Outlook for public-private partnerships in Europe
August 2012 | TALKINGPOINT | FINANCE & INVESTMENT
FW moderates an online discussion on public-private partnerships in Europe between Victoria Bortkevicha, a partner at Clifford Chance CIS Limited, Elisabetta Negrini, a senior associate at Norton Rose LLP, and Jean-Francis Dusch, a managing director at La Compagnie Benjamin de Rothschild.
FW: What recent trends and opportunities have you witnessed in the European PPP market over the last 12 months or so? Have any projects in particular caught your eye?
Dusch: The European market has been a great source of PPP projects for the last two decades. In the last 12 months, despite a difficult economic environment, it has shown significant activity. France itself is a great example, experiencing the financial closing of landmark transactions such as, among others, the Tour Bordeaux High Speed Rail €7bn concession project, the Brittany Loire Valley €3bn ‘Contrat de Partnenariat’, the Balard new headquarters of the Ministry of Defense Contrat de Partenariat for €1bn, and the A150 toll road project. Despite adverse market conditions and banks constrained liquidity and appetite for risk, these landmark transactions were among the significant ones that demonstrated the PPP market is still going strong in Europe.
Bortkevicha: According to the European PPP Expertise Centre, 84 PPP transactions reached financial close in 2011 on the European market. Most of these were in France and the UK, and a large portion concerned the development of roads and related transport infrastructure. The report, however, does not cover Eastern European countries as well as Russia and Ukraine. It is worth mentioning that in Russia two large projects are currently being implemented: the reconstruction of Pulkovo Airport in St Petersburg and a recently signed (during the St Petersburg International Economic Forum) PPP agreement on construction of the central part of a high speed ring road in St Petersburg with more than 80 billion roubles worth of private investment. This is a clear indication of interest in such projects in Russia. Kiev has just conducted a tender, the results of which are yet to be announced, in relation to the first Ukrainian PPP project on the construction of a new underground line.
Negrini: After healthy activity in the Italian PPP market in 2010, 2011 was marked by a slowdown triggered by the ongoing economic crisis. However, the Italian PPP market now appears to be recovering with strong growth in the number of opportunities for project sponsors and the value of infrastructure projects recorded during the first quarter of 2012. In April 2012, the number of PPP initiatives increased by 3.8 percent compared to April 2011 and their aggregate economic value reached €564.2m, a 101.6 percent increase on April 2011. This was largely due to the €250m tender issued by the Veneto Region for the construction of a new highway between Carceri-Palugana (Padua Province) and San Vito di Legnago (Verona Province) and a number of significant tenders in the healthcare sector, specifically the construction and operation of hospitals and healthcare centres in southern Italy. As activity in the Italian PPP market increases, ‘project bonds’ are now becoming more attractive for potential investors in the public works market. Project bonds are bonds available to qualified investors that special purpose companies (SPCs) set up for the construction and operation of public works, and other concessionaries of public works, can issue in order to finance projects during the construction phase, before the project is operational and generating cash flow. Recently, the Italian Government passed Law Decree 22 June 2012 no. 83 (the so called ‘Development Decree’) aimed at, inter alia, making project bonds a viable alternative to bank lending, by removing several obstacles which in the past prevented their concrete utilisation. In particular, the Italian government focused its efforts on creating a less onerous tax regime in order to encourage the use of project bonds, providing for a fixed tax of 12.5 percent on interest paid to the bond-holder and flat registration taxes on the security interest granted in relation to the issued bonds. This favourable tax regime, however, is limited in that it is only applicable to bonds issued in the three years following the entry into force of the Development Decree. The Italian parliament is now reviewing the Development Decree, a necessary step before it is converted into law.
FW: Which sectors seem to be generating the most opportunities for PPP deals?
Bortkevicha: In terms of investment by volume, first place is taken by transport infrastructure – airports, roads, railways and related infrastructure assets. Two largest European deals are the Tours-Bordeaux high speed railway and the Bretagne-Pays de la Loire high speed railway in France, with a total value of about €7bn. In terms of deal numbers, with much smaller deal sizes, the leading sectors are education and general public sectors. For example, in Belgium four PPP prison transactions were closed. Although the value of each project is relatively small, it shows how PPP can be used within the public sector.
