In the context of PPP defaults, having to estimate post-default recovery (the complement of loss-given-default) for PPP projects is instructive. The simple approach is to (a) define the most likely default scenario; (b) calculate the discounted present value of - perhaps impaired - subsequent cash flows; then (c) divide this value by a measure of exposure (quantum of outstanding debt) at default. The starting point for the analyst is to define a credible default scenario. And here's the rub.
In a PPP project with market risk exposure - a toll road, for example - it is not difficult to imagine a default scenario. Asset under-performance (lower-than-anticipated traffic usage) has historically been a, if not the, default trigger in distressed post-construction road projects - with toll income failing to meet debt servicing obligations. But toll roads are in a minority. The vast majority of the PPP universe relies on state payment albeit with penalties for under-performance or non-availability.
It's one thing to talk glibly about penalty regimes in PPP projects, the discipline they instil and the incentivising role they play in terms of service delivery. It's quite another to wade through the contractual documentation of availability-based PPP projects to construct a realistic default scenario. Sure - the accumulation of sufficient penalty points for (non-trivial) contract violations will eventually do it. But when you translate this into 'real life', if it means hospital wards being closed for extended periods or entire wings of schools being out of service, buying in to this state of affairs seems a big ask. Especially when the scenario requires project participants to sit back, watching the escalating crisis, with zero intervention. Money is at risk and reputations on the line, so early warnings and cure periods would not be ignored. Remedial measures would be taken; stakeholders would - and do - act. Sponsors' step-in rights are usually set to trigger at levels prior to lenders' step-in right triggers for this very reason.
From an analytical perspective, it is important that credits be subjected to stresses to demonstrate resilience - but these stresses need to remain commensurate with the rating. An 'AAA' credit, for example, should be bombproof; lenders insulated from almost all conceivable hostile conditions and downside scenarios. But you would not expect 'BBB' credits to survive 'AAA' stresses. This begs the question: exactly what situation or set of circumstances - commensurate with low investment-grade - would put a post-construction availability or performance-based PPP into default? If you have the financial model in front of you and the contract documents to your side, yet you still find it difficult to default the project - what does that say about its credit rating? Distance to default is an important concept in credit analysis.