Module 2

Financing of Projects

Module 2: Financing of Projects

Funding Sources – Long- and short-term sources, mezzanine finance, equity, quasi-equity,
debts - Local financing, Working Capital advances, Private equity funds, External
commercial borrowings- Export Credit Agencies and Development Banks - Multilateral
development finance institutions*, Viability Gap funding. Appraisal by Financial
Institutions. Financing Infrastructure Projects-Project Parties-Contracts, Power,
Telecommunications, PPP model, Concession Arrangements-Recommendations of the
Committee.

Learning outcome:
LO: have an idea about different sources of finance available for projects, and models of
infrastructural projects

Core concepts
• Source of finance
• Debt
• Equity
• Mezzanine finance
• Quasi equity
• Working capital
• Export credit agency

Assessment
• Student presentations – Assessment 2
• Quiz
2.1. Meaning and Importance of Project Finance
International Project Finance Association (IPFA) defines Project finance as “the financing of
long-term infrastructure, industrial projects and public services based upon a non-recourse or
limited recourse financial structure where project debt and equity used to finance the project
are paid back from the cash flow generated by the project”.
Project finance is used by private sector companies as a means of funding major projects off
balance sheet. At the heart of the project finance transaction is the concession company, a
special purpose Vehicle (SPV) which consists of the consortium shareholders who may be
investors or have other interests in the project (such as contractor or operator). The SPV is
created as an independent legal entity which enters into contractual agreements with a number
of other parties necessary in the project finance deals.
(A concession agreement typically refers to a contract between a company and a government
that gives the company the right to operate a specific business within the government's
jurisdiction, subject to certain terms)

Importance of Project finance and steps in Project finance

Project financing is being used throughout the world across a wide range of industries and
sectors. This funding technique is growing in popularity as governments seek to involve the
private sector in the funding and operation of public infrastructure.
Private sector investment and management of public sector assets is being openly encouraged
by governments and multilateral agencies who recognize that private sector companies are
better equipped and more efficient than government in developing and managing major public
services.
Project finance is used extensively in the following sectors.
• Oil and gas
• Mining
• Electricity Generation
• Water
• Telecommunications
• Road and highways
• Railways and Metro systems
• Public services
Advantages of Project Financing

• Eliminate or reduce the lender’s recourse to the sponsors.

• Permit an off-balance sheet treatment of the debt financing.
• Maximize the leverage of a project.
• Avoid any restrictions or covenants binding the sponsors under their respective
financial obligations.
• Avoid any negative impact of a project on the credit standing of the sponsors.
• Obtain better financial conditions when the credit risk of the project is better than the
credit standing of the sponsors.
• Allow the lenders to appraise the project on a segregated and stand-alone basis.
• Obtain a better tax treatment for the benefit of the project, the sponsors or both.

Disadvantages of Project Financing

• Often takes longer to structure than equivalent size corporate finance.

• Higher transaction costs due to creation of an independent entity. Can be up to 60bp
 • Project debt is substantially more expensive (50-400 basis points) due to its non-
recourse nature.
• Extensive contracting restricts managerial decision making.
• Project finance requires greater disclosure of proprietary information and strategic
deals.

A few terms which need further explanation are as follows:

1. Non-recourse : The typical project financing involves a loan to enable the sponsor to
construct a project where the loan is completely "non-recourse" to the sponsor, i.e., the sponsor
has no obligation to make payments on the project loan if revenues generated by the project
are insufficient to cover the principal and interest payments on the loan. In order to minimize
the risks associated with a non-recourse loan, a lender typically will require indirect credit
supports in the form of guarantees, warranties and other covenants from the sponsor, its
affiliates and other third parties involved with the project.
2. Maximize Leverage: In a project financing, the sponsor typically seeks to finance the costs
of development and construction of the project on a highly leveraged basis. Frequently, such
costs are financed using 80 to 100 percent debt. High leverage in a non-recourse project
financing permits a sponsor to put less in funds at risk, permits a sponsor to finance the project
without diluting its equity investment in the project and, in certain circumstances, also may
permit reductions in the cost of capital by substituting lower-cost, tax-deductible interest for
higher-cost, taxable returns on equity.
3. Off Balance-Sheet Treatment: Depending upon the structure of a project financing, the
project sponsor may not be required to report any of the project debt on its balance sheet
because such debt is non-recourse or of limited recourse to the sponsor. Off-balance-sheet
treatment can have the added practical benefit of helping the sponsor comply with covenants
and restrictions relating to borrowing funds contained in other indentures and credit agreements
to which the sponsor is a party.
4. Maximize Tax Benefits: Project financings should be structured to maximize tax benefits
and to assure that all available tax benefits are used by the sponsor or transferred, to the extent
permissible, to another party through a partnership, lease or other vehicle.

