ISMED Support Programme Public Private Partnership Overview

Andrew Fitzpatrick

Cairo 17 September 2014

The ISMED Support Program PPP Overview

What is a Public Private Partnership PPP?

• Contract between public-sector and private-sector entities for the provision of an asset and in many cases the delivery of related services and maintenance. Some element of risk transferred to the private party.

• Contractor paid pre-determined fees or granted revenue-raising power.

• Contracts usually of a 25-30 year term plus construction period.

• Ownership of the asset often retained by the state, operational hand-back at end of term.

•Design Build •Design Build Finance •Design Build Finance Operate •Design Build Finance Operate Maintain 2

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Two Major Types of PPPs: Who pays the Private Sector? Who takes traffic risk?

Where does the private sector’s revenue come from? • Two main types of PPPs: Concession-based. Availability-based. • Concession-based PPP: Private-sector’s revenue, to cover costs plus

profit, comes from fees paid by users. Only possible with well-defined and predicable traffic/volume. Pushes traffic/volume risk to the private sector.

• Availability-based: Private-sector’s revenue comes from payments paid directly to the developer by the state. The state is paying for the asset being “available for use.” Deductions made for poor quality or periods when the asset/facility is not available. State takes traffic/volume risk.

• Possible to share traffic/volume risk: A minimum payment is made on the basis of availability. Additional revenue for the private sector to depend on traffic/volume.

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Risk allocation

It is all about allocation of Risk • PPPs are contracts. Contracts are simply a method of assigning risks. • Risks should be faced by party, private sector or public sector, best

able to control them, or mitigate them if the risk event occurs: • Risks typically within the control of the private-sector include those

involved with construction and operations. • Risks typically within the control of the public sector include those

related to government actions, issuing of permits and licences and adverse impacts from a change in law for example.

• Traffic/volume risk: Always a big issue in transport sector PPPs. Possible for private sector to influence with good or bad service, but government can also have an impact. And there are economic factors beyond the control of the public or private sector.

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Why a Public Private Partnership (P3)? • Private sector expertise and experience; efficiencies lower

construction and lifecycle cost creating savings for state. • Private sector takes construction risk; agrees to build at a fixed price. • Private sector contributes equity; lowers cost to the state. • Frees up state resources (money and capacity) to pursue multiple

projects simultaneously. • Gets state out of the “building/development business,” allowing focus

on core role of government. • It works, infrastructure gets built, usually on time and on budget.

Rationale for a P3 Advantages: Good Reasons to contract by PPP

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Myths about PPPs

Bad reasons to contract by PPP • As a substitute for public investment: Will always involve liabilities for

the state. • To transfer all risks away from state: Only makes sense to transfer risks

that the private sector can control. • To provide revenue: A PPP is very unlikely to provide net revenue for

the government. • To drive development in underdeveloped regions: PPPs should be built

to meet demonstrated needs or anticipated needs.

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Rationale for a PPP Disadvantages?

Downsides? • Theoretically more expensive due to profit motive, higher interest rate

on debt. • Complexity; legal and structuring costs. • Governments often lack expertise in deal structuring, can agree to

sub-optimal terms. • Can create government accounting/transparency issues; it is not a free

asset, payment obligations remain a liability of the state. • Most effective with a highly-rated public sector counterparty; will be

more difficult to find investors with a non-investment grade state counterparty.

• Construction Phase – Most risky phase – Usually 2-5 years, can be

longer – Contractor must finance;

no cash flow from state without hitting milestones (or from users)

– Strength/ability and reputation of builder paramount

• Service/Operations Phase – Seen as much less risky,

typically routine tasks – Up to 30 years – Predictable cash flow

from a state entity (availability)

– Main risks: imperfect inflation adjustment, lifecycle risk and pricing too low

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Conceptually Two Stages

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Presentation format

Part 1: Transaction Structure, Transaction Parties and

Major Contracts Part 2: Financing, Capital Structures, Cash Flows

Tra

Transaction Structure

Transaction Parties

Major Contracts

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Public Private Partnership Overview: Part 1

Typical Availability-Based PPP Transaction Structure

Public Sector Counterparty

Project Co.

Construction Contractor

Service Provider

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Lenders Sponsors

Construction milestone + Substantial completion + Service Payments

Project Agreement

Equity

Dividends

Service Payments

Debt Financing

Principal and Interest

Service Contract Construction Contract

Construction Payments (milestone + substantial completion)

Lenders’ Remedy Agreement

= contract = cash flow

Typical Concession-based PPP Transaction Structure

Public Sector Counterparty

Project Co.

