09 Dec 2013


Authored by: Nicholas McGrenra


In this article Nicholas McGrenra, Senior Legal Consultant at Hadef & Partners discusses the role of Public Private Partnerships in financing and delivering infrastructure projects. Nicholas provides an overview of the UK’s Private Finance Initiative and looks at bond finance and corporate finance variants.

In brief this article provides:

  • A background of Public private partnerships (PPP’s) and definitions of the associated terminology.
  • An overview of PFI and the typical structures available.
  • Guidance on bond finance and corporate finance variants.

Background and Terminology

Public private partnerships (PPP’s) can take many forms. Historically, the terminology used to describe the involvement of the private sector in the delivery of public services has often been quite broad, and the different perceptions of the various terms and acronyms associated with such involvement means that it is quite difficult to identify a common understanding.

In the UK, the term “privatisation” was initially used to describe the government’s restructuring of the public sector more generally, covering all forms of private involvement from the sale of national industries to the more straightforward contracting (or outsourcing) of functions such as refuse collection. Other terms such as “concession” and “private sector participation” have also been widely used in other jurisdictions, sometimes with a more common, specific meaning. However, none of these terms is legally or technically exact.

Likewise, more recent terms (such as PPP), whilst having been adopted to identify private sector involvement characterised by a collaborative, typically longer term partnering approach between the different sectors, are not intended to be precise. A typical PPP would not be a partnership in a strict legal sense, but a contractual relationship between the public and private sectors. This quite general term can encompass a variety of different models (and therefore another subset of acronyms), such as DBO (design, build and operate) and DBFO (design, build, finance and operate) models.

For the purpose of this article we will focus on the DBFO model, a form of which has been adopted and developed for the UK’s Private Finance Initiative (“PFI”) since 1997. It is informative to consider the experiences of this specific type of PPP over approximately 15 years in the UK, which has resulted in the development of common procurement and evaluation methodology procedures, and highly standardised contract documentation.

Overview of PFI

In broad terms, this is a form of PPP that combines public procurement programmes for the design and build of capital assets, and an extended form of contracting-out of specific services in respect of such asset. It differs from other PPP’s/contracting-out arrangements in that the private sector contractor arranges the finance for the project, and provides the capital asset as well as the services. The procuring authority will specify the outputs required in respect of works and services, and it will be for a private consortium to produce the detailed designs and other technical inputs, as well as sourcing the necessary finance, by way of a competitive tender process.

PFI has been used extensively for accommodation based projects in the education, health and defence sectors as well as for certain transport and waste disposal projects. It should be noted that the services provided have typically been “building services”, such as cleaning, maintenance and catering over a period of 25 to 30 years after completion of the construction phase. Therefore, in sectors such as education and health, teaching and clinical services remain with the public sector. Typically, the capital asset will be owned by the public sector, but leased or given on a concession to the private sector, and upon the expiry (or early termination) of the contract control will be handed back to the public sector.

Typical PFI Structure

The key elements of this structure are:

  • a special purpose vehicle (“SPV”) project company will contract with the procuring authority but sub-contractor(s) will provide the actual performance of the project on its behalf, pursuant to “flow-down” sub-contracts entered into with the SPV;
  • the project is wholly or partly financed by limited recourse debt borrowed by the SPV (typically in the UK PFI model a debt to sponsor equity ratio of 85 or 90% to 15 or 10% has been utilised). The project therefore remains off balance sheet for the sponsors and the procuring authority;
  • no payments by the procuring authority until completion of the construction phase (SPV will utilise senior and subordinated debt/equity contributions to fund capital costs during the construction phase, and make payments accordingly under the construction sub-contract); and
  • upon completion of the construction phase payment of a “unitary” charge by the procuring authority commences. Essentially this comprises 3 elements, (i) the amount required by SPV to service its senior debt; (ii) returns to equity/junior debt; and (iii) the operation and maintenance fee calculated in accordance with an availability/performance based payment mechanism.

This structure is often referred to as “project finance”, which essentially means the debt finance (sourced by the SPV from banks or in the bond market) is raised on a project-specific basis, and primarily relies on the project documentation for security, and on the specific project cash flows for repayment.

Accordingly, the security typically required of an SPV in respect of its debt obligations would include assignment of its rights under the project documentation (which will include payment of the unitary charge to it) to the funder, and the funder will require a direct agreement with the procuring authority dealing with issues such as step-in rights. It should be noted that, in the UK context, whilst the majority of these types of projects have not required mortgages over the physical asset to be delivered, this has been dependent on the nature of the asset and the financial covenant strength of the procuring authority (which ultimately services the debt via the unitary charge). It is also likely that the funder will require charges over the project bank accounts held by the SPV, and through which the project revenue streams flow, as well as share pledges in respect of the SPV.