PROJECT COMPANY AGREEMENTS

Depending on the form of project company chosen for a particular project financing, the
sponsors and other equity investors will enter into a stockholder agreement, general or limited
partnership agreement or other agreement that sets forth the terms under which they will
develop, own and operate the project. At a minimum, such an agreement should cover the
following matters:
1. Ownership interest
2. Capitalization and capital calls.
3. Allocation of profits and losses.
4. Distributions.
5. Accounting.
6. Governing body and voting.
7. Day-to-day management.
8. Budgets.
9. Transfer of ownership interests.
10. Admission of new participants.
11. Defaults
12. Termination and dissolution

MAIN PROJECT CONTRACTS

1. Concession Agreement
The agreement entered into between the sponsors / Project Company and the host government
by virtue of which the project company is authorized to develop the project. The main clauses
of this agreement involve : - scope of responsibility of the project company and host
government, - statutory requirements and host government authorizations, - the description and
specifications of the site granted to the project company for the purposes of the development
of the project, - the technical specifications of the project, - payments to be made by the project
company to the host government (concession fee), - payments to be made to the project
company if the host government is the off-taker, - guarantee by the host government of foreign
exchange availability and transfer of funds, - tax regime of the project company and the project,
- performance guarantee, - reporting and regulation, - Force Majeure, - guarantee against
change in circumstances, - duration, - governing law, - dispute resolution.
2. Construction Agreement
A construction agreement is the agreement whereby one person (the contractor) agrees to
construct a building or a facility for another person (the employer) for an agreed remuneration
by an agreed time. In a complex construction project comprised of various interlocking parts
(involving both civil and mechanical and electrical works), the basic decision to be taken is
whether to have a contractor responsible for all of the works or to have the individual
contractors enter into separate contracts with the employer but to have them subject to control
by one overall project manager.
Often a turnkey contract is preferred in order to ensure that the turnkey contractor assumes
overall risk for completion as well as the risk of performance of the subcontractors. The main
clauses of this agreement involve : - technical specifications, - authorizations to be obtained
for the works, - completion agenda, - testing procedures and performance parameters,-
determination of phase / final completion, - fixed price and provision relating to "overruns"
and payments, - liquidated damages payable for delay in achieving completion, - transfer of
property and risk, - construction bond/completion guarantees (garantie d'achevement), -
insurance arrangements, - cooperation and coordination during the works, - final provisions
(governing law, dispute resolution etc.).
3. Shareholders Agreement / Joint-Venture Agreement
The shareholders of the project company are in most instances the sponsors of the project. Due
to the particularities of some jurisdictions and more generally those involved in the
management and financing of a project company, the shareholders often enter into a
shareholders' agreement. The main clauses of this agreement involve: - voting rights, -
nomination of management / major decisions, - dividend distribution, - pre-emption rights, -
each shareholder's contribution in equity to the project company and its agenda, - non-dilution,
- shareholders loans, - conflict of interests (if one of the shareholders is a party to an agreement
to be entered into with the project company), - non-competition clauses, - final provisions.
4. Operating and Maintenance Agreement
In most instances the project company will enter into an agreement with an operator which will
be responsible for the operation and maintenance of the project facility. The main clauses of
this agreement involve : - scope of responsibility of the operator, - operator's fees, - guarantee
that the project will achieve certain operating levels (production and efficiency), - operation
bonus/liquidated damages, - cooperation and coordination, - operation and maintenance fees,
- final provisions.
5. Supply Agreements
In most instances the project company will need to enter into a number of supply agreements
in order to purchase the main supplies for the operation of the project facility. These may
include feed stock (raw materials for the manufacturing process), fuel (for electricity generation
or for the supply of power to the plant) or renewable equipment. The main clauses of this
agreement involve: - level of supply, - price (fixed or indexed), - supply guarantee, - quality of
supply, - liquidated damages, - final provisions.
6. Off-Take Agreements
A project need not necessarily have an off-take agreement in the sense of a long term product
purchase agreement since: - its products may only be capable of being sold on world spot
markets (e.g. crude oil), - its revenues may simply be payments from the general public (of
tolls or fares). An off-take agreement is a long-term sale agreement of the project products with
one or more off-takers with the following characteristics: - long-term sales, - fixed or agreed
price, - purchase guarantee ("take-or-pay"). Other The project company will in all instances
enter into assurance arrangements. The project company may also enter into a technical
assistance agreement.
Some of the common Project finance contracts which every project company enters into are
depicted in the diagram shown below.

