Project finance structures

In a project finance transaction, a PPP company would usually be set up by the sponsors solely for the purpose of a PPP. It will act as borrower under the underlying financing agreements and will be a party to a number of other project-related agreements. <1>

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 make up the financing package.

Since senior lenders do not have access to the sponsors' balance sheets in project financed transactions, they need to ensure that the project produces 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 addition, lenders will usually also seek additional credit support from the sponsors and/or third parties to hedge themselves against 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 project sub-contractors, these shortfalls impact on payments to the subcontractor leaving the ability of the project company to service the debt unimpaired.

Even though in a PPP it is the private sector that arranges the financing and it is the PPP company that is the borrower, it is important for public sector officials and their advisers to understand the financing arrangements and their consequences for a number of reasons:

□  When the public authority evaluates the bidder's proposal, it must be able to assess whether the proposed PPP contract is bankable and whether the proposed financing is deliverable. Otherwise it will be a waste of time to award the PPP contract to a company that ends up being unable to finance the project.

□  The allocation of risks in the PPP contract (developed by the public contracting authority and their advisers and set out in the draft contract included in the invitation to tender) can affect the feasibility of different financing packages and the overall cost of 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 that in bad times the PPP company will run the risk of a loan default, 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 EU funds, as is the case in TEN-T projects, the public contracting 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 public contracting authority - e.g. the payments the public sector would have to make if the contract were terminated for various reasons.

□  The public contracting 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 enhancements to be provided by the state (or to be initiated by the state - e.g. by a request to an international financial institution like the EIB or to the European Commission in the case of a TEN-T project) are described in the invitation to tender (see  , Invitation to tender).  (2),(3)