership Relatively Stable Macroeconomic Environment Only a few countries have truly stable macroeconomic environments. A number of countries. rather than eliminating..e. their application in the real world is often untested due to the continuing propensity to negotiate financial arrangements outside the courts. operate after winning a concession contract and recover a return on its investment. as well as lender remedies under bankruptcy and insolvency. including Chile. countries that have taken steps to control inflation and external debt. Nevertheless. as lender rights become codified. a clear process for dispute resolution and the ability to enforce contracts. Developing Legal Framework The private sector requires clear and stable rules of engagement as provided through a country’s legal framework. If a country’s public policy wants to encourage private-sector participation in the financing of infrastructure. Nevertheless. dispute resolution systems in many countries look good on paper but do not work well in practice. Brazil) where a court upheld a contested concession provision (in this case. a national and economic crisiscreates not only risk for the financial performance of the infrastructure transaction (i. a scheduled rate increase) are rare. Finally. as in Korea. Equally clear is the process by which the private sector is to bid on an infrastructure project or system. The rules of negotiation continue to prevail over rules for contract enforcement. Bankruptcy laws also have been amended in many countries. This includes laws governing concessions and/or privatizations. the equity participation of construction and project sponsor firms that are in or near bankruptcy. Panama and Korea. its ability to generate sufficient revenues to cover operating and debt service costs) but also added uncertainty as to the range of political responses that might affect its operations during a crisis. increase official international reserves and utilize trading partnerships often provide fertile ground for domestic and foreign private investment. in most legal documentation. have developed comprehensive and transparent concession laws. legal precedents (such as in the state of Parana. Still. as borrowing migrates from commercial bank loans to the capital markets. its laws should support that policy. For an infrastructure project. where public-sector goals and objectives in private participation are clear. For these reasons. may 42 MGM IBM .
” while the foreign capital markets should be the “icing. With new and untested legal regimes. Of equal concern is the belief. The base set of regulations should be developed in tandem with the legal framework for concessions and privatizations. This process takes time. project economics often lack the flexibility to adapt to a shifting regulatory environment. especially during a financial and economic crisis. In the case of termination of a concession. that a future flow securitization can sidestep the ongoing bankruptcy proceedings of a private-project partner.” since in most cases the source of 43 MGM IBM . Relatively Stable Regulatory Framework A country’s regulatory framework is simply the reflective implementation of its legal and public policy framework. For infrastructure finance. Developing a Domestic Debt Market Development of a domestic capital market is key to creating a sustainable supply of capital for infrastructure. provisions are increasingly present that provide compensation based on some measure of the net present value of revenues over the remaining life of the concession but for no less than the amount of debt outstanding. the project selection process involves representatives of all the governmental ministries that will be involved with that project over its lifespan. it is dangerous to rely solely on the integrity of financial structuring techniques.Project Finance on public private partnership unnecessarily expose an otherwise economically viable project to bankruptcy and consolidation risk. In Korea. This mitigates much of the regulatory risk upfront. For the private partners. but it allows the host government to gain its own comfort level with the classic trade offs between access to private capital and the dilution of its own sovereignty.. as in Mexico. the range of compensation mechanisms for political risk is still developing. the domestic debt market should be the “cake. However. thereby affecting the project’s operating environment.e. The privatesector operator can choose to adapt its concession expectations to an onerous regulatory environment. Public-sector partners can and will change their minds. Compensation is usually expressed as extraordinary rate relief or as an extension of the term of the concession. since the concession agreement can reflect the concerns and agendas of the various government ministries that will be involved with the project. to operation and to its eventual return to the public sector). to construction. Regulations should focus on the lifecycle of the project (i. from design.