Tasks of the Project Manager

The project manager’s tasks can be divided into four categories:
(1) Technical
(2) Personnel
(3) Administrative
(4) External Relations
The tasks relating to the technical aspects are planning, scheduling of work, setting of priorities,
task identification, looking into the logistics, and specification of equipment use. The personnel
aspect involves building up of organization and recruitment of staff as per the requirements,
leading and motivating the staff to perform, building communication channels, resolution of
conflicts, conducting negotiation with various parties, and performance evaluation.
Administrative tasks include estimating and controlling of costs, budgeting, cash flow
monitoring, devising and using the management information system, evolving systems and
procedures for various operations including the procurement of raw materials, and finally the
terminal project evaluation. The project manager has also to manage the external relations of
the unit. These tasks include relations of the unit. These tasks include relations with financial
institutions, contracting and using the consultants, dealing with suppliers and sub-contractors,
and co-ordination with other agencies including government agencies. All the above-
mentioned tasks of the project manager need to be performed at both pre-operation and
operation phases of a unit. Then nature and complexity of these tasks are, however, different
in the operation phase as compared to the pre-operation phase.

Means of finance and sources of project finance in India

Sources of finance for business are equity, debt, debentures, retained earnings, term loans,
working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds
are used in different situations. They are classified based on time period, ownership and control,
and their source of generation. It is ideal to evaluate each source of capital before opting for it.
Sources of capital are the most explorable area especially for the entrepreneurs who are about
to start a new business. It is perhaps the toughest part of all the efforts. There are various capital
sources, we can classify on the basis of different parameters.
Having known that there are many alternatives to finance or capital, a company can choose
from. Choosing the right source and the right mix of finance is a key challenge for every
finance manager. The process of selecting the right source of finance involves in-depth analysis
of each and every source of fund. For analyzing and comparing the sources, it needs the
understanding of all the characteristics of the financing sources. There are many characteristics
on the basis of which sources of finance are classified.
On the basis of a time period, sources are classified as long-term, medium term, and short term.
Ownership and control classify sources of finance into owned and borrowed capital. Internal
sources and external sources are the two sources of generation of capital. All the sources have
different characteristics to suit different types of requirements. Let’s understand them in a little
depth.

LONG TERM SOURCES OF MEDIUM TERM SOURCES OF SHORT TERM SOURCES

FINANCE / FUNDS FINANCE / FUNDS OF FINANCE / FUNDS

Preference Capital or
Share Capital or Equity Shares Preference Shares Trade Credit

Preference Capital or
Preference Shares Debenture / Bonds Factoring Services

Retained Earnings or Internal

Accruals Lease Finance Bill Discounting etc.

Advances received from

Debenture / Bonds Hire Purchase Finance customers

Medium Term Loans from

Term Loans from Financial Financial Institutes, Short Term Loans like
Institutes, Government, and Government, and Commercial Working Capital Loans
Commercial Banks Banks from Commercial Banks

Venture Funding Fixed Deposits (<1 Year)

Asset Securitization Receivables and Payables

International Financing by way

of Euro Issue, Foreign Currency
Loans, ADR, GDR etc.
According to Time Period
Sources of financing a business are classified based on the time period for which the money
is required. The time period is commonly classified into the following three:

