PUBLIC PRIVATE

PARTNERSHIPS (PPPs)

Francis Can
MBA, PMP, FCCA, CPA(K), CPA(U),
CIPS(Cert), Prince2, BSc(Ed), PgDIMA
fcan1961@gmail.com
Tel: 256 772 989401
 FINANCING PPP PROJECTS

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 4. FINANCING PPP PROJECTS
4.1.1 What is project financing?
PPPs in infrastructure are normally financed on project basis (as opposed to
corporate financing).
This refers to financing in which lenders look to the cash flows of an
investment for repayment, without recourse to either equity sponsors or the
public sector to make up any shortfall.
Advantages:
reduces/isolates the financial risk of investors;
more careful project scrutiny, risk analysis leading to change in project
structure, reduction in level of risk and more appropriate allocation of risks
between parties.
Disadvantages
more complex transactions than corporate or public financing;
higher transaction costs (the due diligence process conducted by parties
results in higher development costs, which could be up to 5-10 per cent of
project value);
protracted negotiation between parties;
requirement of close monitoring and regulatory oversight (particularly for the
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 4.1.2. Sources of Finance

 Project finance may come from a variety of sources. The main

sources include equity, debt and government grants.
 Financing from these alternative sources have important
implications on project's overall cost, cash flow, ultimate liability and
claims to project incomes and assets 
 Equity refers to capital invested by sponsor(s) of the PPP project
and others.
 Debt refers to borrowed capital from banks and other financial
institutions. It has fixed maturity and a fixed rate of interest is paid
on the principal.

 Equity is provided by project sponsors, government, third party

private investors, and internally generated cash. Equity providers
require a rate of return target, which is higher than the interest rate
of debt financing. This is to compensate the higher risks taken by
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equity investors as they have junior claim to income and assets of
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 4.1.2. Sources of Finance

 Lenders of debt capital have senior claim on income and assets of the
project. Generally, debt finance makes up the major share of investment
needs (usually about 70 to 90 per cent) in PPP projects. The common
forms of debt are:
 Commercial loan
 Bridge finance
 Bonds and other debt instruments (for borrowing from the capital market)
 Subordinate loans
 Commercial loans are funds lent by commercial banks and other financial
institutions and are usually the main source of debt financing.
 Bridge financing is a short-term financing arrangement (e.g., for the
construction period or for an initial period) which is generally used until a
long-term financing arrangement can be implemented.
 Bonds are long-term interest bearing debt instruments purchased either
through the capital markets or through private placement (which means
direct sale to the purchaser, generally an institutional investor.
 Subordinate loans are similar to commercial loans but they are

5 secondary or subordinate to commercial loans in their claim on income and

55 assets of the project.
 4.1.2. Sources of Finance

 The other sources of project finance include grants from various sources,
supplier's credit, etc.
 Government grants can be made available to make PPP projects
commercially viable, to reduce the financial risks of private investors, and to
achieve socially desirable objectives such as to induce economic growth in
lagging or disadvantaged areas.
 Many governments have established formal mechanisms for the award of
grants to PPP projects. Where grants are available, depending on
government policy they may cover 10 to 40 per cent of the total project
investment.

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 4.1.3 Financing Choice
 PortfolioTheory
 Options Theory
 Equity vs. Debt
 Type of Debt
 Sequencing

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 1) Financing Choice: Portfolio Theory
 Combined cash flow variance (of project and sponsor)
with joint financing increases with:
 Relative size of the project.
 Project risk.
 Positive Cash flow correlation between sponsor and project.
 Firm value decreases due to cost of financial distress
which increases with combined variance.
 Project finance is preferred when joint financing
(corporate finance) results in increased combined
variance.
 Corporate finance is preferred when it results in lower
combined variance due to diversification (co-
insurance).

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 2) Financing Choice: Options Theory

 Downside exposure of the project (underlying asset)

can be reduced by buying a put option on the asset
(written by the banks in the form of non-recourse
debt).

 Put premium is paid in the form of higher interest and

fees on loans.

 The underlying asset (project) and the option provides

a payoff similar to that of call option.

