Public Private Partnerships (PPPs) are always structured as Special Purpose Vehicles (SPVs) for reasons outlined in our previous article on the Fundamentals of PPPs. An SPV’s financial performance is analyzed on its own merit, it carries its own risks and it does not affect other investments made by the parties who have invested in it. Therefore, to understand how PPPs work, it is imperative to dissect the SPV structure and the different stakeholders involved in the whole operation.
The two main parties in a PPP model are the private and public sector partners. The public sector player has the mandate to deliver infrastructure and other public goods to the citizens; while the private sector seeks to invest in profit-making ventures to grow their wealth. With the public sector pursuing a social goal while the private sector is profit-oriented, the two parties need to create a separate entity that serves their objectives and ensures each party achieves its goals when the project is executed. An SPV is created as a separate entity from the private sector investors and the involved public sector entity.
Under the SPV structure, each of the two main stakeholders (private and public sector players) have their key roles and responsibilities outlined clearly from the onset. In most cases, the public sector will provide the land where the project will be developed, as well as other guarantees to provide security to the private sector investment once the project kicks off. On the other hand, the private sector will in most cases provide the technical expertise needed to undertake the project as well as mobilize capital from other sources to fund the construction phase of the project.
When mobilizing funding for the project, new stakeholders are added to the SPV based on the roles they play in the financing cycles of the project. Equity investors are typically the private sector players that are getting into the PPP arrangement with the government agency. In some cases the government can also be an equity shareholder in the SPV. Equity investors inject the initial capital needed to fund the preparatory phases of the PPP project; and their risk exposure is limited to the amount of equity capital they invest in the project.
To fund the construction phase of the PPP project, the SPV raises debt capital on its own balance sheet from debt investors. This category of investors extend credit to the PPP project and they vary depending on the phase of the project over its lifetime. In the early days, banks extend short-term credit to the SPV to undertake the initial construction works. Banks hope to recover their money plus the interest thereon from future refinancing when the SPV raises long-term capital. To complete the project development the SPV raises long-term debt in form of revenue bonds; whose repayment is pegged on the cash-flow generation capacity of the PPP project. This long-term debt can also be raised from pension funds and insurance companies that have long-term investment horizons aligned to the PPP project lifetime.
In order to attract long-term funding from institutional investors like mutual funds and pension funds, the SPV needs to have a strong credit standing. To achieve this goal, the SPV engages commercial banks and insurance companies to provide bank guarantees and credit insurance. On the other hand, the SPV engages credit rating agencies in order to get their credit rating assessed and published by a trusted third party. This then creates confidence in the target institutional investors for them to consider extending long-term credit facilities to the SPV.
Apart from the financing side stakeholders, the SPV also has to engage with stakeholders who will get the construction done and the project maintained over its lifetime. In this case the SPV may appoint its parent company as the construction contractor for the project; or it might outsource it to a third party. By contracting its parent company to run with the construction works, the SPV creates a channel for the equity investors in the project to recoup their investment sooner; once certain milestones have been achieved as agreed with the debt investors.
Finally, after the construction phase is over, the SPV appoints another company to maintain the project over its lifetime. The SPV can allocate this role to its parent company too. However, the parent company cannot deliver on the maintenance mandate directly; but it will create another SPV to handle the maintenance contract. This is meant to protect the risk-free revenues generated by the PPP project from other riskier investments being undertaken by the parent company.
Author: Jeremy Riro