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Structuring a project’s capital
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This chapter provides an overview of various ways to structure the financial elements of an urban bus public-private partnership (PPP). It explains how external financing instruments come together with revenue sources to achieve project bankability (given the appropriate technical and legal elements). In the process, the chapter outlines key financing and funding instruments that have been used in urban bus systems around the world and discusses their application to urban bus PPP structures.
Funding sources and financing instruments are key to the viability of a project’s structure. How they are defined for each function or component of a project may either generate or mitigate a risk. Funding sources are revenues that will be used to pay for project functions and components during the life span of a project. They will be used to cover, for example, up-front costs, investment needs over the project’s life cycle, and expenses associated with operations and maintenance (O&M). Financing instruments allow project planners to bring funding sources’ future cash flows into the present in exchange for remuneration (interest). In this sense, funding sources should be sufficient to repay financial instruments with interest. Financing instruments differ in their conditions (cost, tenure) and the level of risk assumed by the financier (depending on the particular rights and obligations associated with the instrument).
Given the importance of public subsidies for maintaining most urban bus projects, this chapter ends with a brief discussion of subsidies.
STRUCTURING A PROJECT’S CAPITAL
Corporate finance vs. project finance
Project finance differs from corporate finance in that it allows planners to isolate a project’s financing risks into a special-purpose vehicle (SPV) that ring-fences both these risks and cash flows. Project finance is commonly used in large infrastructure projects. In some cases, the capital required for infrastructure exceeds the borrowing capacity of sponsors or project finance is more sustainable for the sponsors’ financial structure than a loan on the books (from an accounting perspective, participation in an SPV looks like an asset, instead of an obligation, and
the SPV is the borrower, leveraging debt over the equity provided by investors). Pure project finance separates the sponsors’ risk profile from that of the project. However, most bus projects do not have pure project finance.
In practice, the financial profile of an SPV’s shareholders—particularly when they are not competitively selected—influences the financing mechanisms’ terms and conditions and the overall bankability of the project. Pure project finance is nonrecourse, meaning that it does not create any contingent obligation for the public sector. The main advantages of pure project finance are that it (a) allows for off-the-book financing, (b) eases the implementation of risk allocation and mitigation mechanisms, (c) makes it easier to achieve higher debt-toequity ratios, and (d) involves additional due diligence on the part of investors, which look not only at the financial condition of the borrower but also at other technical and legal considerations. among the main disadvantages are (a) higher transaction costs for structuring and due diligence; (b) the need for greater capacity and experience in the sector on the lender’s side; and (c) the need for capacity among the SPV’s shareholders to understand project finance plans and a capital stack that differ from those seen in traditional bus operations (in which the operators are the borrowers and the owners of buses and bear operation permits or rights derived from an operation concession). unlike other infrastructure projects, urban bus PPPs are rarely financed with pure or nonrecourse project finance plans. because of urban bus projects’ relatively small size, complexity, and variety of stakeholders, many lenders in low- and middle-income countries have not developed the capacity to assess their eligibility for project finance. even so, many urban transportation projects are structured as if they were targeting project finance. In practice, most of these projects involve credit enhancement instruments (for example, partial credit risks in most bus projects supported by the central government in Mexico), by which the public sector assumes contingent responsibility to remunerate the operator if the agreed-on revenue does not cover the fares (bogotá, colombia). In other cases, the SPV transfers the debt to the sponsors’ companies (Tijuana, Mexico), or the debt is generated on the books of the sponsors (león, Mexico; Dar es Salaam, Tanzania).1 These loans are backed by the balance sheet of the borrowing company instead of future cash flows arising from the project.
The capital stack
regardless of the nature of the borrower, the composition of all external sources of financing is known as the capital stack. Figure 10.1 is a simplified representation of a project’s capital stack. (a real-world project might feature a variety of structures for its transactions and a variety of instruments for external financing.) In the figure, the bottom of the green section of the pyramid represents the most senior level of debt, while the top represents sponsor equity (the least senior instrument). The gray bottom section represents obligations, which delayed payment would make into financing. Degrees of seniority have various associated features:
• Risk level. The higher the seniority, the lower the associated risk. Senior debt is at the base of the pyramid. • Priority of payment. One of the factors that determine the level of risk is the priority of payments. More senior debt is afforded greater priority.
