This section of Visionary Consulting Company’s Guide explores key concepts of Public-Private Partnership (PPP) financing, examining the main financing options, key contractual relationships, and methods to assess financing costs and overall profitability.
Financing Alternatives for PPP Projects
Two primary methods exist for financing PPP infrastructure projects: corporate finance and project finance.
1. Corporate finance: In this approach, the borrower, typically a company, borrows money directly from a bank and repays the loan using revenues generated from the completed infrastructure. If these revenues fall short, the borrower must rely on other business activities to cover the shortfall. The risk with corporate finance is significant, especially for large infrastructure projects. A project failure could endanger the entire company.
2. Project finance: Project finance, the preferred method for PPPs, offers a solution by establishing a dedicated project company known as a special purpose vehicle (SPV). The SPV is legally separated from the parent company, insulating it from direct exposure to financial risk. Financing is secured by the project itself, which means lenders rely solely on project revenues to recover their loans. Although this increases the risk for lenders, leading to increased scrutiny, it protects the parent company from financial fallout if the project fails. In a project finance structure, most contractual relationships involve the SPV, with the most critical being the PPP contract signed between the government entity and the project company. The SPV subcontracts project activities, such as construction and operation, to specialized firms, while the parent companies involved agree on rights and responsibilities through shareholder agreements.
Equity and debt financing in PPP projects
Financing a PPP project typically involves both equity and debt.
1. Equity Financing: Equity contributors, often a consortium of companies involved in the project, provide the initial capital for the project company. Institutional investors may also participate. Equity holders bear the highest risk as they are the first to invest but the last to be repaid. This risk also means they have the potential for the highest returns. The dynamic is similar to purchasing a home: if you invest personal savings and borrow the rest, when selling the house at a lower price, the lender gets repaid first before you see any return. In PPP projects, lenders have financial recourse before equity contributors receive any repayments or returns.
2. Debt Financing: Debt is usually issued to PPP projects by commercial banks, international finance institutions like the World Bank, or export credit agencies. Interest rates depend on the level of risk involved. Lower-risk projects enjoy lower borrowing costs, while high-risk projects may struggle to secure financing. One challenge with bank financing is that banks rarely issue loans for the long durations PPP projects require, typically 20 years. Loans often mature after 5-10 years, leading to the need for refinancing. While refinancing poses a risk if financing becomes unavailable, it can also offer opportunities to lower borrowing costs if done after the construction phase when the project’s risk profile decreases.
Calculating the cost of PPP project financing
The cost of financing a PPP project is influenced by risk, cost, and bankability factors, and is often expressed through the concept of leverage, the ratio of debt to equity. For example, if a project is financed with 25 percent equity and 75 percent debt, it has a leverage ratio of 3:1. The financing cost is calculated using the Weighted Average Cost of Capital (WACC). If equity providers expect a 15 percent return and lenders charge 5 percent interest, the WACC would be 7.5 percent. Reducing the equity share decreases the WACC, as equity financing is more expensive than debt. However, increasing leverage (more debt) also raises financial risk, as a smaller equity base is available to absorb potential losses.
Governments usually prefer reasonable leverage ratios to balance risk and financing costs. The analysis of private financing shows that PPP project financing costs are generally higher than those for traditional infrastructure projects financed through public debt, which is considered less risky. For a PPP project to be worthwhile, these additional financing costs must be offset by efficiency gains or other advantages.
Assessing PPP project profitability
A key factor in determining the success of a PPP project is profitability, which depends on the cash flow generated over the life of the project. Revenues typically come from either end-users or the government. Profitability is determined by comparing projected revenues against estimated costs over the project’s life, with cash flows generally negative during construction but turning positive afterward. PPP projects require a comprehensive financial model to generate accurate cash flow projections and profitability indicators like the Internal Rate of Return (IRR). The IRR measures the profitability of an investment by comparing the initial investment to the returns generated over time. A higher IRR indicates greater profitability.
For example, if a project has an IRR of 10 percent, it is equivalent to investing $100 and selling it for $110 after a year, generating a $10 profit. The quality of these profitability indicators depends on the accuracy of revenue and cost projections. Adjusting key assumptions, such as increasing cash flow, can significantly impact profitability measures like the IRR. Ultimately, a PPP project becomes more attractive as projected profitability (IRR) increases beyond the cost of financing (WACC).
Investors and governments must carefully evaluate these projections to ensure the financial viability of the project. Based on the discussion above, it is obvious that financing and profitability are critical factors in the success of a PPP project. Project finance, typically preferred for PPPs, offers a way to mitigate financial risk through the establishment of a special purpose vehicle. Equity and debt financing play key roles, with equity contributors bearing higher risks but potentially enjoying higher returns, while debt financing introduces both challenges and opportunities.
Assessing the cost of financing and the project’s profitability is crucial for making informed decisions about the viability of a PPP project. These calculations, along with careful risk management, ensure that the project can deliver value while maintaining financial stability.
Note: Hassan Abdulrahim is senior instructor, Economics & Finance, at Canadian College Kuwait and Deputy CEO at Visionary Consulting Company