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 Financing Choice: Options Theory

 The put option is valuable only if the Sponsor might be

able/willing to exercise the option.
 The sponsor may not want to avail of project finance
(from an options perspective) because it cannot walk
away from the project because:
 It is in a pre-completion stage and the sponsor has provided a
completion guarantee.
 If the project is part of a larger development.
 If the project represents a proprietary asset.
 If default would damage the firm’s reputation and ability to
raise future capital.

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 Financing Choice: Options Theory

 Derivatives are available for symmetric risks but not

for binary risks, (things such as PRI are very
expensive).

 Project finance (organizational form of risk

management) is better equipped to handle such risks.

 Companies as sponsors of multiple independent

projects: A portfolio of options is more valuable than
an option on a portfolio.

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 3) Financing Choice: Equity vs. Debt

 Reasons for high debt:

 Agency costs of equity (managerial discretion,

expropriation, etc.) are high.

 Agency costs of debt (debt overhang, risk shifting)

are low due to less investment opportunities.

 Debt provides a governance mechanism.

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 4) Financing Choice: Type of Debt

 Bank Loans:
 Cheaper to issue.
 Tighter covenants and better monitoring.
 Easier to restructure during distress.
 Lower duration forces managers to disgorge cash early.
 Project Bonds:
 Lower interest rates (given good credit rating).
 Less covenants and more flexibility for future growth.
 Agency Loans:
 Reduce expropriation risk.
 Validate social aspects of the project.
 Insider debt:
 Reduce information asymmetry for future capital providers.
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 5) Financing Choice: Sequencing

 Starting with equity: eliminate risk shifting, debt

overhang and probability of distress (creditors’
requirement).

 Add insider debt (Quasi equity) before debt: reduces

cost of information asymmetry.

 Large chunks vs. incremental debt: lower overall

transaction costs. May result in negative arbitrage.

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 4.1.3. The Viability Gap Funding Scheme

 The viability gap funding scheme of the Government is an example

of an institutional mechanism for providing financial support to public-
private partnerships in infrastructure. A grant, one-time or deferred, is
provided under this scheme with the objective of making projects
commercially viable.
 The viability gap funding can take various forms including capital grants,
subordinated loans, operation and maintenance support grants, and
interest subsidies. A mix of capital and revenue support may also be
considered.
 A special cell within the Ministry of Finance manages the special fund,
which receives annual budget allocations from the Government.
Implementing agencies can request funding support from the fund
according to some established criteria. In case of projects being
implemented at the state level, matching grants are expected from the
state government.

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 4.1.4. Main Providers of PPP Finance

 The main providers of finance for the PPP project are:

 Equity investment from project promoters and individual investors
 National and foreign commercial banks and financial institutions
 Institutional investors
 Capital markets
 International financial institutions
 Loans provided by national and foreign commercial banks and other
financial institutions generally form the major part of the debt capital for
infrastructure projects. The rate of interest could be either fixed or floating.
Loans are normally provided for a term shorter than the project period.
Often two or more banks and financial institutions participate in making a
loan to a borrower known as syndicated loan. Refinancing of the loan is
required when the loans are provided for a maturity period shorter than the
project period.
 In addition to commercial banks, international and regional financial
institutions such as the World Bank or the Asian Development Bank often
provide loans, guarantees or equity to privately financed infrastructure
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 4.1.4. Main Providers of PPP Finance

 Institutional investors such as investment funds, insurance companies,

mutual funds, or pension funds typically have large sums available for long-
term investment and could represent an important source of funding for
infrastructure projects either through private placement or via bonds
purchases.

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 4.1.4. Potential Funders

 Consortium – Sithe Global and Aga Khan Development

Network for Bujagali Dam Project. A special purpose
vehicle (Company) required.
 Joint Venture – Equity can increase. Example
 Asian Development Bank
 African Development Bank
 World Bank
 China Exim Bank
 Private Sector Foundations
 Investors from matured economy with low growth

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 4.2 Due diligence

 When investors and financiers consider financing a project, they

carry out extensive due diligence work taking into account
technical, financial, legal and other aspects of the PPP deal.
 This due diligence is intended to ensure that the project company's
(or SPV's) business plan is robust and the company has the
capacity to deliver on the PPP contract.
 The financing arrangement for a large project can be quite
complex. For such a project the required finance typically comes
from a large number of providers