dollar revenue stream or with construction or acquisition costs that exceed the financing capability of the local debt market make better candidates for foreign capital but not without structural enhancements. Generally. but they soured throughout the emerging market countries with the contagion effect of the Asian financial crisis of 1997. in most cases without a proper transition period. It also necessitates a savings plan. where revenue growth and financial margins may not be able to accommodate interest rate volatility. Infrastructure transactions with either a U. Until these userbased revenue streams prove themselves. A growing number of emergingmarket countries are developing domestic debt markets. many domestic investors will continue to require other forms of government support. Investments also are limited to short. This resulted in an inevitable clash between public policy goals.S.Project Finance on public private partnership repayment will be generated in the host country’s currency. these markets are shallow in that investments are usually limited to the bonds of the central government and a handful of other governmental or privatized entities. Typically. Evidence from the past decade points to difficulties caused by the government sector’s rush to privatize basic public services. 44 MGM IBM . The initial efforts of the 1990s were promising. such as offshore reserves and multilateral risk guarantees. it does not fully explain why infrastructure finance never really recovered. including the ability to invest funds in more than direct government debt. Even in countries that have robust domestic debt markets. the average life of a corporate bond is still approximately 3–7 years. The belief was project finance could infuse new capital and better management practices into poorly maintained and over utilized infrastructure systems. like Korea and Mexico. where to date nine projects have been financed in the national bond market at terms of 20 years. Local investors also are in a better position to assess the concession’s service area and political risk. Critique of Traditional PPPs The drive toward privatization and concession-based project financing in the mid-1990s was seen by many governments as a way to jump start infrastructure investments. The development process requires financial sector reforms. While this explains the sudden interruption of new capital.and medium-term maturities. The ability to issue the long-term debt maturities needed by infrastructure projects simply does not exist throughout most of the world. Finally. the remarketing of these medium-term debt maturities is a big risk for infrastructure projects. infrastructure bonds often represent a new form of asset class for domestic investors. a notable exception is Chile.
slant resources and regulation at state owned water utilities. like Mexico and Brazil. This is partly because local governments in many parts of the world depend on central government transfers as their main source of 45 MGM IBM . most of these transactions did not have the transitional underpinnings to operate as independent enterprises or the credit enhancements necessary to withstand macroeconomic volatility. It will be difficult to engage private capital until the ownership issue is legally addressed. external financing was seen as synonymous with external expertise and both sides misinterpreted the consequences. among others). Public-Sector Risk in Traditional PPPs It is important for the private and public sectors to understand the risks of transacting with each other.g. outside of central government transfers. rarely make a dependable revenue stream for infrastructure debt in emerging markets. In many cases. this is not intended to discourage interaction but to point out areas where proper structuring can enhance the survivability of an infrastructure transaction. Ownership disputes lend uncertainty to the continuity of utility revenue streams. The developed world pushed its construction and financing contractual frameworks onto the developing world. and the utilities desire longer-term debt. ownership disputes over certain public services continue between state and municipal governments.operate.Project Finance on public private partnership public expectations and the private sector’s desire for a reasonable rate of return on capital. Creating Dependable Project Revenue Streams Capital markets count on dependable revenue streams to make full and timely payment of debt service.. build transfer. buildoperate-transfer. build-own-operate. In all cases. buy-build operate and design-build-operate. State and local revenues (including infrastructure user fees). Determining Service Ownership In many countries. but these are often short-term contracts. While some governments. actual title to the water services remains unresolved. While the project finance community enjoyed creating a new vocabulary for the many iterations of these partnerships (e. The key risks the private sector faces in dealing with the public sector are described below followed by the key risks of dealing with the private sector. state-owned utilities have contracts with neighboring municipalities.
