Public sector Capital Contributions to funding PFI/PPP/P3 Projects
We have reviewed the treatment of CCs across a range of jurisdictions and reached out to many public sector procurement entities to understand their approach, and our conclusion is that CCs generally have an adverse impact on senior debt credit risk in most new PFI/PPP/P3 projects. To understand this rationale it is helpful to start with a reminder of why CCs may sometimes have a positive impact on other sectors
CCs can materially improve the viability and credit quality of market risk project financings
Many capital-intensive revenue risk projects cannot expect to attract sufficient direct revenues to cover their capital, operating and financing costs in full. They may be of material socio-economic value to a wider community, which may justify a CC from the public sector, but without such a CC their internal cashflows are too weak for the project to be viable.
Credit quality absent the CC will be weak, and there will be a consistent positive relationship between the level of CC and the resulting credit quality of the entity. Most likely there will come a tipping point when the CC is sufficiently large to convert the viability of the project from a speculative to an investment grade proposition. In summary, CCs represent additional income so have a positive credit effect.
Why is PFI/PPP/P3 different?
The key difference is that with an availability-based PFI/PPP/P3 project, the public sector is paying for 100% of the assets and services whichever funding route is chosen. Viability is never in doubt, and when the public sector offers a CC up front with one hand, it reduces subsequent availability payments with the other hand. The CC is not an additional income stream.
In fact, far from being an additional income stream, the decision to inject an up-front CC is usually justifiable and even desirable on economic grounds. Pure public sector funding in the form of a CC will be cheaper than private sector funding in the form of blended at-risk debt and equity, so wherever the public sector can inject a CC without compromising risk transfer onto the private sector, that will benefit the public sector since they will end up paying less overall for the same assets and services. As we noted in our previous RFC, what is good for the public sector is generally bad for the private sector debt.
Preserving full risk transfer onto the private sector
Funders are usually exposed to completion risk on 100% of a project's scope during the construction phase. Availability payments from the offtaker (which are essential if debt is to be repaid) will only start to flow once the asset is completed and operational. Funders will take steps to mitigate the risks to which they are exposed (through sponsor equity, subcontracting, third party bonding etc.), but the essence of proper risk transfer is that if extra cost ("rectification cost") has to be incurred, the impact will be borne by private sector funders and will erode their recovery. Funders are in a first-loss position1 relative to the offtaker, and it is only once their debt recovery has been fully eroded that excess rectification costs may affect the offtaker.
By requiring a project to achieve overall completion before availability payments start to flow, the public sector can preserve this first-loss principle even when CC funding is present.
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1 Sponsor equity is in a first-loss position relative to senior debt, and sponsors themselves typically try to pass down risk to construction subcontractors who assume substantial liability exposure, often supplemented by third party bonding; but we are assuming that all of these supports have already been eroded to zero in an unsuccessful attempt to achieve completion.