The Queensland Government is presently running a pilot program for a PPP in the education sector using a hybrid variation of CGF described as the supported debt model (SDM). The SDM has several distinguishing characteristics:
1. The State refinances a predetermined level of project debt when the PPP is commissioned and operational.
2. The level of state debt employed is calculated using a formula that equates to a minimum asset value (or recoverable amount) in the event of consortium default.
3. The construction and residual (junior) debt finance needs of the project will be met by private financiers. SDM preserves traditional ex ante incentives and does not require credit enhancement or supporting private guarantees.
4. The lower cost of state debt reduces lifecycle finance costs which are passed on to the state through an improved value for money outcome.
The SDM takes advantage of the significant change in risk profile that accompanies the commissioning of a PPP project. The SDM is calculated against a notional risk-free minimum value for the project against which the state can make debt capital available to the project at cost. The SDM has three distinctive characteristics:
1. SDM financing is attractive from a value for money perspective, particularly given the recent increased spreads for private sector debt following the global credit crisis.
2. The SDM model attracts high initial administrative tasks although this reduces once the project is commissioned. Overall contractual friction should be less for SDM than CGF with lower transaction and agency costs.
3. The state debt is senior in status and private junior debt providers assume a stronger role in the administration of the transaction preserving the important incentive framework that underpins lifecycle contractor performance.
SDM has parallels with conventional project finance but shares little in common with the short to medium-term corporate finance employed in most Australian PPPs. An implication of the model that may adversely affect improved value for money outcomes is the requirement for higher levels of privately sourced junior or mezzanine debt or equity capital which carries high risk premiums. Recent research suggests that the average state contribution to PPP debt capitalisation will be around 70% suggesting a mezzanine/junior debt participation of around 30% in addition to an equity contribution. The overall cost of debt will be determined on a project basis and particularly on the underlying credit strength of the consortium and its members. The use of higher levels of private mezzanine/subordinated debt and equity capital in prevailing market conditions may in fact increase a PPP project's average cost of capital. The break-even point for SDM is narrow and estimates suggest that this may occur when average private debt spreads exceed 500 basis points (McKenzie 2008). Depending on the unsystematic risk profile of the underlying transaction, this is most likely to occur in prevailing market conditions. SDM may raise the sponsor's overall cost of capital and this could offset a significant part of the cost savings achieved with lower cost senior state debt.
A second issue is the likelihood that SDM may remove the incentive for the consortium to revalue the contract and refinance. Refinancing has several important advantages for mature projects - it permits an increase in senior debt (thereby reducing more costly subordinated debt and overall cost of capital), it permits higher leverage and it permits a withdrawal/return to equity. Refinancing gains are shared with the state under Australian PPP guidelines.