Financial structure refers to the way that a PPP project is financed, using a mix of equity, debt, and government assistance. Although there is continual innovation in financing techniques, there are some constants in assessing the appropriateness of the financial structure of a project. Changes to financial structure will not transform an unprofitable business into a profitable one, but it is possible for a poor financial structure to cause problems for a business that, otherwise, would have been sound.
Sources of finance for a PPP project include the following:
● Equity from the project promoters
● Equity from other investors (passive private shareholders)
● Government grants, equity, or other support
● Loan capital derived from:
❖ domestic banks
❖ municipal bonds
❖ development agencies
PPPs often have fairly complicated financial structures. As a general rule, the following principles help to minimize financial uncertainty:
● Maximize long term debt
● Maximize fixed rate debt
● Minimize refinancing risk
A project will be more attractive to potential bidders if it is structured such that barriers to accessing financing sources are minimized. For example, lenders will often want "step-in" rights to allow them to take over the operation of the facility if the project company defaults. As bidders will often finalize their financing arrangements only after the bidding process, government is often unaware of the full extent of lender requirements until concession terms have been set. It is difficult to avoid this situation entirely. It is possible to insist that all bidders lock in their financing plan prior to submission of their bids, but this stipulation risks deterring bidders from preparing a bid, particularly when the project is new or risky. Preliminary discussions with lenders as part of a market sounding process before tendering, provides valuable information on how to structure the transaction.
The annual debt service ratio (ADSCR) measures the expected ability of the project to meet its debt service obligations each year. This is calculated from the annual cash flow forecast of the project's financial model. Because the future cash flows are not known with certainty, lenders will want to see some cash flow safety margin above the minimum required to service debt. It is common for lenders to insist on a minimum ADSCR of around 1.5 for infrastructure projects. This minimum ratio must be met for each year of the loan, and this is often a problem during the early years of a project. Any shortfall must be met by a combination of other, more expensive debt financing or equity injections.
Lenders will closely examine the assumptions underlying the financial projections, and will tend to be conservative in what they will accept. Financial analysts should be aware that some best case scenarios may rely on optimistic financing assumptions that lenders might not accept. If the cover ratios are not met, the company can encounter financial difficulties.
The financial structure of the project company is reported each year in the company's balance sheet. The debt and equity ratios measure the proportion of debt (equity) in the company's capital structure. The ratios are calculated as follows:
Debt ratio = D / (D + E)
Equity ratio = E / (D + E)
Where,
D = the total amount of debt on the Balance Sheet, and
E = the total equity
PPP projects normally use a large amount of debt financing, with equity forming only 25% to 35% of the capital structure. The use of debt financing provides a positive leverage effect that magnifies project returns. When return to equity is graphed against pre-tax project return for three different capital structures - zero debt, 50% debt and 75% debt - it can be shown that the high debt structure produces the highest returns to equity, as long as project returns are above a critical point. For project returns below this point, high leverage will produce lower returns to equity. Even if the expected project return is above the critical point, the returns to equity are more risky under a high debt structure.
The financial model calculates the ADSCR and the debt/equity ratios. For a project with poor early profitability, these ratios may indicate that additional equity is required. If so the model should be re-run with the additional equity, and this process should be repeated until the financing ratios are acceptable. The critical point occurs at the point where pre-tax project return equals the cost of debt.