Module 12: Financing (investments)

12.2.What are the key processes?

The main indicator of the effectiveness of the financial operation is a profitability of business. The key issue for the private sector in this respect is that tools be provided for clear analysis and planning of financial and investment activities in future periods. Thus, to compare pros and cons, the private sector should have the ability to perform a complete evaluation of the business and so must have access to operational and financial activities of the company.

The key processes of financing PPP include:

1. Defining investment options
2. Business valuation
3. Bankability assessment
4. Investment management

1. Defining investment options

Partners should agree on the main applicable and available forms of financing and choose the most effective one. This process is usually governed by legislation and general practice and requires a careful and detailed investigation of each form.

A. Subsidised finance

National governments, international donors and specialised financing institutes (for example, the International Financing Institutions and local development banks) usually provide grants and subsidised loans to local authorities for financing the capital costs of wastewater collection treatment facilities.
The following types of subsidised financing (or soft financing) can be distinguished:

◊ direct investment subsidies as a grant;

◊ subsidised loans through:
– interest subsidy or
– credit risk guarantee;

◊ subordinated loans (longer repayment period, higher risks); and

◊ Tax allocations, typically though deductions against taxable income to the private industry to enable companies to comply with new pollution regulations.

Through grants and subsidised loans, lower tariffs for cost recovery can be maintained. However, direct grants do not provide for incentives to improve efficiency and may discourage pollution abatement. As a direct grant is usually expressed as a percentage of total costs, wealthier areas (large cities) tend to benefit relatively more. The same is true in the case of subsidised loans. The subsidised finance can be provided by:

1. Local special financial intermediaries.
In many countries special purpose government-owned development banks or financial intermediaries have been established to respond to the needs for medium- to long-term project financing. Governments may also manage environmental funds that provide loans and grants to municipalities for environmental investments. Such funds could come from revolving funds and/or from multi- and bilateral funding.

2. International Financial Institutions (IFIs)
IFIs may provide low-cost sanitation project finance. As highly creditworthy institutions, their key function is to channel financing from the international capital market to recipient developing countries. They provide this financing on, mostly, favourable terms (for example, low-interest margins or long repayment periods), and in many cases accept the recipient country’s credit risks. Constraints for utilising IFI loans are that in many cases IFIs require a public sector guarantee and that the loans are denominated in a foreign currency, exposing the projects to a currency risk.

B. Market financing

Local governments’ access to long-term (international) capital markets and equity financing is limited by a perceived lack of creditworthiness and limited confidence in the capacity of local governments to repay debts.

Commercial banks are not usually very interested in long-term lending for sanitation and wastewater treatment projects. They would require a public sector guarantee, which might not be available. This makes international commercial lending even more difficult. Several mechanisms for securing bank loans exist—for example, contracts and documentation to assure lenders that their funds will be used to support the project in the way intended; or a mortgage on available land and fixed assets.

Municipal bonds for infrastructure guarantee full repayment in the case of default through the levying of additional taxes, and thus are only available to governments. Revenue bonds are secured by the revenues of the project and, given the higher risk, typically offer slightly higher interest rates than governmental bonds.

The most creditworthy countries might issue an international bond (backed up by a sovereign guarantee). The critical requisites for developing a countries’ access to this international bond market are: having a good name with respect to governance; a sound municipal fiscal policy; and adequate collateral or other means of securing risk (for example, royalties from state assets, tax revenues or loan guarantees) to cover foreign exchange and other risks involved.

C. Attracting private capital

An innovative finance instruments to attract financing sources is a project pool structure whereby lender’s and investor’s risks are spread over a number of projects. The primary source of repayment is not a single’s project cash flow, but the performance of a number of projects. The aim of this pooling structure is to gain access to long-term private financing.

Revolving funds
A fund financed from various sources can be set up to finance project costs. Subsequent repayments from the projects are then used to replenish the fund to permit funding of other investments. The large, diversified pool of borrowers is attractive to lenders because risks of debt payment are spread. In the sanitation sector, revolving funds are usually created with extensive government or donor involvement. Households and communities can also apply revolving funds to finance on-site and local sewerage systems.

