Public-private partnerships in Asia
July 2012 | TALKINGPOINT | FINANCE & INVESTMENT
FW moderates an online discussion on public-private partnerships in Asia between Harvey Weaver, a partner at Ashurst, Simon Booker, a director at KPMG Corporate Finance, and John Walker, senior managing director at Macquarie Capital.
FW: What recent trends and opportunities have you witnessed in the Asian PPP market over the last 12 months or so? Have any projects in particular caught your eye?
Booker: The level and intensity of discussion around PPPs has changed. PPPs are increasingly coming of age and are recognised as a way of accelerating the delivery of infrastructure throughout the region, and importantly, as a means of promoting efficiency in the delivery of services by making use of private sector expertise. Importantly, however, it is clear that the PPP concept itself is in a state of transition. Increasingly, more complex PPPs are coming to market, demonstrating an evolution from discrete PPPs, to those with more complex serviced infrastructure components. Examples include hospital PPPs which include clinical services, such is the case in Hong Kong. So, what is facilitating this change? In some cases it is driven by a growing recognition of the need to scale-back the role of government and transfer greater service delivery responsibility to the private sector. This is about creating and expanding commercial markets. In other cases, economic, funding and liquidity constraints drive interest. Vietnam, for example, is projected to hit domestic power generating capacity by 2015. As a consequence, the regulatory environment in these markets is shifting perceptibly, and is increasingly providing comfort to investors in the market. Confidence is on the rise.
Walker: More Asian markets are actively starting to use PPP and other private sector financing structures for essential infrastructure and utilities projects. In particular, there are increasing deal flows in the power and transport sectors. Another trend is in the emergence of local banks in the financing of PPP projects in Asia. More developed Asian markets such as Japan and Korea have always had local lenders provide financing for infrastructure project financing, and indeed these banks are now looking to participate in global markets with Japanese banks already a major provider of liquidity globally. However, this has not been the case in emerging markets, which have a heavy reliance on multilateral, development and export credit financing. However, we are seeing more activity within loan lending markets, particularly in markets such as Indonesia and Philippines. Some projects that are particularly interesting include the CHP5 project in Mongolia and the LRT1 project in Philippines.
Weaver: We have seen a marked increase in government promotion of PPPs in places such as Indonesia, the Philippines and Vietnam, with deal pipelines being announced to attract investors. This has usually been accompanied by legislative reform to try and remove legal impediments to PPP development. While this has led to an increase in the number of projects supposedly being brought to market, many projects are small scale and are likely to attract only domestic investors and financiers. There are still relatively few large scale projects of a size and complexity that will attract overseas investors. The LRT-1 rail project in the Philippines appears to be attracting international interest along with some of the ‘mega projects’ with PPP elements such as the dedicated freight corridor in India – although some of these have tied funding which is becoming another feature of the market in developing countries.
FW: Which sectors seem to be generating the most opportunities for PPP deals?
Walker: We see the greatest number of deals in power and transport. However, between these two sectors it is the power market, both conventional and renewable, that is the most active and successful in reaching financing close. This is probably due to there being a greater need for power than transport assets and also due to there being a higher level of sophistication in the power sector, in both the public and private sectors. There is a lot of data demonstrating that the private sector is more efficient in generating power and hence it makes sense for governments to have the private sector responsible for power generation. I expect that there would be continuing need for power after which, transport infrastructure, particularly in roads and logistics, and then environmental utilities, will be needed in growing volumes.
Weaver: Setting aside power, which many still class as PPP in Asia, the two ‘hot’ sectors appear to be rail and water/waste water. Given the need for better transport links and faster routes to market, rail projects, both heavy and light rail, are starting to come to the fore. Apart from the mega rail projects in India there are upcoming heavy or light rail in projects in countries such as the Philippines, Vietnam and Indonesia. Given population growth in Asia, water and waste water projects are now becoming a priority. We see a lot more interest from Asian clients in this sector. Japanese companies in particular often have leading technology in this area but in Asia have tended more towards being suppliers or contractors rather than upfront investors. This is changing and they are now looking at both investment and contracting opportunities, and the liquidity of Japanese banks is also to their advantage.
