Master Slide

1
Public Private Partnerships Financing Aspects of
PPPs
ALAIN TERRAILLON European Investment Bank
 Concessions and Public-Private
Partnerships Ankara, 10-11 March 2008
2
Overview

• Introduction
• 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
UK Education PPP
Local authority (Promoter)
Equity providers
Ministry of Education
Educational services
Catering, cleaning, Security, energy etc
Concession Contract
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
Hyder Laing Tarmac
Welsh Office
Direct Agreement
DBFO Contract
Equity / subdebt
Laing Tarmac
Senior loan
Borrower / Concessionaire
EIB
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?
Equity Banks Bondholders
Shareholders
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 sectors 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- (SP) / Baa3
  (Moodys) 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