Negrini: The transport sector, including road infrastructure and rail transportation, is generating the most opportunities for PPP deals in Italy. Water, waste management, healthcare, energy and the construction, and the renewal and operation of public buildings such as schools, prisons and cemeteries, are also providing opportunities. The healthcare sector in particular has grown significantly in recent years. In May 2011 we registered 15 projects in the structuring phase with an aggregate value of €801m, six projects in the tender phase with an aggregate value of €656m, and 53 projects awarded with an aggregate value of €3.693bn. We expect the market to continue to grow even though a recently passed law decree (Law Decree n. 95/2012) containing provisions to cut public expenditures and costs to be borne by the public administration in a number of sectors including healthcare, has created some concern among operators.
Dusch: There is a wide range of sectors driving the PPP pipeline. From a deal size standpoint, transport and especially roads and rail projects often represent projects worth billions. But social infrastructure, such as schools, universities, prisons, hospitals, albeit of a smaller size at around €50-250m, are key contributors to PPP deal flow and are important infrastructures the local authorities are keen to promote. Obviously, the wide range of sub sectors and geographies involved in PPP deals make it interesting for investors, and also lenders, as they offer natural portfolio diversification from a risk exposure standpoint. Construction duration and complexity, revenue generation, operation and maintenance obligations and complexity, and duration of the underlying contract between the private company developing and operating the project with the public sector, all make for a variety of risk and returns.
FW: In your opinion, what are the major benefits of public-private partnerships, both to stakeholders, the public sector and the wider community??
Negrini: In Italy, the major benefit to stakeholders is the possibility of receiving funding from the awarding authority towards the cost of the project, together with the protection offered by the domestic legal framework. This framework came into effect in 1994 and is intended to encourage public-private partnerships and limit risk for the sponsor and the bank lenders to the project. For the public sector, PPP provides private financial resources for infrastructure which would otherwise be funded solely by the public, with constraints on public funding limiting the number and the scale of projects. PPP also helps to limit the risk of projects being abandoned by the project sponsor – especially before the completion of the works – as the sponsor is incentivised to complete the works quickly in order to begin operating the project and generate returns to repay the bank lenders and make a profit. The wider community also benefits from the fact that the sponsor’s profits depend on starting and finishing the construction phase of the project as quickly as is practical and on operating initiatives in the most efficient and profitable way.
Bortkevicha: The public sector and the government believe that the main aim of PPP is to attract financing for public needs not from the budget but from private investors. It is also expected that there is an opportunity to transfer risks related to such projects to the private sector. Another attraction for the public sector is an opportunity to use new technologies available to the private sector without investing funds in the development of such technologies. Effective project management and efficiency in the incorporation of projects is expected by the public sector. The private sector sees PPPs as an opportunity for the efficient use of public sources of financing. Investors are willing to use their substantial experience in projects that produce stable and long term income. They are not willing to take on excessive risk and believe that for an appropriate project, risk allocation is key for its successful implementation. It is also possible for the private sector to use different forms of cooperation with the public sector under a PPP umbrella, such as BTO, BOT, BOO and similar variations. The general public of course benefits considerably from these projects, as many of them would not be available without the participation of the private sector.
Dusch: For the public sector the thinking process is that a PPP may be a clever and pragmatic way to address budget constraints by implementing a private, external financing via a special purpose vehicle to whom specific missions and risks are assigned and transferred. The idea is that the public and private sector take responsibility for what they are the best equipped and experienced for: this is the source of the partnership concept. But the target of the public sector is to ideally have a time and cost effective project. For the wider community, the implementation of infrastructure is key for economic and social development and is needed in daily life: a motorway or high speed rail will save time; schools, hospitals, prisons and accommodation provide benefits and create jobs. Also, these projects are now subject to stringent environmental considerations, whether as part of the tender criteria set by the public sector or by the funds providers. Stakeholders have identified infrastructure PPPs as an alternative investment class that offers a good risk/return profile, with relatively predictable cash flows over a long time horizon. Against this backdrop it is easy to understand the appetite of institutional investors for the sector and their contribution to the emergence of a significant number of private equity funds dedicated to infrastructure and PPPs.