1. Long-Term Sources of Finance

Long-term financing means capital requirements for a period of more than 5 years to 10, 15,
20 years or maybe more depending on other factors. Capital expenditures in fixed assets like
plant and machinery, land and building, etc of business are funded using long-term sources of
finance. Part of working capital which permanently stays with the business is also financed
with long-term sources of funds.
2. Medium Term Sources of Finance
Medium term financing means financing for a period of 3 to 5 years and is used generally for
two reasons. One, when long-term capital is not available for the time being and second when
deferred revenue expenditures like advertisements are made which are to be written off over a
period of 3 to 5 years.
3. Short Term Sources of Finance
Short term financing means financing for a period of less than 1 year. The need for short-term
finance arises to finance the current assets of a business like an inventory of raw material and
finished goods, debtors, minimum cash and bank balance etc. Short-term financing is also
named as working capital financing.

According to Ownership and Control:

Sources of finances are classified based on ownership and control over the business. These two
parameters are an important consideration while selecting a source of funds for the business.
Whenever we bring in capital, there are two types of costs – one is the interest and another is
sharing ownership and control. Some entrepreneurs may not like to dilute their ownership
rights in the business and others may believe in sharing the risk.

OWNED CAPITAL BORROWED CAPITAL

Equity Financial institutions,

Preference Commercial banks or

Retained Earnings The general public in case of debentures.

Convertible Debentures

Venture Fund or Private Equity

ACCORDING TO SOURCE OF GENERATION:

Based on the source of generation, the following are the internal and external sources of
finance:

INTERNAL SOURCES EXTERNAL SOURCES

Retained profits Equity

Reduction or controlling of working capital Debt or Debt from Banks

All others except mentioned in

Sale of assets etc. Internal Sources

According to Ownership and Control:

Sources of finances are classified based on ownership and control over the business. These two
parameters are an important consideration while selecting a source of funds for the business.
Whenever we bring in capital, there are two types of costs – one is the interest and another is
sharing ownership and control. Some entrepreneurs may not like to dilute their ownership
rights in the business and others may believe in sharing the risk.

ACCORDING TO SOURCE OF GENERATION:

Based on the source of generation, the following are the internal and external sources of
finance:

INTERNAL SOURCES EXTERNAL SOURCES

Retained profits Equity

Reduction or controlling of working capital Debt or Debt from Banks

All others except mentioned in

Sale of assets etc. Internal Sources

Internal Sources
The internal source of capital is the one which is generated internally by the business.
The internal source of funds has the same characteristics of owned capital. The best part of the
internal sourcing of capital is that the business grows by itself and does not depend on outside
parties. Disadvantages of both equity and debt are not present in this form of financing. Neither
ownership dilutes nor fixed obligation/bankruptcy risk arises.
External Sources
An external source of finance is the capital generated from outside the business. Apart from
the internal sources of funds, all the sources are external sources.
Deciding the right source of funds is a crucial business decision taken by top-level finance
managers. The usage of the wrong source increases the cost of funds which in turn would have
a direct impact on the feasibility of the project under concern. Improper match of the type of
capital with business requirements may go against the smooth functioning of the business.

An explanation about important sources of capital

1. Equity Capital
This is the contribution made by the owners of business, the equity shareholders, who enjoy
the rewards and bear the risks of ownership. However, their liabilities, limited to their capital
contribution.
From the point of view of the issuing film, equity capital offers, two important advantages:
a) It represents permanent capital. Hence there is no liability for repayment.
 b) It does not involve any fixed obligation for payment of dividend.
The disadvantages of raising funds by way of equity capital are:
a) The cost of equity capital is high because equity dividend are not tax-deductible
expenses.
b) The cost of issuing equity capital is high.

