Private financing instruments

Securitization of public project assets

Securitization of public assets often happens when state-owned enterprises (SOes) and the government are unable or unwilling to issue more debt (because they have a high ratio of debt to GDP). If the SOes and government are heavily in debt, they may securitize future cash flows arising from user fees (or even their own availability payment) to float bonds and then refinance the whole project.2

Development finance

urban bus projects have a high social rate of return. Therefore, bilateral and multilateral development banks can provide public entities with loans and credit enhancement instruments to finance urban bus projects. Maximizing finance for development principles calls for a subsidiary use of development finance. In this sense, development banks should focus on ensuring viability and need to be careful that they are not crowding out local commercial banks.

PRIVATE FINANCING INSTRUMENTS

This section considers several private sector financing instruments.

Senior debt

banks’ commercial loans are the most common senior debt instrument. Such loans can include various financial terms, grace periods, interest rates, and tenures depending on the market and the borrower’s financial status. In colombia or Mexico, most banks feel more comfortable financing traditional operators than SPVs, because of the bad reputation of the sector. The conditions of the loans vary significantly, depending on the financial status of the borrower. In Mexico, the most common conditions include rates that range from 10 to 15 percent (although some operators could access cheaper rates) with tenures of around six years, equity requirements of 10 to 20 percent, and a six-month grace period.3 banks usually require a partial-risk public guarantee to consider the project bankable. Other instruments are also available for raising senior debt.

Bond issuance a bond issued by a concessionaire accrues interest for its entirety from day one of placing it with bondholders. This is different from bank borrowing, in which case only funds needed to invest in the project accrue full interest, whereas the unused balance involves only a small commitment fee. To offset the problem of interest accrual, bonds can be issued and placed in tranches. but this process of matching tranches can pose its own problems, especially given the expensive issuing fees charged by bankers and lawyers. another problem can arise when projects have a long period of capital expenditures (caPeX) (say, five years), with the largest disbursements in the final years. The concessionaire issuing the bond often pays interest over time, whereas the full principal amount is due at

the end of the period. In PPPs, the principal and interest on bond issuances are paid only after the project is complete.

Asset securitization asset securitization usually involves bond issuance. The securitization of cash flows arising from an asset’s use and sale are directed to pay interest on the bond issued from that securitization. In the case of a bus project, all cash flows arising from user tariffs can be securitized and directed to service a loan that funded the buses, and a firm can use the availability payments to pay its expenses and its expected return (profit) on the project. In this case, the securitized asset is the PPP contract itself that provided the rights for the concessionaire to capture these cash flows. These rights are transferred via the securitization operation to the bondholder, which agreed to hold that bond at a given credit rating against the right to capture cash flows. The bondholder is not expecting the bus company to turn a profit. rather, it only cares about the cash flows to which it has rights (such as user tariffs). It is clear, though, that investors care about other accounting ratios and indicators, such as the debt service coverage ratio and other covenants that can make the bond callable (or due at the time the covenant is broken). but, overall, the bondholder only cares about its cash flows.

Bus manufacturers’ loans The bus manufacturer lends money for a bus operator to acquire buses, using the vehicles as collateral. In markets where most operators do not have access to finance, bus manufacturers need to fill this gap in the market to keep their business. There are three main advantages to this structure. First, the bus manufacturer understands the borrowers’ business better than most banks. Second, it may be a more flexible player than other financiers, which often have more rigid requirements in terms of down payment amount or tenure. bus manufacturers understand the conditions in the market and the volatility of the business cycles of the bus industry. Third, if all else fails, it can recollect assets and resell them more effectively than other players. Thus, it might be able to charge lower rates than other lenders. However, bus manufacturers can manipulate the price of a bus to compensate for better financial terms or an operator’s inability to provide a down payment.

Export credits export credit agencies (ecas) may be publicly operated, private, or some combination of the two. ecas offer various instruments to help domestic producers finance international export operations. While most of these instruments are directed toward manufacturers, they indirectly help bus rapid transit (brT) interventions to procure supply from foreign companies by eliminating the risks that bus manufacturers take when exporting their products. These instruments include financial support, interest rate equalization, credit insurance, and guarantees, depending on the specific eca and country of brT operations. Furthermore, ecas can support imports directly by offering a buyer’s credit. Doing so helps to eliminate transaction costs by paying exporters up front and having importers pay over a period of time. a buyer’s credit was used to acquire 90 low-emission, double-decker buses from a british firm for the brT system in Mexico city. This credit required the participation of a domestic financing institution. While many ecas operate in high-income countries, many south-south

exchanges facilitated by ecas have been operating out of low- and middle-income countries as well.

Leasing leasing is a sector-specific instrument usually related to fleet provision. Instead of assets being purchased, the project structure might include leasing them and expending their entire value instead of depreciating it over time. In theory, depreciation should function like lease payments, but the interest involved means that lease payments are usually bigger. The risk allocation involved in financial leasing differs from that involved in operational leasing. Financial leasing transfers to the lessee risks related to the operation of an asset. usually, financial leasing also allows for an option to purchase the asset when the leasing period ends. also, each type of leasing may be categorized differently for accounting purposes, with operating leasing most often considered an operating expenditure and financial leasing considered a financial expenditure. advantages of leasing include the possibility of having shorter concessions, more flexibility for fleet allocation, and easier implementation of technology upgrades.

Subordinated debt

Subordinated debt consists of financial obligations with less seniority than senior debt. Subordinated debt gets more remuneration due to higher risk exposure but gets paid after senior obligations are satisfied. Subordinated debt can be used to extend the length of the period needed to pay back the bus acquisition capital. Therefore, combining subordinated debt with senior debt (which usually has a shorter payback period) helps to relieve some stress from the financial model for the initial years of operations. Subordinated debt is usually available for infrastructure caPeX. as for bus acquisitions, subordinated debt is only available for those operators that have gained a reputation for reliability in the market. national development banks are the most likely institutions to offer this type of debt for bus acquisitions.