Booker: Power and utilities are hot sectors at present in the Asia-Pacific PPP market. There is an increasing recognition of a supportive regulatory environment around these assets in key markets, coupled with a genuine need for urgent provision. Airports and healthcare are also resurgent, with some high profile hospital PPPs recently coming to market in Hong Kong and the Philippines. But road and rail deals still dominate the market when defined in terms of capital value, with Indonesia, Thailand and the Philippines accounting for over 70 percent of the market.
FW: In your opinion, what are the major benefits of public-private partnerships, both to stakeholders, the public sector and the wider community?
Weaver: Asia has a significant need for new infrastructure but the public sector cannot fund all the capital expenditure required. While there are always debates about the real ‘value for money’ of PPP, the fact is that many new facilities would not exist without this procurement route and there is risk transfer to the private sector. This benefits the wider community and delivers more modern facilities that they may otherwise never see. As PPP procurement usually transfers the responsibility for both the construction and operation/maintenance, it often achieves a more integrated project which can have whole life cost benefits. This is not necessarily the case in a straight design and construction or separate operation/maintenance procurement. For stakeholders, from an international perspective PPP gives them the opportunity to access new markets, often alongside domestic players who know and understand that market. This can remove an element of risk and is a good way of gaining experience in a new market which may lead to further business expansion.
Booker: PPPs offer the opportunity for governments to increase budgetary flexibility, by avoiding the need to pre-fund large capital programmes that require significant up-front financing. Many governments throughout the region have deserving and competing calls on resources, and transferring the funding burden to investors is an increasingly attractive proposition. The community of course benefits in two ways: firstly, through the timely provision or enhancement of social infrastructure through the PPP itself, that would otherwise not have been delivered; and secondly, by freeing up public resources from large scale infrastructure projects and allowing governments to focus resources on grass roots community needs that are so often overlooked.
Walker: There are several benefits of PPP structures when done properly. As with any other tools, used wrongly, PPP structure could result in quite significant adverse outcomes. However, the key benefits include the following. The first is cost benefits to the public sector and therefore reduced burden on taxpayers. Private sector efficiencies and innovation could lead to lower costs over the life of the asset. Although publicly procured infrastructure may have a lower ‘sticker price’ in the form of construction price, many such contracts results in substantial cost and time overruns, which leads to higher cost to users ultimately. The second benefit is clear delineation of government functions. The PPP structure permits governments to concentrate on its core functions, namely regulation and policy. With PPPs governments can continue to control these functions without unnecessarily needing to engage in functions outside of their normal competencies. The third benefit is deepening of markets. Infrastructure assets investment provides long term stable investment products to local and global investors leading to the development of a long term investment market with a focus on robust risk management. Also, such products allow pension funds and insurance companies to match their investments to funding sources, thereby contributing to increased stability of a nation’s financial backbone.
FW: What key challenges often arise when negotiating a PPP deal in Asia, such as legal and regulatory issues, financing mechanisms, deal structures, etc?
Booker: The challenges of closing a PPP deal in many Asia markets cannot be underestimate, but these challenges must of be considered within the context of the growth potential presented by these markets. In many cases, the size of the prize is considerable. Nonetheless, we see a large pipeline of PPP deals throughout Asia, but historically few of these have converted through to financial close. Those that do, suffer from protracted procurement processes that can extend over several years. The greatest frustration for investors often centres on the lack of certainty that the regulatory and legal environment offers. In many cases there is scope for great interpretation of contracts and incentive mechanisms, and a lack of clarity around the role and responsibility of government authorities.
Weaver: The Asian PPP market is still developing. Investors need to be patient and pick their projects carefully, using market soundings where possible to influence structures. Unfortunately we still see badly structured projects which often leads to few or no bidders. The increasing availability of technical assistance grants, such as from the Asian Development Bank, will hopefully help change this. Due to the differing levels of development of the legal regimes across Asia, investors need to understand that the legal and regulatory framework may often be unclear in certain respects. This must be factored into ‘country risk’. As regards financing, currency issues often pose significant risks if there is a local currency payment stream but, say, US dollar debt. In many developing countries there is no hedging market to speak of so investors need to consider ways of dealing with this risk. While certain programmes, such as the Vietnam power programme, have come up with structures to deal with this, it remains a key issue.
