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.
As a general principle, the higher the gearing of a project, the more affordable it is likely to be to the public sector.11 This is because senior debt is less expensive than other forms of financing (except grants). Other things being equal, project gearing (i.e. the level of debt senior lenders will provide relative to the level of equity) will be determined by the variability of a project's cash flow. The greater the degree of riskiness in the cash flows, the greater the "cushion" lenders will need in the forecast of available cash flow beyond what will be needed for debt service. This is necessary to reassure lenders that the debt can be repaid even in a bad-case scenario. Lenders will specify their requirement in terms of forward-looking (i.e. predicted) "annual debt service cover ratio" (ADSCR)12 above a specified minimum level. The value of required ADSCR will depend in large part on project risk, and therefore variability of cash flows.13
For a given gearing (or volume of debt in the project), the target ADSCR will determine the level of the service fee to be paid by the Authority. Alternatively, for a given level of service fee (perhaps the affordability limit), the target ADSCR will determine the project's gearing. In other words, the lower a project's gearing (the more equity relative to debt), the higher the cover ratio from a given service fee.
The Authority's financial advisers need to understand lenders requirements in this regard. It will greatly facilitate financing if the project developed and taken to the market is structured in such a way that the cover ratios are compatible with lenders expectations for the particular sector and type of project. This will also facilitate achieving the best possible cost for the financing and will thus have direct implications for the public sector, which is usually the ultimate payer for a PPP.
One of the fundamental trade-offs in designing PPPs is there-fore to strive for the right balance between risk allocation between the public and private sector, the risk allocation within the private sector consortium and the cost of funding for the PPP Company.
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11 In a typical PPP project, up to 70%-80% of financing would be procured in the form of senior debt while the share of equity would not normally exceed 20%-30%.
12 The ADSCR is defined as the ratio of free cash (i.e. cash left to the project after payment of operating and essential capital costs) available to meet annual interest and principal payments on the debt.
13 For example, if the payment mechanism is designed so that the PPP Company does not take demand risk, lenders might be satisfied with a projected annual debt service cover ratio (ADSCR) of 1.3x. But if a PPP Company bears substantial traffic risk, then lenders may insist on a minimum ADSCR as high as 2.0x. Lenders use detailed forward-looking financial models to estimate future cash flows and cover ratios.