Credit enhancement can be helpful for PPP Projects that face challenges in long-term financing, or might otherwise not be financeable at all. It is also useful for large PPP Projects where liquidity may be an issue. While credit enhancement is not always essential, it is likely to be extremely useful, if not vital, in successfully financing PPP Projects with particular risks (e.g. political, technological or development). The Contracting Authority needs to be alive at an early stage of the procurement process to where credit enhancement and particular credit ratings are likely to be required by investors and how this could benefit it by possibly lowering the cost of financing and resulting in a more competitive price and better value for money. The Contracting Authority should be prepared to engage early on with potential credit enhancement providers. See Section 9.2.10.
One example of a key challenge in achieving a successful bond financing at financial close is construction risk. The bond market has traditionally been averse to investing prior to construction completion, due to the perceived risk of the asset not being built and being unable to start earning income to meet principal repayments under the bonds.72 There are signs that investor attitudes are slowly changing as the investors begin to understand PPP Project risk better. Studies of infrastructure projects (e.g. by Moody's73) have shown that the default rate in PPP Projects is relatively low (perhaps because of the level of due diligence typically carried out by all parties before PPP Contract signature, the in-built checks and balances in the project and finance documentation and the mutual desire of all parties to ensure the PPP Project starts generating income). However, credit enhancement can also help mitigate this risk to encourage non-bank investors' appetite.
Credit enhancement usually has the effect of taking the "first loss", insulating bondholders against a certain level of loss in a default or termination scenario, and/ or providing liquidity in times of cashflow stress. This can provide reassurance to potential investors as well as potentially resulting in a higher credit rating. Depending on the form of credit enhancement, it may also result in the credit provider being the controlling creditor for decision-making purposes. See Section 9.3.8.
| EMERGING AND DEVELOPED MARKET DIFFERENCES The institutional investor market for infrastructure in Europe has evolved to the extent that there is now a ready supply of institutional capital for robust PPP Projects in stable countries. Credit enhancement is not always needed. However, it will continue to be needed to facilitate the use of non-bank funding in PPP Projects with technology risk, unusual development or construction risk, significant demand risk or in challenging jurisdictions. |
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72 As in a bank financing, a bond financing is typically structured so that interest payments during construction are met out of drawdowns.
73 Moody's Investors Service Data Report (6 March 2017): Default and Recovery Rates for Project Finance Bank Loans, 1983-2015