1. Public Private Partnerships: Financing Aspects of PPPs
ALAIN TERRAILLON
European Investment Bank

2. Overview Introduction Financial structures for PPPs
What are PPPs
What is project finance
Risk allocation
Financial structures for PPPs
Role of equity, debt, mezzanine and subcontractor finance
Issues for Senior Lenders
How do Senior Lenders look at risk in PPP transactions?
Issues for the Public Sector
Why finance is important for the public sector counterpart

3. What are PPPs?
Delivering public infrastructure through procuring services rather than capital assets
Public sector defines service requirement
Private sector designs, finances, builds, operates, (usually transfers) the asset
Mainly private (not public) financing
Fiscal environment & EMU
Does not exclude public component (e.g. from Structural / Cohesion Funds)
Improve the efficiency and quality of public services
Accelerating investment in infrastructure
Achieving private sector efficiencies

4. Features of PPPs Contracts for services, not procurement of assets
Output, not input, specifications
Payments related to service delivery
Whole life approach to design, build and operation
Private sector funding to underpin risk transfer
Project Finance for all but smallest projects

5. Project Finance
Project Finance is specialised form of finance based on:
A ‘stand alone’ project
A Special Purpose Company (SPC) as the borrower
High ratio of debt to equity (‘gearing’)
Lending based on project cash flows (not balance sheet)
Lenders rely on project contracts, not physical assets, as project security
Non recourse finance (ie no claim on investors)
Finite project life (ie debt to be repaid at project close, in contrast to corporate debt which can be ‘rolled over’)

6. Pops and Value for Money
In principle, PPPs can improve VFM by:
Facilitating and incentivising on time and on budget project implementation
No service / no pay
Incentives to cost control
Optimisation of capital & maintenance spends over project life
Innovation in design and financing structures
Improving management of operational risks
Optimal risk allocation  reduced cost of risk
Reduced cost of risk  better Value for Money

7. Structuring PPP transactions
Alignment of risk, incentive and reward is the key to value for money in PPP transactions
Improved management of risks reduces overall cost of project
This reduced cost secures value for money
Correct risk transfer also critical to securing affordability
Risks are being priced that were previously left unpriced
Pricing impact on current defined budgets (not future undefined budgets)
Private funders play lead role in taking on, allocating and managing PPP project risks

8. Which risks? Meeting service delivery standards
For example: if the project design is unable to meet service need, private sector must pay costs of rectifying

9. Which risks? Meeting service delivery standards
For example: if the project design is unable to meet service need, private sector must pay costs of rectifying
Cost overrun during construction
For example: unstable ground conditions requiring additional foundations would be a private risk
On time completion
For example: if facility is delivered late due to ground conditions, no payments until availability
Underlying and future costs of service delivery
For example: latent defects risk in an existing building
Physical damage to a building
Market risks in some projects

10. Borrower / Concessionaire
UK Education PPP
Local authority
(Promoter)
Equity providers
Ministry of Education
Educational services
Concession
Contract
Catering, cleaning,
Security, energy etc
Services
Sub-contract
Students
Borrower / Concessionaire
(the SPC)
Lifecycle
maintenance
EIB
Lifecycle
Sub-contract
Senior Loan
Construction
Sub-contract
Commercial
Banks/
Bondholders
Construction
Direct agreements

11. Welsh DBFO Road - A55 project Borrower / Concessionaire
Hyder
Laing
Tarmac
Welsh
Office
Direct
Agreement
DBFO
Contract
Equity /
subdebt
Laing
Tarmac
Senior loan
EIB
Borrower / Concessionaire
Senior /
Junior Loan
Commercial
Banks
Construction
guarantee
Construction
contract
Construction
joint venture
Direct
Agreement

12. Financial structuring
Senior debt
Mezzanine debt
Equity
Sub-contractor finance

13. Financial structuring
Senior debt
Typically 80-90% of capital requirement
Interest and repayment in priority to all other capital
Seeks to minimise risk of unremedied failure of PPP contractor:
Disciplined approach to due diligence
Pass through of risks
Entitlement and incentive to step in to remedy significant failings
Priced accordingly

14. Financial structuring
Sources of senior debt
Bank debt
Debt raised in capital markets
With a financial guarantee (‘wrap’) from a monoline insurer (monoline takes risk)
Without a guarantee but rated by a rating agency (investors take risk)
European Investment Bank
With or without a guarantee / wrap

