A Highway to Cheap Money
Project finance proved to be an effective way to skip problems of escalating costs that afflict the traditional public tender system. In the tender system contractors have an incentive to bid low to win the order and, then, charge extra-costs to the purchaser. Project finance, on the contrary, is based on the creation of a special purpose vehicle (SPV), i.e. a project company for the design, construction and management of a single project. SPV's equity providers (the so-called sponsors) are often involved in the construction as contractors and have to seek debt financing for the SPV.
"Even if the sponsor/contractor could be tempted to extract more value charging higher costs to the SPV", Stefano Gatti of the Department of Finance says, "the system avoids ex-post costs surprises and is thus particularly fit to Italian infrastructure like toll roads".
The relationships between the SPV and any other counterparty are regulated by non financial contracts (NFCs) that affect both the cost of debt and the capital structure (debt-to-equity ratio) of the SPV, according to Gatti, Francesco Corielli (Department of Finance) and Alessandro Steffanoni (Meliorbanca) in Risk Shifting through Nonfinancial Contracts: Effects on Loan Spreads and Capital Structure on Project Finance Deals (Journal of Money, Credit and Banking, Vol. 42, No. 7, October 2010, doi: 10.1111/j.1538-4616.2010.00342.x). Examples of NFCs are construction (or engineering, procurement and construction - EPC) contracts closed on a turnkey basis to make plant and equipment available to the SPV, usually at predefined prices, times of delivery and standards of performance; purchasing agreements that guarantee raw material to the SPV at predefined quantities, quality and prices; selling agreements that enable the SPV to sell part or all of its output to a third party that commits to buy unconditionally at predefined prices and for a given period of time; operation and maintenance agreements, designed to provide the SPV with efficient and effective plant maintenance, complaint with predefined service-level agreements. All these contracts are designed to limit agency problems (creating mutual obligations) and to shift corporate risk. "Sponsors negotiate all these contracts in a vertical chain", the scholars write, "from construction and input supply to output sale. This contractual bundle is then presented to creditors to seek debt financing".
Using a sample of more than 1,000 project finance loans worth around US$ 195 billion closed between 1998 and 2003, the authors find that NFCs are an effective way to cap debt service cost or to increase leverage. The absence of NFCs translates into a higher loan cost of 115 basis points, but only if these contracts are signed by parties other than project sponsoring firms. In the same way, the presence of key NFCs allows SPV shareholders to increase the debt-to-equity ratio by 0.8 points, but only when sponsors are not counterparties to contracts. The results, anyway, confirm the existence of a tradeoff between spreads and leverage: for any given configuration, sponsors cannot enjoy both high leverage and low spreads, because a higher debt-to-equity ratio increases the risk for lenders that respond with a higher spread.
"Careful contract design", the authors conclude, "prevents agency problems between SPV sponsoring firms and lenders, and establishes an effective risk management package. Precommitting future obligations is also a risk management policy that has the further advantage of reducing the volatility of the cash flows available for debt service and dividend payments. This allows sponsors to negotiate higher debt-to-equity ratios for the deal in question". On the other hand, the contractual structure of the deal is important: NFCs matter when defining the financial package only if sponsors are not involved in the deal as project counterparties.
With regard to Italian toll roads, "citizens should be happy when they are financed with a project finance deal", Gatti says, "because SPV sponsors have a real interest in constructing them within the predetermined times and costs".