New risk sharing models for privately financed infrastructure projects
First published on LinkedIn on October 9, 2020
I’ve recently been having lots of conversations about the allocation of construction risks on infrastructure projects. There seems to be a growing consensus that project owners are transferring too much risk to their supply chain, and that whilst project owners may achieve a cheap price for this risk transfer at the time of contract award, the longer term outcomes are sub-optimal for all concerned, including owners. Much of the blame for this situation is laid at the feet of government and their lawyers.
I have recently suggested (see links below) some solutions that can be applied to publicly funded projects, including:
embracing alliancing and other collaborative contracting approaches that involve greater risk sharing by the project owner; and
abandoning tendered fixed prices in favour of alternative commercial frameworks that better align the commercial interests of the owner and non-owner participants by reimbursing the costs incurred by the non-owner participants and tying their profit margin to the achievement of whole-of-project outcomes desired by the owner.
It has long been considered, however, that such approaches cannot be applied to privately financed projects. This article offers a contrary view.
But first, some private finance 101.
Private finance 101
Private sector investors in new infrastructure projects seek to limit their financial exposure to the amount of equity they invest. They do this by establishing a special purpose vehicle (SPV) that borrows the balance of the funds needed to pay for the design and construction of the infrastructure.
The debt finance is borrowed on a ‘limited recourse’ basis, meaning the financiers can only have recourse to the SPV and its assets for repayment of the loan – the lenders cannot have recourse to the equity investors, beyond the amount of their equity in the SPV. The consequence of this is that the lenders are exposed to the construction risks faced by the SPV. If the occurrence of such risks affects the SPV’s ability to complete the project and repay the loan, the lenders are exposed.
The providers of limited recourse debt finance have a relatively inflexible risk/reward equation. They require a high degree of certainty that the debt will be repaid. Accordingly, they have little appetite for risks that could adversely affect the ability of the SPV to repay the loan. Commensurate with their low risk profile, they only receive a fixed margin by way of interest on the loan. The lenders don’t share in profits generated by the SPV if the project is successful. Nor do they wish to, as doing so would require them to accept the same or a similar level of risk as the equity investors, which would expose the lenders to greater risk of the loan not being repaid.
The upshot of using limited recourse debt is that the ability of the SPV to accept and manage risk (including construction risks) is constrained by the amount of equity invested in the SPV. The lenders need to be satisfied that the SPV has sufficient equity funding to absorb the foreseeable consequences of the risks to which the SPV is exposed. If the SPV wishes to accept a higher level of risk, it will need more equity, and less debt.
Because equity finance is exposed to greater risk than the debt finance, the reward that equity investors expect is higher than that expected by debt financiers. As such, equity finance is more expensive than debt finance. To minimise its cost of finance, the SPV will look to minimise the amount of equity it needs, and maximise its use of debt. But doing so also minimises the SPV’s financial capacity to accept and manage risk.
It is for this reason that the SPV’s have traditionally sought to transfer the risks associated with the design and construction (D&C) of a project to a D&C contractor under a fixed price D&C contract, with very few entitlements to extra money or extra time.
Can alliance contracting principles be combined with private finance?
It is often said that project alliance contracts can’t be combined with private finance. This is broadly true, in that the risks that a SPV would be exposed to as the owner participant in a project alliance are so great that the level of equity it would need to manage and absorb such risks would make the use of project finance uneconomic.
Project alliance contracts represent the high water mark of collaborative contracting. The owner participant shares in all risks associated with the delivery of the project, including construction cost and time blowouts. The other participants also share these risks but generally only to the extent of their profit margin. Once the pain share cap of the non-owner participants is reached, they have no further obligation to share the financial pain suffered by the owner. Whilst this risk sharing arrangement incentivises non-owner participants to help the owner to solve problems arising from the occurrence of risks, it also exposes to SPV to greater risk than a traditional fixed price contract that allocates the risk to the contractor. This, in turn, exposes the SPV’s debt financiers to unacceptable additional risk, unless the SPV substitutes enough debt with equity, to cover the additional risk.
The ‘no-blame’ regime found in most project alliance contracts raises similar project finance issues, as it prevents the SPV owner participant from suing the non-owner participants for the additional O&M costs and/or lost revenue if the facility is not fit for purpose or fails to perform as specified. Rather, the SPV can only claim the pain-share payments in accordance with the agreed pain-share regime, up to the agreed cap. The additional equity that the SPV would need to be able to absorb this risk will make the use of limited recourse project finance uneconomic.
Solution – government commits to provide the necessary ‘contingent’ equity
But the risk sharing arrangements and no blame regime found in project alliance contracts could be made compatible with the use of limited recourse private finance if government shared the owner participant’s risks with the SPV. For example:
the pain-share exposure of the SPV could be capped at the amount of equity invested in the SPV; and
government could commit to providing the additional ‘contingent’ equity funding that the project financiers consider is necessary to cover the balance of the risks that the SPV faces under the alliance contract.
Another solution – keep the equity finance and use full recourse debt
Another alternative is to forget about exposing the debt financiers to project risk and instead:
government borrows, on a full recourse basis, any additional finance that the SPV needs to pay for the design and construction of the asset, and on lend finance this to the SPV;
the equity investors capitalise the SPV with pain-share equity, which can fund additional costs and losses in a pain-share situation; and
once the pain-share equity is exhausted, government takes 100% control of the SPV and may exercise the rights and/or reserve powers that the SPV has under the alliance contract to continue with (or abandon or vary) the project.
Better outcomes for all
Each of these arrangements would allow governments (and other project owners) to:
access private sector capital; and
share project risks with the private sector investors and debt financiers in a manner consistent with the usual risk/reward parameters of these parties.
The key difference between the two solutions is that the private sector debt financiers are only exposed to project risks under the first solution, not the second. But the private sector equity investors provide government with a buffer against project risks under both solutions. And the reduced risk exposure of the lenders in the second solution will also reduce the cost of the debt finance to the government’s cost of borrowing.
Most importantly, both solutions will enable governments (and other project owners) to contract with the infrastructure delivery supply chain under contractual arrangements that avoid the pitfalls of traditional fixed price contracts and instead incentivise the supply chain to optimise the project outcomes that the owner is after.
A better outcome for all project participants!