15. Financial structuring
Equity
Typically 10-20% of capital requirement
Shareholder loans that earn interest (‘subordinated debt’)
Share capital that receives a dividend
Primary risk taking tier – also seeks significant pass through of risks
Equity funders paid to take this risk

16. Financial structuring
Equity
Typically 10-20% of capital requirement
Shareholder loans that earn interest (‘subordinated debt’)
Share capital that receives a dividend
Sources include contractors and (increasingly) institutional equity investors
Primary risk taking tier – also seeks significant pass through of risks
Equity funders paid to take this risk

17. Financial structuring
Mezzanine debt
Lies between senior debt and equity in transfer of risks
Repayment affected by poor performance before senior debt
Return greater than senior debt
Usually provided by banks offering senior debt (ie prepared to accept a higher risk / return tranche)

18. Financial structuring
Subcontractor finance
SPV (and lenders) need assurance that contractors can meet contingent obligations
Parent company guarantees
Letters of credit
Performance / surety bonds
Providers of guarantees etc have no recourse against SPV

19. Implications for Senior Lenders
Minimisation of risks retained by the SPV
Gearing determines maximum value of risks that can be retained in the SPV
Acceptable project structure
Project agreement, sub contracts, financing agreements, security package, insurance
Acceptable financial structure
Sufficient liquidity
Reserve accounts (debt service, lifecycle etc)
Robust cashflows and acceptable ‘waterfall’
Adequate cover ratios

20. Cover ratios
Surplus cash senior lenders require to be retained to meet (potential) shortfalls in debt repayments
Loan life cover ratio:
NPV of cash flow available for debt service during the life of the debt
Debt principal outstanding
Annual debt service cover ratio:
Cash flow available for debt service
Debt service due in the period

21. How do lenders control cash?
Using ratios
If ‘base case’ minimum LLCR is, say, 1.30 and ADSCR is 1.20
At, say, LLCR 1.15 and ADSCR 1.10 equity distributions stop (‘lock up’)
At, say, LLCR 1.10 and ADSCR 1.05 borrower is in default (‘default’)
Other factors
A range of other lock up and default circumstances (reserve accounts not funded, project agreement defaults, insolvency etc)

22. Financial structuring
Insurance
Inability of SPV to take financial losses means risks held by SPV must – to maximum extent possible – be insured
Borrowers contractually required to hold a range of insurances (construction, material damage, 3rd party liability, business interruption,etc)
Lenders engage insurance advisors, and implications of future insurance cost increases a major issue in negotiating deals
What happens if an insured risk becomes uninsurable?

23. Risk and reward
What happens when things go wrong?
Implications for the public sector

24. Where do the risks go?
Shareholders
Equity
Banks
Bondholders
Taxpayers

25. When things go wrong
Public sector defaults
No fault defaults (Force Majeure)
Private sector (concessionaire) defaults

26. Public sector defaults
Vires
Can the public sector sign the contract?
The public sector covenant
Can the public sector be forced to pay?
Public sector defaults
Compensation on termination
Debt plus some remuneration of equity on public sector default

27. Force Majeure No fault reasons for termination
Public sector generally seeks to limit to prevent risk transfer from private to public
UK contract does not include all ‘Acts of God’ e.g. bad weather
War, civil war, armed conflict, terrorism;
Nuclear, chemical, biological contamination not caused by contractor
Pressure waves caused by devices travelling at supersonic speed
Equity and debt back (but no equity return) following force majeure termination

28. Relief Events UK contracts defined as:
Fire, explosion, storm, flood, earthquake, riot
Failure of e.g. power companies to supply power
Accidental loss to the sites
Fuel shortages
General construction strikes (but not contractor specific strikes)
Archaeological finds
But only relief from termination – principle of no service, no pay remains

29. Concessionaire default
Concessionaire default means failure to meet the terms of the concession contract
Termination of sub contractors (insolvency, poor performance, corruption etc)
Technical due diligence
Importance of liability caps
Step-in by senior lenders
Ability of lenders to act to save the project
Public sector relies on lenders to control the project
Importance of Direct Agreements and ability to replace the concessionaire
Compensation on concessionaire termination

