Theme4: Finance

The fourth theme of this discussion is regarding Finance.

1: Main sources of finance for the PPP projects

• What are the main sources of finance for the PPP project? (e.g. private financing, subsidy, public bond etc.)
• What are the main sources of debt and equity for the PPP project? (e.g. banks, debt from capital markets, equity from third party, sponsor etc.)
• Does mezzanine finance play a significant role?
• How is equity typically subscribed to projects?
• Are there sectoral differences in terms of sources of finance and gearing?

2. Improvement of bankability of projects

• Have clear principles been established by senior lenders in terms of what kinds of risks they will, and will not accept in projects? How has this evolved in recent times? (e.g. attitudes to the demand risk such as traffic risk in transport projects)
• Has the public sector had to take specific initiatives to improve the bankability of projects? (e.g. guarantees of various sorts to secure funding for previously unbankable projects)

3. Other issue

• Is there a clear understanding in the forms of financial commitments (e.g. performance guarantees, parent company guarantees, bonds, letters of credit etc.) sub contractors will need to provide to banks, to support their (the contractors´) obligations under PPP contracts?
• Have clear principles been established with respect to the public sector´s interest in refinancings (for example, gain sharing arrangements)? How does the public sector control a possible increase in its contingent liabilities as a result of project refinancings?

[1] Author: Richard Foster

Organization:

Acting Head, Partnerships Victoria Unit
Commercial & Infrastructure Risk Management Group
Department of Treasury and Finance

Here is some analysis from a Partnerships Victoria perspective of the sub-topics Nicholas Jennett has raised in relation to finance. Thank you to my colleague Brent Chandler for his contribution to this response.

1. Main sources of finance for the PPP projects

What are the main sources of finance for the PPP project? (e.g. private financing, subsidy, public bond etc.)

Under the Partnerships Victoria (PV) approach to procurement, the concessionaire (through the SPV) is generally required to arrange and source its own capital. This will be a combination of debt and equity (note gearing levels are discussed below). Once commissioning is achieved, government will begin making quarterly service payments (QSPs) to the SPV (except in the case of user-pays projects such as toll roads, where third party revenues replace QSPs). The QSPs continue over the term of the concession agreement (subject to any abatement for failing to meet the required outputs). The QSPs cover the concessionaire´s debt servicing costs, as well as operating/maintenance costs and a return on equity.

What are the main sources of debt and equity for the PPP project? (e.g. banks, debt from capital markets, equity from third party, sponsor etc.)

From a PV perspective, debt has been provided in the form of both bank debt and bonds. On the bond finance side, we have seen both nominal and inflation-linked issues. The continued growth of the Australian inflation-linked bond market has arguably led to a recent trend towards inflation-linked bonds. Bond issues for PV projects have been largely domestic to date, although there was a US issue as part of the financing of the Southern Cross Station project. On the bank debt side, it is normal to see construction facilities established initially, before conversion at the end of construction to term facilities.

In terms of equity in PV projects to date, it has been largely the investment banks that have assumed the project sponsor role and provided initial equity, although we do also see the major sub-contractors providing equity in some instances. Large toll road projects have also raised equity through initial public offerings. There is an emerging secondary equity market, although it should be noted that government consent is required for changes in ownership. Australia has a very large pool of superannuation (pension) funds, which show significant interest in operational infrastructure assets.

Does mezzanine finance play a significant role?

Mezzanine finance in the strict sense has not to date played a significant role.

How is equity typically subscribed to projects?

Equity is typically committed at financial close but often not injected into the project until late in the construction phase. Much of the equity is often provided in the form of subordinated shareholder loans. In part, this reflects an investor preference to access pre-tax rather than post-tax cash flows.

Are there sectoral differences in terms of sources of finance and gearing?

There doesn´t appear to be clear sectoral differences in terms of sources of finance.

Gearing levels tend to be driven largely by the allocation of demand risk. Debt typically makes up 90% to 95% of SPV capital structures for social infrastructure projects in which the private sector does not take demand risk, such as our hospital projects. Conversely, projects where significant demand risk rests with the SPV (ie the project relies on significant third party revenues) tend to have lower gearing levels. For example, in toll road projects, the SPV capital structures at the completion of construction are more likely contain 50% to 60% debt, with the remainder being equity.