2. Preference Capital
A hybrid form of financing, preference capital partakes some characteristics of equity capital
and some attributes of debt capital. It is similar, to equity capital because preference dividend,
like equity dividend, is not a tax-deductible payment. It resembles debt capital because the rate
of preference dividend is fixed.
3. Debenture Capital
In the last few years, debenture capital has emerged as an important source for project
financing. There are three types of debentures that are commonly used in India: Non-
Convertible Debentures (NCDs), Partially Convertible Debentures (PCDs), and Fully
Convertible Debentures (FCDs). Akin to promissory, NCDs are used by companies for raising
debt that is generally retired over a period of 5 to 10 years. They are secured by a charge on
the assets of the issuing company.
4. Rupee Term Loans
Provided by financial institutions and commercial banks, rupee term loans which represent
secured borrowings are a very important source for financing new projects as well as
expansion, modernisation, and renovation schemes of existing units. These loans are generally
repayable over a period of 8-10 years which includes a moratorium period of l-3 years.
5. Foreign Currency Terms Loans
Financial institutions provide foreign currency term loans for-meeting the foreign currency
expenditures towards import of plant, machinery, equipment and also towards payment of
foreign technical know-how fees. Under the general scheme, the periodical liability towards
interest and principal remains in the currency/currencies of the loan/s and is translated into
rupees at the then prevailing rate of exchange for making payments to the financial institution.
6. Deferred Credit
Many a time the suppliers of machinery provide deferred credit facility under which payment
for the purchase of machinery is made over a period of time. The interest rate on deferred credit
and the period of payment vary rather widely. Normally, the supplier of machinery when he
offers deferred credit facility insists that the bank guarantee should be furnished by the buyer.
 7. Leasing and Hire Purchase Finance
With the emergence of scores of finance companies engaged in the business of leasing and hire
purchase finance, it may be possible to get a portion, albeit a small portion, of the assets
financed under a lease or a hire purchase arrangement.
8. Public Deposit
Public deposits have been a peculiar feature or industrial finance in India. Companies have
been receiving public deposits for a long time in order to meet their medium-term and long-
term requirements for finance. This system was very popular in the cotton textile mills or
Bombay, Ahmedabad and Sholapur and in the tea gardens or Assam and Bengal. In recent
years, the method or raising finance through the public deposits has again become popular for
various reasons. Rates or interest offered by the companies are higher than those offered by
banks. At the same time the cost of deposits to the company is less than the cost or borrowings
from banks.

9. Bank Credit
Commercial banks in the country serve as the single largest source or short-term finance to
business firms. They provide it in the form of Outright Loans. Cash credit, and Lines of Credit.

2.2. Mezzanine Financing

Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to
convert to an equity interest in the company in case of default, generally, after venture capital
companies and other senior lenders are paid.

Mezzanine debt has embedded equity instruments attached, often known as warrants, which
increase the value of the subordinated debt and allow greater flexibility when dealing with
bondholders. Mezzanine financing is frequently associated with acquisitions and buyouts, for
which it may be used to prioritize new owners ahead of existing owners in case of bankruptcy.

• Mezzanine financing is a way for companies to raise funds for specific projects or to
aide with an acquisition through a hybrid of debt and equity financing.
• This type of financing can provide more generous returns compared to typical corporate
debt, often paying between 12% and 20% a year.
• Mezzanine loans are most commonly utilized in the expansion of established
companies rather than as start-up or early-phase financing.
How Mezzanine Financing Works
Mezzanine financing bridges the gap between debt and equity financing and is one of the
highest-risk forms of debt. It is subordinate to pure equity but senior to pure debt. However,
this means that it also offers some of the highest returns when compared to other debt types, as
it often receives rates between 12% and 20% per year, and sometimes as high as 30%.

Companies will turn to mezzanine financing in order to fund growth projects or to help with
acquisitions with short- to medium-term time horizons. Often, these loans will be provided by
the long-term investors and existing funders of the company's capital. A number of other
characteristics are common in the structuring of mezzanine loans, such as:

• Mezzanine loans are subordinate to senior debt but have priority over both preferred
and common stock.
• They carry higher yields than ordinary debt.
• They are often unsecured debts.
• There is no amortization of loan principal.
• It may be structured as part fixed and part variable interest.

Advantages of Mezzanine Financing

Mezzanine financing may result in lenders–or investors–gaining equity in a business or
warrants for purchasing equity at a later date. This may significantly increase an investor's rate
of return (ROR). In addition, mezzanine financing providers receive contractually obligated
interest payments monthly, quarterly, or annually.

Borrowers prefer mezzanine debt because the interest is tax-deductible. Also, mezzanine
financing is more manageable than other debt structures because borrowers may figure their
interest in the balance of the loan. If a borrower cannot make a scheduled interest payment,
some or all of the interest may be deferred. This option is typically unavailable for other types
of debt. In addition, quickly expanding companies grow in value and restructure mezzanine
financing into one senior loan at a lower interest rate, saving on interest costs in the long term.

