Investment Banking project Finance
This Annex introduces some basic concepts of project finance and shows how they relate to the financing structure of PPP projects. It is not meant to cover all the issues relevant to PPP financing structures, which are many complex and often project-specific. Authorities should rely on the expertise of financial and legal advisers to understand the relevant trade-offs in project finance issues.
PPP projects are generally financed using project finance arrangements. In project finance, lenders and investors rely either exclusively (“non-recourse” financing) or mainly (“limited recourse” financing) on the cash flow generated by the project to repay their loans and earn a return on their investments. This is in contrast to corporate lending where lenders rely on the strength of the borrower’s balance sheet for their loans.
It is important to stress that the project finance structure should be designed to optimise the costs of finance for the project. It should also underpin the allocation of risks between the public and private sectors as agreed in the PPP contract. In particular, the project financing should ensure that financial and other risks are well managed within and between the PPP Company shareholders, sponsors and its financiers. This should give comfort to the Authority that the PPP Company, and particularly its funders, are both incentivised and empowered to deal in a timely manner with problems that may occur in the project. Indeed, to a very large extent, the project finance structure should ensure that the interests of the main lenders to the project are aligned with those of the Authority – that is, that both need the project to succeed in order to meet their objectives. Where this is the case, the Authority can be confident that the lenders will take on much of the burden of assuring the ongoing performance of the project. This is a key element of the transfer of risk from the public to the private sector in PPPs.
Principles of project finance
In a project finance transaction a PPP Company would usually be set up by the sponsors solely for the purpose of implementing the PPP project. It will act as borrower under the underlying financing agreements and will be a party to a number of other project-related agreements. Guidance
The top-tier funding provided by lenders or capital market investors, usually referred to as “senior debt”, typically forms the largest but not the sole source of funding for the PPP Company. The rest of the required financing will be provided by the sponsors in the form of equity or junior debt. Grants, often in effect a form of public sector unremunerated equity, may also contribute to the financing package.
Since senior lenders do not have access to sponsors’ financial resources in project-financed transactions, they need to ensure that the project will produce sufficient cash flow to service the debt. They also need to ensure that the legal structuring of the project is such that senior lenders have priority over more junior creditors in access to this cash. In limited recourse financings, lenders will seek additional credit support from the sponsors and/or third parties to hedge against downside scenarios and the risk of the project’s failing to generate sufficient cash flow. Finally, lenders will wish to ensure that where a project suffers shortfalls in cash as a result of poor performance by one or more of the PPP Company’s subcontractors, these shortfalls flow through to the subcontractor, leaving the ability of the PPP Company to service the debt unimpaired.
Even though responsibility for arranging the financing of a PPP rests with the private sector (the PPP Company is the borrower), it is important for the Authority’s officials and their advisers to understand the financing arrangements and their consequences, for the following reasons:
- When the Authority evaluates a bidder’s proposal, it must be able to assess whether the proposed PPP contract is bankable and whether the proposed financing is deliverable in light of the market conditions and practices prevalent at the time. Awarding the PPP contract to a company that ends up being unable to finance the project is a waste of time and resources.
- The allocation of risks in the PPP contract can affect the feasibility of different financing packages and the overall cost of the financing.
- The financing can have an impact on the long-term robustness of the PPP arrangement. For example, the higher the debt-to-equity ratio, the more likely it is that in bad times the PPP Company will run the risk of a loan default, possibly terminating the project. Conversely, the more debt in a project, the more lenders are incentivised to ensure that project problems are addressed in order to protect their investment.
- If the PPP includes State guarantees or public grants, the Authority will play a direct role in some part of the financing package.
- The amounts and details of the financing can directly affect contingent obligations of the Authority (e.g. the payments the public sector would have to make if the PPP contract were terminated for various reasons).
- The Authority’s financial advisers should have a thorough understanding of what will be needed to make the PPP project bankable, given market conditions and practices prevalent at the time. Carrying out market sounding exercises at different points during the project preparation stages will greatly assist in developing a good understanding of investor and lender attitudes. It will save a great deal of time if any credit enhancement is to be provided by the public sector. Guidance,
As outlined above, the financing of a PPP project consists principally of senior debt and equity (which may sometimes be in the form of junior shareholder loans). The financing structure may also include other forms of junior debt (such as “mezzanine” debt, which ranks between senior debt and pure equity) and in some cases grant funding.
PPP projects should seek to achieve optimum (as opposed to maximum) risk transfer between the public and private sector. But the allocation of risks among the private sector parties is also crucial. Financial structuring of the project relies on a careful assessment of construction, operating and revenue risks and seeks to achieve optimum risk allocation between the private partners to the transaction. In practice, this means limiting risks to senior lenders and allocating this to equity investors, subcontractors, guarantors and other parties through contractual arrangements of one kind or another.