30. Replacing sub contractors
Sub contractors have a key role in taking risk in PPP projects
Lenders look for contractual right and practical options replacing non performing contractors
On termination, sub contractors typically required to pay termination damages
Lenders seek unlimited damages, contractors seek to limit these (for UK PPP construction contracts, cap of 50% of contract value typical)
Lenders seek to be assured that damages payable will be sufficient to meet additional costs with a new contractor
Lenders will regard geographically remote or highly specialised projects as particularly risky

31. Compensation on termination
Extent of compensation for lenders depends on the cause of termination
Lenders will always require full compensation for termination for authority default or authority voluntary termination
UK PPPs: lenders fully compensated for Corrupt Gift and Force Majeure termination
Compensation for other concessionaire defaults based on either Market Value (retendering) or Fair Value (no retendering) methods

32. Market value based compensation on termination
A feature of UK schools and hospital PPPs
Applies unless there is no ‘liquid market’ in concessions (defined as at least two potential bidders)
On default by concessionaire, public authority ‘sells’ unexpired period of concession contract
Bidders determine what (capital) sum they will pay to buy future cashflows – bearing in mind they must deliver service to achieve these cashflows
Lenders’ compensation = bid capital sum
If no bids (or negative bids), compensation is zero

33. Fair value based compensation on termination
Applies only where no liquid market
Present value of future cash-flow over concession minus present value of future costs minus rectification costs = lender compensation
In theory, fair value and market based compensation should be identical
In practice, lenders would always prefer greater certainty of fair value

34. Conclusions: What do senior lenders need?
A clear public sector covenant
A good understanding of the risks taken on by the private sector
Limitation of the risks taken on by borrower
Sound insurance arrangements
A liquid market in sub-contracted services
Step-in rights
Appropriate compensation on termination

35. Senior Lenders: the public sector’s best friend!
Senior lender due diligence
Public sector gains some reassurance on deliverability from senior lender due diligence
Clear identity of interest with the public sector once project is underway
Good project performance key to lenders being repaid
Public sector looks to senior lenders to control the project and deal with problems
Lenders take controls and powers necessary to do this
Public sector should be wary of too ‘tight’ cover ratios and other financial parameters

36. Issues for the public sector
Public or private finance?
Senior debt: Bank or bonds?
Refinancing
Funding competitions
Innovations in the funding market

37. Public or private finance?
Options for national funding
Grants or loans?
Public funding:
upfront capital or on-going revenue?
budgetary resources and value for money
Private finance
Testing bankability
Testing affordability
Testing value for money (public sector comparator)

38. Bank or bond?
Bonds: a debt instrument that pays bondholder a rate of interest in return for bondholder paying principal amount to the Issuer on issue
Repayment according to a pre agreed repayment profile
Bonds issued by project companies, rated by Rating Agencies
Investment grade bond [minimum BBB- (S&P) / Baa3 (Moody’s)] converted to AAA via monoline wrap
May be floating, fixed or index linked

39. Bank or bond?
Size: In the UK, public bond issues unlikely to be less than EUR 75 million
Maturities: traditionally bonds offer longer maturities (up to 40 years on some UK PPPs)
Flexibility: generally bank debt more flexible as (tradable) bond conditions fixed. Project variations more easily dealt with in bank finance (multiple bond holders)
Early redemption conditions: may be disadvantageous for bonds

40. Refinancing
PPP transactions typically refinanced to take advantage of better funding conditions at some stage
Usually post construction, when riskiest part of project is complete
May be refinance from bank debt to bonds, or increase in senior debt (i.e. reduction in equity reflecting lower risk profile)
Issues for public sector:
Should it seek a share of refinancing gain?
Implications of increased senior debt – potential increase of public sector contingent liability?

41. Mechanics of LGTT
Revenue shortfall during ramp-up - stand-by-facility drawn to cover debt service;
If stand-by-facility can be repaid during the 5-year ramp-up, guarantee not called;
If revenues are insufficient to repay the stand-by-facility during the 5-year ramp up, the guarantee is called – guarantee is then repaid during project life from revenues left over after senior debt service.

42. Conclusions: Implications for the public sector
Realistic risk sharing expectations
Clear legal and institutional framework
Effective use of experienced advisors
But also need for new public sector skills – you cannot leave it to the lawyers!
Focused, dedicated and experienced public sector team – PPP Task Force
Transparent and competitive procurement
Recognition of lenders’ concerns