FW: What key challenges often arise when negotiating a PPP deal in Europe, such as legal and regulatory issues, financing mechanisms, deal structures, etc.?
Dusch: In the past, the key challenge as always has been to allocate risks between the public sector and the private sector, by identifying who is the best suited to take an identified risks and how fair it is to allocate to one party versus another. Equally, such risk transfer was driven by the investment and lending criteria from equity investors and debt providers. Also, it is key to put in place a financing structure well suited to the long term nature of the underlying contract between the granting authority and the private partner. The nature of these projects has involved highly leveraged financing structures, with a significant use of long term senior debt. But the equity component has been significant too. When a multibillion project comes to the market, several hundreds of millions worth of equity are required. It can be a daunting task to raise the required amounts. The latest challenge of course has been the constrained liquidity and risk appetite from banks that also face some potential tenor constraints due to, among others, Basle III. This is currently a key issue to be addressed as the flow of PPP projects remains high despite the uncertainty surrounding the European economy.
Negrini: From a legal point of view, it is essential to create well coordinated contractual arrangements between the major project parties – the sponsors, the SPC, the lenders, the public authority, the contractor and the operator. These contracts will be put in place to govern the concession agreement with the public authority, the construction, operation and maintenance of the project and the financing of the project. These contracts will be drafted with the aim of mitigating, through allocation to another project party, any possible risk threatening the special purpose company, which it typically achieves through the use of consolidated contractual structures (fixed price turn-key construction contracts, direct agreements between the lenders, the SPC and the other major project parties) and specific contractual provisions (such as pass through mechanisms, step-in rights in favour of the lenders so that they can replace the defaulting SPC into the concession agreement or the other major project contracts).
Bortkevicha: Most regulatory issues actually should be identified and resolved prior to singing or negotiating a PPP. Usually, a deal structure will be selected by the public authorities prior to announcing a tender and the agreement should reflect this structure. For some projects tariff regulations and the possibility of adjusting tariffs is key to a successful project implementation. If during the bid stage a financing is secured by the participants and potential lenders have an opportunity for preliminary analysis of the documents, it would also make the negotiating process easier and less time consuming, as in this case these will not be negotiations with three parties participating in them. Issues which have direct relevance to the risk allocation are site risks (such as planning, permitting environmental issues, utilities, etc.), construction and completion risks before the operation stage, and operation and termination. The fee structure is usually determined at the bidding stage and ideally should not be changed after the winner is selected.
FW: What considerations should be made when allocating risk between parties in a PPP structure?
Bortkevicha: It is usual for PPP projects to allocate particular risks to one party or another, instead of sharing it. Public authorities would try to transfer as much risk as possible to the private sector as they are obliged to deliver the product which is the subject of the agreement. It is also possible for the private sector to reallocate the risk to third parties – insurance companies, sub-contractors, etc. The risk allocation needs to be ‘bankable’ – that is, lenders need to be comfortable lending against such allocation. Each risk needs to be addressed specifically in a PPP agreement. An evaluation of different risks needs to be performed by the government in the pre-bid stage. Further reallocation of risks should be identical to the process undertaken by the private investor. The authorities are always responsible for ensuring that the project and services they have ordered match the public need, as it will be almost impossible to change their requirements during the life of the project.
Negrini: Before granting any financing to the SPC or sponsor, the first consideration for the bank lenders will be to ensure that any possible risk which may derive from the construction or the operation of the project has been duly transferred from the SPC – the borrower – to other project parties. This will typically be done via tailor-made contractual arrangements or mitigated in other ways, such as through specific insurance coverage. Such risk allocation should mitigate the lenders’ main risk: that the borrower will fail to repay the loan in full. Lenders will pay particular attention to the provisions contained in the concession agreement to verify, firstly, if and how the main risks connected with the implementation of the project – market risk, construction risk, operation risk, force majeure risk, fiscal risk, technology evolution risk – have been allocated between the SPC/concessionaire and the public authority, and to determine whether contractual arrangements between the SPC and other project parties are necessary to transfer or mitigate the non-allocated risks. Secondly, lenders will look to verify whether the concession agreement contains any protection for their financing, such as the possibility for the SPC to grant security over the assets in favour of the lenders and to receive indemnities in case of termination of the concession agreement.
