Debt

Senior debt enjoys priority in terms of repayment over all other forms of finance. Mezzanine debt is subordinated in terms of repayment to senior debt but ranks above equity both for distributions of free cash in the so-called "cash water-fall" (i.e. priority of each cash inflow and outflow in a project) and in the event of liquidation of the PPP Company. Since mezzanine debt's repayment can be affected by poor performance of the PPP Company and bearing in mind the priority in repayment of senior debt, mezzanine debt typically commands higher returns than senior debt.

Debt to a PPP project is normally priced on the basis of the underlying cost of funds to the lender plus a fixed component (or "margin") expressed as a number of basis points to cover default risk and the lender's other costs (e.g. operating costs, the opportunity cost of capital allocations, profit).

It is important to bear in mind that the underlying cost of funds is typically determined on the basis of floating interest rates (i.e. rates that fluctuate with market movements). These are normally based on interbank lending rates such as EURIBOR in the euro market or LIBOR in the sterling market. In contrast to these floating rate funds, the revenues received by the PPP Company do not generally change along with the interest rates. This mismatch is typically remedied by the use of an interest rate swap, through which the PPP Company ends up paying a fixed interest rate (this is referred to as the "hedging"). Responsibility for incorporating hedging instruments into the financing structure should be left to the PPP Company, as it is the PPP Company that has the right incentives to take appropriate action. However, the cost of these swaps is relevant to the public sector as they may result in costs in certain termination situations. For this reason, they should be analysed by the Authority's financial adviser.

Debt for major PPP projects may be provided by either commercial banks, international financial institutions (such as the European Investment Bank) or directly from the capital markets. In this last case, project companies issue bonds that are taken up by financial institutions such as pension funds or insurance companies that are looking for long-term investments.  Guidance 121

Financial advisers will be able to advise on the likely sources of funding for a given project. They would also be expected to make an assessment of the anticipated costs and benefits of funding options. This will include an assessment of the debt tenors (the length of time to maturity, or repayment, of debt) likely to be available from various sources. This is particularly important if long-term funding is not available for the project and where the public sector may be drawn into risks associated with the need to refinance short-term loans (so-called "mini-perm" structures).  Guidance 121