As outlined above, the financing of a PPP consists principally of senior debt10 and equity (which may sometimes be in the form of junior shareholder loans). The financial 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 up-front 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 amongst 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, sub-contractors, 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 the other forms of financing (except for 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 project's cash flows. 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 give comfort 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 annual charge to be paid by the authority. Alternatively, for a given level of charge to the authority (perhaps the affordability limit), the target ADSCR will determine the project's gearing. In other words, the lower a project gearing (the more equity relative to debt), the higher the cover ratio from a given unitary charge.
The public authority's financial advisers need to understand lender 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 lenders expect to use for the particular sector and type of project are justified when the lender carries out a risk analysis. This will also facilitate achieving the best possible cost for the financing and will thus have direct implications for the public sector as the public sector is the ultimate payer for a PPP.
One of the fundamental trade-offs in designing PPPs is therefore to strive for the right balance between risk allocation between the public and private sector, the risk allocation with the private sector consortium and cost of funding for the project company.
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10 I.e. where debt service is paid from cash flow on a priority basis.
11 In a typical TEN-T 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 debt.
13 For example, if the payment mechanism is designed so that the project 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.