Construction Contractor

Service Provider

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Lenders

Sponsors

Percentage of revenue above a threshold

Project Agreement

Equity

Dividends

Service Payments

Debt Financing

Principal and Interest

Service Contract Construction Contract

Construction Payments

Lenders’ Remedy Agreement

= contract = cash flow

Users Fees/tolls

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Transaction Parties: Public Sector Counterparty

• Usually a ministry, department or government agency. Often referred to as “the Authority.”

• Must be clear that the public sector counterparty is authorized to enter contracts on behalf of the state and that the sovereign will be bound.

• In practice, a central P3 office or agency will often act as an intermediary between the public and private sector counterparties.

• The P3 agency acts as a type of transaction advisor with a ministry or department as their client.

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Transaction Parties: ProjectCo

• ProjectCo is at the heart of the transaction.

• ProjectCo will enter the Project Agreement with the Public Sector Counterparty and will incur any debt needed to finance the project.

• Subsequently passes on obligations under the Project Agreement to a Construction Contractor and a Service Provider.

• ProjectCo is usually structured as a Special Purpose Vehicle (SPV) with no employees or assets beyond contractual rights and business powers limited to those necessary to carry out the project.

• ProjectCo should be bankruptcy-remote from its sponsors, i.e. a bankruptcy of one of the sponsors will not impact the SPV.

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Transaction Parties: Sponsors

• Owners of ProjectCo. (sponsors)

• Usually subsidiaries of multinational (MNC) construction and infrastructure companies.

• May also include private equity sponsors and institutional investors.

• Contribute equity and will receive dividends from ProjectCo.

• Structured as Special Purpose Vehicles with no employees and no assets other than equity stake in ProjectCo.

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Transaction Parties: Lenders

• Provide financing to ProjectCo.

• Two main sources, banks and bond market.

• Sometimes will see both banks and bonds – hybrid lending structure.

• Lenders will have certain rights if ProjectCo, the Construction Contractor or the Service Provider are not meeting their obligations.

• Lenders cannot take security in physical asset (retained by state): take security in Project Agreement (ProjectCo’s right to a cash stream from the Authority) and financial security posted by Construction Contractor and/or the Service Provider.

Transaction Parties: Construction Contractor

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• All of ProjectCo’s construction-related obligations under the Project Agreement will be passed on to the Construction Contractor under a fixed-date price certain contract.

• Consortium of multinational corporations (MNC) often with local participation.

• Typically related to Sponsors and Service Provider.

• Will often employ subcontractors.

• Structured as subsidiary company, obligations to ProjectCo will therefore be guaranteed by parents.

Construction Contractor

Parent 1 MNC

45%

Parent 2 MNC

45%

Parent 3 Local

10%

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Transaction Parties: Service Provider

• All of ProjectCo’s service, maintenance, operations and lifecycle obligations under the Project Agreement will (usually) be passed on to a Service Provider.

• May be a single company or more likely a joint venture of companies with complimentary skills.

• Typically related to Sponsors and construction providers.

• May be structured as subsidiary companies, will therefore be guaranteed by parents.

• May employ subcontractors.

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Major Contracts: Project Agreement

• Master agreement between the Public Sector Counterparty and ProjectCo governing all aspects of their relationship.

• In well-developed markets, typically a standardized contract with multiple appendices. The appendices are drafted as appropriate for the requirements of each particular project.

• ProjectCo agrees to deliver the infrastructure at a fixed-date and price and to provide the services as defined in the Project Agreement.

•Outlines construction and operational requirements, risk sharing, variations and dispute settlement.

•ProjectCo may be allowed to pursue revenue generating activities beyond the scope of the services required under the Project Agreement, for example operate retail space.

Major Contracts: Project Agreement – Construction

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• Project Agreement may contain very detailed requirements regarding construction or it may be more general outlining functional needs leaving more scope to ProjectCo to innovate. (Greater flexibility generally lowers cost.) • Penalties if construction milestones are not met.

• Onerous financial penalties if construction is not completed on time. Liquidated damages.

• Subject to cure periods, ProjectCo can be terminated for non-performance and replaced. Costs associated with replacement will be paid by ProjectCo.

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Major Contracts: Project Agreement – Operations

• Operational requirements will usually be very detailed.

• Usually includes lifecycle maintenance (overhauls/rehabilitation).

• Depending on project, may not include core public services. I.E. in a hospital project, clinical services may be provided by the Public Sector Counterparty with ProjectCo responsible for cleaning, building maintenance etc.

• Payments made to ProjectCo on a monthly or quarterly basis. (Frequency should be matched with debt service.)

• Penalties for poor performance.

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Major Contracts: Project Agreement – Operations (cont.)

• Availability payments vs. volume payments. Availability payments made if the asset is available, i.e. public sector takes volume risk.

