Corruption and The Rule of Law: Impacts on Value Creation

We have already discussed the importance of the rule of law in developing a public-private partnership, because the rule of law is essential to brokering stable, binding contracts. We have also discussed the degree to which corruption can impede progress and create an undesirable environment for private-sector investment. Expressed another way, these failures of governance are impediments to value creation.

The instability that comes from a corrupt government cannot be overstated. While corruption within a government may not place a project out of reach, it certainly impacts the financial considerations of a potential private-sector partner. To see this in concrete terms, let's return to India, and to the Dharavi Redevelopment Project.

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CASE STUDY

Dharavi: Developing Asia's Largest Slum

Recall that in the case of the Dharavi Redevelopment Project, the residents of the Dharavi slum were able to organize politically, effectively register their demands for the project, and ultimately shape outcomes. The political clout of the residents of Dharavi added an unstable element to the project's negotiative landscape, and increased risk for investors by forcing financial analysts to act as political analysts as well. These circumstances underscore the importance of cultural sensitivity and country context in PPPs.

But the residents' concerns were far from the only unstable element present in the DRP. Corruption within the government added significantly to costs, reducing the viability of the project for private-sector investors.

If we examine Exhibit 5C-a budgetary breakdown of the Dharavi Project pulled directly from the case study-we can begin to get a sense of how corruption within the government can create inefficiencies and hinder value creation.

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This chart, which enumerates the sources and uses of funds within the Dharavi project, gives a relatively detailed overview of the costs associated with the project. Costs for transitional housing, infrastructure, construction, and labor, (all listed here) are relevant to private-sector investors, and obviously have profound impacts on the bottom line. However, the chart apportions a curiously large value-31,963,100,000 rupees (or roughly $445 million dollars) for "Approval Costs." As a percentage of other costs, approvals constitute 23% of the project's total budget.

That is a large number. Roughly speaking, one in every five dollars spent to redevelop Dharavi was to be spent not on the construction of valuable infrastructure or the mitigation of community concerns, or but on the securing of approvals and the navigation of the Indian bureaucracy.

It is impossible to say whether a number this large stems primarily from corruption, the costs associated with facilitation and even bribery, or from an involved bureaucratic process. But what is clear from the chart alone is that the "cost of doing business" within the Indian government (as imagined by private-sector investors) was entirely too high, and would-by necessity-cut into the value created by the project.

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Ultimately, these kinds of financial considerations are key to the long-term viability of a PPP, and the Dharavi case demonstrates the degree to which reducing friction within the government can actually have a financial impact on outcomes. Governments interested in pursuing cross-sector partnerships with high-quality partners should strive to reduce this kind of friction by either rooting out corruption, simplifying approval processes, or reducing bureaucratic overhead.

Even seemingly small-scale financial considerations can have outsized impacts on the viability of a PPP project. Let's return once more to Dharavi.

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CASE STUDY

Dharavi: Developing Asia's Largest Slum

While the costs associated with redeveloping Dharavi are clearly outlined in the chart above, another exhibit from the case study provides an even clearer view of how seemingly small technical adjustments to a project can have outsized effects on its cost, its viability, and ultimately the value that it creates.

Let's examine Exhibit 5b, a sensitivity analysis which expresses potential profit margins with respect to the cost of construction, the sale price for apartments, and the cost of capital.

Exhibit 5b: Sensitivity analysis with respect to cost of construction, sale price and cost of capital

Source: Illustrative computations by casewriters.

Each of these three charts demonstrates the relationship between construction costs ("cost per square foot"), sale price of apartments ("price per square foot"), and an investor's return on equity ("ROE"). On first examination, it's clear that a cheaper cost of construction and a higher sale price yields the highest return on equity. That would seem obvious enough.

But, begin to examine the differences between the three charts. The first chart models a five percent cost of capital, the second, a ten percent cost of capital, and the third, a fifteen percent cost of capital. Here, "cost of capital" refers to the costs associated with procuring capital, or utilizing debt and equity to finance a project. In other words, the cost of borrowing money. As this exhibit shows, even maintaining the exact same construction cost and sale price conditions, the cost of capital can be seen to have an enormous impact on the return on equity. So much so that, in some cases, the cost of capital alone can turn a profitable endeavor into an unprofitable one.

There are many forces dictating the cost of capital-the riskiness of the project, the reliability of financial models, and even monetary forces totally beyond the scope of the project itself. Stability in the cost of capital is elemental to the project's success-it is vital that, once a project has begun, costs do not balloon and tip the project into unprofitability. Instability associated with the politics of a large project adds to uncertainty within a partnership, and can also negatively impact value creation.

In many ways, value creation is a qualitative process involving the alignment of incentives, allocation of risks, and the creation of clear value structures. But, as Exhibit 5b reminds us, value creation can also be quite literal and quantitative. Simply put, if the numbers don't work, neither will the PPP.

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64Iyer, Lakshmi, John D. Macomber, and Namrata Arora. (2009). "Dharavi: Developing Asia's Largest Slum (A)." Harvard Business School Case 710-004. (Revised June 2011.)