Government Efficiency Unit, Hong Kong SAR PPP Project Financing

1. Government Efficiency Unit, Hong Kong SARPPP Project Financing Introduction and overview of PPP project financing Rupert Sydenham, Partner September 2005

2. Presentation content • Key PPP concepts • Receivables financing • Basic sources of funding • Basic funding characteristics • Features of equity • Features of debt • The key to success

3. Key PPP concepts • PPP is a structure for long term service provision using project-dedicated assets • Public sector employs private sector finance to fund public service infrastructure • Capex (and other costs + profit) recovered over time from service fee

4. Key PPP concepts • Performance related payment • “no service, no fee” • For private sector to pay costs and make a profit from the scheme, there must be: • a robust income stream, ie, predictability of amount and timing of payments • effective risk allocation and management • These are characteristics of “receivables financing”

5. Receivables financing • Debt is raised on the security of the income stream • There is: • limited, basically unrealisable, asset security • limited sponsor (shareholder) support

6. Receivables financing Loan Sponsors Project Co Lenders Sponsors/ Project Co Income Stream Project

7. Receivables financing • Typically a “special purpose company” / “project co.” is formed to hold the concession • to ring fence project assets: a new business • to protect sponsor groups’ other assets (exposure would increase price)

8. Receivables financing • Repayment depends on earning the service fee • So financiers need to be confident the income stream (amount and timing) will be preserved • This means the performance of the project to contractual standards must be viable

9. PPP Project Finance (Receivables Financing) 1: basic deal Promoter Concession Agreement/ project permit Project Company “Public sector” “Service delivery”

10. Receivables financing • To obtain service payments, Project Co. must: • procure the assets • provide the services • Typically Project Co. does this through sub-contracts • (Project Co. retains single point responsibility to client)

11. PPP Project Finance (Receivables Financing) 2: project delivery Promoter Concession Agreement/ project permit Project Company EPC Contract Builder(s) ServiceProvider 1 Services Agreements ServiceProvider 2 Insurance Package Insurers “Public sector” Feedstock Contract Supplier “Service delivery” “Others” Offtake Contract Purchaser

12. Receivables financing • The assessment of project viability involves close scrutiny: • Technical achievability • is the technology tried and tested? • what could go wrong with construction or operation?

13. Receivables financing • Legal framework • what is the effect of underlying law/regulation eg health & safety/ environmental/pricing control? • does the public sector have legal capacity to undertake the scheme? • what is the effect of the contract and sub-contract terms? • How are they interpreted? • Are they enforceable?

14. Receivables financing • Commercial achievability • what are the underlying market forces eg demand risk? • are there adequate available resources (people & know how)? • finance • what is the credit risk of each participant? • financial modelling of revenue and costs

15. Basic sources of funding • Project sponsors • shareholders in project co. providing shareholder funds: “equity” • Lenders • commercial banks / multilateral agencies / capital markets - bonds

16. Basic funding characteristics • Two basic types • debt (loans) • equity (shares) • Type of funding influences • the provider’s attitude to risk • the cost of funds

17. Basic funding characteristics • Debt is cheaper than equity • Debt takes fewer risks, so • is paid first • needs lower returns (lower interest) than equity • Risk aversion leads to pressure for clarity in risk allocation • So debt is less flexible than equity

18. Basic funding characteristics • Equity is more entrepreneurial than debt • Equity makes seasoned judgments on risk • For a higher investment return, paid after debt service

19. Basic funding characteristics • Typically, the Project Co. will be highly geared • say 80:20 debt:equity ratio • 80%: to exploit cheaper debt • 20%: to absorb risk (the “equity buffer”) and incentivise sponsor supervision

20. Features of equity • Shareholders often investment arms of contractor and operator • conflict of interests • Venture capitalist may provide true “ownership interest”

