Project finance and PPPs: how large projects get funded

Most large power plants, pipelines, toll roads and mines are not financed the way a company funds its next product line. They are financed as stand-alone projects, with their own company, their own contracts and debt that depends on the project's cash flow. The structure explains why contracts in this field are so long, why lenders read them so closely and why a clause that looks minor to a newcomer can decide whether a project is built.

The project company

The World Bank's PPP Knowledge Lab describes the usual structure. The project is held by a special purpose vehicle, a project company with no previous business or record, whose sole activity is carrying out the project. It subcontracts most of the work through construction and operation contracts. Its shareholders are called sponsors. Because the company is new, nobody can lend against a track record. They lend against the project.

That is the heart of the model. Project financing is limited or non-recourse to the shareholders. If the project company defaults, lenders can generally claim only against project assets, which include completion and performance guarantees and bonds, and not against the sponsors' other assets. The page notes that lenders can reach shareholders' assets mainly where the shareholders deliberately breached their obligations. Sponsors are generally liable only up to their shareholding, and the project can stay off their balance sheet.

In return for taking that risk, lenders charge a higher margin than in ordinary corporate lending. They also lend only when the project's revenue is secure enough to service the debt. For a new build, debt service is possible only once the plant operates, because there is no revenue during construction. The sole revenue stream is typically an offtake agreement or a power purchase agreement. This is why the earlier guide on PPAs matters: the contract is both the revenue and the collateral story.

What a PPP is

The World Bank defines a public-private partnership as a long-term contract between a private party and a government entity for providing a public asset or service, in which the private party bears significant risk and management responsibility and remuneration is linked to performance. The words significant risk and linked to performance separate a PPP from an ordinary construction contract, where the contractor is paid for building and walks away.

The same source lists the forms you will see in tenders. Names vary by country.

• Concession. Usually a user-pays PPP in which the private party earns its revenue from service users. The source notes that terminology varies: in Brazil a concession is fully user-paid, while in Chile the term covers all PPPs.
• BOT. Build-operate-transfer, used for new assets. The private company owns the assets until handing them back at the end of the contract. Under build-transfer-operate arrangements, ownership transfers when construction is complete.
• DBFOM. Design-build-finance-operate-maintain, a label that lists the functions transferred to the private sector.
• Availability payments. A government-pays structure in which the government pays periodically if the asset or service is available at a contractually defined quality, such as a highway that people use free of charge.

The distinction between user-pays and government-pays is the first thing to establish in any PPP tender. User-pays projects carry demand risk: if traffic or consumption is lower than forecast, the private party earns less. Availability payments move that risk to the government and put the credit of the paying authority at the centre.

Who takes which risk

Risk allocation is the drafting task of a PPP. The World Bank Group's report on recommended PPP contractual provisions, prepared with a law firm and funded by PPIAF, is a reference for how it is done. It describes a PPP contract as a long-term agreement under which the private partner bears significant risk and is paid for performance, and it notes that the private partner often takes the form of a special purpose company.

The report treats force majeure as a risk that should not fall on a single party. Relief covers delay and generally not the affected party's own costs, and a prolonged event may let either side terminate. Material adverse government action, which covers failures to grant permits, expropriation and similar acts, sits with the public side, which may owe compensation and termination rights. It suggests the list of such events be narrower than the force majeure list. Change in law has two options: protection against all changes, or protection only against discriminatory, specific and certain capital-cost-related general changes.

Termination is where lenders look first. For a termination caused by the public authority, the report says compensation generally covers senior debt, redundancy and subcontractor costs, and the invested equity with a return, calculated by one of three methods. For private partner default, it describes debt-based compensation, often with a haircut, or market value.

What lenders and sponsors check

Lenders check whether the revenue source is creditworthy, whether the construction contractor can deliver at a fixed price and date, whether the project has all permits, and whether the contracts fit together. A gap between obligations in the construction contract and in the revenue contract, for example a longer delay period in one than the other, is a mismatch that lenders call a back-to-back problem, and they fix it before they sign.

Sponsors check the equity return and the downside. A project that depends on one customer, one government approval or one fuel supply has a thin margin for error. Sponsors also think about their exit, because a project company with stable cash flows may later be sold to an infrastructure fund.

Evidence from the market

The World Bank's Private Participation in Infrastructure database holds data on over 6,400 infrastructure projects in 137 low- and middle-income countries. It covers energy, transport, water and sewerage, ICT backbone and municipal solid waste, and the projects include management or lease contracts, concessions, greenfield projects and divestitures. Custom query data goes back to 1990. Use it to find comparable projects in your target country: the contract type, the sponsors, the year and the sector. If nobody has done a deal like yours there, that is information as well.

Questions for a first project-finance review

Who pays, and how creditworthy are they? Which contracts do the lenders hold security over? What is the construction contractor's liability, and for how much? How are exchange-rate and inflation risks allocated? What happens on termination, and for which defaults? And what is the plan if the project completes late? A project that answers these clearly is easier to finance than one that answers them only in the term sheet.

Guides explain how things generally work. They are not legal, tax or investment advice for a specific project or country. See our editorial policy.