• There should be a minimum payment regardless of performance sufficient to pay debt service.

• Payments will usually include a capital component (paying for service provided + paying for cost of the asset).

• Payments should be inflation-linked using a relevant index.

• Subject to cure periods, ProjectCo can be terminated for non-performance/poor performance and replaced.

• Costs associated with replacement will be paid by ProjectCo.

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Major Contracts: Project Agreement – Risk Sharing

• The Project Agreement will outline which party will pay for increased costs arising from certain events.

• For example, increases in construction costs due to circumstances that were inferable from the information available to ProjectCo while formulating their bid will be borne by ProjectCo.

• Expenses arising from unforeseeable events or changes in law are borne by the Public Sector Counterparty.

• Basic principal: risks should fall to the party best able to avoid/mitigate the risk.

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Major Contracts: Project Agreement – Variations

• Variations: The Project Agreement should contain a detailed variation procedure.

• Both ProjectCo and the Public Sector Counterparty may request a variation.

• Unforeseen circumstances (e.g. geotechnical), changing requirements (e.g. need to handle more cargo).

• Variation procedure will be subject to dispute resolution provisions.

• Basic principal: Any variation to the Project should leave each party in the same position as before the variation. I.E, each party retains the benefits and burdens of the original contract, no better and no worse.

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Major Contracts: Project Agreement – Dispute Settlement

• There will be a detailed dispute resolution procedure.

• A series of escalating steps with binding arbitration as the final step.

• Both parties agree to continue working while a matter is subject to dispute resolution.

• Basic Principal: avoid litigation and continue to build/operate during a dispute, any losses arising can be compensated later.

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Major Contracts: Project Agreement – Hand Back Provisions

• At the end of the term of the PA the asset is “handed back” to the authority.

• Not an actual change of ownership as title has usually been retained by the state all along.

• Detailed provisions to address the condition of the asset.

• Will involve numerous inspections in years prior to PA expiry and a requirement that ProjectCo make physical improvements and/or begin reserving money to do so.

• ProjectCo is responsible for any work required to satisfy a ‘’hand back inspection” at the end of the term.

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Major Contracts: Construction Contract

• Entered between ProjectCo and the Construction Contractor.

• The Construction Contractor agrees to deliver the infrastructure at a fixed-date and price.

• Virtually identical to the construction-related sections of the Project Agreement; passes the obligations and benefits of the Project Agreement to the Construction Contractor.

• The Construction Contractor will face penalties for not meeting its obligations and can be replaced at their cost.

• Cure periods shorter than the PA, this allows ProjectCo to replace the Construction Contractor before the Public Sector Counterparty is able to replace ProjectCo.

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Major Contracts: Service Contract

• Entered between ProjectCo and the Service Provider.

• The Service Provider agrees to perform all of ProjectCo’s service, maintenance and lifecycle obligations under the Project Agreement. (Some lifecycle responsibilities may be retained.)

• Virtually identical to the service/maintenance/lifecycle related sections of the Project Agreement; passes the obligations and benefits of the Project Agreement to the Service Provider.

• Cure periods shorter than the PA, this allows ProjectCo to replace the Service Provider before the Public Sector Counterparty is able to replace ProjectCo.

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Major Contracts: Service Contract (cont.)

• Lifecycle refers to major planned preventive maintenance and upkeep. For example, repaving a road at years 14 and 29 of a 30-year contract or a scheduled overhaul of a turbine at a power plant. • Monthly payment based on availability (not usage). Mechanisms to compensate for increased volume.

• Penalties for poor performance/non-performance.

• Service Provider can be terminated and replaced at their cost.

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Major Contracts: Lenders’ Remedy Agreement

• Entered between ProjectCo, the Public-Sector Counterparty and Lenders.

• Public-Sector Counterparty acknowledges Lenders’ security interest in Project Agreement and to cash flows from the Authority to ProjectCo.

• Authority agrees to provide Lenders notice before terminating ProjectCo for a default under the Project Agreement.

• Sets out power of Lenders to step in and cure a default by ProjectCo under the Project Agreement.

• Sets out power of Lenders to replace ProjectCo for non-performance.

• Similar agreements for Construction Contract and Service Contract.

• Basic Principal: Lenders will have an opportunity to cure defaults and replace ProjectCo/Construction Contractor/Service Provider before non-performance leads to a debt service default.

Key contacts

Mr. Andrew FITZPATRICK ISMED Support Programme

Andrew.Fitzpatrick@oecd.org

For general enquiries: mena.investment@oecd.org

www.oecd.org/investment/psd/ismed.htm

With the financial assistance of the European Commission

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