October 1, 2012
FOR REVIEW BY P3 EVALUATION TOOLKIT BETA-TESTERS
Most P3 projects are financed through the concessionaire by using a combination of private equity and debt. This combination of sources of capital, referred to as "financial structure," impacts the cost of capital employed for the funding of a P3 investment. The nature and sources of financing will depend on a wide range of aspects, such as the project characteristics and its general risk structure, possible public sector financial support, the ability of the concessionaire to raise capital, the interest of third party investors, the availability of capital markets and the time available for raising the financing.
The Role of Equity Investors
Equity investors assume the highest risks but may also receive the highest returns. Subcontractors, who sign contracts with the concessionaire to perform specific services such as the construction, operation, and maintenance of the project, may contribute an equity stake as well. Other potential investors include financial institutions, such as investment banks, insurance companies, pension funds, foundations and infrastructure investment funds. These institutions may also serve in the role of a lender, along with commercial banks and public agencies.
Infrastructure investment funds attract money from long-term investors such as pension funds, insurance companies and foundations. They are attracted to highway infrastructure projects since they often offer stable cash flow with a moderate risk. They help the concessionaire to structure project financing and make projects "bankable," providing equity (and sometimes subordinate debt) for P3 projects.
Equity investors become owners of the concessionaire (i.e., shareholders) in proportion to their share of capital and expect to be remunerated from their invested capital through the payment of dividends. Dividends are usually paid on a yearly basis from the (after tax) profit generated by the concessionaire, after lenders are paid.
Equity investors are exposed to greater financial risk than lenders because project revenues typically must be used to pay operational costs and repay lenders before equity investors can be paid. If a project does not generate sufficient anticipated revenues, equity investors may lose some of or their entire investment. Equity investment also has a potential upside, as surplus net revenue from efficient management of costs or higher than expected revenues is captured in dividends to investors (although they may be subject to revenue sharing provisions with the public sector if revenues are higher than expected). As a result of the risks that equity investors take, the expected rate of return on equity may be significantly higher than the expected rate of return on debt.
Equity investors may also receive tax benefits from their investment. The tax benefits of equity investment, i.e., depreciation deductions that shield other taxable income, may account for 10 percent or more of the project’s value to the investor. These tax benefits vary over the period of the agreement and may be factored into the bids of project sponsors.
The Role of Private Lenders
Private debt is mainly made available by commercial lenders through bank loans or by the capital markets through bonds. Subordinated debt can also play a limited role in financing P3 projects. Maturity (i.e., term of the loan or bond) and interest rates depend on the project specifics.
Private lenders are often investment or commercial banks that specialize in project finance. They tend to be more conservative and have a lower risk tolerance than equity investors and seek a fixed rate of return, i.e., a return with no upside potential. They require lower rates of return than equity investors, but seek to structure deals that minimize their risk by ensuring that they have first call on the net cash flows of a project.
Lenders undertake extensive and detailed reviews of the project’s financial model (discussed in Chapter 6) and require "investment grade" traffic and revenue studies (for toll concessions) to assess the risks of a project and determine if it is a good credit risk. They want to see that there is a reasonable expectation that the project can be completed on time and on budget; that the revenues and expenditures are relatively predictable; and that projected net cash flows are adequate to cover debt service payments. If lenders perceive that a project is less risky, they may be willing to lend more. If lenders perceive more risk, they will demand greater investment of equity, thereby raising the overall cost of the project, since equity requires a higher rate of return than debt.
Lenders maintain oversight responsibilities throughout the term of their loan and may retain "step-in" rights that allow them to take over a project that is not meeting expectations.
Bank Loans: Commercial banks have an interest in being paid back as quickly as possible and often structure loans to encourage refinancing after seven to ten years, which tends to coincide with the initial period of construction and project "ramp up", (Ramp up is the period during which traffic demand has yet to rise to the levels forecasted by travel demand models because potential users are not familiar with the new travel option.) Consequently, borrowers often seek to refinance their loans after seven to 10 years.
The normal approach to arranging a project-finance loan is to appoint one or more banks as "Lead Arranger(s)." Lead Arrangers may reduce their exposure (i.e., risk that they may not be able to resell the loan) by "placing" part of the financing with other banks in the market in advance of closing the loan. This loan-sale process is known as "syndication." Some bank loans are rated by credit rating agencies (see Chapter 4) to assist in wider syndication.
Taxable Bonds: Buyers of taxable bonds are typically institutional investors such as insurance companies and pension funds looking for a predictable long-term return on investment. As indicated in Chapter 4, bonds offer advantages over commercial loans such as greater capacity, lower interest costs, and longer terms; however, they can be less flexible than loans. An investment bank arranges and underwrites financing. The issuer (i.e., the concessionaire) makes a presentation to a credit rating agency (e.g., Standard & Poor’s, Moody’s or Fitch), which assigns the bonds a credit rating (see Chapter 4).
The Balance Between Private Equity and Debt
Every P3 project must bring in equity. Equity plays an important role in strengthening incentives for the private sector to perform efficiently and effectively and can be vital in attracting private lenders to a project. Commercial bankers take comfort from the borrower investing considerable amounts of its own money before borrowing. Additionally, if the project gets into financial difficulties and its (resale) value decreases, the equity portion can provide a buffer for the debt providers since the balance of the debt could still likely be paid back from sale proceeds in case of bankruptcy of the concessionaire (although equity investors could lose most or all of their equity).