2. Improvement of bankability of projects

Have clear principles been established by senior lenders in terms of what kinds of risks they will, and will not accept in projects? How has this evolved in recent times? (e.g. attitudes to the demand risk such as traffic risk in transport projects)

The overriding concern of senior lenders is the security of the project cash flows used to service the debt. Senior lenders are therefore wary of any risk assumption which threatens cash flows. As indicated above, cash flows are most at risk when the SPV assumes significant demand risk (although all project risks are carefully considered). In higher risk projects, financiers are likely to require a greater level of equity in the capital structure and/or require greater risk sharing by way of specialised mechanisms such as material adverse effect regimes. The Partnerships Victoria ´Standard Commercial Principles´ (released in June 2005) provides guidance on risk allocation more generally. These principles are generally accepted in the market.

In relation to how risk acceptance has evolved in the market in recent times, the contrast between our CityLink and EastLink toll road projects provides a good example. With CityLink, which was completed in 2000, government took on the risk of changes in the state-controlled road network (that connects to CityLink) adversely affecting CityLink patronage. In the less mature market that existed at that time, this helped ensure the project was bankable. In contrast, the EastLink project (currently under construction) was bankable, even though government has retained the freedom to make changes to the surrounding road network without incurring any obligation to compensate the contractor for the impact upon demand.

Has the public sector had to take specific initiatives to improve the bankability of projects? (e.g. guarantees of various sorts to secure funding for previously unbankable projects)

Most PV projects undertaken to date have been social infrastructure in nature, with government assuming demand risk. The relative revenue certainty (derived from the QSPs) from social infrastructure projects tends to make them quite attractive to financiers. However, government does not guarantee the financiers´ returns.

Tripartite agreements between financiers, government and the SPV are the norm. These agreements ensure that financiers have the right to rectify defaults prior to termination. Financiers under these agreements are free to step-in and engage contractors to address a default to ensure the project and Government QSPs continue. Financiers include requirements in the debt agreements that they receive copies of any default notices.

3. Other issues

Is there a clear understanding in the forms of financial commitments (e.g. performance guarantees, parent company guarantees, bonds, letters of credit etc.) sub contractors will need to provide to banks, to support their (the contractors´) obligations under PPP contracts?

Letters of credit, bank guarantees and performance bonds are quite prevalent in PV projects. Partnerships Victoria policy does not however dictate the type and form of financial commitments that banks may seek from sub-contractors. Partnerships Victoria Guidance material does provide guidance on issues relating to security provided to government where this is required.

Have clear principles been established with respect to the public sector´s interest in refinancings (for example, gain sharing arrangements)?

Yes. Government has articulated its position on re-financings in our Partnerships Victoria Standard Commercial Principles. In short, all re-financings other than those contemplated at financial close will require government consent, and any re-financing gain is to be shared between government and the private party on a 50:50 basis provided the projected equity return at the time of the re-financing (taking into account any refinancing) is above that reflected in the original base case financial model.

How does the public sector control a possible increase in its contingent liabilities as a result of project refinancings?

If this question is referring to an increase in possible future termination payments as a result of a refinancing, the key to dealing with the issue lies in the contractual requirement for the contractor to seek government consent for changes in its financing arrangements. This requirement is additional to the requirement for sharing of refinancing gains. Thus, if a proposed refinancing also materially increases government´s contingent liabilities, the appropriate analysis is that government is entitled to 50% of the refinancing gain and, in addition, government should receive value (e.g. compensation) in return for agreeing to a material increase in its contingent liabilities.

[2] Author: Edward Farquharson

Organization:

Project Director
Partnerships UK

Here are some brief comments from a UK perspective. In many ways the UK and Victoria approaches are similar. I will touch on a few issues:

A note of caution with inflation hedging products ­ while they may appear be attractive in terms of affordability etc, one needs to be clear about the consequences in the event of termination as any unwinding obligations with these complex products need to be fully understood. I draw your attention to a recent application note we issued on this (available of the HM Treasury website)

Unlike Victoria, I guess our sources of equity have generally been the contractors although there are specialist primary equity funds as well. As in Victoria though, we are seeing an explosion in the growth of secondary market equity funds bidding quite aggressively for yields on operational PFI assets. Also mezzanine is rare as the debt markets are highly competitive and provide 90%, sometime more, of the total capital and the availability of equity for the (limited) balance is not generally an issue.