hikes in user fees after an improvement in service. first implementing tolls along this important route and then increasing rates commensurate with capital improvements or with inflationary cycles. such as water authorities. until recently. The absence of corporatization. • Choose projects with sound economic value. its customers had already adjusted their behavior to paying for service enhancements. 46 MGM IBM . whereby the publicly owned enterprise is organized and run as an independently financed and operated business. are often plagued with poor revenue collections. Local enterprises. These challenges are coupled with a still weak public acceptance for user fees and. as mentioned. were caught up in the rush to privatize now and worry about the consequences later. government budgetary capabilities and public expectations are at odds with one another. Corporatization. including productivity gains and rate increases for capital improvements. effective ways to mitigate political risk are as follows: • Select projects that best fit the national. state or local priorities for economic development. the state of São Paulo. the National Water Commission in Mexico has targeted certain service-level and administrative efficiencies as prerequisites before stateowned water utilities can borrow for additional water or sewer capacity. where project contractual covenants. For countries where the prerequisites attract privatesector investment and the legal system supports compensation. Along this line. Protecting Against Political Risk Many governments. Similarly. operated the Anchieta-Imigrantes toll road as a public enterprise.Project Finance on public private partnership revenues. reflecting relative inexperience and feeble administrative capacity to operate their enterprises as a business. This is especially the case in Latin America. The relative newness of decentralized governmental services is another factor. Brazil. can prepare users for the consequences of improved and reliable services. The opportunity for a public enterprise to operate as a publicly owned business. causing a general public backlash against privatization. When the private consortium Ecovias won concession over the toll road. can facilitate its transition to the private sector. and the lack of public participation at the local level resulted in an escalation of political risk for both privatizations and concessions. equally.
However. • Provide an adequate period of corporatization prior to privatization to ensure interim improvements in the efficient delivery of public services. • Clarify the relationship between the sub national entity and its publicservice companies. the flows of capital and the administrative control between parent government and enterprise should be well understood. “Governing by covenants” provides investors with minimum legal parameters for an infrastructure transaction’s financial margin and limits the events of default that could lead a project into bankruptcy. efficiency and capital that the private sector can bring to infrastructure and local government services. there is less reason to worry about testing the host country’s legal environment. credit quality can be enhanced by the structure of the project’s financial transaction. operating ramp-up risk and economic cycles. • Endow projects with sufficient financial protections to mitigate risk. which in most cases is either underdeveloped or untested. After that. PPP structures are improving upon their ability to isolate voluntary bankruptcy risk (via starting with an economically viable project). the relative newness of revisions to bankruptcy codes contributes to a lesser understanding of the risk of involuntary bankruptcy in countries where this legal concept applies. Typical infrastructure project covenants include the following: • A revenue covenant with minimum required debt-service coverage levels. If it has strong economic value. 47 MGM IBM . the foremost rating consideration is the economic value of the infrastructure project or system. Evaluating bankruptcy risk requires a full understanding of who the project’s partners are and their roles with respect to ultimate ownership of the project’s land. Private-Sector Risk in Traditional PPPs Host governments want the expertise. equipment and cash Mitigating Voluntary Bankruptcy For mitigating voluntary bankruptcy. facilities. such as liquidity to offset completion risk.Project Finance on public private partnership • Seek project partners with strong levels of commitment and expertise with infrastructure assets. They should avoid exposure to the corporate sector’s bankruptcy and consolidation risk.
