Infrastructure PPP's typically require financing; that is, external funds are required for the initial investment costs that are recovered over time from future revenue streams. The funds may be sourced from the public sector or the private sector. Regardless of the source of finance, such funds have a cost and, therefore, impact the project's economics and required tariffs (and thus affordability). Fundamental to the question of project financing is the correlation between perceived credit risk (resulting from various technical, commercial, and other risks associated with the project) and the cost of finance.
A government's cost of funding is typically lower than that of a private operator even of the same originating country. Providing private financing may therefore increase the financial costs of PPP. However, the efficiency gains from PPP are expected to outweigh this additional cost and result in net savings and efficiency gains, with an ultimate benefit to consumers. In addition, public sector financing is usually scarce, creating one of the initial drivers for PPP.
The operator will typically establish a project company for implementing the contract, often called special purpose vehicle (SPV). The company owners may be a consortium of companies or a single large company. The company owners will not usually finance all project requirements; instead, they will provide a proportion as equity and borrow the remainder of the required financing from financial institutions or place debt securities in the capital market.
The creditworthiness ("bankability") of a project depends on a number of factors, some of which are within the control of the government when designing PPP. They include commercially attractive project design and tariffs (shorter payback and, hence, financing periods) as well as strong off-take arrangements to reduce market/revenue risk (predictability of cash flows), together with the level of certainty and transparence of regulatory settings, which affect future cash flows.
Infrastructure project financing in general, whether from banks or bond markets, faces a number of challenges including (i) long-term debt maturities to match project cash flows, (ii) limits to the availability of local currency debt financing to match local currency revenue steams, (iii) limited available equity and resulting high degree of leverage, and (iv) no security/guarantee except for project assets available ("nonrecourse financing").
As a result, project finance is a specialized activity and, depending on prevailing market conditions, may or may not be available at any time. To make financing possible or to secure better borrowing rates, the operator may seek credit enhancement through insurance or guarantees. These might include (partial) credit guarantees (e.g., from the government itself or from a development finance institution) or political risk guarantees (from insurers or development finance institution) against the government or regulator not adhering to agreements (e.g., take-or-pay off-take agreement, concession agreement, etc.).
To determine the amount of debt finance the project can sustain, lenders perform their own calculations related to project performance and cash flow. These include debt service cover ratios, loan life coverage ratios, and project life coverage ratios. Project financing requires a very thorough appraisal process because of the sole reliance on project cash flows. Lenders will undertake due diligence exercises to get comfort that the project assumptions and risks are reasonable.
It is critical to understand that the bidders may not fully know the prospective financing arrangements until the last stage of the contracting process. The bidders will have potential financiers lined up, but the final arrangements and risk allocations will only be put in place when the contract is near certain. At this late stage, the lenders may impose their requirements on the project. This creates the risk that a winning bidder fails to complete financing and may have to withdraw. This highlights the importance of critically assessing the financial resources and borrowing capacity of potential bidders during prequalification. A useful tool is the imposition of a bid bond or a deposit payment by the bidder that is forfeited in case the winning bidder withdraws.