The amount of equity depends on the maximum amount of debt sustainable by the project, given the revenue stream and risk profile. Projects are structured so that debt service payments can be met by project income under various risk-based scenarios. The equity share can be somewhat lower for shadow toll and availability payment concessions, since the economic risks are much lower than those for toll roads. Toll-based concessions typically require a relatively high level of equity (about 20% - 30% of the total funding needed), while projects financed on the basis of a shadow toll payment or availability payment may require only 10%-20% equity.
The ratio of debt to equity is called "leverage." Higher leverage helps to ensure a lower cost to the public agency, as illustrated in Table 5-1, which is a simplified example. As the table shows, if the required return for equity investors is 15 percent, annual net revenue of $100 million is required with a low leverage of 50/50 (debt-to-equity ratio), but only $69 million is required using high-leverage financing of 90/10. Availability payment or toll revenue requirements would likewise be reduced. Note that the interest rate on debt may be higher when leverage is higher (due to the higher risk for lenders), but the net effect is still favorable with respect to the amount of net annual revenue required to provide for returns demanded by investors.
|Low Leverage||High Leverage|
|Project cost (million $)||$1,000||$1,000|
|(c) Return required on equity [(b) x 15%]||$75||$15|
|(d) Interest rate on debt (per annum)||5%||6%|
|(e) Interest payment [(a) x (d)]||$25||$54|
|Revenue required [(c) + (e)]||$100||$69|
|Adapted from E.R. Yescombe, Public-Private Partnerships: Principles of Policy and Finance|
Equity investors have an interest in maximizing the return on their investment by borrowing as much as feasible, i.e., maximizing the leverage of their equity. If equity investors are able to achieve higher lender participation, they may be able to accept lower revenues and still make the same or higher returns on a percentage basis.
Table 5-2 illustrates the effect of higher leverage on equity return. For a $1 billion project that achieves $75 million per year in net revenue over the life of the investment, greater leverage – that is, higher levels of debt – lowers the amount of equity that investors must contribute to the project up front. If the investors only have to contribute $100 million, with $900 million covered by debt, they will realize $12 million in profit once the revenue has been realized and interest is paid. That represents a 12 percent return on their investment. By contrast, if the equity investors have to contribute $400 million, they may have lower interest costs due to lower risk to lenders, but the profit of $39 million will represent only a 10 percent return on their investment.
|High Leverage||Low Leverage|
|Debt (in millions)||$900||$600|
|Equity (in millions)||$100||$400|
|Annual Net Revenue (in millions)||$75||$75|
|Interest Rate on Debt||7%||6%|
|Interest Payable (in millions)||$63||$36|
|Profit (in millions)||$12||$39|
|Return on Equity||12%||10%|
|Adapted from E.R. Yescombe, Public-Private Partnerships: Principles of Policy and Finance|
Debt may be "structured" or "sculpted" to match project characteristics. This section discusses some techniques used to structure debt over the life of the project to match expected cash flows.
Loan repayments generally begin about 6 months after the construction of the facility is completed and are usually made at 6-month intervals. Project-finance bonds are also generally repaid in a similar way to loans. Repayments (known as "debt service") are normally based on an "annuity" schedule, i.e., with level payments over the life of the debt, similar to payments on a home mortgage. However, there will often be variations in the cash flow (e.g., due to a cyclical maintenance schedule). The loan repayment schedule may need to be "sculpted" to smooth these out and ensure that net cash flow is always sufficient to make the debt service payments.
For toll concessions, usage levels could be lower than anticipated during ramp-up. To provide some flexibility to the concessionaire, lenders may agree to flexible repayment, by agreeing to two repayment schedules: the first would be the level that the lenders wish to receive if the ramp-up is as expected, and the second would be the minimum level of payment required to avoid default by the concessionaire. In the second case, payments in later years would be higher to compensate for the lower payments during the early years.
On some toll projects with a long concession period of 50 or more years, traffic growth may be expected to be slow but steady over the first 15 – 20 years. With "capital accretion bonds," interest and principal repayments can be delayed for several years after completion of construction. This is done by capitalizing all or part of the interest on the bond and adding it to the principal amount. The peak loan balance may occur after 15 – 20 years, and the bond is repaid thereafter.
In markets where lenders are reluctant to lend for the longer term, a balloon structure may be used. In the U.S., banks provide short-term construction loans, which are refinanced by long-term "permanent" loans or bond issues sometime after construction is completed. Principal repayments after completion of construction are based on a long-term debt-service schedule, but are cut off after 3-5 years, giving rise to a balloon repayment of the balance of the loan.
There are often constraints imposed by lenders that affect debt structure. For example, the lenders’ requirements for a "cash-flow tail" determine the length of debt financing. The cash-flow tail is the period between the scheduled final repayment of the debt and the end of the P3 contract, during which revenues continue to be received by the concessionaire. If the cash-flow during the term of the loan is not sufficient to repay the debt, there may still be sufficient cash flow left at the tail end of the P3 contract to ensure full repayment of the debt.
However, the longer the tail period, the higher the availability payments or toll revenues will have to be, because debt will need to be repaid over a shorter period. Also, equity dividends will be pushed to the back of the P3 contract term, reducing their value due to discounting. (Discounting is discussed in Chapter 7).
In some cases, lenders may require a "cash sweep." A cash sweep requirement forces all of the cash-flow that would otherwise have been distributed to investors to be used for debt repayment instead or placed in a reserve account to secure the debt. It may be used where a balloon-payment structure is used, to encourage refinancing of the debt well before the final balloon repayment date. It may also be used where there is uncertainty about the growth of future revenues, where lenders are concerned about the tail risk, or where substantial costs are to be incurred a long time into the future, e.g., for renewal, replacement or expansion of the highway facility.