as well as the market volatility of certain corporate activities. Structuring the Issuer (Creating a BankruptcyRemote Entity) The type of vehicle employed to issue project debt will depend on the possibilities afforded by national laws. In the United States and other countries. Thus. Involuntary bankruptcy exposure of infrastructure projects to which these corporate entities are counter party assumes the project is functioning fine. as well as certain tests prior to making equity distributions. The latter provides some latitude for reaching compliance without placing the project into immediate default. The further this independent entity is removed from the operations of the infrastructure project or system. Chile created a special corporation under its concession laws. bankruptcy-remote entity. in Mexico the trust is the one entity that enjoys legal person status under Mexican law. • Requirements to re-engage financial consultants if the performance of a project does not meet the minimum covenant levels. • Minimum financial tests for the issuance of additional debt. Conditions that cause an infrastructure transaction to default should be sufficiently limited to promote its survival. Mitigating Involuntary Bankruptcy More difficult to detect is the involuntary bankruptcy risk of a privatesector partner. a nationally incorporated subsidiary or consortium can be created as a specialpurpose.Project Finance on public private partnership • Lowest required funding levels for various debt service and operating reserves. debt service and the replenishment of reserves. Typical defaults are for nonpayment of debt service and a continuing breach of other covenant requirements beyond a prescribed cure period. • An order of priority for the payment of operations. This partly reflects shortcomings in corporate sector accounting. trusts and special purpose vehicles are also available. but its ability to meet financial obligations is interrupted externally by investor claims on the corporate parent or subsidiary to the company associated with the project. with respect to which bankruptcy risk mitigation is the most vital characteristic. A special purpose entity can be a 48 MGM IBM . There are a number of ways to mitigate this involuntary bankruptcy risk. Generally. the more bankruptcy remote it becomes.
special-purpose companies are not so limited. Many so-called. They may be incorporated under the host country’s law. Structuring the Transaction (Creating a Trust Estate) Another approach structures the infrastructure debt transaction. the operator has no legal rights to the cash) can eliminate its bankruptcy risk. A special-purpose entity also can own an asset. Their role is important since it is often the operator that holds the cash. it can still earn returns from the project. Legal structures that limit the operator’s interest in the project to that of an agent contractually obligated to provide a specified service for the project (i. particularly where a project trust is created during the ongoing bankruptcy of a parent project sponsor company. In addition. many articles permit engagement into ancillary businesses.Project Finance on public private partnership shell. Under this “deed of trust. Nevertheless. rights and obligations are sold to a trustee on behalf of the bondholders. there are cases in which a trust’s value may be overestimated.e. A bankruptcy-remote structure can be an independent commercial entity and protects against consolidation of the issuer’s assets in a bankruptcy case involving either its parent corporation or another subsidiary of the parent. creating an additional window for bankruptcy risk. project operators are the other private partners in an infrastructure transaction. It is also important to have provisions in an operating agreement for the potential replacement of an operator under certain conditions of nonperformance. Alternative structures can include a limited liability corporation (LLC) or a limited partnership.. 49 MGM IBM . although no money is released until the trustee has satisfied all other financing agreement requirements.” all of the issuer’s interests. securing the debt holder’s obligation to a specially created trust estate. Limiting the Operator’s Interest in the Project In addition to sponsor companies in a project consortium. with it solely responsible for receiving and transferring a given asset to a trustee. but their articles of incorporation and shareholder documents may not create enough distance from the parent company or subsidiaries. The trust estate concept is gaining acceptance in such domestic debt markets as Mexico through the creation of a master trust agreement. The debt issuer sells its rights to the cash flow. While the issuer has assigned away its rights. have no ability to voluntarily file for bankruptcy and contract out for operations.
This leads to the secondary reason. Mexico and Chile. revised bankruptcy regimes. Fitch has categorized four as myths. some important misconceptions about PPPs have emerged. the creation of special-purpose entities and new trustee relationships have set the stage for an exciting evolution in infrastructure finance for both local governments that have large infrastructure financing needs and domestic investors that need to diversify their investment portfolios. Traditional PPPs are often single asset facilities instead of a portfolio of thousands of credit card or mortgage accounts. while PPP transactions have much of the appearance of securitizations. which concerns the ratio dynamics that drive much of the structured finance world. the essentiality of the public service can persuade a court under certain circumstances to dictate against the interests of the private sector and cut off investors from the revenues and assets derived from the project. which carries both positive and negative consequences. a public-sector partner in the PPP can and will change its mind about public policy objectives. they will never be true securitizations. This diminishes the value of traditional structured finance ratio-driven analysis. such as residential mortgages. its regulatory framework and interest in cooperating with private-sector requirements for return on capital. in the legal frameworks in which most public infrastructure is developed. The most positive consequence is that domestic debt markets for infrastructure bonds are now developing in countries like Korea. Namely. The primary reason is the role of administrative law. In addition. The lines between PPPs and structured finance have blurred considerably. Add to this individuality the constant possibility that a PPP’s operating environment can change with the policies of a new administration. are based on the collective behavior of thousands of loans observed over a long period. 50 MGM IBM . There are not enough existing PPPs from which to derive statistically meaningful default behavioral patterns or to develop fixed-coverage tests for a given rating category. From this experience. not only corporate law. where until recently such projects were financed only by commercial or government development banks. especially during difficult economic times. not because their claims are never true or cannot be made true but because they are frequently misconstrued as true.Project Finance on public private partnership Common Myths Concerning Public Infrastructure Finance Much of the discussion has centered on how structural elements enhance the credit profile of PPP transactions. Strong concession laws. Nevertheless. Collateral and other tests that are developed for the securitization of traditional asset classes. There are two explanations for this.