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 4.3. Financial structure

 
Why financial structures matter?
Careful analysis of alternative financial structures is required to
establish the right financing structure for a project.
As the expected return on equity is higher than the return on debt,
the relative shares of debt and equity in the total financing package
have important implications for the cash flow of the project.
Their relative share is also important for taxation purposes.
Generally, the higher the debt, the lower the tax on return.
However, a higher proportion of debt, requires a larger cash flow for
debt servicing, which can be problematic, especially in the early years
of project operation when revenues are generally low.
This is often the case in transport and water sector projects, which
implies high risks of default.

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 4.4 Cost of Capital

What is the cost of capital?

The cost of capital for a project is a weighted sum of
the cost of debt and the cost of equity.
The cost of capital is often used as the discount rate, the
rate at which projected cash flow is discounted to find the
present value or net present value of a project

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 Cost of Capital
 Risk is an important element which is factored in to determine the
cost of debt and equity. Interest rate charged by lenders will
depend on the level of risk they estimate for the project.
 The higher the risk perceived, the higher the interest rate will be
(interest rate can be decomposed as the sum of a risk free rate -
practically the rate at which government can borrow money from
the market - to which a risk premium is added).
 Similarly, the cost of equity is defined as the risk-weighted
projected return required by investors and is established by
comparing the investment to other investments with similar risk
profiles.
 Government regulators need to consider the cost of capital when
determining the appropriateness of tariff levels.
 Ideally, the Internal Rate of Return of a project should be equal to
its cost of capital. If IRR is greater than the cost of capital, the
concessionaire/investor makes excess profit, and if the IRR is less
than the cost of capital, the concessionaire/investor loses money
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and may even go bankrupt.
 Cost of Capital
Why the debt - equity ratio matters
Usually, banks will be more comfortable to lend to an
entity which has a higher share of equity as it makes the
project safer while investor will try to reduce equity
investments to the minimum to increase their potential
return through higher leverage.
How the cost of capital can be lowered 
The cost of capital of may be lowered through refinancing
of PPP projects after their construction phase.
Sponsors may be required to provide a significant amount
of equity capital at the beginning of a project during the
construction phase when the risk is high.
Once the construction is complete, the construction risks associated
with it have been overcome, and the cash flow begins to materialize,
the expensive equity or debt capital can be refinanced using cheaper
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 Cost of Capital

How refinancing helps 

The relationship between risk and return of a project
changes over different phases.
The highest level of risk exists during the construction
phase of a project when construction delays and cost
overruns can have serious consequences to a project's
success.
It is during this phase that investors require the highest
return on their capital to compensate for the risk, thus the
higher cost of capital.
Once construction is over and the cash flow from
operations has begun, project risks drop off substantially
and it is possible for sponsors to refinance at a lower cost.
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 4.5. Cash flow analysis

Why cash flow analysis is important?

It is important to analyze a project's cash flow as
available cash is used to service any debt obligations.
The analysis is done through the development of a cash
flow model.
Once the financial model for a project is developed, the
implications of alternative financial structures and effects
of changes in other parameter values on cash flow can be
analyzed.
The next figure shows a typical cash flow situation.

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 Part 4: Specify the outputs

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 Cash Flows Components

Critical components of a cash flow

model are:
•Capital investment
•Terminal cash flow
•Discount rate
•Assumptions on parameter values

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 Components of a cash flow model
 The capital investment is the cost of developing a project,
regardless of funding sources. Typical components of capital
investment cost are: land and site development costs, buildings and all
civil works, plant and machinery, and technical, engineering and other
professional service fees.
 The terminal cash flow is the cash that is generated from the
sale or transfer of assets upon termination or liquidation of the PPP
contract tenure. In the case of a PPP project, the residual or
transfer price is generally negotiated and included in the contract
agreement.
 The discount rate is the rate that is used to calculate the present
value of future cash flows. It is often the weighted average cost of
capital for the project from different sources.
 In order to calculate the future cash flows, it is also necessary to make
assumptions for important parameter values over the project's life. The
main parameters for which values need to be assumed include:
 interest and inflation rates, the pricing mechanism, demand for the goods and
services produced by the project, construction time, debt repayment method,
depreciation schedule, tax structure, and physical and technological lifetime of
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 Effects of Subordinate Debts

