4. A Basic Description of Major Sources of Funding

There are three basic sources by which a PPP project can be financed: debt, equity and government support[4].

Debt

Senior debt enjoys priority in terms of repayment over all other forms of finance. Mezzanine debt is subordinated in terms of repayment to senior debt, but ranks above equity both for distributions of free cash in the so called “cash waterfall” (that is, the priority of each cash inflow and outflow in a project) and in the event of liquidation of the PPP company. Since mezzanine debt repayment can be affected by poor performance of the PPP Company, and bearing in mind the priority in repayment of senior debt, mezzanine debt typically commands higher returns than senior debt.

Debt for a PPP project is normally priced on the basis of the underlying cost of funds to the lender, plus a fixed component (or “margin”) expressed as a number of basis points to cover default risk and the lender’s other costs (for example, operating costs, the opportunity cost of capital allocations, profit).

Debt for major PPP projects may be provided by either commercial banks, international financial institutions or directly from the capital markets. In this last case, project companies issue bonds that are taken up by financial institutions, such as pension funds or insurance companies that are looking for long-term investments.

Financial advisers will be able to advise as to the likely sources of funding for a given project. They would also be expected to make an assessment of the anticipated costs and benefits of funding options. This will include an assessment of the debt tenors (the length of time to maturity, or repayment, of the debt) likely to be available from various sources.

Equity

Equity is usually provided by the project sponsors, potentially including the contractors who will build and operate the project as well as by financial institutions. A large part of the equity (often referred to as “quasi-equity”) may actually be in the form of shareholder subordinated debt for tax and accounting benefits. Since equity holders bear the primary risks under a PPP project, they will seek a higher return on the funding they provide. In some projects, the sponsors contribute to equity in the form of “sweat equity” which is not easily accepted by lenders[5].

Government Support

Government support can be defined as a direct funding support by way of public sector capital contributions, usually in the form of grants. These may come from community, national, regional, or specific funds. They may be designed to make a project bankable or affordable. They may take the form of contingent support or guarantees by the public sector for the PPP Company or other private sector participants. This may be for certain types of risks which cannot otherwise be effectively managed or mitigated by the PPP Company or by other private sector participants (for example, a minimum revenue guarantee for a toll road).