Disadvantages of Mezzanine Financing

However, when securing mezzanine financing, owners sacrifice control and upside potential
due to the loss of equity. Owners also pay more in interest the longer mezzanine financing is
in place.
 For mezzanine lenders, they're at risk of losing their investment in the event of bankruptcy. In
other words, when a company goes out of business, the senior debt holders get paid first by
liquidating the company's assets. If there are no assets remaining after the senior debt gets paid
off, mezzanine lenders lose out.

Example of Mezzanine Financing

For example, Bank XYZ provides Company ABC, a maker of surgical devices, with $15
million in mezzanine financing. The funding replaced a higher interest $10 million credit line
with more favorable terms. Company ABC gained more working capital to help bring
additional products to the market and paid off a higher interest debt. Bank XYZ will collect
10% a year in interest payments and will be able to convert to an equity stake if the company
defaults.

2.3. Differences between Equity and Debt

Table 1: Differences between Equity and Debt

Equity Debt
Equity shareholders have a residual claim on Creditors (suppliers of debt) have a fixed
the income and the wealth of the firm. claim in the form of interest and principal
payment.
Dividend paid to equity shareholders is not a Interest paid to creditors is a tax deductible
tax deductible payment. payment.
Equity ordinarily has indefinite life. Debt has a fixed maturity.
Equity investors enjoy the prerogative to Debt investors play a passive role – of
control the affairs of the firm. course, they impose certain restrictions on
the way the firm is run to protect their
interest.

The key factors in determining the debt-equity ratio for a project are:

• Cost
• Nature of assets
• Business risk
• Norms of lenders
• Control considerations
 • Market conditions

Table 2: Checklist to use debt or equity as a source of finance

Use more equity when…. Use more debt when….

The corporate tax rate applicable is The corporate tax rate applicable is high.

negligible.

Business risk exposure is high. Business risk exposure is low.

Dilution of control is not an important issue. Dilution of control is an issue.

The assets of the project are important issue. Dilution of control is an issue.

The assets of the project are mostly The assets of the project are mostly tangible.

intangible.

The project has many valuable growth The project has few growth options.

options.

2.4. Export Credit Agencies

Project financing from export credit agencies is generally available in two forms and often in
a combination of both: either from the national export-import bank and / or as foreign aid.
When tied together they are called mixed credits, and if the country is a member of the Group
on Export Credits and Credit Guarantees (ECCG) of the OECD Trade Committee, these credits
are regulated by OECD arrangements. Most foreign aid of this type is used to purchase goods
and services from the private sector in the country that provides the financing. These agencies
provide a number of project finance services.

2.5. Multilateral agencies

These are organizations formed between three or more nations to work on issues that relate to
all of the countries in the organization. The main characteristics of Multilateral agencies are

• They are organizations formed between three or more nations

• They Pool funds from multiple governments and parties
• Many countries are involved in deciding the priorities and activities of multilateral
agencies
• Provide technical and commodity assistance (Cash grants, Commodity transfers,
Technical assistance, and Loans)
 The World Bank, International Finance Corporation and regional development banks often act
as lenders or co-financers to important infrastructure projects in developing countries. In
addition, these institutions often play a facilitating role for projects by implementing programs
to improve the regulatory frameworks for broader participation by foreign companies and the
local private sector. In many cases, the multilateral agencies are able to provide financing on
concessional terms. The additional benefit they bring to projects is further assurance to lenders
that the local government and state companies will not interfere detrimentally with the project.

2.6. Viability Gap Funding

A major constraint for India’s infrastructure sector is inadequate finance. Apart from the overall
difficulty in raising funds, some projects, though economically worthwhile and necessary, may
not be financially viable. To promote such projects, the government has designed Viability Gap
Funding (VGF). It represents a grant to support projects that are economically justified but not
financially viable. The VGF scheme was launched in 2004 to support PPP projects. VGF is
administered by the Ministry of Finance and a provision for it is made in the budget on a year-
to-year basis. VGF grants are given only for infrastructure projects where the selection of the
private sector sponsors is through a process of competitive bidding. The VGF grant is disbursed
during the construction stage but only after the private sector sponsor makes the equity
contribution required for the project. VGF is usually limited to 20 percent of the total capital
cost of the project. In case of projects being implemented at the state level, matching grants are
expected from the state government

2.7. Financing infrastructure projects

Infrastructure projects, which typically provide essential services, have one or more of the
characteristics mentioned below:

• They are highly capital-intensive.