  Amount Coverage Ratio

Revenue: $1,050  

Senior claims: $700 1,050/700 = 1.50

Junior claims: $200 1,050/(700+200) =1.17

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 Subordinate Debts
 On a combined claim (if the whole amount of loan was of the same type,
i.e. senior debt), the coverage ratio is 1.17, which in most circumstances
would be considered low and not qualify for cheaper credits. The
coverage ratio, however, is significantly improved if the debt is divided
into two parts: a senior debt and a subordinate debt. As the senior debt
is only a portion of the total debt and has the first claim on all the
revenues available for debt service, its coverage is increased to 1.5 and
its credit quality would be enhanced. The credit quality is very important
to debt financing. With a good credit rating the project may find cheaper
debt financing.
 The availability of subordinate debt helps in reducing the risk to senior
debt lenders and allows the project sponsor to borrow at lower interest
rates. The subordinate debt provider, however, absorbs a share of the
risk if revenues fall short of debt service requirements.
 Because of this feature of subordinate debt in reducing the monetary
cost of debt, some governments provide loans to implementing agencies
(under public credit assistance programmes) to improve the credit
quality of senior debt. It lowers the risk to lenders and helps the
implementing agency to obtain loans at a lower interest rate reducing
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 4.6. Financial Indicators
A number of financial indicators are used to assess
the financial viability of a project and alternative
financial structures for its implementation. Some of the
main indicators include:
 Return on Equity (ROE)
 Annual Debt Service Coverage Ratio (ADSCR)
 Project Life Coverage Ratio
 Payback period
 Net Present Value (NPV)
 Financial Internal Rate of Return (FIRR)
These are explained next:
1) Return on Equity. The net income earned on an
equity investment. It measures the investment return on
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the capital invested by shareholders and should not be
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less than the expected return on equity.
 4.6. Financial Indicators

2) Annual Debt Service Coverage Ratio.

It is a measure that calculates the cash flow for a period in
relation to the amount of loan interest and principal payable for
that same period.
The ratio should be (at the minimum) equal to or greater than 1
as that demonstrates that the project is earning enough income to
meet its debt obligations. It is an important criterion used by
financiers to monitor financial performance of a project.
3) Project Life Coverage Ratio.
It is also similar to debt service coverage ratio but considers debt
service coverage on a given date based on future cash flows from
that date until the end of the project life.
This ratio enables lenders to assess whether or not there would
be sufficient cash flow to be able to service the debt in the event
that the debt needs to be restructured.
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 4.6. Financial Indicators
4) Payback period.
The length of time needed to recover initial investment on a
project.
It may be determined using either discounted cash flow or non-
discounted cash flow.
5) Net Present Value.
It is the sum of the present value of all future cash flows.
The present value refers to discounted value of cash flows at
future dates. A project is considered for investment if its NPV is
positive.
The Internal Rate of Return is the discount rate at which the net
present value of the cash flow of a project is zero. The IRR may be
calculated based on either economic, or financial (ie, market) prices
of all costs and revenues (or benefits). If the financial IRR is less
than the cost of capital, it implies that the project would lose
money. If the economic IRR is less than the opportunity cost of
capital (ie, a predetermined cut-off rate of investment), the project
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 4.7. Special nature of infrastructure financing
need
 Infrastructure financing needs investments over a much longer
period than for commercial loans. However, typical commercial
lenders find it difficult to work with long-term investments, e.g., on
the order of 20 to 30 years.
 The capital markets are most suitable sources for long-term
investments in the infrastructure sector (for the supply of both
equity and debt). Thus, a successful capital market is very helpful
for a thriving PPP programme in a country.
 Many countries have established special financing institutions to
meet the long-term debt financing needs for their infrastructure
sectors.
 Public-private partnership projects awarded to private companies
for development, financing and construction receive priority for
financing from such institutions.
 Another important role such financing institutions playing is the
refinancing of those private sector projects initially financed by
banks, which find long-term financing for infrastructure projects
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difficult.
 4.7. Special nature of infrastructure financing
need

 It may be mentioned here that in countries with large PPP

programmes, unlike in the past, domestic financing has become
more common than foreign investment.
 This trend is expected to continue in the future. This has made
establishment of special infrastructure financing institutions, and
development of domestic capital market and innovative financial
instruments more important.
 One major advantage of domestic financing is that it reduces the
risks due to fluctuation of the local currency. It also reduces
country's obligation to allow repatriation of capital and profit.