21. PPP Project Finance (Receivables Financing) 3: equity finance Promoter Concession Agreement/ project permit EquitySubscription Agreement Holding Company Equity Project Company EPC Contract Builder(s) ServiceProvider 1 Shareholder Agreement Services Agreements Sponsor 1 Sponsor 2 ServiceProvider 2 Insurance Package Insurers “Equity finance” Feedstock Contract “Public sector” Supplier “Service delivery” Offtake Contract “Others” Purchaser

22. Features of equity • Shareholder funds can take the form of true shares or loans • Shareholder loans (“quasi-equity”) • subordinated to external debt • flexibility (capital repayment/interest: freedom from Companies legislation rules on distributions and capital reductions)

23. Features of debt • Senior commercial debt is the traditional funding source • experienced lenders • so, active management • so, tight covenants

24. PPP Project Finance (Receivables Financing) 4: debt finance Promoter Concession Agreement/ project permit EquitySubscription Agreement Holding Company Senior Lenders Debt funding Equity Project Company Bond Holders Third Party Funders EPC Contract Builder(s) ServiceProvider 1 Shareholder Agreement Services Agreements Sponsor 1 Sponsor 2 ServiceProvider 2 Insurance Package Insurers “Debt finance” Feedstock Contract Supplier “Equity finance” “Public sector” Offtake Contract Purchaser “Service delivery” “Others”

25. Features of debt • Construction phase • period of highest risk for lenders • so higher interest rate • Operations phase • objective test of completion/commissioning • cash flow starts; debt service begins

26. Features of debt – Lender controls • Draw down against construction milestones • Controls (matrix) • Sanctions • draw stops and lock up • acceleration • Reserve accounts • Priority of payments • Performance ratios (actual and forecast)

27. Features of debt – Mezzanine debt • Subordinate to senior debt, but paid in priority to equity • Takes some equity risks, encouraging senior lenders, at cheaper cost than equity • Less control/protection than senior debt • Commensurately higher interest rate • Can take the form of preferred shares or subordinated debt

28. Features of debt - Intercreditor issues • Different funding layers require co-ordination • Extent of subordination • Extent of senior funder controls • Priority of payment • “cascade”/“waterfall”

29. Features of debt – Debt security • Asset security is mostly defensive • Security assignment of receivables and other rights is key • Direct agreements • with public sector • with sub-contractors

30. PPP Project Finance (Receivables Financing) 5: security package Promoter Concession Agreement/ project permit Direct Agreement EquitySubscription Agreement Debt funding & security package Holding Company Senior Lenders Equity Project Company InterCreditor Agreement Bond Holders Third Party Funders Security Assignments & Direct Agreements EPC Contract Builder(s) ServiceProvider 1 Shareholder Agreement Services Agreements Sponsor 1 Sponsor 2 Security Assignments & Direct Agreements ServiceProvider 2 Insurance Package Security Assignments & Direct Agreements Insurers “Debt finance” Feedstock Contract Security Assignments & Direct Agreements Supplier “Equity finance” “Public sector” Offtake Contract Security Assignments & Direct Agreements Purchaser “Service delivery” “Others”

31. PPP Project Finance (Receivables Financing) 6: final structure Promoter Concession Agreement/ project permit Direct Agreement EquitySubscription Agreement Debt funding & security package Holding Company Senior Lenders Equity Project Company InterCreditor Agreement Bond Holders Third Party Funders Security Assignments & Direct Agreements EPC Contract Builder(s) ServiceProvider 1 Shareholder Agreement Services Agreements Sponsor 1 Sponsor 2 Security Assignments & Direct Agreements ServiceProvider 2 Insurance Package Security Assignments & Direct Agreements Insurers “Debt finance” Feedstock Contract Security Assignments & Direct Agreements Supplier “Equity finance” “Public sector” Offtake Contract Security Assignments & Direct Agreements Purchaser “Service delivery” “Others”

32. The key to success • PPP can maximise public sector ability to provide/improve infrastructure • To work, schemes must have • inherent business viability • a viable payment mechanic • viable risk allocation • effective controls over the income stream and contract rights

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