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Home > Financing Viewpoints > Closing the Deal: Public–Private Partnerships (PPP) for Infrastructure

Financing Viewpoints

Closing the Deal: Public–Private Partnerships (PPP) for Infrastructure

by Chris Brown and Joanne Emerson Taqi


This article was first published in Quantum magazine.

Public–private partnerships (PPP) developed as a convenient and cost-effective way to involve the private sector in public services without busting the budget, but are traditional forms of PPP procurement meeting current market demands and what alternatives are there in the sector to address these issues?

Conventional Public–Private Partnerships

The conventional PPP concession contract, which has evolved over the last 20 years in many developed markets, is increasingly being questioned. In its purest form, the contract provides for the private sector partner (PSP) to design, build, finance, and operate (DBFO) a project over typically 20–30 years, in exchange for the payment of a monthly fee which repays back the costs and provides a return to the PSP.

By incorporating a mechanism that reduces the fee in case of failure to deliver, the public sector should have a guarantee that the PSP maintains the quality of the services provided through the life of the concession. But perfecting such a mechanism is difficult, and it has not always worked. Furthermore, the public sector has tried to use the concession contract to transfer risks to the PSP that it is not best able to manage; this leads to overpricing and in some cases the project’s failure.

Consequently, the contracts and projects have not been able to attract investment-grade status, which makes it more difficult for institutional investors, such as pension funds, to get involved with financing them. Many governments were attracted to these arrangements in the first place because the private sector raised the finance, and public-sector accounting rules kept the projects off its balance-sheet. Now some people question if this was ever the right approach. As governments have tried to rebalance the contracts and allocate the risks more appropriately, costs have had to be added to the public-sector balance-sheet, which is particularly undesirable in the present economic climate.

Governments generally run a tender process on public projects in order to demonstrate value for money. By their very nature, these tenders require bidders to invest considerable time preparing sometimes quite complex proposals, so that ministers and officials are able to assess the best value for money over the concession’s life. The more complex the project, the more complex the proposal—and the more difficult it is to assess the best value option. This can lead to protracted tender periods and delays to projects, as well as significant losses for bidders. It can also tie up significant resources. If governments are to run successful programs, they must be able to offer a decent-sized contract and a transparent streamlined process. Many don’t.

The Strategic Partner Approach

With deal-fatigue creeping in, and the need to expedite the DBFO process, some governments are increasingly attracted by strategic partnering, particularly where there are a large number of relatively small projects or the possibility of a range of related projects. This system requires the government to invite private-sector firms to bid to take over a geographic area or type of project. The winner forms a strategic partnership with the government for a period of time, during which the PSP has the exclusive right to develop certain types of projects—provided it continues to show value for money. If it does, the state will enter into DBFO contracts with the PSP or its subsidiaries.

These contracts could be full PPP concession contracts, or design and build contracts, or operating contracts, depending on requirements. The concept has mainly been applied to social infrastructure but may be equally relevant to transport networks. Clearly, the structure is quite complex and requires up-to-date information on pricing in order to ensure continuing value for money.

Problems with Funding Models

Whatever approach is adopted, one of the main challenges is funding. Rarely able to gain an investment-grade rating, these projects have often been financed through bank debt, with investment bankers negotiating, accepting, and pricing the risks. Commercial banks could struggle to accommodate the typical 20- to 25-year tenure for a PPP infrastructure project, but it could be managed in developed markets. But it remained problematic in many emerging markets. By designing cash sweeps, upping margins, and syndicating large parts of the debt—as well as securitizing portfolios of project loans—a healthy market evolved, particularly in developed economies.

The economic recession exposed the pricing on many of these loans, and meeting new, more onerous capital requirements, as well as the forthcoming Basel III regulatory constraints, added to the problems. As a result, commercial lenders are increasingly turning their backs on project loans. This aversion to long-term debt and the sheer size of the financing requirement for infrastructure has meant that financial advisers are now seeking alternative sources of finance for project loans.

They turned instead to the international capital markets, which had what seemed to be unending capacity. At this stage the problem was to match bond-purchasers with little or no knowledge of project risk with the underlying project. Because the project was not investment-grade, institutional investors who made up the bulk of potential holders were not interested. It thus became necessary to enhance the credit rating of the projects and, if possible, to list the bonds issued by the PSPs or their special purpose vehicles on the international exchanges to provide liquidity.

This was achieved by introducing mono-line insurers—financial institutions with the highest AAA credit rating. They would take part in negotiating the DBFO contracts and, once comfortable with the underlying risks, issue (in exchange for a fee) bond policies akin to insurance policies. These would, in effect, pay out all outstanding principal and interest on the project bonds. It was therefore unnecessary for financial institutions to investigate the project itself. Instead, they looked to the AAA covenant of the mono-line insurer, which made the project bonds investment-grade.

Many projects were financed in this way. The tenor of the bonds was longer than bank debt, making project bonds attractive, as annual payments of principal were lower and so the tenor of the DBFO might be extended. Furthermore, mono-lines seemed able to offer lower pricing than bank debt, in part because they did not have to set aside as much capital as the banks.

But here too the recession exposed the weaknesses of the model. Most mono-lines became insolvent and/or lost their AAA rating. It is difficult to see this model reviving for quite some time. Consequently financial advisers, governments, and sponsors are actively looking at ways of attracting the capital markets back into the field. Rebalancing the risk profile of the DBFO contracts, introducing mezzanine finance or first-loss instruments, and providing government support have all been suggested.

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