Walker: Every country has different issues to make PPP deals difficult. However, some of the more common challenges arise from legal and regulatory, and procedural issues. PPP projects often need very high levels of clarity in legal and regulatory matters as PPPs are founded on a surgical identification and distribution of risks. Some of the more common legal and regulatory issues faced in new markets for PPP include real property security and ownership laws, enforcement rights and land acquisition related laws. However, assuming that legal and regulatory matters can be fixed over time, a more chronic issue in emerging markets is in the process for the procurement of PPPs. Often there are substantial delays leading to the dilution of returns. Also, in many cases, there are substantial uncertainties relating to the completion of a project procurement process so that there are delays and increased costs to all parties.
FW: What considerations should be made when allocating risk between parties in a PPP structure?
Walker: PPPs are done on the basis that a risk should be allocated to the party best placed to manage that particular risk. With certain risks, this is quite straightforward – for example, the risk related to connecting a power plant to the government owned grid network. However, on others, it is not so clear – for example, long term interest rate risks. Risk allocation should be done on the basis of a combination of precedents, market conditions and the involved parties. Focusing too much on just a part of the balance will lead to issues later.
Weaver: The public sector in Asia needs to understand that the private sector is used to taking and managing risk, but will resist doing so where it has no control over a risk or it cannot be priced appropriately. In Asia I often feel that the aim is to transfer as much risk as possible to the private sector. Even if this were to be achievable – and the result is usually few if any bidders – it leads to high pricing for risks that the public sector is best placed to absorb. The public sector needs to be realistic. For example, land acquisition is usually a risk best borne by the public sector, which in most jurisdictions has the relevant compulsory purchase powers. These powers may not be available to the private sector, and even if they were the potential cost, time and political ramifications of leaving land acquisition to the private sector would be significant.
Booker: The balance of risk in any PPP is critical. Risks must be allocated to the party that is best able to manage them. Inefficient and poorly thought-out procurement practices are one of the single biggest reasons why some PPPs do not deliver value for money. Put simply, the transfer of risk to a bidder comes at a price. Transfer too much risk and the resulting increase in the cost of funding acts directly to undermine any efficiency gains that the PPP might have delivered. As a result, value for money for the public sector is diminished. We encourage our public sector clients to think long and hard about which party is best placed to manage risk. Inflation and foreign exchange risks are good examples of risks that are often mismanaged. Why transfer all foreign exchange risk to a bidder who will simply price-in a worst-case scenario, when government could better manage the risk itself by compensating for out-turn exchange rate movements? In some cases, the latter approach delivers better value for money for government.
FW: How can investors improve their chances of creating value and generating expected returns in a PPP?
Weaver: It is key that investors properly due diligence the jurisdiction they are considering investing in, both from a legal and regulatory point of view and to find the right local partner. They will know the political landscape, how business operates on the ground and will usually have connections with local funders. These external factors, if not handled correctly, can significantly impact the bottom line. Of course there is also the due diligence on the transaction itself. This is always vital but particularly so in a developing market with little standardisation. Is there room to innovate and use cost saving techniques that the investor may have developed elsewhere to deliver efficiencies and enhance their earnings? Finally, while there is no developed secondary market in Asian PPP as yet, a well run and value generating project will in time be attractive to investors looking for more mature assets, enabling value to be released.
Booker: Investors must not only create value, they must also protect it. First and foremost, conduct thorough due diligence. In emerging markets where, more often than not, significant hope value is attached to future growth – often from a comparatively low base – investors must understand the drivers of growth and the extent to which these could generate real returns. Secondly, structure your bid from the outset in a way that protects value. Involving multilaterals as co-investors in some territories is always helpful, as is the involvement of export credit agencies. No matter how small their involvement in the deal, their presence at the negotiating table should things go wrong is an asset. Consider also the merits of making the most of bilateral trade treaties by incorporating SPVs in locations which enjoy bilateral treaties with the host nation, as risks can be reduced and bidders stand a better chance of securing fair and reasonable treatment in the course of any dispute.
Walker: Largely, whether an investor makes money or not in a PPP is determined upfront. As PPPs are often structured to be quite rigid with capped upsides in most cases, the relative profitability will be determined and locked down at financial close. Additional value can be achieved through market conditions such as higher than estimated inflation for inflation linked PPPs or lower interest rates for deals with interest rate exposure. However, all of this needs to be set up upfront. Investors should approach PPP opportunities with a very robust risk management mindset and think carefully about the risks within the project and how to manage such risks. Infrastructure investment should not be led by a consideration of returns – but an assessment of the risks leading to the appropriate returns requirements.