Mezzanine debt

Hybrid in nature, mezzanine debt usually involves a very junior debt bond that may be converted into equity in the case of default, generally after venture capital companies and other senior lenders are paid. This happens because of its junior position. In bus contracts, mezzanine instruments are often featured in larger deals, where multiple layers of debt are required to finance large infrastructure caPeX and sizable bus fleets need to be upgraded or purchased at the same time. In these cases, lenders often will acquiesce to being put in relatively less secure positions, but they may also request the right to convert the loan into equity during insolvency procedures. In low- and middle-income countries, mezzanine instruments are rarely suitable for the acquisition of new buses in brT projects.

Equity

Pure equity is an investment that does not grant a fixed remunerated coupon (as debt instruments do, for instance). Since equity requires a more variable source of revenue (if there are no profits, there are no dividends and thus no payout to

investors), its expected return is usually far higher than that of debt instruments. Thus, equity investment becomes very expensive in PPP deals. Sponsors of the project are usually expected to provide equity. They can have an interest in the project’s construction or operation (as with construction, operation, or specialized funds), or they can be institutional investors (as with pension funds).

Preferred equity In contrast to pure equity, preferred equity is an option given to some institutional investors or development banks willing to provide equity to help the project achieve bankability. usually, preferred equity investors will have less control than sponsors of pure equity, but they also will enjoy a lower risk exposure by, for instance, having priority for remuneration or having the right to sell their participation at a given time.

Letter of credit When investors provide some equity capital, they may also give some small bridge lending or a “letter of credit” to support initial working capital or small investments. after the bridge loan is conceded, the concessionaire should find a more permanent loan. as soon as the permanent loan is contracted, the first task of the concessionaire is to repay the bridge loan right away. The debt cost is lower, as debt interest is paid first from the concessionaire’s cash flows. Debt can be even cheaper with government guarantees. Thus, the expected return on equity, or the equity internal rate of return (Irr), can weigh a lot on the overall project Irr, which is brought down by the debt’s lower Irr.

Rate of return Pure equity investments require an expected rate of return. equity returns are uncertain by nature. While fixed-income payments have higher seniority, equity payouts to investors in the form of dividends are uncertain. The required expected return on equity is the cost of equity in the project, which together with the cost of debt will lead to the weighted average cost of capital. This rate should be the discount rate for the project, according to many financial analysts. after all, this is the rate that the market has charged to concessionaires looking for equity and debt to fund the project. even if a government is not structuring a PPP, it should price concessionaires’ discount rate according to the weighted average cost of capital in a transparent bidding competition.

Level of equity risk and pricing equity investment in bus projects involving the private sector is often related to the component(s) financed by the private sector. Two very different types of risk are involved. The first is the infrastructure investment in caPeX. This type of risk is related to building bus stations, exclusive lanes and corridors, bridges, and overpasses for the bus system. This is traditional construction risk, which is well understood and priced by engineering, procurement, and construction (ePc) companies worldwide. Since ePc activity is generally understood, it becomes a known risk, to which is added the premium charged to the municipality in a given country, according to the risk listed in JPMorgan’s emerging Market bond Index. The second type of risk is for bus operations. Operators in the local market know this business very well. Incumbent operators are often well integrated into the political economy landscape, especially at the municipal level. It is of critical importance to engage these operators

early in the process when working on bus system reform. The risk of incumbent operators delaying or opposing the project is far less clear to investors than is the ePc risk—especially if the incumbent operators are somehow involved in the construction phase. as a result, international financiers would charge a much higher risk premium (if they consider the project to be bankable at all) when dealing with incumbent operators. as for bus acquisition, other than equity injected into the SPV by informal operators, equity is rarely available in low- and middle-income countries, particularly in brand-new transportation interventions. Potential investors might perceive bus acquisition as high risk given its low bankability. Furthermore, informal operators themselves might oppose the participation of a third party in the SPV, fearing it will threaten their long-term participation in bus provision.

Credit enhancement mechanisms

credit enhancement mechanisms are financial instruments that allow transactions to have access to financial conditions or even achieve bankability. These mechanisms can be internal (contingency funds, overcollateralization of assets) or external (insurance, guarantees). Guarantees are the most common instrument in urban bus PPPs and are essential for them to achieve bankability in some emerging markets. credit guarantees help to improve the bankability of brT projects by eliminating all (full guarantee) or some (partial guarantee) of the risk to lenders. They are useful in securing relatively favorable loan conditions and are particularly helpful for new brT interventions where the public transportation authority or local operators do not have a track record of reliability, particularly in the acquisition of buses. new brT operations can establish a successful record of compliance with repayment under the favorable terms of an external loan guarantee. These guarantees are particularly important where tariffs are controlled for political and social reasons, increasing the risk associated with defaults by commercial banks. Partial guarantees can be provided by the government or by multilateral development banks. Depending on the nature of the project, the cost of these guarantees either is covered by the public sector or, most often, is attached to the terms and conditions of the loan to the private sector (premiums).

Multilateral development bank instruments

a variety of instruments offered by the World bank Group can help countries structure bus projects. These instruments can both attract private investors, by boosting investor confidence and helping private firms to secure better terms and conditions, and improve overall project structures, by, for example, introducing best practices in project management and design.

World bank Group instruments are both nonfinancial and financial (table 10.1). nonfinancial instruments can improve the overall performance of the project and are suitable for the following:

• Preparation of overarching and sector-specific policies, laws, and regulations • additional governance work, including institutional design • Sectorwide planning and master planning