Re standard risk transfer, much is now encapsulated in the standard PFI contract and we released a latest version, SOPC4, last week (see our website). This has been updated for areas such variations and operational issues such as benchmarking/market testing based on our experience of contracts now in their operational phase.

As in Victoria, the agreement between the authority and the lender is usually limited to the direct agreement in order to effect step-in rights. Guarantees need to be treated with caution as they can be lightning rods for all forms of risk­ the whole point of the PFI payment mechanism is to ensure a more precise allocation of risk. Key to driving performance under PFI is to ensure that capital is at risk to the performance risk allocated under the payment mechanisms. However, one of the key challenges for any new markets (as indeed was the case in our early days) is often to encourage the lenders to accept performance risk AND for the authorities to keep to the terms of the contracted risk allocation in the event that the contract comes under stress. In some markets (not the UK), the authority may guarantee a percentage of the debt on the basis that market needs to develop and perhaps the un-guaranteed portion is enough to provide some incentive of capital at risk to performance together perhaps with a strategy to drive these to more aggressive levels over time. The level required might be an interesting topic for separate debate. And the corollary might be the issue of paying a risk premium on that part of the debt that is unlikely ever to be at risk especially for projects with good liquid market prospects.

Regarding refinancing, this is often an area that on the surface might appear simpler than in practice. As Richard rightly mentions consents are a method of control. But one also has to be crystal clear about the consequences of such consents (hence the reason we felt it important to have guidance in this area as well as support mechanisms such as the refinancing taskforce to help procuring authorities with these complex issues ­ admittedly in the UK we have contracts spread across a wider variety of procuring authorities so it is perhaps more of an issue for us). Access to information at the SPV level also is key and in any new market one might even consider the authority having a small stake at the SPV level for this purpose.

[3] Author: Jennet Nicholas

Organization:

Structured Finance and Advisory Services
European Investment Bank, Luxembourg

Thanks for these interesting contributions. There are clearly many similarities between the approaches in Victoria and the UK, although the contrast on contractor equity is particularly interesting. I have heard it argued that contractor equity is particularly important for lenders in order to maximise incentivisation for contractors to ´get out of bed´ to deal with problems. Are people aware of any evidence of differential performance between contractor led and bank led consortia in this regard?

The secondary market issue is also an interesting one. I have sometimes heard the public sector express concern about trading of operational concessions on the that they have "sold" the concept of PPP internally on the basis of long term partnership ... and then suddenly you don´t know who your partner is. I detect a general feeling of unease within the public sector about whether the secondary market undermines the incentives for long term performance that they (the public sector counterparts) were relying on. My response to this as a banker has been along the lines of (a) as long as yoru have debt there as a ´financial hostage´ (I wish I could claim authorship of this phrase!) you don´t need to worry about long term incentives and (b) any attempt to curtail secondary trading would reduce the amount of liquidity in the market and the public sector would pay the price. Am I right - or does the public sector have a point?

Finally, and in a way related to the last point, is Ed´s interesting observation on just how much debt is required to perform the ´financial hostage´ role? There is a tendency to be somewhat dismissive of PPP regimes that offer debt guarantees (and Ed´s lightning conductor point is well taken) but is it really the case that 100% of debt need to be (in principle) at risk in order to incentivise banks?

[4] Author: Jennet Nicholas

Thanks to Richard and Ed for their contributions on this. The points raised here have been quite diverse, and so I am not going to attempt to summarise. Rather, I will just finish with the observation that even a number of years into PPP in many countries, we are continuing to see innovation in finance. In part, this is about the lifecycle of projects : issues around refinancing and the development of secondary markets are related to the fact that projects are now successfully delivering. But there are also other interesting issues on the horizon, particularly around whether, and how, the additional costs of private finance vis a vis public finance (even when the relative costs are risk adjusted - the so called liquidity premium on private finance) can be addressed without undermining the financial disciplines which come from involving the private sector. The UK Treasury is piloting an interesting initiative in this area in a scheme in which public capital is provided to PPP projects, but this capital is guaranteed by the private sector (thus not undermining overall risk transfer). Similarly, there is the issue of whether 100% private sector finance is necessary to achieve the benefits of private sector financial discipline - might lenders not be equally incentivised if only 50% (of whatever figure) of their debt was a risk? So although this is the last comment in this discussion, it´s certainly not the last word!