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Project finance for PPPs

Guidance

Guidance 1 HM Treasury (2006)
Preferred Bidder Debt Funding Competitions

Guidance 2 EPEC (2009)
The Financial Crisis and the PPP Market
Potential Remedial Actions

Abridged version of a study providing a framework for analysing some potential responses to the financial crisis (as it affects PPPs market across the EU) and identifying a list of issues and considerations for the attention of the public sector

Guidance 3 E. R. Yescombe (2007)
Public-Private Partnerships
Principles of Policy and Finance

Includes a good summary of what project finance is and why it is often used for PPPs

Guidance 4 G. Vinter (2006)
Project Finance
A Legal Guide

Includes discussions on how to negotiate a credit loan agreement and credit security and related issues

Conclude the financing agreements

PPPs are normally financed in whole or part through project finance arrangements (see Project Finance for an introduction to project finance issues as they apply to PPP projects). Insofar as possible, the Authority should require bidders to secure fully committed financing packages along with their bids. This will ensure that the finalisation of the financing agreements can take place simultaneously with or shortly after the signing of the PPP contract.

In difficult financial market conditions (e.g. reduced liquidity), fully committed financing packages may be difficult to obtain at the time of bidding. This may mean that the financing agreements will not be concluded immediately once the PPP contract is signed.

In the past, PPP financings for major transactions were usually provided through “syndication” arrangements, whereby a small number of banks underwrote the financing of the project and “re-sold” it to a syndicate of banks after financial close. Most PPP projects are now funded through “club deals”: each bank assuming it will hold its stake of project debt to maturity. In some cases, these club arrangements can only be concluded after the appointment of the preferred bidder (the so-called “post preferred bidder book-building” explained below).

The strength of the financiers’ commitment to fund the PPP project at the bidding stage will depend on the particular project and market. The Authority should at least require that bidders provide evidence of a reasonably deliverable financing plan in their proposals. Bidders should demonstrate that the debt, the equity and, where applicable, the grant providers have reviewed and accepted the broad design of the PPP and the major contractual provisions (e.g. the proposed risk allocation). A funding commitment from the lenders will often be conditional since they will generally not be in a position to complete their detailed due diligence and approval process until a few weeks before financial close.

Once the lenders have carried out their detailed review of the project documentation and their detailed due diligence, they will sometimes require changes to the PPP contract. The Authority’s ability to accept the lenders’ requests will be limited, as significant changes to the PPP contract will go against good procurement principles. Before signing the financing agreements, the lenders will also need to review and be satisfied with the full set of project contracts the PPP Company will enter into (e.g. construction contract, operation and maintenance contract).

In large PPPs, in particular in the UK, it is not unusual to see the Authority taking an active role in securing competitive financing terms by imposing a debt funding competition. A debt funding competition requires the preferred bidder to carry out a competition amongst potential lenders in order to obtain the best financing terms possible. The Authority picks up part or all of the benefits gained through any improvement in the financing terms. The Authority needs to oversee the competition process, which means that it often has to retain experienced financial advisers. Debt funding competitions may not be suitable for projects or in markets where financial innovation is expected to play a significant role in the competitive position of bidders. Moreover, it may not be suitable in conditions of limited financial liquidity. Guidance 1 In these circumstances, the private sector may need to engage in post-preferred bidder “book-building”, under which the full lending group is assembled using lenders that may have supported unsuccessful bidders. Guidance 2

A large number of financing agreements are needed for a project-financed PPP. These agreements have three basic purposes:

  • They are designed to protect the interests of senior lenders vis-à-vis other providers of finance (e.g. equity investors) and subcontractors of the PPP Company. In particular, the senior lenders will want to ensure that the risks borne by their borrower (i.e. the PPP Company) are satisfactorily mitigated. In practice, this means that, to the greatest extent possible, the risks borne by the PPP Company under the PPP contract are ‘passed through’ to the subcontractors.

  • The agreements need to clearly establish that the servicing of the debt takes priority over the remuneration of all other forms of finance (this is what “senior” debt means).

  • The suite of financing agreements is designed to ensure that, should there be problems with the project that jeopardise the servicing of the debt, the lenders have the powers to take the action they deem necessary to protect their loan.

This last point is crucial as it goes to the heart of the benefits that a PPP can deliver for an Authority. A well-designed PPP aligns the interests of the lenders with those of the Authority, as both parties aim to achieve a successful project. The lenders are incentivised and empowered to ensure that potential project problems are addressed in a timely manner and that their loan is safe. For this reason, the Authority should be able to rely on the incentives the lenders have to deal effectively with problems (during both construction and operation) that would threaten the project’s performance. This reliance on the lenders is a major source of risk transfer from the public to the private sector. Guidance 3

The typical financing agreements to be prepared and concluded comprise:

  • senior loan agreements: agreements between the lenders and the PPP Company setting out the rights and obligations of each party regarding the senior debt;

  • a common terms agreement: an agreement between the financing parties and the PPP Company which sets out the terms that are common to all the financing instruments and the relationship between them (including definitions, conditions, order of drawdowns, project accounts, voting powers for waivers and amendments). A common terms agreement greatly clarifies and simplifies the multi-sourcing of finance for a PPP project and ensures that the parties have a common understanding of key definitions and critical events;

  • subordinated loan agreements (where subordinated or mezzanine debt is used in the financing structure). These loans are provided by the project sponsors and/or by third party investors;

  • a shareholders’ agreement (as part of the constitutive documents of the PPP Company);

  • a direct agreement between the lenders and the Authority: this allows the senior lenders to take over the project (to “step in”) under certain circumstances specified in the PPP contract;

  • an accounts agreement: this involves a bank which will control the cash flowing to and from the PPP Company in accordance with the rules set out in the agreement;

  • an intercreditor agreement: an agreement between the creditors of the PPP Company that spells out aspects of their relationship with one another and the PPP Company, so that, in the event of a problem emerging, ground rules will be in place;

  • hedging agreements: agreements which enable the PPP Company to fix the interest rate on all or part of its debt or to limit its exposure to exchange rate risks;

  • security agreements (e.g. share pledge, charge over accounts, movables pledge, receivables pledge);

  • parent company guarantees and other forms of credit enhancement where the sponsors of the PPP Company or its subcontractors do not offer sufficient financial strength; and

  • legal opinions from the lender’s legal advisers on the enforceability of the contracts. Enforceability of contracts is a key issue the lenders will tackle in their due diligence. This will include the review of the powers of the Authority to enter into transactions (the so-called vires issue).

The financing agreements often contain many cross-references and will have to be prepared as a coherent package. Guidance 4