The financial structure of PPPs should minimize financing costs, be bankable, and fulfill contractual obligations by transferring the responsibility of allocating funds for large infrastructure projects to the private sector partner. Neither governments nor private companies alone have the financial resources to build all the infrastructure they need, and to cover all the risks inherent in these projects.
PPPs are at the core of government efforts in developing countries to attract private infrastructure investments. But these investments cannot be made without mitigating the considerable risks inherent in these projects. From the nexus of infrastructure development, economic growth, and financial market development, these risks are generally worth taking.
Governments might not provide private sector sponsors or operators with sufficient incentives to design and monitor their projects carefully, if they show their explicit or implicit readiness to cover losses of failed projects in any event. Contrary to the original intention of PPPs to reduce fiscal burdens, some infrastructure projects in emerging economies have not done this because they had to be rescued by government funds because of social necessity when they failed. In some cases, government support without appropriate risk-sharing mechanisms might have caused moral hazard problems with the private sector partners.
In general, commercial risks are best controlled and absorbed by private partners in PPPs, while political and regulatory risks are best left to governments to deal with. An optimal risk-and profit-sharing mechanism must, therefore, be designed to strike a balance between a project's public purpose and its viability to attract private financing. Hyun, Nishizawa, and Yoshino (2008) argue that it is essential to design risk-sharing mechanisms to prevent moral hazard, and to strike a balance between a PPP project's public nature and its commercial viability.
PPPs are mainly financed through three mechanisms: public sector finance, corporate finance, and project finance. When the public sector finances a project, the state or government provides all or part of the capital investment, while the private partner provides know-how. With corporate finance, the private partner finances the project; this mechanism is typically used when private operators are large enough to finance a project from their own resources. Project finance is limited-resource financing through a company, usually called a special purpose vehicle (SPV), which is set up to implement the project.
An SPV functions as a bankruptcy-remote subsidiary for a parent company, and its role is limited to the acquisition and financing of specific project assets. An SPV can raise capital without carrying the debt or other liabilities of the parent company. A subsidiary is often set up and run by the same parties that control the SPV, which builds and operates a project to meet the requirements of a PPP contract. A private partner in a PPP contract often needs an SPV as part of the contract arrangement, especially for large infrastructure projects. The SPV is responsible for funding, usually in the form of project finance in which the main source of payment is based on a project's future cash flows.
PPPs financed by SPVs have two funding sources: equity and debt. Equity financing is an optimal shareholding structure for governments because they can lower the cost of capital, attract more private participation, and consequently increase the quality and viability of PPP projects. For emerging economies with underdeveloped financial markets, government participation can help secure private investment by correcting market failure (Moszoro 2014). This is because the cost of capital for private partners is on average 100-300 basis points higher than for the public sector (Moszoro and Gąsiorowski 2008). By contrast, PPPs are highly leveraged, with debt financing accounting for 70%-90% of a project's cost. Debt providers care about downside risks and measures to mitigate risk. Although the contractual arrangement is made between the public and the private partners, it is the lender who sets the parameters to mitigate risk. And this risk evaluation is reflected in the risk premium, which is incorporated in the cost of debt (Singh and Kalidindi 2014).
Many developing countries reformed their infrastructure sectors in the late 1980s and early 1990s to promote competition through liberalization and privatization, to strengthen regulatory environments, and to attract private and foreign actors in the ownership, management, and operation of infrastructure. These countries now need to further harness private sector investment in infrastructure with coordinated reforms for their financial markets. Financing accessibility, especially bond financing, has become an alternative means for infrastructure financing because of rising fiscal burdens and falling bank lending under regulatory changes, such as Basel III.3
How are bank loans and bonds compared in PPP project financing for infrastructure? For loans for PPP projects, banks investigate the creditability of prospective projects and screen safe borrowers from less safe ones. After a loan is made, banks often monitor the borrower's business to prevent moral hazard. For PPP projects, gathering information and monitoring are conducted on a bilateral basis between borrowers and lenders.
Issuing bonds for infrastructure PPPs is a form of direct financing channeled through capital markets from a broad base of investors. To issue bonds, an issuer's financial health is scrutinized and rated, and the information can be made public if necessary. Underwriting is vital for disseminating this information to the public, as well as for dealing with risks related to public offerings. Bonds are standardized financial instruments and, importantly, transferable through capital markets. Bond financing suits the financing needs of PPP projects for infrastructure by matching the long gestation periods of these projects, and by financing the large amounts of capital needed for their construction, operation, and maintenance. By contrast, bank financing cannot match the long gestation periods and the funding requirements of capital-intensive infrastructure PPP projects because of single lending limits, credit controls, and concentration risks on bank loans.
Against these backdrops, looking at new avenues to increase private sector participation in infrastructure financing to advance infrastructure development in developing countries is getting increased attention. Our empirical results show that bond financing by the private sector does not contribute to increased PPP investment in infrastructure. And, interestingly, they show that heavy government bond financing for infrastructure projects disincentivizes private investment. Low-and middle-income developing countries still depend on fiscal financing for infrastructure instead of private investment. This might be because of their underdeveloped corporate bond markets, which cannot offer long-term financing for infrastructure.