• They involve huge sunk costs.
• They have a long operating life.

The vital role of infrastructure in the economy, the essential nature of its services, the size of
individual projects, and its important social dimensions call for governmental role in planning
and promoting, and in ensuring independent regulation that provides a level playing field for
both public and private sector enterprises. Given the massive investments required in
infrastructure, there is a broad consensus that private sector participation in this activity must
be encouraged.
Public Private partnership models

Definitions

1. The European Commission: PPP is cooperation between the public authorities and
economic operators.
2. The Organization for Economic Cooperation and Development (OECD): PPP is
an agreement between the government and one or more private partners (which may
include the operators and the financiers) according to which the private partners deliver
the service in such a manner that the service delivery objectives of the government are
aligned with the profit objectives of the private partners and where the effectiveness of
the alignment depends on a sufficient transfer of risk to the private partners.

A PPP has these key characteristics:

• A PPP is a clearly defined project, where government carefully defines its objectives;
• The contractual relationship spans a set length of time, which may range from 5 to 30
years;
• Risks are allocated to the party most able to carry them out. This means mitigating their
impact and/or being able to absorb the consequences;
• Fixed and operational assets are adequately maintained over the project’s lifetime;
• The private party plays a key role at each stage of the project: funding, development,
design, completion and implementation.

The arguments in favor of PPP

• Limitations of government resources and capacity to meet the infrastructure gap

• Need for new financing and institutional mechanisms

• Access to project finance

• Optimum risk allocation system

• International best practices, better technology, innovative project and financial designs etc

The arguments against PPP

• Concerns regarding its viability and effectiveness especially in big infra, which requires
significantly large investment for a long period

• Who will be in charge of the cost recovery from the projects whose gains due to their public
nature are often indivisible?

• Loaded against projects which

a) promote basic social, as against purely economic, objectives

b) result in economic gains which cannot be appropriated through user charges and
c) trigger with a time lag a cumulative process of regional or national economic
development
• Since, capital expenditure on infrastructure like a highway project is indivisible and very
large, fixed charges form the major component of the costs of providing the road services.
• When gains from a highway project are purely economic and accrue only to users with no
externality present, the toll rate cannot exceed the marginal benefit from road services with
the result that despite tolling consumer surplus may be substantial.
• Though the net economic benefits from a road project are positive, it may not be
commercially viable.
• There is a tendency for the private investment to be less than the optimal level Government
enacts policies for neutralizing bias in private investment.

• Government bears the cost of Project feasibility study, Land acquisition for road, Land for
the right of way and wayside amenities, Environment clearance, cutting of trees etc.

• Launches various schemes like viability gap funding, tax exemptions period and duty free
imports of equipment. The rules for borrowing abroad are eased and tax exemptions are given
to financial institutions financing such projects.

• Negate the basic arguments in favor of PPP i.e. it will reduce the burden on government funds.

• Has the govt fiscal liabilities reduced or increased?

• Distortionary effects and strengthen bias against investment with high social but low private
returns. Duty rebates on inputs and interest subsidies erodes allocative efficiency and give rise
to deadweight loss for the economy.

Risks in PPP

• Pre-operative task risks: Delays in land acquisition, Financing risks, Planning risks

• Construction phase risks: Design risk, Construction risk, Approvals risk, Additional Site Risk
• Operation phase risks: Technology risk, Operations and maintenance risk, Traffic risk,
Payment risk, Financial risk

• Handover risks

• Other risks: Force Majeure, Concessionaire event of default, Government event of default,
Change in law.

PPP MODELS

1. Build, Operate and Transfer (BOT)

• Under this category, the private partner is responsible for designing, building, operating
(during the contracted period) and transferring back the facility to the public sector.