Dusch: It is key, when allocating risks between parties, to ensure and understand the following. First, that the right party bears the risk. Second, that the risk itself is bearable. And third, when transferred to the private partner, to what extent the risk can affect the liquidity available, both from an equity and debt standpoint, as well as from the terms and conditions. A risk transferred to the special purpose vehicle that will implement and operate the infrastructure may indeed create a no-lending decision from the debt providers or result in an increase, for example, in the margin to reflect the risk involved which may render the project’s economics unsustainable. It is key – with the support of legal and financial advisers who have experience in PPP project financing – to anticipate these issues to ensure that an appropriate risk transfer is proposed and agreed whilst keeping the project ‘bankable’.
FW: How can investors improve their chances of creating value and generating expected returns in a PPP?
Negrini: Investors can, when setting up an SPC to build and operate a public infrastructure project, consider joining with other companies with the capabilities to build and operate the project. This will ensure that the SPC shareholders will be able to negotiate the best terms for the SPC with third party sub-contractors.
Dusch: First of all, investors need a mandate and sufficient experience to make an investment decision in a particular PPP project on the basis of sound fundamentals, including an IRR prospect in line with their investment strategy and a reasonable probability of realisation. But once in the project, the life of a PPP asset can involve refinancing opportunities that can help enhance the equity and IRR position of an investor in the asset. Lower margins, looser distribution covenants, longer tenors, and re-leverage possibilities are ways to increase the initial equity position in a project. In the current environment of expensive and less abundant debt, some investors may take the view that within a reasonable time horizon, refinancing opportunities may help achieve a higher IRR.
Bortkevicha: Proper due diligence needs to be performed by a private investor prior to the project. Avoidance of unnecessary risks should be based on the results of such due diligence. Any additional risk always means either additional investment or extra implementation costs. Investors need to be viewed by the public sector as experienced, joined (if more than two are going to operate a consortium), interested in long term investments, and financially stable. The cost of debt funding is a key issue. Tax analysis also needs to be undertaken. Creating an appropriate structure for the project company, including tax considerations, is of paramount importance.
FW: How has the banking crisis and constrained liquidity and risk appetite affected the ability to finance PPP projects, especially over the last 12 months? To what extent has it also changed the perception of investors and sponsors towards developing PPP projects?
Dusch: This issue really depends on the type of assets. For PPPs involving a volume/revenue risk, such as a motorway project, it is currently very difficult to find lenders in a risk averse market. We have come a long way from the golden years of 2003-7 when these assets were oversubscribed by banks, on terms and conditions that seem a distant memory. On the other hand, availability based projects, where the lenders are ultimately exposed to a public authority risk, in numerous cases the State, still attract liquidity, although one can argue that the margins paid are quite high in relation to the underlying risk. Without entering into a debate this means that investors’ IRR generation is affected as the cash flow available post debt service is lower, hence delays or reduced distribution potential. But overall, 2011 was a strong year and major deals, including some multibillion transactions, closed with the support of banks and investors. Investors may see their equity position at a higher risk depending on their investment strategy. But the bottom line is that existing private equity funds invest in PPPs and some existing funds have recently raised significant amounts from institutional investors.
Bortkevicha: The perception of investors has changed considerably. There was a significant reduction in the number of deals closed in 2011 compared with previous years, as well as a drop in average transaction size. In order to finance PPP projects these days, it is very important to secure either government support, such as budget guarantees or special investment funds support, or support from international finance organisations such as the EBRD, IFC, EIB, and so on. ECAs are now playing an extremely important role. The possibility of using elements of capital markets financing should also be explored. European reforms regulating the capital and returns of European banks has created constraints in the availability of funding. Banks are carefully choosing the projects that require investment, and PPPs without proper public sector support will not be their first priority due to the high investment risk.