FW: How do you expect the Asia PPP market to unfold in 2012, and beyond? Against this backdrop, what is your general advice to investors considering a public-private partnership in Asia?
Booker: There is a strong pipeline of PPP projects under consideration in 2012. Closing these deals will depend on government support gathering momentum in key markets. The complexity of PPPs will also increase. The trend is towards greater sophistication in the procurement of not only hard infrastructure, but managed services too. Project financing will also continue to evolve. We have seen the first project bonds being applied in Taiwan and trialled in China, but we must also look more creatively at financing solutions, potentially extending the reach of project finance into pension funds. We also expect to see a greater role for PPPs in markets that have not historically presented opportunities. China is a great example, although like many Asia markets, regulatory reform will be key. For investors, the time is now. The opportunity is real, albeit the risks are higher than in more established markets. But the flight to seek out higher returns on investment should increasingly favour the Asia PPP market. Consider risks carefully, and mitigate them where you can by structuring the deal in a way that protects value.
Walker: I expect that the Asian PPP market will become more active over the near future. There will be increasingly larger projects with greater competition from local and international parties as they all seek opportunities in growing markets. My advice to investors would be to be very calculating. Importantly, do not say no to a deal simply because it looks ‘risky’, ‘difficult’ or ‘different’ – often enough, such views are derived from past practices and experiences from different markets, which may not be relevant in Asia. However, at the same time, remember that PPP structures are based on a set of logics derived from a very simple philosophy: risk/reward. Always be pragmatic in the assessment of a project’s risks and where possible try to find ways to take risks rather than blindly refuse risks, however, ensure that each decision is based on a serious assessment.
Weaver: I would not expect to see one market becoming dominant and investors often see ‘country risk’ differently. I am cautiously optimistic that the recent momentum will continue but for this to accelerate governments need to take the initiative and push through projects in a realistic way to create confidence. Currently there is a lot of potential but unless governments take the initiative, are realistic and learn lessons from more developed PPP markets, we could be saying the same in three years’ time, by which time investors may have run out of patience. Recent years have seen developing PPP markets in places such as the Philippines, Indonesia, India, Thailand and Vietnam. Beyond 2012 we may well see jurisdictions such as Mongolia and Myanmar starting to look more seriously at PPP, though this will take time. There is also talk of a revival in the Singapore PPP market following a loss of its early momentum, which would be welcome.
Harvey Weaver is a partner at Ashurst Horitsu Jimusho Gaikokuho Kyodo Jigyo, Tokyo. Mr Weaver has advised on PPP projects across Asia including projects such the North Luzon Expressway (Philippines), the Pune-Solapur Expressway (India) and the ITE College West Project (Singapore). He is currently advising the Philippines Government on a schools project. He also has a significant track record of advising on UK PPP projects. Mr Weaver has worked in Hong Kong, Tokyo and London. He can be contacted on +81 3 5405 6209 or by email: email@example.com.
Simon Booker is a director in KPMG’s Infrastructure Finance practice and head of Infrastructure Finance, Hong Kong and China. He specialises in project finance and advises both bidders and Governments across a range of sectors from healthcare, to roads, rail and aviation. Prior to joining KPMG, Mr Booker worked for both PwC in the Global Infrastructure Team based in London and the UK Civil Aviation Authority as their Senior Financial Advisor. He can be contacted on +852 2140 2336 or by email: firstname.lastname@example.org.
John Walker is senior managing director at Macquarie Capital. On 8 June 2011 he was appointed as Head of Infrastructure, Utilities and Renewables Asia for Macquarie Capital. In that period Macquarie has completed its first Dim Sum bond for a Chinese utility and has been appointed on a number of cross-border M&A transactions, listed and unlisted capital raisings and project financings. In 2000, Mr Walker established Macquarie’s Korean business with only five staff. It now comprises 12 businesses with 7 funds and has a total value of assets invested of approximately $A20bn in Korea and internationally. He can be contacted on +852 3922 1805 or by email: email@example.com.
© Financier Worldwide
KPMG Corporate Finance