While it is quite common to grant private operators the responsibility for the delivery of services in specific cities, region or at the country level, the investment components of these responsibilities are often subject to specific contractual forms. These specific forms of the contracts supporting the investments are driven by the ability to pull together financing schemes around the specific investment project. Project finance is indeed typically used in those sectors that require large capital expenditures, that have long-lived assets, and that require long periods to amortize investment costs and generate required rates of return for both creditors and equity holders.
Project finance is generally used to describe financings in which the lenders look to the cash flows of an investment project for repayment, without recourse to either equity sponsors or the public sector to make up any shortfall. The sponsor usually tries to structure the project so that the gross assets and liabilities of the project are kept off the sponsor's balance sheet.
In the end, the deals are financed from a wide range of very different potential sources, each with different positions, stakes, and incentives that influence the project outcomes. Some of these sources may only be available at different stages in the life cycle of the project. These sources include equity, mezzanine finance, commercial lending, bond finance, project leasing, development finance institutions, export credits, finance, or guarantees provided by bilateral export credit agencies and derivative products, including securitization.6
This is roughly how it works in practice. In general, the private operator is granted a concession by the government to design, build, and/or operate transport services or infrastructure for a specified period. This concessionaire typically is responsible for raising the finances required to carry out the project. At the end of the concession period, the facilities and their operation may be transferred to the host government, depending on the nature of the contract. The concessionaire will typically form a Special Purpose Vehicle (SPV), in which a project or a set of projects is treated as a separate entity from the sponsors. Funds are then borrowed solely based on the project's or project package's cash flows and the equity in the SPV itself.7 This independence allows the project package to be separated from the equity investors' balance sheet; therefore it is frequently referred to as "off-balance sheet financing".8
The financing structure has a number of recurring characteristics. For instance, bank debt is the primary debt funding source and sponsor equity is committed, and sometimes paid up-front, prior to the provision of any debt finance. In general, the cash flows of the project's package is the principal basis for returns for both debt and equity investors, and the project's assets are the principal collateral for any borrowings. It is important to note that payments to equity holders are subordinate to operating costs and debt service obligations. Once the project is operational, lenders have no or very limited recourse to the credit of the project's owners (either sponsor equity or government in the case of BOT projects). Overall, the transaction heavily relies on contractual commitments between the project participants which is why the regulatory and supervision capacity of governments is so crucial to the success of these transactions.
The difficulties encountered in emerging markets in the 1990s and the well-publicized problems experienced by some transport infrastructure projects have forced both the private and public sectors to expand the idea of project financing. While the ultimate goal may be to arrange project borrowings which will provide a minimally expected rate of return to sponsor equity and at the same time be completely not demanding for the sponsor or the government, such a goal has proven almost impossible to accomplish, except in a few extraordinary situations.
The advantages of project finance vary across participants in the transactions. Promoters of project finance (sponsors and investment bankers) prefer project finance because it has allowed them to undertake projects without exhausting their ability to borrow for traditional projects, and without increasing debt ratios (or at least those that are calculated based on reported financial statements). Project finance structures can be used by companies to limit their financial risk to a project to the amount of their equity investment.9 In addition, if the project itself has particularly strong and secure cash flows, project finance may allow more debt to be employed in the financing mix, since creditors do not have to worry about project cash flows being siphoned off for other corporate uses.
Project finance may provide stronger incentives for careful project evaluation and risk assessment. Since the project's cash flows are keys to obtaining financing, such projects should undergo careful technical and economic review and sensitivity analysis. This may lead to clarification of the nature and magnitude of project risks and what causes them. Having a detailed, objective assessment of project risks and potential may not only enable risks to be allocated to the appropriate parties, but in some cases, the project analysis itself may reveal ways to change the project to reduce the overall level of risks or to improve their allocation. For example, demand analysis of a toll road may show opportunities to delay expansion until certain traffic levels trigger new investments in capacity.
