However, if the risk is one which carries a significant probability of inter- rupting or diminishing the payment stream that will service the debt, a signif- icant premium may be demanded to assume that particular risk. This in turn greatly increases the cost of financing the project. The private party’s uneasi- ness becomes more acute when the risk is not within its control. In such cases, it may be possible to change the nature of the risk so that it can be taken on.
If this cannot be done, it may well be more cost-effective for government to
‘take back’ the risk and reduce the costs of financing the project.
Hence one way to get value for money in a PPP is through sensible risk allo- cation, but it is not the only means. One of the appeals of PPPs is that they may be a vehicle through which the ‘can do’ mentality of the private sector is imported into public services, and the integrated PPP structure creates incen- tives to realize ‘synergy’ gains (such as fewer disputes between builder, opera- tor and owner and a closer examination of capital/maintenance costs) that are not available if the owner is government and the other functions are simply contracted out. Effective use of public funds on a capital project can accord- ingly come from private sector innovation and skills in asset design, construc- tion techniques and operational practices, as well as from shifting the responsibility for design risks, construction delays, costs overruns and finance and insurance to the private sector entities. Without the risk transfer the incen- tives would be blunted, and all parties need to understand the implications of the risks to be managed. The value-for-money test, considered in Chapter 6, is one way of drawing attention to the risks. So is the development of a risk matrix for the purpose of risk management and allocation, examined in Chapter 7. For the moment, we consider the parties to a PPP and their respective functions.
In a project, each retains its own identity and responsibilities. They combine together in the SPV on the basis of a clearly defined division of tasks and risks.
Special purpose vehicle
An SPV is simply a separate legal entity, generally a company, established to undertake the activity defined in a contract between the SPV and its client, in this case the public procurer. Execution of the activity generally requires the involvement of a number of parties, and the SPV enters into subcontracts with a number of organizations for the execution of these activities. SPVs are used in PPPs for the following reasons:
• to allow lending to the project to be non-recourse to the sponsors by virtue of the limited liability nature of the SPV;
• to enable the assets and liabilities of the project not to appear on the sponsors’ balance sheets, by virtue of no sponsor having more than 50 per cent of the shares in the SPV and the application of normal consol- idation principles when preparing the group accounts; and
• for the benefit of the project lenders, to help to insulate the project from a potential bankruptcy of any of the sponsors (‘bankruptcy remote- ness’).
Two approaches
Figure 5.3 illustrates the generic form of the consortium, which is likely to include debt financiers (often in a syndicate arranged through a bank), equity investors and sponsors (who invest in the fortunes of the project and are there- fore exposed to both the ‘upside’ and ‘downside’ risks), a design and/or construction contractor and the operator. In terms of which parties take the lead in organizing the arrangement and putting together the bid, there are two alternative approaches: the traditional construction and facilities management- led approach, and the new financier-led approach.
Traditional approach
The traditional approach, commonly seen in the UK, is for the contractors and the service providers to sponsor the SPV and to take equity stakes in it as a sign of their commitment to the project and its delivery. Financiers are involved in the consortium, and they may take minority equity stakes in the SPV and, as long run investors with a strong financial interest, may assume a more prominent role in the project after the construction phase is over.
Nevertheless, the initial organization and bidding process is directed by the engineering and construction companies in tandem with the facilities managers, third party equity investors and debt investors.
Financier-led approach
Under the newer financier-led approach that has developed in recent years in Australia, specialized investment banks have taken a more active role in managing the SPV from the outset. The bank invests the equity in the SPV, manages the bid, decides on the pricing, guarantees the commercial revenue from the project, underwrites the senior debt and subcontracts to the contrac- tor and the operator under a letter of credit issued to debt-holders. Obviously, the bank cannot perform all the functions and must liaise and conclude agree- ments with the other parties that come together contractually to form the consortium. Nevertheless, it is the investment bank that takes 100 per cent of the equity in the SPV and underwrites capital market issues and all other elements of the contract.
Pros and cons
It is fair to say that the development of the financier-led approach has caught the PPP industry by surprise and there has been some disquiet about its novelty and lack of road-testing, although there was an earlier precedent in the inter- national capital markets for the issue of new securities where the ‘bought deal’
(whereby one investment bank bids for a mandate at a fixed price and amount and places these in advance with institutional investors) superseded the old,
Gvt Advisers
Public Sector
Funding Advisers
SPV Advisers Operating
Company (SPV)
Debt Funding
Equity funding
Construct/
Manufacture ‘Hard’ Design/Spec Operation/FM
‘Soft’
Building Contractor
Equipment Provider
Services
Installer FM Catering Service
Support
Figure 5.3 Typical private sector consortium
cumbersome and drawn-out issue procedures organized by a syndicate of participating banks (Lewis and Davis, 1987, pp. 327–8). The bought deal gave greater certainty of process, faster placement and keener pricing, and much the same reasons underpin the financier-led model.
In the case of PPPs, of course, we are dealing not with a process over a matter of weeks but with procedures governing contractual arrangements last- ing 25–30 years. Concerns have been raised about the nature of the partner- ship created, and who bears the service performance risk, when the components are ‘unbundled’ by the financier into subcontracts after the bid is successful. Equity participation in the SPV is one way of aligning the interests of those involved in delivering the project with policy objectives and the long- term partnership with the government. Certainly, in the traditional approach, connectivity exists between service delivery outcomes, those providing the services (and taking the risks), and the extent and proportion of equity invest- ment from the contractors and service providers in a way that is not so readily apparent in the financier-led model.
Against this, there are clear pricing benefits when the whole process is an integrated one under the direction of the bank, one aim of which is to reduce transactions costs and generate a competitive bid. It also enables the bank to control the various elements that underpin the financing deal. This is a reflec- tion that financing in the PPP market is changing from traditional project finance to corporate financing methods, with the end process being the issue and underwriting of bonds that are placed directly with institutional investors.
In addition, some leading banks have created special ‘social infrastructure’
pooled investment funds and it remains to be seen to what extent they will look to direct the cash flows from the projects to those funds, tapping a wider investment market for infrastructure financing.
These two issues are taken up later when case studies of the two alternative approaches are presented in the final section of this chapter. One case study relates to the ‘traditional’ PPP project approach and involves privately built and operated prisons in Bridgend, Wales and Fazerkerley, Merseyside. The other case study is of a ‘financier-led’ PPP for the construction of a public hospital in Berwick, Victoria. In the meantime, bearing the distinction between the two models in mind, we now outline the role of the various participants.5