Given the nature of the aforementioned security interests, the lender will need to undertake its own due diligence process in respect of the project documentation, and will probably also insist upon parent company guarantees and collateral warranties (including step-in rights) to be provided to it by the SPV’s sub-contractors. Alternatively, it may take an assignment of any such security provided in favour of the SPV, as well as any construction related bonds provided.

This structure can bring a number of benefits for the procuring authority, including:

  • the systemic and rigorous application of funder legal due diligence in respect of the project which is required for the funder’s credit analysis/approval process, and which plays a significant role in achieving a value-for-money risk transfer to the private sector;
  • an SPV is “bankruptcy-remote”, and hence the project can survive the insolvency of its shareholders (there are step-in rights for a funder pursuant to its direct agreement with the procuring authority in circumstances where a project is struggling); and
  • proven track record of on-time completion of construction phase (in part due to the timing of unitary charge payments, which are not triggered until completion of the construction phase).

It should be noted that for UAE purposes and UAE Federal Commercial Company Law purposes there is likely to be a requirement to establish an appropriate UAE company that is the SPV owner, and which will comprise of the procuring authority and the private sector partner. The usual corporate vehicle used in UAE infrastructure projects is the private joint stock company (PJSC). The anticipated new Commercial Companies Law may permit foreign sponsors to “own”, and to be the sole shareholders in, certain projects that are considered to be of important economic value to the UAE.

Until the new law is enacted we must rely on the existing law that may require the project SPV to be a joint venture between the procuring authority and the private sector sponsor. This is not typical of PFI projects to date, where SPV equity has been provided solely by the private sector sponsors. However, the UK is in the process of adopting a new approach, referred to as PF2, as the government’s successor to PFI for the delivery of infrastructure and services through PPP’s. This new approach anticipates the investment of public sector equity in a PPP.

Bond finance and corporate finance variants

The UK government’s guidance and detailed drafting for the standardisation of private finance contracts (both PFI and PF2) has generally assumed and provided for a typical project finance type structure on the basis of bank debt. However, it does outline how a bond or corporate financing solution can be accommodated within the standard form PPP procurement process, and contract documentation, with certain amendments related to their distinguishing characteristics.

Bond Finance

PFI projects with larger capital values have previously been successful in raising money on the bond markets. They have been used most extensively in countries with significant private sector pension schemes having long term liabilities, which need to be matched to long term assets. This source of finance has been used both as an alternative to, or to supplement, bank debt.

In the UK, these project bonds nearly always benefited from a wrap provided by the monoline credit insurance industry. That is, they were given a financial guarantee of scheduled payments of principal and interest. This “credit wrap” enabled the bonds to be rated according to the rating of the guarantor, thereby providing an affordable financing solution. However, the effectiveness of the monolines in facilitating PPP funding through the capital markets was severely impaired by the reduction in their ratings, precipitated by the global economic crisis, which caused bond investors to effectively withdraw from the PPP market. It should be noted that the monoline credit downgrades are generally accepted to be unrelated to their activities in the public finance and infrastructure sectors, but rather as a result of exposure in respect of other securities.

It should be noted that PF2 projects are now being structured in such a way that will hopefully revive access to the capital markets, or other alternative sources of long term debt finance.

Corporate Finance

This is where a private sector bidder proposes to raise the finance required for the project based on the credit strength of that bidder’s, or its parent company’s, general (not project-specific) business and balance sheet. This can be distinguished from a project finance transaction in the following respects:

the fixed-price nature of bids - there should be no adjustment for interest rate movements between bid and financial close;
the SPV structure generally does not apply, and the prime contractor (with the appropriate financial standing) contracts directly with the procuring authority;
the project documentation will not require references to third-party finance, or associated issues;
there is no third-party creditor due-diligence process (which, although producing benefits in terms of simplicity and speed and savings in respect of the lender’s fixed financing costs, means the procuring authority will need to pay special attention to the due-diligence process itself); and
no direct agreements, assignments or other documentation required by the procuring authority in favour of a third-party funder (although this also means there is an absence of lender(s) who may step-in and rescue the project should it get into difficulty, so ensuring continued service provision).
However, the amount of finance needed to meet the investment needs of many infrastructure projects is beyond the balance sheet capacity of the majority of the individual companies potentially interested in bidding for such projects.

This article, including any advice, commentary or recommendation herein, is provided on a complimentary basis without consideration of any specific objectives, circumstances or facts. It reflects the views of the writer which may, in some cases, differ from those of the firm, especially in the develop jurisdiction of the UAE.