“Nothing is free.”

That was the view of Bonnie Lysyk, the Auditor General of Ontario, last year when she launched an open criticism on the structuring of construction financing for public-private partnerships (PPP’s) in Canada.

According to the Ontario Auditor General’s 2014 annual report, Infrastructure Ontario’s use of PPP cost $8 billion more than traditional public financing. The report stated that “this shows that if the public sector could manage projects successfully, on time and on budget, taxpayer money could be saved.”

Of course, if it was that simple everyone (not just the government) would structure their projects using Private Finance Initiative (PFI). Major construction projects routinely suffer from cost overruns and delays, mainly because of the level of risk usually associated with projects of a certain size.

However, when we look at Ontario, British Columbia and Alberta’s Infrastructure projects since the 2008 financial turmoil, it is evident the way PPP’s are financed is indeed evolving.

Plugging the money sink

One way to restructure the current process for construction financing in PPP is to employ milestone payments. These payments are growing in popularity as procurement authorities push to reduce the financing costs incurred during construction (Interest During Construction – IDC). Infrastructure Ontario, for example, are moving to increase their use of Capital Contributions (milestone payments and substantial completion payments (SCP) for several hospital and transit projects on the basis of the 2014 AG Report.

One of the main benefits of increasing the Capital Contributions is in reducing the amount of private capital accrued during the construction process, utilising regular repayments to the project company over this period. This not only brings the debt down after each payment, it significantly reduces the amount of interest accrued over the project’s lifecycle.

But while this approach to project financing seems like an easy fix that will save billions of taxpayers’ money, the rationale for using private debt and equity in the funding mix is definitely not anchored in their cost-effective nature but rather in the aligning of public and private interests with the goal of delivering first-class, well managed and long-lasting public sector assets for end-users.

As rightfully indicated in Moody’s report on Public Sector Capital Contributions to Funding PFI/PPP/P3 Projects, the public sector is paying for 100% of the assets and services whichever funding route is chosen; the question remains how should the funds be allocated and in what proportions?

The three arguments for extending the milestone process:

  • Reduced interest costs on drawn amounts during construction
    Ultimately, the public authority will replace higher cost financing (priced at the private partner’s cost of financing) by public sector debt (drawn from the Public Authority’s traditional financing sources such as general provincial or municipal bond programs).
  • Reduced size of the construction financing
    As the private partner receives a milestone payment, the short term facility is repaid in part or in full. They can then reuse the facility without having to increase it (e.g. for a $100 million financing with three milestone payments of $25 million, the private partner will only need a $25 million construction loan, as opposed to the full $100 million financing if they pay upon completion of the project).
  • Reduced overall risk profile of the transaction
    The overall risk profile of the transaction would theoretically be reduced as the private partner is not “on the hook” for the full amount of the capital expenditure program until the very end.

There are strong arguments for ensuring that private sector financing remains commensurate with the size of the financing:

  • Reduced leverage on the private partner during construction
    As indicated in the 2010 DBRS Report on PPP Milestone and Completion Payments, in a “pure P3” with no milestone payments, the private partner would be fully at risk until the infrastructure is fully operational and receives all appropriate independent certifications. If there was any kind of issue during construction, the private partner would be the only one bearing the risk and since the public partner only has limited “money in the game”, it would have more leverage to ensure the private partner reacts swiftly.
  • Reduced leverage on the private partner on the long-run
    As Moody’s points out, reducing the amount of private financing in the project mathematically reduces the amount of risk transfer to the private partner and would have an adverse impact on the loss given default and the probability of default, should a rectification cost be required by the private partner. Over time, the project will become less robust against overruns in operating costs, lifecycle costs and other operating risks throughout the entire lifecycle, effectively increasing the “operational gearing” point. In the case of a PPP, operational gearing represents the ratio of operating and maintenance costs to debt service costs.  A government contribution will reduce debt service costs which can, in turn, increase operational gearing and the operational risk for the private partner.  Debt and equity providers may seek higher returns in light of the additional risk.
  • Increase overall transaction risk profile
    Using the same example of a $100 million project, of the $10 million private financing, in order to be competitive, the private partner would most likely aim at leveraging up to $9 million of the private funds required with debt and use only $1 million of his own equity. In such a scenario, the private partner would be responsible for a $100 million project with only $1 million “skin in the game”. Should a major rectification be required from the private partner, with only 10% private financing engaged chances are higher that the rectification cost outweighs the amount of private equity and debt, increasing the chance of total loss.
  • Reduced equity size may reduce competitive tension in the procurement process
    Finally, the absence of project finance transactions with more significant private debt and equity components may reduce interest from key infrastructure players on the bid side and in the long run, reduce the potential for a healthy secondary market for infrastructure transactions. Investors in both private debt and equity for infrastructure transactions are in the vast majority public and private pension funds, life insurance companies and related institutional investors seeking to secure reliable and steady placements over a long period of time. The involvement of these players on the private sector’s side through massive debt and equity contributions ensure public and private interests are aligned

Finding the ‘sweet spot’ for construction financing:

There needs to be a balance between public and private financing for future P3 projects. Larger amounts of capital contributions can often reduce the robustness of a project, as they limit the ability of a project to deal with financial shocks during both the construction and operations phases. While other factors may impact the project’s resilience (e.g. the complexity of the services to be provided, the creditworthiness of the O&M and Lifecycle subcontractors, the extent of risk transferred, as well as the degree of prudence in a project’s O&M and Lifecycle budgets, etc.), since the 2008 crisis, general consensus has set the cursor for private financing required in a typical availability-based accommodations P3 to 50% or more of total project cost. In its 2014 Report, the Ontario AG recommends increasing the amount of total Capital Contributions (milestone payments + substantial completion payments) from 50% to 60% for social projects and from 75% to 85% for transportation and transit projects. As hinted by both Moody’s and DBRS, reducing the amount of private financing engaged in these projects may have an adverse effect on the otherwise best intentions sought by the public authorities in delivering best-of-class major infrastructure projects.

The alternative pointed out in Moody’s conclusion is to opt for a Co-lending solution by the public sector whereby the Authority no longer is awarding a grant or a capital contribution to the project but rather joins the other senior lender on a pari passu basis. It is noteworthy to point out that this alternative may well be in line with Trudeau’s commitment to establish a Canadian Infrastructure Bank (CIB) comparable to entities such as the European Investment Bank (EIB) or the Infrastructure UK Loan Guarantee Program (the UIK Guarantee Scheme).

If you’re trying to find your own sweet spot for infrastructure finance, we’d love to hear from you.

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