Equity funds
Over the past few years, infrastructure equity funds have provided a means by which developers can raise financing for infrastructure projects in emerging markets. Such funds allow developers to leverage their contributions with those of investors and thus to spread their capital. For investors, equity funds mitigate project and country risk by creating a portfolio of projects under one company.

Multi-utilities
Combining utilities may enlarge the scope for economies of scale, but also ensures larger balance sheets. Furthermore, the wide diversification of projects increases credit strength to attract long-term private financing. In the UK, multi-utilities provide the whole range of utility services – electricity generation and distribution, water supply, sanitation services, but also gas distribution and telecommunication.

2. Business valuation

Every initiative starts from the evaluation of the entire business in order to receive a comprehensive picture of the current stage and to consider participation forms and further development. Such an evaluation demands from the public sector guarantees of financial, operational and accounting transparency of the business. As a result of evaluation, the private sector should be aware of all the strengths, weaknesses, opportunities and threats (SWOT analyses) and be sure of the feasibility of its financial or other benefits.

The main criteria for the PPP investment must be the economic and social benefits that will improve the welfare of society. Because of positive externalities, the economic and social benefits often outweigh financial profitability; however, the private sector can only fund projects that are financially profitable. Public-private partnerships must therefore be financially viable. Cost-benefit analysis (CBA), the best-known tool of economic feasibility analysis, deals with aggregate economic efficiency; however, it does not focus directly on who pays the bills. It is a tool for identifying the option that best conforms to the economic goal of maximising benefits net of costs for society as a whole.

3. Bankability assessment

The PPP assessment should include an assessment of the “bankability” of any project that will be part or wholly financed by the private sector. This specifically relates to projects that are expected to be procured and managed under Design, Build, Operate and Finance or Concession contracts.

In general, providers of finance for infrastructure projects will look favourably on projects with the following characteristics:

◊ Contractual balance – where there is a commercial incentive for all parties to complete the transaction and deliver the project throughout its life.

◊ Bankable cash flows – projects with characteristics that make them an attractive proposition for debt providers, possibly lowering the projects cost of financing.

◊ Security of cash flows – providers will have a preference for availability based payment mechanisms. They may be satisfied in some sectors by usage based payments underpinned by market testing of demand related revenues, or when the project involves an increase in existing capacity, where the level of demand is already known.

◊ Opportunity to innovate – projects where technical innovation is introduced can significantly reduce a component of the whole-life cost of the asset.

◊ Synergies – may be important where the equity provider is also the operator of complementary facilities.

◊ Opportunities for financial engineering – which increase the overall return on equity.

◊ Appropriate risk transfer – appropriate allocation of risk between the public and private sector, and between parties best able to manage the risks, should result in optimal project pricing.

◊ Repayment cushion – a reliable net revenue stream in excess of capital and interest repayment requirements (supported by sufficient equity/guarantees and loan reserve accounts) to provide sufficient funds to service debt.

◊ Sponsor credit – strong performance bonds or completion guarantees given by the PPP Contractors during the construction and operation phase, and any mitigation used to enhance the creditworthiness of the Contractors.

◊ Vires/legislative framework – very clear legal powers of the public sector body to enter into the contract and to pay on termination.

◊ Technical complexity – a project solution that is based on proven technology, ease of replacing the operator and minimal complicating factors such as planning, licensing or environmental constraints.

◊ Residual interests – good alternative use value of the assets, and ease of access for the lender to utilise them.

◊ Compensation on termination – the contractual basis for termination does not provide either party with an incentive to terminate; however, if the project is aborted a formula exists for the lenders to step in to solve the problems or be compensated, and the public sector can meet break costs on termination.

The conclusions of the bankability assessment will help to establish the suitability of projects for Design, Build, Finance and Operate and Concession contracts. In addition, it will help to identify those issues that need to be addressed prior to commencing a procurement, or that need to be reflected in contract documentation.

4. Investment management

The main purpose of investment management is to provide a programme of further investment development of the company; that programme’s implementation is expected from successful public and private participation. All partners should have to commit resources (financial, human and capital) to increase their interest in seeing the partnership succeed. The programme should comprise all potential benefits and opportunities that can be brought from the partnership; hence performance of the programme of investment requires a careful and competent approach.

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