Myth 2: Financial Transaction Through a Special-Purpose Entity Every project has internal and external bankruptcy risk unless it has statutory protection that prevents a default from leading into bankruptcy. as previously discussed. the financing documents are not harmonized with the concession document. can act as the best mitigant to voluntary bankruptcy risk. with a maximum allowable rate of return on capital). and under a certain set of conditions. construction and operating agreements fall into this category.g. providing a 51 MGM IBM . The other governs financing: trustee. For financial transactions involving PPPs. it is important to remember the concession agreement actually sets the tone for everything to do with the project.or private sector partner to build. All of the protections afforded by the financing documents should be calibrated to these overriding rights and obligations under the concession agreement if they are to remain enforceable. operate and benefit from a project’s revenue stream for a period. the best protection comes from a special-purpose entity. assignment and inter creditor agreements. combined with structural elements. but they generally fall into two broad sets. Governments from China to Argentina to the United States can and do change the rules governing PPP transactions. One set governs the project: concession. and that is where bulletproof turns into bullet-ridden. The concession agreement can also determine the circumstances and timing of fee increases (e. This includes the government’s grant to the project partner to charge and collect user fees that will recover operating and capital costs of the project and pay debt service and potential dividends to private-sector partners. For involuntary bankruptcy and consolidation risk. until the project reverts back to the government. A determination of whether or not the transaction benefits from a special-purpose entity status requires an opinion from a qualified local counsel or other source (such as a third-party guarantee). sheer economic strength.. Sometimes. annual increases tied to inflation.Project Finance on public private partnership Myth 1: Bulletproof Financial Transaction Experience with PPPs suggests it is not possible to structure the kind of bulletproof transaction common among more conventional securitization asset classes. Every project has multiple agreements. While the financial community likes to focus its attention on the protections afforded by the financing documents. Strengths of various Mexican toll road master trust agreements are the broad cross-referencing to the underlying concession agreement and the enabling legislation for the toll road. The concession agreement is the government’s grant to a public.
