PPP PROJECTS : HOW THEY ARE FINANCED
A key motivation for governments considering public-private partnerships (PPPs) is the possibility of bringing in new sources of financing for funding public infrastructure and service needs. A number of financing mechanisms are available for infrastructure projects, and for public-private partnership (PPP) projects in particular.
Corporate or On-Balance Sheet Finance
The Government may choose to fund some or all of the capital investment in a project and look to the private sector to bring in expertise and efficiency. This is generally the case in a so-called Design-Build-Operate project where the operator is paid a lump sum for completed stages of construction and will then receive an operating fee to cover operation and maintenance of the project. Another example would be where the Government chooses to source out the civil works for the project through traditional procurement and then brings in a private operator to operate and maintain the facilities or provide the service.
Even where Governments prefer that financing is raised by the private sector, increasingly Governments are recognizing that there are some aspects of the project or some risks in a project that may be easier or more sensible for the Government to take. This is discussed in Government Support in financing PPPs.
Corporate or On-Balance Sheet Finance
The private operator may accept to finance some of the capital investment for the project and decide to fund the project through corporate financing – which would involve getting finance for the project based on the balance sheet of the private operator rather than the project itself. This is typically the mechanism used in lower value projects where the cost of the financing is not significant enough to warrant a project financing mechanism or where the operator is so large that it chooses to fund the project from its own balance sheet.
The benefit of corporate finance is that the cost of funding will be the cost of funding of the private operator itself and so it is typically lower than the cost of funding of project finance. It is also less complicated than project finance. However, there is an opportunity cost attached to corporate financing because the company will only be able to raise a limited level of finance against its equity (debt to equity ratio) and the more it invests in one project the less it will be available to fund or invest in other projects.
One of the most common - and often most efficient - financing arrangements for PPP projects is “project financing”, also known as “limited recourse” or “non-recourse” financing. Project financing normally takes the form of limited recourse lending to a specially created project vehicle (special purpose vehicle or “SPV”) which has the right to carry out the construction and operation of the project. It is typically used in a new build or extensive refurbishment situation and so the SPV has no existing business. The SPV will be dependent on revenue streams from the contractual arrangements and/or from tariffs from end users which will only commence once construction has been completed and the project is in operation. It is therefore a risky enterprise and before they agree to provide financing to the project the lenders will want to carry out an extensive due diligence on the potential viability of the project and a detailed review of whether the project risk allocation protects the project company sufficiently. This is known commonly as verifying the project’s “bankability”.
The complexity of PPP projects leads to the need for appropriate legal frameworks and institutions to support successful PPP programs. As a result in recent years, governments have considered various changes in the legal and regulatory environment, as well better administrative procedures, in order to reduce uncertainties for private investors. In particular, dedicated PPP Units have been created in some governments. What are the most important considerations in this respect?
Legal Basis Of PPPs
In most countries, provision of infrastructure services is the responsibility of the public sector. Depending on the political and administrative structure of the country, legislation may govern the infrastructure sectors at different levels of government (local, provincial, and national). Generally, some form of government authority is required to permit private involvement in infrastructure development. Legal provisions may also be required to process, promote and facilitate private involvement.
Administrative Mechanism and Coordination
The administrative mechanism of PPP project implementation depends on the system of government and the overall administrative structure, and the legal regime concerning PPPs. As these elements vary from one country to another, the administrative mechanism also varies from one country to another. Generally, the sectoral agencies at the national and provincial levels (in a federal structure) initiate and implement most of the PPP projects. However, in many countries, the Philippines for example, local level governments such as city governments are also allowed to undertake PPP projects.
Depending on the system in a country, the implementation of PPP projects may require the involvement of several public authorities at various levels of government. The authority to award PPP contracts and approve contract agreements is generally centralized in a separate public authority. This may be a special body for this purpose and is usually at the ministerial or council of ministers level.
The legal instruments and/or government rules and guidelines define how the sectoral agencies and local governments may initiate, develop, submit for approval of the national/provincial government, procure, negotiate and make deal with the private sector, and finally implement a project. These legal instruments may also define the authority and responsibilities concerning PPPs at different levels or tiers of government.
Steps in PPP Project Development and Implementation
The figure below shows the steps that are generally considered in a PPP project implementation process. Clear definitions and procedures of various tasks and administrative approval from competent authorities at different stages of project implementation process are necessary in running a successful PPP programme. Streamlined administrative procedures reduce uncertainties at different stages of project development and approval and help to reduce the transaction cost of a PPP project.
Risks in PPP Project Development
Risks can be hard to define, manage and mitigate. In infrastructure projects that cross regional or national borders and involve multiple parties from both the public and private sector, these risks may be amplified. Risks are evaluated on the magnitude and likelihood of their impact on project cash flows.
Lenders focus on certain risks more critically because they play a large role in the certainty of project cash flow. Investors often require certainty that market instruments and regulatory support are available to better align the risk profile of investment with their own risk tolerance before investing in a cross-border project.
Multiple currencies can further complicate a cross-border project, with multiple currency fluctuations to manage, as well as risks associated with currency convertibility and transferability. Some governments impose restrictions and/or limits on investors that receive their revenue in a local currency on converting that revenue to a foreign currency or transferring it abroad.
Even when a project receives revenue in a foreign currency, there may still be restrictions on transferring it abroad. Political risk insurance cover may be available to mitigate currency convertibility and/or transferability risk, although this can be expensive.