Negrini: The global financial crisis has undoubtedly affected the Italian PPP market and closing a deal has become more complex. Despite this, appetite for new projects has not diminished, largely because of the very real need for infrastructure in Italy. Moreover, the global crisis continues to stimulate investor interest in new financing instruments such as project bonds. The combination of a need for infrastructure development and investor need for innovative financing solutions could push the national legislator to establish a favourable legislative framework for the use of project bonds, including the provision of tax incentives.
FW: How do you expect the European PPP market to unfold in 2012, and beyond? Against this backdrop, what is your general advice to investors considering a public-private partnership in Europe?
Bortkevicha: Investors will need to select projects cautiously. Both the private and public sectors need to understand the level of leverage in negotiations. The requirements of potential financiers for financing, and their willingness to finance projects, will change. Investors will need to calculate more carefully than ever potential cashflows as demand may fluctuate due to financial difficulties. It is very important to evaluate the ability to manage the project in the current environment and to understand the volume of investment a potential investor is willing to put into a project before it produces any results.
Negrini: The global financial crisis will continue to affect the Italian PPP market for the rest of this year, making it more challenging to reach financial close, but the market continues to provide good opportunities for investors. The development of the project bond market, a legislative framework specifically created to encourage and protect both the private company investing in public works and the bank lenders, and the need for infrastructure in Italy, will ensure that the Italian PPP market remains active.
Dusch: This is the crystal ball question. A cynical answer would be to say that so many deals are in the pipe and at advanced stages of fundraising that 2012, despite the difficulties and potential austerity measures implemented by governments, may still be a decent year for the European PPP market and with interesting opportunities for investors. We should not forget that secondary market PPP assets are also in the market, perhaps up for grabs at a certain discount. Also, austerity may be compatible with the pursuit of a PPP scheme since, from the public sector standpoint, it is supposed to be time and cost efficient. My advice to investors considering PPP investments in Europe is: buy.
Victoria Bortkevicha is a partner at Clifford Chance CIS Limited and head of Projects. She specialises in asset finance, pre-export/import financings, trade and project finance, export credit agency backed financing, has particular expertise in the energy and infrastructure sectors. Ms Bortkevicha was a leading Russian partner, advising on such groundbreaking PPP projects such as the development, reconstruction and operation of St Petersburg's Pulkovo Airport, the construction and subsequent operation of the Yanino waste treatment facility, and the implementation of the Nadzemny Express light rail transit line in St. Petersburg. Besides this, she is a member of the Moscow International Financial Centre Taskforce (Moscow infrastructure development project group) and a member of the Expert Council on PPP legislation of the State Duma's Committee on Economic Policy and Entrepreneurship. She can be contacted on +7 495 725 6406 or by email: Victoria.Bortkevicha@CliffordChance.com.
Elisabetta Negrini is a senior associate based in the Milan office of Norton Rose LLP. She specialises in project finance in the energy and infrastructure sectors. She graduated in law from the Università Cattolica del Sacro Cuore of Milan and qualified as a lawyer in Italy in 2005. Prior to joining the Norton Rose practice in Italy Ms Negrini worked in the project finance department of Bayerische Hypo-und Vereinsbank, Milan branch. Ms Negrini is co-author of the chapter on Italy in ‘A Practitioner’s Guide to PPP in the European Union’ (City & Financial, 2010). Her recent experience includes advising the borrower on the financing of the Bre.Be.Mi. Highway Project and the banks on the Garbagnate Hospital PPP, both projects in Northern Italy. She can be contacted on +39 02 8635 941 or by email: firstname.lastname@example.org.
Jean-Francis Dusch is a managing director and head of Project Finance at La Compagnie Benjamin de Rothschild. He joined La Compagnie Benjamin de Rothschild in 2004, in their Project Finance department which he co-runs, contributing to the development of the PPP financial advisory and private equity structuring activities. He is in charge of the advisory mandate such as CDG-express, GSM-R, Dakar-Diamniadio motorway, the MAPPP debt guarantee programme for PPP projects on the public sector side. He advised private consortia on the HSL BPL, A150 and University Toulouse projects. He also led the recent successful closing of Transport Infrastructure Investment Company in 2008, an international transportation investment fund and currently structures a French PPP-focused investment vehicle. He can be contacted on +44 7860 439 089 or by email: email@example.com.
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