as determined by the trust indenture. the trustee can only have full contractual control over the revenue flow under normal circumstances. the trustee is not the first participant to handle the revenue. As mentioned. the trustee can follow the dictates of the financing document with respect to when deposits are required into predetermined accounts for operations. The now familiar theme of bankruptcy remoteness plays a role here. The tightest trustee control over revenues requires frequent (often daily) deposits of project revenues into an account maintained by the trustee. there are a variety of ways the trustee can lose control over the revenue flow. Legal circumstances can limit the value and effectiveness of trustee control. The other is when the court decides to wind up the project’s assets as part of the ultimate creditor 52 MGM IBM . From here. among other costs. If the court decides to allow project assets as collateral under the proceeding. In most countries. They provide passive bond investors with the comfort that project revenues and accounts are assigned to the trustee on their behalf and payments from these accounts will be made in a prescribed manner and timetable. The shortest period that loss of control can occur is when the court determines whether to allow project assets under the proceeding. investors should be aware of when the trustee takes control of the revenue flow and the full range of circumstances under which the trustee retains control. debt service and reserves. The second consideration is the full range of circumstances under which the trustee retains control over the revenues. One is where the court allows the project to continue operating but diverts revenues into the ultimate creditor settlement. the market does simply not demand it. The project operator collects user fees from the project’s patrons and channels them to the trustee. If it decides not to allow the project’s assets. as part of the documentation to market such bonds.Project Finance on public private partnership clear description of the powers and obligations of the entity and certainty with respect to the obligation pledged. it is important to structure around operator bankruptcy risk. Only a handful of countries require this opinion to be rendered or even requested. thus it is necessary to return momentarily to the risks posed under the second myth (the importance of determining whether the concessionaire is really a special-purpose entity). trustee control can resume under normal operating conditions. Myth 3: Trustee Controls Revenue Flow Trustee relationships are a critical feature of project and structured finance. Under an involuntary bankruptcy proceeding. their fate can take several courses. If the bankruptcy remoteness of the project entity is not established. Nevertheless. To begin with. while it is customary for Fitch to request this opinion as part of its due diligence for a rating.
which although it may not be guaranteed or collateralized is still a high bar for the vast majority of guarantees provided to PPP transactions. • Investors should know the guarantee’s priority of payment with respect to other government obligations.e. equal to its unsecured obligation risk).. emphasizing the importance of an independent bankruptcy opinion. In fact. Myth 4: Financial Transaction Debt Is Government Guaranteed Debt guarantees from host governments are often required by investors if an infrastructure asset class is new or unfamiliar to the market or investors do not believe the user revenue stream from the project can provide a reliable payment source for the debt. While part of the rationale for bringing private partners into an infrastructure project is to provide the skills and efficiency to run the project on a business basis. or because the organizational and administrative mechanisms to operate infrastructure on a self-sufficient basis are either untested or not trusted. such as the following: • It is important to determine whether the guarantee is automatic or subject to appropriation as part of the government’s budgetary process. It is important to remember that the court may consider not just project revenue as an allowable asset but also amounts held by the trustee under the reserve. often causes investors to still demand a government guarantee. This can either be because the project has a public developmental purpose in a region that needs the infrastructure but cannot pay debt service solely through user fees. A financial obligation that is subject to budgetary appropriation is of lesser credit quality than the sovereign’s unsecured debts. A sovereign obligation is an unconditional. For an investor to assign a value to the debt guarantee. irrevocable risk. experience suggests a number of considerations. Anything less than pari passu is a subordinate obligation and of lesser credit quality than a general obligation. investors should question the logic of why a government would grant the same pledge to a project with a private sector partner as it does to its own bonds. There is a long-held financial proverb that the government guarantee is as good as the sovereign’s own credit risk (i. among other things. 53 MGM IBM . the high probability of political risk with respect to rate flexibility.Project Finance on public private partnership settlement. Pari passu status with respect to general obligation debt is the strongest. The legal process and interpretations of bankruptcy proceedings vary from country to country.
