Limiting the amount of debt allowed

Projects shareholders often have an incentive to finance a PPP with a high ratio of debt to equity-that is, to achieve high leverage. As Yescombe [#295] describes, higher leverage typically enables equity investors to achieve higher returns, and makes it easier to manage the financial structure, since it can be easier to raise debt than equity. Moreover, as described in Ehrhardt and Irwin [#72], governments often provide more protection to debt investors than to equity investors, providing a further incentive for high leverage. For example, governments may provide guarantees on demand designed to ensure revenue can cover debt service, or agree to payments in case of early termination that are set equal to the level of debt, such that lenders are repaid even in case of default by the project sponsor on its obligations under the contract.

However, highly-leveraged projects can also be more vulnerable to default and bankruptcy, as also described in Ehrhardt and Irwin [#72, pages 35-38]. Box 1.9: Example of an Over-Leveraged PPP-Victoria Trams and Trains below provides an example of a highly leveraged PPP that resulted in default.

To ensure a sustainable level of leverage, and large enough equity stake in the project, governments can consider introducing a minimum equity ratio for PPPs. As Ehrhardt and Irwin [#72, pages 49-50] note, this can be particularly important if the government is also providing guarantees that are designed to protect lenders' investment. However, restricting an investor's ability to choose its capital structure can increase the cost of capital, as described in a World Bank Gridline note on financing Indian infrastructure [#125, page 2]. The authors also note the importance of structuring any guarantees or termination payment clauses to avoid creating incentives for high levels of debt and leverage.