ENABLERS TO THE PUBLIC PRIVATE PARTNERSHIP PROCUREMENT PROCESS
3.3 Project Financing
Mangan, et al. (2012) defines a sourcing strategy as a business case used by an organisation to decide on the best way to procure resources. Chew, Jr. (2001) concedes that project financing is expensive to arrange as it involves establishing the project company and the treasury guidelines refer to it as a project advisory council. Government commonly advertises for competing bids as a sourcing strategy. In preparing their bids, “companies recognize both the cost of doing so and the probability that they will not be awarded the contract” (Shendy, et al. 2013:19)
3.3.1 The Agency Theory
This section presents and analyses the sourcing strategy for any organisation or partnership to source funding for big projects. It further provides the origins of the agency theory and traces the theoretical background that led the South African Treasury, in particular, to develop PPPs as a procurement process. Sourcing strategies are the first steps for any organisation to consider as to how they will assist in securing supply either on a local, national, regional or global basis, and interact with the market place and suppliers. A sourcing strategy with a clearly defined requirement “should include the level or amount of spend to be considered and the potential risk involved” (Timothy, 2007:81). There is also a need to consider whether supply is needed for a once–off project or recurring project, market maturity, technology lifecycle of the market, number of sources and potential suppliers, contract duration and potential for performance improvement and cost reduction.
Throughout most of the history of the industrial world, much of the funding for large-scale public works such as roads and canals has come from private sources of capital, (Timothy, 2007). It was only towards the end of the 19th century that public financing of large
‘infrastructure’ projects began to dominate private financing and these trends continued to date. The principal features of such project financing have been where a project is established by a separate company which operates under the concession obtained from the host government; a major proportion of equity of the project company is provided by the project
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manager or sponsor thereby trying to the provide finance for the management of the project;
the project company enters into comprehensive contractual arrangements with the suppliers and customers, and lastly, the project company operates with a high ratio of debt to equity, with lenders having only limited resources to the government or to the equity-holders in the event of default (Shendy, et al., 2013). These characteristics clearly distinguish project finance from traditional lending.
Centralization appears as a clear trend in sourcing strategy for public procurement (Dimitri, et al., 2006). Governments all over the world are encouraging public sector organisations to collaborate in purchasing, so as to achieve economies of scope and scale, with examples including the United Kingdom, The Netherlands, United States, and Australia (Reeves, 2014).
If purchasing is decentralized, all governmental units and agencies have the flexibility to order products and services according to their needs. However, many of these needs are similar across agencies (e.g., office supplies, cleaning services), and the government forgoes certain benefits if such purchases are not coordinated from the centre (Obicci, 2017), hence the rise of centralized strategies of sourcing.
According to the agency theory, management acts as agents of control for others. Thus, it treats incentives as the centre of success within the public private partnership procurement method. The big question though, relates to how the different kinds of financing within the procurement process influence the project selection and support by the managers or leaders within an organisation. The critique of this section is that it provides the theoretical background on the key element that actually has driven government entities in response to the shortage of infrastructure funding, to consider other project financing options which have led to the PPP procurement process.
The agency theory by Chew, Jr. (2001) advocates the view that the foundation of project financing is contained within agency theory which suggests that management is retained to run firms which they do not necessarily own. It provides a study on management acting as agents of control for others. It further treats agency theory and incentives as the centre of success within the public private partnership procurement method. The big question concerns how the different kinds of financing within the procurement process influence the
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project selection and support by managers or leaders within an organisation. The critique of this section is that it provides the theoretical background of the key element that actually has driven government entities in response to the shortage of infrastructure funding, to consider other project financing options that have led to the PPP procurement process, (Bailey, 2003).
Throughout most of the history of the industrial world, much of the funding for large-scale public works such as roads and canals have come from private sources of capital with larger public funding for infrastructure starting to emerge only towards the end of the 19th century (Bodmer, 2017; Brealey & Myers, 2002).
Zein (2016) argues that a project is established by a separate company, which operates under the concession obtained from the host government; a major proportion of equity of the project company is provided by the project manager or sponsor thereby tying the provision of finance to the management of the project. The project company enters into comprehensive contractual arrangements with suppliers and customers, and lastly, the project company operates with a high ratio of debt to equity, with lenders having only limited recourse to the government or to the equity-holders in the event of default. These characteristics clearly distinguish project finance from traditional lending. McLaney (2003:72) argues that “in conventional financing arrangements, projects are generally not incorporated by separate companies.” This study notably, also sought to briefly explore some rationale for project financing from the view point of both the private sector and the public sector. Thus, this section probes the notion that project financing represents ‘expensive’ finance for the government and contrast project financing with other private-sector options such as privatization and the use of service-contracts with private-sector companies. Chew, Jr.