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 4.8. Compensation to project sponsor/developer

Forms of compensation to private sector

There are five main ways to compensate a private investor of a PPP
project:
Direct charging of users
Indirect charging of (third party) beneficiaries
Cross-subsidization between project components
Payment by the Government (periodic fixed amount or according
to use of the facility, product or service)
Grants and subsidies (already discussed in a separate section)

1) Direct Charging of Users

Direct charging of users by the private investor is most common for
economic infrastructures such as power, telecommunication, water,
and transport, particularly for port, airport and railway projects. In
case of road projects however, compensation may be made either
through direct charging of users or payment by the government.
Direct charging of road users may not always be possible because
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 4.8. Compensation to project sponsor/developer
Forms of compensation to private sector
2) Payment from indirect beneficiaries
Systems for collecting payment from the indirect beneficiaries of
transport projects can constitute a major source of funding.
Such systems, which include a capital gains tax in the form of
certain land-related taxes and fees imposed on property owners
and developers, are used, for example, in China; Hong Kong,
China; and Japan as well as in the United States of America to
capture a part of the development gains generated by new
transport projects.
However, in most countries such payment systems either do not
exist or have very limited applications. Japan and the Republic of
Korea have used the land readjustment tool for the financing of
urban infrastructure projects.

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 Land readjustment
 Land readjustment is a comprehensive technique for urban
area development that provides network infrastructure and other
utility facilities and amenities in an integrated manner together
with serviced building plots.
 This approach is also known as land pooling or reconstitution of
plots. It may be undertaken by a group of landowners or by a
public authority.
 In this method all the parcels of land in an area are readjusted
in a way that each land owner gives up an amount of land in
proportion to the benefits received from the infrastructure which
is determined on the basis of the size and location of each site.
 The provision of public facilities enhances the land value and a
sound urban area is created.
 The land contributed by the landowners is used to provide
community facilities and amenities and can also be sold or
leased out to meet the project costs including those for the
infrastructure. 
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 3) Cross-subsidization in PPPs
 PPPs can be designed based on cross-subsidization between
project components, when excess revenues generated from one
component can be used to compensate the shortfall in another
component in order to make the whole project commercially
self-sustainable.
 The rail-property development model used in Hong Kong, China
is a good example of such an arrangement. In this model, part
of the profit made from real estate development on lands at or
close to station areas, and along the right-of-way of rail transit
routes is used to partly finance the rail system.
 A differential pricing policy with the objective of cross-
subsidization may be adopted in an urban utility service project.
For example, the industrial and commercial users of a water and
sanitation project in Tirupur, South India pay a higher price for
water to subsidise the residential users who are charged much
lower than the actual cost of water.
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 4) Government buys the service
on behalf of the beneficiaries
 The government can make payments of periodic fixed amount or
according to use of the facility, product or service at a
predetermined agreed price. This type of arrangement is
common for social infrastructures such as school, hospital and
other public buildings.
 Shadow tolling of roads is another example. Shadow tolls are
payments made by government to the private sector operator of
a road, at least in part, based on the number of vehicles using
the road.
 Shadow tolling is practiced in the U.K. However, instead of
shadow pricing, the government may also make payments of
periodic fixed amount, as the National Highway Authority (NHAI)
in India pays for their PPP projects implemented under the
"annuity model".

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 5) Why grants may be considered
 Grants and subsidies by the government, if available,
can be used to finance in part. Such grants and
subsidies can be justified on the following grounds:
 To meet public service obligations (PSOs)
 To achieve social objectives (for example, to
ensure no body is priced out in a water project)
 To rectify market imperfections (that create
externalities)
 To make economically viable and socially desirable
projects commercially viable
 The size of government support should depend on
what extent a particular project may qualify for such
grants and subsidies considering such grounds.
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