Public-Private Partnerships (PPP) are a form of collaboration between public and private entities where the private party takes over the provision of services or development of projects. PPPs can create value for all parties involved providing a fair compensation of each party based on the effort, responsibility and risk undertaken. That is why PPPs have become increasingly popular over the past ten years. And this is thanks to the assumption that private entities can develop and implement certain economic activities more efficiently than the public sector.
PPP arrangements associated to infrastructure developments usually take the form of concession agreements. Once the public sector has established the legal and regulatory framework to enable private sector participation, private entities are appointed to source, finance, develop, manage and operate infrastructures on behalf of the public sector for a given period of time. Concession agreements usually entail large upfront investment, followed by low-to-moderate risk cash flows. By the end of the concession period, assets return to public management and the PPP arrangement is terminated.
Concessions and other similar forms of PPP are commonly financed through project financing. Project financing provides private shareholders and public entities (grantors) off-balance-sheet, non-recourse financing of the project, enabling high leverage capital structures with contained risk. As any other highly leveraged operation, risk is shifted to debt holders. However, infrastructure PPP have relatively good access to debt markets given the high value of physical assets and considering asset ownership is being retained by the Government.
Project financing in infrastructure PPPs provides shareholders and grantors off-balance-sheet, non-recourse finance with moderate cost of debt
Beyond concession agreements, other forms of private sector participation in public infrastructure include:
- Management contracts: contractual arrangements where the public sector pays a fee to a private entity to perform asset maintenance and operation activities
- Listed companies: infrastructure asset management and operating companies listed on the stock exchanges
- Freeholds: infrastructure fully owned by a private entity
As governments and private investors around the globe realize the value created by PPP arrangements, new forms of private sector participation emerge. Corporatizing public infrastructure companies is usually the first step to enable a capitalization in the private equity markets, as well as progressive private stakeholder involvement.
Hurdles and brakes to transportation & logistics infrastructure PPPs
National infrastructure is a fundamental enabler of economic development. The globalization is pressing on governments of both developed and developing countries to enhance their infrastructure in order to cope with the growing demand for transportation, energy, healthcare and telecommunication, among others. PPPs aim at easing the pressure on government budgets by enabling alternative means of finance, facilitating the access to the capital markets while promoting competition between private operators.
Maximizing the value created by PPPs requires flexibility for public and private sectors to choose the PPP model that suits better to each project. Regulatory framework in many countries, as well as the financial products available in capital markets, tend to bias PPP arrangements towards a limited number of models. In many of the ongoing PPP processes, the model has been chosen attending to economic policies as well as benchmarking similar projects carried out in other countries. However, the nature of each project from a business perspective is often left aside during the conception of the PPP, shaping key aspects of the arrangement with limited (if any) consultation with the private sectors. This approach generates inefficiencies down the road during the bidding process and project financing cycle: asymmetric information between private and public sectors; agency conflicts and higher probability of financial distress, which commonly translates into higher cost of debt.
In line with the previous, three main sources of inefficiencies have been identified in some of the ongoing infrastructure PPPs: pre-established terms and conditions; imposed upfront CAPEX; and constrained operating models.
- Pre-established PPP terms and conditions: tightly defined terms for PPP arrangements limit the creativity of private entities to provide added-value solutions to infrastructure development and operation. Common aspects in all PPPs such as PPP scheme, duration, assets to be transferred from public to private hands and level of service to be provided, are often imposed at early stages of the process and without a clear view on the impact these terms will have on the overall profitability of the project, funds raising capacity, return to shareholders and impact on end users;
- Imposed upfront CAPEX: the need for large upfront investment is one of the main incentives for public sectors to seek project financing for their PPP. However, the need for short-term capital expenditure is often subject to market uncertainties. Imposing large short-term investments to the private sector, as oppose to enabling a flexible (although committed) investment plan in line with market needs, leads into increasing project risk, translating into higher cost of capital, potentially jeopardizing one of the fundamental benefits of project financing;
- Constrained operating model: one of the main sources of value creation of PPPs is the capacity of the private sector to operate and maintain assets more efficiently than the public sector. Enabling this benefit requires the private sector to have the possibility to adopt the operating model that better suits the internal and external conditions of each project. Limiting the services to be retained in-house versus those to be outsourced, or pre-establishing a split of public and private services, hurdles the capacity of private companies to deploy expertise, enhance end-user experience and maximize returns for both public and private entities.
To sum up, failing to establish a multilateral communication framework between public and private sectors at early stages of the PPP process in order to discuss and agree on the most suitable terms of the PPP may restrain some of the fundamental benefits of involving the private sector in infrastructure development projects.
The need for a B2B approach to foster infrastructure PPP
Based on our recent experiences in infrastructure PPP, we have identified some specific drivers for success in the definition and implementation of successful PPP operations. These success factors have the common denominator of promoting a B2B approach between public and private entities. All parties must adopt a common value-creation-focused mind-set from the beginning of the process.