• The private sector partner is expected to bring the finance for the project and take the
responsibility to construct and maintain it. The public sector will either pay a rent for using the
facility or allow it to collect revenue from the users.

• The n-ational highway projects contracted out by NHAI under PPP mode is an example

2. Lease, Operate and Transfer (LOT)

• Already existing facility is entrusted to the private sector partner for efficient operation,
subject to the terms and conditions decided by mutual agreement.

• The contract will be for a given period and the asset will be transferred back to the government
at the end of the contract.

• Leasing a school building or a hospital to the private sector along with the staff and all
facilities by entrusting it with the management and control, subject to pre-determined
conditions could come under this category.

3. Build, Own, Operate (BOO) or Build, Own, Operate and Transfer (BOOT)

• This is a variation of the BOT model, except that the ownership of the newly built facility
will rest with the private party during the period of contract.

• This will result in the transfer of most of the risks related to planning, design, construction
and operation of the project to the private partner.
• The public sector partner will however contract to ‘purchase’ the goods and services produced
by the project on mutually agreed terms and conditions.

• Under (BOOT) the facility / project built under PPP will be transferred back to the
government department or agency at the end of the contract period, generally at the residual
value and after the private partner recovers its investment and reasonable return agreed to as
per the contract.

4. Design, Build, Finance and Operate (DBFO) or Design, Build, Finance, Operate
and Maintain (DBFOM)

• The private party assumes the entire responsibility for the design, construct, finance, and
operate or operate and maintain the project for the period of concession. These are also referred
to as “Concessions”.

• The private participant in the project will recover its investment and return on investments
(ROI) through the concessions granted or through annuity payments etc.

• Most of the project risks related to the design, financing and construction would stand
transferred to the private partner.

• The public sector provides guarantees to financing agencies, help with the acquisition of land
and assist to obtain statutory and environmental clearances and approvals and also assure a
reasonable return as per established norms or industry practices, throughout the period of
concession.

Questions
1. Explain the differences between investment decisions and financing decisions.
2. Describe the key factors that have a bearing on the debt-equity ratio for a project.
3. Discuss the features of various domestic sources of finance as well as their pros and
cons. Compare the various methods of raising finance.
4. Describe the features of eurocurrency loans and bonds.
5. Distinguish between a full recourse structure and a limited recourse structure.
6. Specify the kind of information lenders want for apprang term loan requests.
7. Discuss how financial institutions appraise a project.
Case study-To be discussed by students in groups of five

Reliance Petro Jamnagar Refinery Ahead of Schedule

For the June quarter Reliance Petroleum Ltd has overshot its budget by 1,390 crore for setting
up the Greenfield refinery at Jamnagar.
The refinery project is expected to be completed ahead of the December deadline. It has
achieved 94 per cent overall progress in implementing the project, the company said in a
BSE statement.
Reliance Petroleum is setting up the export-oriented refinery, with a capacity to process
580,000 barrels a day of crude. It is also setting up ‘900,000 tonnes a year’ polypropylene
plant.
Reliance Petroleum in the statement said, "As on June 30, the company has utilised 25,515
crore for the project against a projected utilisation of funds of 24,125 crore. The variation is
mainly due to payments in advance under project contracts for continued efficient and speedy
implementation of the project."
The company added that the project engineering, procurement and contracting activities have
been completed for the refinery.
Pre-commissioning Activities
Construction activities are progressing rapidly to meet pre-commissioning requirements.
Planning for project start-up is completed.
The statement said the pre-commissioning activities are proceeding at a fast pace with
necessary infrastructure facilities already under commissioning. The company has mobilised
sufficient resources to sustain pre-commissioning and commissioning activities on fast track.
The quarter witnessed close-out of procurement and contracting activities for equipment and
bulk materials.
Deliveries of equipment are nearly complete. Deliveries of bulk materials, including pipes,
fittings, electrical and instrumentation bulks matched the pace of equipment deliveries and
 their installation at site. Focus has now shifted towards achieving a rapid close-out on this
front, the statement added.
Questions:
1. Study and analyze the case.
2. Write down the case facts.
3. What do you infer from it?
Source: http://www.thehindubusinessline.in/2008/07/23/stories/2008072351730200.html

Key facts of the case and feasible solution: