The use of government capital contributions to partly finance PPPs requires a careful balancing act. How can governments maximise cost savings while retaining the risk transfer and performance incentives associated with private finance?
In May 2013, the Victorian Government released new ‘Partnerships Victoria Requirements’, signalling a shift in the way the State will procure PPP projects.
Among the reforms is a requirement for procuring agencies to consider using government capital contributions in two circumstances – where there is insufficient private finance available or where the ‘value for money’ outcome for the State can be improved (by leveraging the lower cost of government borrowing to reduce the level of more costly private finance).
The reform formalises what is already happening in practice. The Victorian Comprehensive Cancer Centre project involved a significant government contribution. One is also proposed for the New Bendigo Hospital project.
It also follows a trend in other states with projects such as the Sydney International Convention, Exhibition and Entertainment Centre, Gold Coast Rapid Transit and Sunshine Coast University Hospital all involving government contributions.
Sensibly, the Victorian Requirements are not overly prescriptive. Agencies will have flexibility to structure a government contribution to address project specific requirements and prevailing market conditions.
This flexibility will be essential to achieve the right balance between competing considerations – cost reduction versus risk transfer and the level of private finance investment necessary to deliver required performance standards.
Key features of any government contribution structure will be the size of the contribution, the time at which it is to be made and the conditions to its payment.
The contribution’s size will depend on the shortfall in available private finance (where relevant), the level of contribution which delivers the optimal net present cost outcome for the State, and available State funds.
In principle, the higher the government contribution, the lower the private finance requirement and, in turn, the lower the raw overall net present cost to the State.
However, procuring agencies need to consider potential flow on effects of making a contribution.
In the case of a PPP, operational gearing represents the ratio of operating and maintenance costs to debt service costs. A government contribution will reduce debt service costs which can, in turn, increase operational gearing and the operational risk exposure of debt and equity providers. Debt and equity providers may seek higher returns in light of the additional risk.
A government contribution can also increase the level of equity required relative to debt to satisfy target debt service cover ratios. Equity comes at a higher cost than debt and an increase in equity will increase the raw net present cost to the State.
Overlaying the above is the reality that the higher the government contribution relative to total project costs, the lower the financial stake of the private sector in the project. This impacts on the point at which a rational investor will choose to walk away from a troubled project rather than invest in its recovery.
From the State’s perspective, debt and equity providers should have an ‘at risk’ investment which provides the State with a sufficient buffer against project risk and appropriately incentivises performance.
The earlier the contribution, the better the net present cost outcome for the State. But, it also means the State retains a greater level of risk.
For example, if the State contributes at the start of construction before significant debt or equity has been contributed (or committed with sufficient credit backing and appropriately limited conditionality), the State will be more exposed to the private sector walking away if project risks eventuate.
The Requirements indicate that where a government contribution is being made to achieve greater value for the State, it will be made following completion of construction. This approach is attractive from a State risk perspective. The State will not take construction risk, and debt and equity will be fully committed by the time its contribution is made.
The government contribution will deliver lower cost for the State because it will allow the level of private finance to be reduced.
Even lower cost can be achieved if the contribution is made during construction. While it involves the State retaining more risk, it may be that an acceptable balance can be achieved by requiring that significant levels of debt and equity are contributed before government contributions are made.
CONDITIONS TO PAYMENT
From the State’s perspective, its obligation to pay the government contribution should be subject to satisfaction of conditions aimed at limiting the State’s risk.
However, conditions to payment may affect the bankability of a project. Debt and equity providers will want certainty that the government contribution will be paid when it is required. Non-satisfaction of a condition could delay funding and completion of construction.
The Requirements seek to resolve this tension by providing for contributions as milestone payments during construction or, in the case of a contribution to achieve greater value, as a lump sum payment following completion of construction.
There are advantages to this approach. Milestone and completion conditions can be independently certified, which should give debt and equity providers comfort. The risk of a delayed contribution as a result of construction delays can also logically be allocated to the construction contractor. Experienced PPP contractors typically accept delayed funding risks in projects which are financed exclusively by the private sector.
There will, however, be trade-offs.
Requiring the construction contractor to achieve certain milestones may increase its programming risk. Without milestones, the contractor has greater flexibility in scheduling work to achieve completion by the scheduled date. Consortia may price this risk into their bids, with resulting value implications for the State.
A government contribution following completion may also give rise to issues that need to be worked through.
A contribution paid following completion can be used to partly repay debt. In a perfect world, the project’s interest rate hedging arrangements would match a debt repayment profile which provides for the part repayment to occur on the scheduled date for payment of the government contribution. But, if completion and, in turn, the government contribution are delayed, there will be additional, unhedged, interest costs.
One option is to pass the additional interest costs to the construction contractor by charging liquidated damages. However, variable additional interest costs coupled with a cap on the contractor’s liability for liquidated damages would effectively lead to the contractor’s cure period being variable, reducing certainty and increasing risk.
Other options include additional hedging to cover possible interest charges in the period after the scheduled date for payment of the government contribution (though this involves additional cost) or a government contribution which can be resized to cover additional capitalised interest (though this may involve a perception that the State has inappropriately taken back some construction delay risk).
One alternative to the milestone/completion conditions approach is for government contributions to be paid during construction pro rata with remaining debt commitments after significant levels of debt and all equity have been committed.
Ultimately, there is no ‘one size fits all’ approach.
For each project, the government contribution structure will be that which best accommodates State and private sector sensitivities to risk and cost, the particular features of the project and market conditions.