It is worth mentioning that socio-economic aspects of infrastructure projects (such as end user experience, service level provided and environmental sustainability, just to mention a few) must be also be considered as part of the B2B approach, in order to have a broader definition of value creation.
ALG defines five pillars for a B2B approach to transportation infrastructure PPP, applicable to airports, ports, railways and highways concession processes: consensual market understanding; negotiable tariff structure; non-recursive pre-PPP commercial agreements; modular CAPEX; and unconstrained capital structure.
- Consensual market understanding is fundamental to reduce asymmetric information between grantors, bidders and lenders. On one hand, grantor’s over optimism on the market conditions may generate reluctances on bidders and lenders, resulting in an increase of demand risk and, ultimately, the cost of capital. On the other hand, aggressive market projections from bidders may lead into unaccomplished promises to grantors, generating frustrations on the public sector and creating an unhealthy bargaining environment throughout the PPP. Therefore, establishing a common understanding of the market conditions and expected demand growth between public and private sectors becomes a must to manage appropriately the expectations on both sides;
- Negotiable tariff structure enables infrastructure managers and operators to customize the value proposition of their assets and services to the target customers. Historically, transportation infrastructure was commonly considered as a natural monopoly. Consequently, the public sector’s role was to protect the interests of end-users by limiting the monopoly power of infrastructure operators. This mind-set is still dogmatically applied today in many PPP processes where infrastructure do no longer hold monopoly privileges. Secondary airports, alternative highways, specialized logistics parks, etc. are currently undergoing PPP processes where grantors impose tariffs & fees structures to the future operator, hampering the possibilities for the private sector to deliver a customized product filling-in specific market gaps or niche needs. In a competitive environment (as opposed to monopolistic scenarios), grantors are indirectly taking away the decision from bidders to differentiate each asset or service based on market needs. A B2B approach implies that whenever a PPP is promoted in a competitive environment (where assets do not hold local monopolies) tariff structure and fees should be subject to negotiation between public and private sectors. Moreover, recent experiences have demonstrated that in those cases where tariff are not tightly regulated by the public sector, private operators tend to decrease them in order to gain market share and stimulate either latent or induced demand;
- Non-recursive commercial agreements enable private entities to shape their commercial terms with the different stakeholders in the asset management value chain. At the moment of entering into a PPP, grantors usually have a number of contractual agreements with tenants, suppliers and service providers that are expected to be inherited by the private sector. The bargaining power of these stakeholders can hamper the deployment of the envisaged business model, anchoring the infrastructure operation to the pre-PPP situation. To prevent this undesirable situation, grantors can take appropriate actions to ensure that contractual agreements established prior to the PPP can be revisited then by the private sector. For instance, a practical way to implement this measure is ensuring that most of commercial agreements are re-negotiated within the first years of a concession period;
- Scalable CAPEX is the cornerstone for an efficient, fit-for-purpose infrastructure development under a PPP scheme. It is widely accepted that private sectors can manage large capital expenditure in a more efficient manner than public entities. However, one of the success drivers for efficient CAPEX is the possibility to adjust the infrastructure developments to the actual market needs. At the same time, the envisaged level of service to be provided should also respond to target customer needs and in line with sector standards and benchmarks. Enabling a modular infrastructure development will minimize the project risks, which would translate into higher value created for all parties and revert into more competitive landscape for end users;
- Unconstrained capital structure is the “icing on the cake” in a B2B process. Some PPP processes involving private sector consortia request specific equity stakes to be taken by each consortia member in the project SPV. Grantors adopt this measure to ensure commitment from those consortia members involved in strategic activities such as asset management and operation, financing and knowledge transfer. However, the interests of SPV shareholders can differ from the interests of individual consortia members and public sectors. Pre-defining specific equity stakes to be taken by each SPV member may lead into private entities adopting roles and levels of risk beyond their appetite, which naturally translates into higher cost of capital and, most importantly, reduces the list of potential partners (eventually jeopardizing competition during bidding stages). The B2B approach holds on the concept “let each party do what they are good at”. Grantors can use different mechanisms and incentives to guide private entities on the preferred capital structure, while allowing certain degree of flexibility and avoiding internal conflicts of interest between consortia members. This approach fosters participation and competition between private sectors, reverting back to the public sector in the form of competitive bids for the PPP.
Applying a B2B approach to transportation infrastructure PPP unleashes the potential benefits of project finance and private sector participation by establishing a business-oriented mind-set from the very beginning of the process. This approach can be particularly successful in emerging markets, where reducing information asymmetries and aligning the interests of all stakeholders is a must to raise funds, enhance operational efficiency and attract international expertise.
To know more about how ALG can help public and private sectors undergoing PPP processes, please contact the author of this Newsletter.