Although market practice is to pay compensation on Private Partner default termination, the Contracting Authority needs to choose a method which does not result in overly generous compensation. This would not properly incentivise the Private Partner to perform (nor its Lenders to due diligence the PPP Project thoroughly or exercise their rights to monitor and step into the PPP Project); it would also raise value-for-money concerns. The options are outlined below.
(a) Debt-based compensation: under this approach, the Private Partner (or in reality the Lenders) is compensated based on the amounts payable under the senior finance documents bank or bond (i.e. an amount based on the formula under Section 4.3.3.1). The PPP Contract must clearly define the debt elements to be compensated and also applicable deductions of amounts available to Lenders (such as proceeds received on close-out of the hedging arrangements, insurance proceeds and amounts in bank accounts which may include e.g. bond proceeds held in a collateral account).
| EMERGING AND DEVELOPED MARKET DIFFERENCES This debt-based compensation method is the most common approach in emerging markets and "government pays" PPP Projects in France and is also seen in Germany. |
As the main or only beneficiary of compensation upon termination for Private Partner default, Lenders will tend to look for the highest possible recovery rate for their loan and the simplest/most objective solution possible. As a result, debt-driven approaches are likely to be more satisfactory to them. Whether the amount reflects the value of the PPP Project is less clear and the Contracting Authority will need to consider this in its value-for-money analysis.
One major drawback of this method is that Lenders have limited incentive to ensure that the Project performs or to step in to save it. To counter this risk and ensure Lenders have an incentive to conduct proper due diligence and exercise their monitoring and step in rights, in addition to the relevant deductions, the level of compensation usually is a percentage of the total outstanding debt (and not the full amount). This is commonly referred to as a "haircut", though it should be noted that taking the risk of a haircut may not be acceptable to Lenders in all circumstances and will depend on a variety of factors (such as the specific country and sector, in which the PPP Project is conducted). The exact percentage of a haircut (if any) should be assessed on a project-by-project basis. In addition, in the context of a bond financing, consideration should be given as to whether make-whole payments should be included. See Section 4.7, Sample Drafting 4, Schedule, Clause (2).
An alternative (or addition) could be to refer to an amount of outstanding senior debt minus unfunded equity contributions if these are required under the relevant financing documents - the Lenders would then look to recover that amount from the Private Partner/Equity Investors.
(b) Market value: where the PPP market is sufficiently liquid and there is a reasonable prospect of the PPP Contract being retendered, the fairest approach is to calculate the compensation payable to the Private Partner by reference to the market value of the PPP Contract, as determined by a tendering procedure. This ensures, in theory, that the Contracting Authority will not pay the Private Partner more than the remaining value of the PPP Contract. As a result, this calculation protects the Contracting Authority's interests while ensuring that the Contracting Authority does not unfairly benefit from the Private Partner's default.
The fall-back position if there is no liquid market, or if the Authority chooses not to go down this route for any reason, is that the compensation payment is calculated on the basis of the estimated value that would have been obtained in a retendering, as determined by an independent, third-party appraiser. While seemingly straightforward to implement, setting the parameters may require some negotiation, and it may not reflect the true market value of the PPP Contract. This approach is seen in countries with mature PPP markets (such as Belgium, Australia40, the Netherlands and also South Africa).
| EMERGING AND DEVELOPED MARKET DIFFERENCES The market value approach is likely to be more suitable for a developed less volatile PPP market where there are likely to be a number of potentially interested purchasers in the relevant sector. Lenders to PPP Projects in certain jurisdictions or in relation to certain assets may be reluctant to rely on a market-based valuation method for fear of undervaluation or underpayment. This is particularly likely to be the case in emerging markets where there is a limited PPP track record and a limited market. The South Africa PPP Guidelines acknowledge this and provide for an additional payment to be made by the Contracting Authority to the extent the market value approach does not yield a certain percentage of outstanding debt. |
Contracting Authorities should take a view as to whether market-based termination compensation is a viable option on a project-by-project basis.41
(c) Book Value: although seen in some European jurisdictions, the calculation of compensation payments based on book value is not the recommended approach in this Guidance as the result may not accurately reflect the reality of the sums owed.42 See discussion under Section 4.3.2(a).
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40 See the Infra Australia PPP Guidelines (for Social Infrastructure).
41 This option is not in Section 4.7, Sample Drafting 4 - for more detail see the South Africa PPP Guidelines, Infra Australia PPP Guidelines (for Social Infrastructure) and the UK PF2 Guidance.
42 A "hybrid" approach may also be considered in some cases e.g. where termination compensation is equal to the lesser of the appraised market value and outstanding senior debt. This approach has been taken by some State authorities in the United States.