But project finance also has some disadvantages. They are more complex than traditional corporate or public financing, typically involving many more parties and resulting in significantly higher transaction costs. The complexity of project finance deals also makes them very expensive. The due diligence process conducted by lenders, legal counsel, and other technical experts results in higher development costs, with higher fees and interest margins than what is typically charged. It is not unusual for the total cost of a project finance transaction to cost twice as much as straight debt or equity finance. Total costs may reach 7 to 10 percent of total project value. When acting as a financial advisor to a project, investment banks will typically charge high monthly fees, plus all expenses. They also typically receive a success fee if the project reaches financial closure, which can range from .0025 to 1.0 percent of total project value.
Negotiations on various aspects of the project are usually protracted and may be quite contentious. This is especially true for transport projects, which typically are politically sensitive, have high visibility, and retain strong public interest and participation. Getting parties with diverse interests to agree on the nature and magnitude of risks is very hard, let alone getting them to agree on who should bear these risks. The documentation associated with project financing is almost always complex and lengthy.
Even after the financing is closed, the project will usually be subject to closer monitoring by all parties. Because lenders primarily rely on revenue flows to repay their loans, the degree of lender supervision of the management and operation of the project will most likely be greater than for an ordinary corporate loan. Likewise, public officials need an ongoing program to monitor contract compliance and potential exposure to any guarantees that have been provided, as well as regulatory oversight when deemed necessary. Projects finance makes this monitoring particularly complex. In the initial stages, sponsors are likely to fund their equity contribution either internally or from on-balance sheet borrowings. Governments need to be careful to monitor the sources of this initial investment. In some cases, while the project equity appeared sound, the additional borrowing by the sponsor's parent company so weakened the overall company that bankruptcy of the parent impaired the ability to undertake the specific project obligations. In sum, monitoring risk is not only an issue at the beginning of a PPP, it is a issue throughout the duration of the contract.
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6 Equity is generally the lowest ranking form of capital because the claims of the equity investors will rank behind all creditors. On the positive side, the equity holders gain disproportionately if the project performs better than expected Different forms of investment other than straight equity might be considered as "pseudo-equity". For example, in the UK, project sponsors will commonly consider lending debt to the SPV that is subordinated to all other borrowings. This might be considered as an alternative to additional equity, and is normally based on tax considerations and standing in bankruptcy should the concession fail. Mezzanine finance falls somewhere between senior debt and equity. Examples include subordinated debt and preference shares. Payments are made to these investors only after senior debt is serviced and will only be made if certain conditions are satisfied, such as minimum coverage ratios or investment requirements related to the performance of the project. The risks taken by mezzanine providers are greater than those of senior creditors, and so required returns will be higher (but lower than those required by traditional equity investors). Mezzanine capital might be provided by certain investment trusts, mutual funds, or insurance companies..
7 As the SPV is usually only a legal construct, it needs to ensure that it performs its obligations under the concession agreement by sub-contracting those obligations to third parties. The principal parties usually are the construction contractor and the operator of project facilities. It is common for one or both of these parties to be part of the sponsor consortium, or an affiliate of the sponsors. Since there are usually multiple sponsors, the relationship between them is clearly defined and usually set out in a shareholders' agreement. The SPV might have other equity investors, such as development finance institutions or the government. The SPV is capitalized by the sponsors in agreed proportions, normally on the terms set out in an agreement that deals not only with the sponsors' initial capital investments but also with any further obligations with respect to future contribution obligations. In addition, rules are established with respect to how the SPV is to be administered, how it is to be financed, how sponsors share profits, and how, if at all, sponsors may transfer or sell their shareholdings or interests in the SPV.
8 Note that the commercial banks who generally lend directly to the SPV tend to have a very significant control over the SPV. On the one hand they are expected to finance the project on a non-recourse or a limited recourse basis, emphasizing project revenues as the primary source of repayment of interest and principal. It is in return for agreeing to finance the project on such a basis that the banks are likely to require the ability to exercise a considerable degree of control over the SPV and its activities, and to have "step-in rights" should any one of a large number of triggering default events occur.
9 The non-recourse nature of the debt in a project financing may change during the life of the project. For example, debt may be structured to provide recourse to the project sponsor only during the construction and commissioning phases.