(2001:36) argues that “a government that uses project finance to fund a project obtains both private-sector funding and management.” Project finance, therefore, reduces the need for government borrowing and shifts part of the risks presented by the project to the private sector and thus, aims to achieve more effective management of the project.
Project finance, therefore, reduces the need for government borrowing and shifts part of the risks of a project to the private sector as well as including the overall aim for more effective management of the project (Shendy, et al. 2013).
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Robinson, et al. (2010) identifies some desired results for a public private partnership process, that is, value for money, risk transfer, skills transfer and whole life cycle. On the topic of value for money, Robinson (2010) asserts that value for money is central to the PPP debate.
In the United Kingdom, PPP policy argues that they should be used only where a PPP is demonstrated to provide value for money compared to the traditional public sector funded route. Value for money, as argued by Robinson (2010:17) “is the optimum combination of whole life costs (capital and operating costs) and quality of services to meet the requirement of a public sector.” On the risk transfer, Robinson, et al. (2010) asserts that it is important to investigate the type and level of risk involved in a PPP project, and then develops the risk matrix and decides to allocate or retain the risk to the party best suitable to manage such.
According to Robinson (2010:21) the PPP option is selected “only if the whole life cost of the private sector bid is lower than the hypothetical risk adjusted by the Public Sector Comparator based on the same level or quality of service.” On costing, the value of risk transfer is important in determining the bid cost from the private sector perspective and to assess whether it represents value for money or not. On skills transfer, this can be divided into two categories. Firstly, where there is a lack of knowledge to inform decision making, specifically, financially based decision making required by the project operation. Secondly, the transfer of knowledge between various stakeholders is required for both intra and inter projects knowledge transfer. In the Whole Life Cycle Commitment, the whole life approach of PPPs leads to efficiencies through synergies between design, construction of assets and its later operations. Having gone through the analysis of strategic sourcing, definition and analysis of agency theory and the development of project financing in the public private partnerships procurement process, the next focus is on sourcing corporate funding.
3.3.2 Sources of corporate funding
This section analyses the dynamics faced by large scale projects in sourcing funding and responds to the question of why a public private partnership procurement process is a solution to the funding challenges for big projects. Pike and Neale (2003) argue that large scale strategic projects, such as the construction of tunnels, roads and power stations, are often funded through project finance.
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Lewis & Roehrich (2009:91) are of the view that “the private finance initiative (PFI) is a way of creating ‘public–private partnerships’ (PPPs) by funding public infrastructure projects with private capital.” The private finance initiative was developed initially, by the governments of Australia and the United Kingdom, and used extensively there. PFI and its variants have now been adopted in many countries as part of the wider program of privatization and financing model driven by an increased need for accountability and efficiency for public spending. PFI has also been used to place a great amount of debt 'off-balance-sheet.’ Lewis and Roehrich (2009) further contend that PFI has been controversial in the UK; as attested by the National Audit Office in 2003 that it provided good value for money overall (Bodmer, 2017). However, recently the British Parliamentary Treasury Select Committee found that PFI should be brought on a balance sheet. In this regard, Treasury should remove any perverse incentives unrelated to value for money by ensuring that PFI is not used to circumvent departmental budget limits. Campbell, et al. (2003) assert that financial resources, as we have already learned, are an essential input to strategic development. To this end, capital for development can be raised from several sources like share capital, rights issue capital, retained profits and through the disposal of existing fixed assets.
In unpacking these, this study investigates the relevance or applicability of these options within government entities. The key concept of capital according to Campbell et al. (2003) is described as:
“[o]ne particular type of ‘money’. Capital is usually contrasted with revenue. Revenue is money that is earned through normal business transactions and capital is money that is used to invest in the business. The investment of capital enables the business to expand and, through expansion, to increase its financial sustainability. Capital can be raised from shareholders, through retained profits, through rights issues, through loan capital and through the disposal of assets.” (p. 46).
The complication in these financial resources is that they may be an option for a private sector, but not necessarily for a public or government entity. This challenge amongst other issues, was one of the reasons that prompted the consideration of the PPP procurement process. In the discussion that follows, each of these is dealt with in relation to its applicability within the current set up within government entities.
Campbell, et al. (2003) argue that in most limited companies, a sizeable proportion of capital is raised from shareholders (the financial owners of the company) in the form of share capital.
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Share capital, historically, has comprised the majority of capital for a limited company’s start up and subsequent development.