Currency fluctuation risks will depend on asset type, project costs and the project revenues available. As an example, if project revenues are available in foreign currencies and debt finance is available in that same foreign currency, this provides a natural hedge against the currency exchange rate and convertibility risks depending on the volatility of the foreign currency revenue. However, where project revenues are only available in a local currency and the only debt finance available is in a foreign currency, this currency mismatch creates an exchange rate risk.
Hedging instruments may be a solution to currency risk in these circumstances, but they rarely offer a cost-effective solution in many markets due to the costs involved and the lack of long term hedging options for many local currencies. In this case, lenders will have to settle for the maximum tenor the local market will offer and then renew the maturity of the hedge in due course.
Investors in PPP projects in Developing Countries:
Commercial banks (local/ international)
Commercial banks are important investors in infrastructure projects, particularly through senior loans and guarantee products such as performance guarantees and letters of credit. The complexity and duration of project financed projects often means that local banks in many developing countries lack the technical capacity or willingness to enter into these projects, and where they do they tend to be junior members of a syndication.
Capital markets/ bondholders (local/ international)
Bond financing is suited to project finance as it tends to be longer tenure than commercial loans. However, there is less flexibility in the lending. It may be easier for an infrastructure fund to raise finance through the capital markets rather than an individual project, given that many institutional investors can only invest in investment grade products.
Private equity funds (often called “infrastructure funds”) can play an important role in providing mezzanine financing to a project, taking more risk than traditional lenders, but less than the sponsors.
An equity fund is a collective investment scheme investing in equities. Collective investment schemes are a way for investors to invest with other investors order to benefit from the inherent advantages of working as part of a group. These advantages include an ability to:
hire a professional investment manager, which theoretically offers the prospects of better returns and/or risk management
benefit from economies of scale – cost sharing among others
diversify more than would be feasible for most individual investors which, theoretically, reduces risk.
Around the world large markets have developed around collective investment and these account for a substantial portion of all trading on major stock exchanges.
The nature of intervention by a private equity fund will depend largely on the nature of that fund. Some bring significant infrastructure finance experience, and can help improve project management and cost effectiveness. Others are focused on financial investment with only limited infrastructure experience.
For more on private equity in emerging markets, one source is the Emerging Markets Private Equity Association (EMPEA)
Export credit agencies
An export credit agency (ECA) is a private or quasi-governmental institution that acts as an intermediary between national governments and exporters to issue export financing. The financing can take the form of credits (financial support) or credit insurance and guarantees (pure cover) or both.
ECAs are active in a number of developing countries and are increasingly investing in infrastructure. ECAs provide three main forms of support to an importing entity:
Direct lending - This is the simplest structure - the loan is conditional on purchase of goods or services from businesses in the ECA country.
Financial intermediary loans – the ECA lends funds to a financial intermediary, such as a commercial bank, that in turn lends to the importing entity.
Interest rate equalization – a commercial lender provides a loan to the importing entity at below-market interest rates, and in turn receives compensation from the ECA for the difference between the below-market rate and the commercial rate.
Development finance institutions
Development Finance Institutions (DFIs) are bilateral, regional or multilateral institutions that are supported by states with developed economies. DFIs generally have a mandate to provide finance to the private sector for investments that promote development. The purpose of DFIs is to ensure investments where otherwise the commercial markets would not invest. DFIs aim to be catalysts, helping companies get funding in countries where there is restricted access to domestic and foreign capital markets and provide risk mitigation products that enable investors to proceed with plans they might otherwise abandon. DFIs provide loans with longer maturities and other financial products. Examples of DFIs are International Finance Corporation (IFC), European Bank for Reconstruction and Development (EBRD), CDC Group (UK’s development finance institution), DEG (the German development finance institution), Proparco (the French DFI) and European Investment Bank (EIB).
Some of these DFIs also have specialist products and facilities that support project development and seed equity to projects, such as IFC’s Infraventures initiative. For more, go to IFC.
See Risk Mitigation Products for more information on some specific products developed by DFIs and MDBs that can be used in projects.
Bilateral aid agencies are the aid arm of countries that provide aid to the developed world. They provide funding through grants directly or through multilateral and regional agencies and trust funds.
Multilateral Development Banks
Multilateral Development Banks are institutions that provide financial support and professional advice for economic and social development activities in developing countries. The term Multilateral Development Banks (MDBs) typically refers to:
The World Bank
The African Development Bank
The Asian Development Bank
The European Bank for Reconstruction and Development
The Inter-American Development Bank Group
MDBs provide support to governments in development of projects, through Risk Mitigation Products and by providing funds that the governments can use to provide Government Support in Financing PPPs. For more on how the World Bank Group assists in PPPs, go to World Bank Group's Role.
Sovereign wealth funds
Sovereign wealth funds allow countries with superior savings rates to export that capital to other parts of the world and represent significant sources of funding for infrastructure projects. They often come into projects with some sort of mezzanine financing.
Sovereign wealth funds are state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals or other financial instruments. They are typically created when governments have budgetary surpluses and have little or no international debt. There are two types of funds: saving funds and stabilization funds. Stabilization SWFs are created to reduce the volatility of government revenues, to counter the boom-bust cycles' adverse effect on government spending and the national economy. Savings SWFs build up savings for future generations. Sovereign wealth funds invest globally and many like to invest in infrastructure as a long-term investment. Sovereign wealth funds have been around for decades but since 2000, the number of sovereign wealth funds has increased dramatically. The first SWF was the Kuwait Investment Authority.
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