Instead. investors should consider the political risk inherent to every project finance transaction. • Investors should be concerned about the financial sustainability of guarantee commitments. this is a weaker guarantee but also the most common. Nothing is ever simple where PPPs are concerned. Of equal concern is whether the responsible government agency can reach a different conclusion than the trustee or concessionaire as to the deficiency amount. • The concession agreement should outline the process and timing by which the government will evaluate and settle upon the guarantee commitment. then asks the government to retroactively use its guarantee mechanism to make up the payment deficiency. One should not compare the small debt-service commitment of a project to the largess of the government’s budget. • Finally. Essentially. Giving the government prior notice and time to respond by making a deposit of the deficiency into the debt-service account on or prior to the payment date preserves the full and timely nature of the payment and is the strongest type of trigger. there are two types of triggers. A proactive trigger requires a trustee and/or concessionaire to formally notify the government in advance if the debt-service account is deficient for an upcoming debtservice payment. especially at election time or during a crisis. An open-ended review process is the weakest. The most effective guarantee specifies which government representatives are responsible for evaluating the guarantee request and how many days they have to respond. A reactive trigger waits for a payment default to occur. Some projects will be successful and politically popular. It is reckless to believe documentation creates equality among projects in the government’s opinion. The concession agreement should restrict the government’s ability to interpret a guarantee request. the focus should be on the rigidity of the expenditure budget (how much of it is already accounted for under legally mandated programs). while others will be economically or politically unpopular.Project Finance on public private partnership • It is important to be familiar with the mechanism that triggers the guarantee. Nevertheless. governments may exercise their own calculations as to guarantee amounts regardless of the mathematical debt-service deficiency. A time-certain review and payment under the guarantee clause is the strongest form of guarantee. 54 MGM IBM . given other financial and service demands on the government. Governments will not treat each project equally.
The first steps have been taken. Loan repayments for certain municipal users will be made directly by user fees or local taxes. Is the visionary portrait of the future of PPPs in nonOECD countries realistic? I believe that it is close to becoming a reality. the remaining construction conglomerates. the private-sector role shifts to the financial engineers who work in conjunction with government authorities. Old allies. the WSPF has the authority to directly intercept state aid for loan repayment. The process has already begun. Agency for International Development’s (USAID) support of the Water and Sanitation Pooled Fund (WSPF) in the state of Tamil Nadu.S. Enhanced pooled capital is the concept behind the U. Finally. the monoline insurers are exploring opportunities to provide credit enhancement at the ‘AAA’ national scale rating level. The debt-service reserve fund carries an amount equal to one full year of debt service. WSPF is a special-purpose vehicle to be incorporated under the Indian Trust Act. constructing and operating projects. their capital could be extended even further. (TNUIFSL) will manage the fund. Ltd.Project Finance on public private partnership Conclusion In the new generation of PPPs. as well as development and multilateral banking partners. for certain emergingmarket countries with an investment-grade sovereign rating on the international scale. India. If these layers are insufficient. The fund’s debt will be offered to domestic investors. USAID contractually plans to guarantee an amount equal to 50% of WSPF’s principal. For other types of municipal users. Tamil Nadu Urban Infrastructure Financial Services. with some multilateral banks starting to provide credit enhancement (partial credit risk guarantees) to project debt in the local markets and in the local currency. All these signs are important for the development of domestic capital markets and the creation of a sustainable and regenerative supply of capital for infrastructure projects. If they were enhancing pooled project loans. with the ability to intercept state aid if there is a deficiency. Private banks are also exploring the creation of infrastructure banks in select emerging-market countries. The financial engineers from both the public and private sectors will create the next generation of PPPs. These banks would most likely work in conjunction with a host country’s development bank to achieve the risk allocation and cost-of-fund advantages of the SRFs. will still be involved. with an initial debt-service reserve contribution from the Tamil Nadu government. 55 MGM IBM . A more efficient allocation of capital engages a broader set of participants and creates new incentives to enhance the capacity for infrastructure finance while also promoting a more efficient delivery of municipal services. but their role is less for equity and more for their expertise in designing. This enhancement role allows these banks to allocate their capital further than through direct lending. to create enhanced investment vehicles that are attractive to domestic capital.
Esty Magazines Project finance Business World Business Today Webliography www.asp 56 MGM IBM .com www.project-finance-models.pppinindia.economictimes.com www.bloomberg.com www.Clifford Chance Modern Project Finance: A Casebook by Benjamin C.com www.projectfinancemagazine.com/financing.com www.Project Finance on public private partnership Bibliography Project Finance .Euromoney/DC Gardner Project Financing – Nevitt Project Finance .investopedia.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.