Under normal circumstances, share capital is considered to be permanent as it is not paid back by the company. The shareholders’ payback is only in the form of dividends and this is not applicable to a government entity as the government is the shareholder (an institutional shareholder) and the straight definition of dividends is not applicable. So, this approach of funding was not an option. The next option was the loan capital. The loan capital, according to the document on strategic management for travel and tourism (Offutt, 2011) refers to the use of retained profits to fund corporate developments. This is clearly the ability of the company to actually make a profit that can at least in part be distributed to the shareholders as dividends. Some profits are made available to this form of a loan and the interest is paid every year to this loan. Esty (2004) argues that the profits generated by government entities are generally not sufficient to cover the interest nor fund projects as loan funding. Hence, this as well, was not an option for funding large capital projects. The next is the right issue capital. This is when a company issues new shares to a stock market. The new shares might provide access funding for capital projects. Government entities are also unable to sell shares for this option; hence, it is not feasible. The last option as covered by Campbell et al. (2003) is the disposal of assets. This could not be done without some compromise in control, hence, it was also not an option.
The other option provided by McLaney (2003) is the grant funding to public entities. The government in this case, sets up an entity to fund projects be they private or public. This is because of its flexibility as developed and designed by government to support within its environment, was a possible option. However, with most governments, it had to be considered in partnership with the private sector. This therefore, led analysts to consider the procurement process as an option for engaging the private sector and thus address organisational funding requirements. Hence, it was important to look at the procurement process as an area of opportunity. Following is an explanation of the role of agency theory and project financing guiding the procurement process and how it influences government agencies.
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Campbell, et al. (2003:17) argue that “given the financial constraints experienced by states and municipalities, the proceeds of PPP’s could help by providing budgetary relief.” However, all the PPPs that have come into place over the last five years have focused on long term investments and partnerships. Arguably, as the state or local government budget continues taking strain, PPP’s are likely to become a steadily increasing part of the dialogue around deficit solutions (Offutt, 2011). According to Offutt (2011),
“The PPPs recently executed in the space, suggest the potential forms that future transactions will take: long term revenue sharing arrangements, green-fields projects using availability payment structures, and ‘new’ brownfield leases predicated on capturing the benefits of the private sector operations” (p.78).
3.3.3 The influence of law on project funding
A major impediment to private-sector involvement in infrastructure development and maintenance in the U.S. is the lack of Public-Private Partnership legislation since approximately only half of stateshave the legislation to facilitate PPPs (Stanley, 2010). This is true for many countries. With the challenges presented above, the big question relates to why the public private partnership procurement processes are an option for consideration when looking for a funding model (Wahba & Stanley, 2011). This is accounted for by the fact that the private sector is more efficient than most government run entities as argued by Stanton (2012). In a private system, costs are continually being contained, if not, the owner of the business will make no profit. This is because in a competitive environment, the competition will cut their costs and sell at an affordable price. Alternatively, the private company may try to supply more value for the same money. Companies constantly strive to improve their services and lower their costs. Government organisations are managed differently. Generally, there are no such incentives to control costs. If the government organisation makes a loss, the government pays for it. What complicates the situation is that the civil servant with more staff and the biggest budget to spend is considered most important and gets paid the biggest salary. There is an incentive to increase the budget and spend more (Shaw, 2002).
Robinson, (2010) asserts that PPP projects are usually funded on the principle of project finance. In this regard, the source of funding affects the project cost, revenue, risk allocation
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and also the project’s viability. Sources of finance, whether debt or equity, affect the level of risk, returns, lending term and various other conditions. Pike & Neale (2003) argue that large scale strategic projects, such as the construction of tunnels, roads and power stations, are often funded through projects finance. Here, the operation is financed and controlled separately from the operations of the constructor or user. Campbell et al. (2003:49) claim that “financial resources, as we have already learned, are an essential input to strategic development.” Capital for development can be raised from several sources like share capital, rights issue capital, retained profits and through the disposal of existing fixed assets. The key concept of capital, according to Campbell et al. (2003:50), “is described as one particular type of money. It is usually contrasted with revenue. Revenue is money that is earned through normal business transactions and capital is money that is used to invest in the business. The investment of capital enables the business to expand and through expansion, it increases its financial sustainability. Capital can be raised from shareholders, through retained profits, through rights issues, through loan capital and through the disposal of assets.” The complication in these is that they may be an option for a private sector, but not necessarily for a public or government entity. This challenge, amongst other issues, was one of the reasons that prompted consideration of the PPP procurement process. Following is a consideration of each of these in relation to its applicability within the current set up within government entities.