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 118

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 119, 120