The Public-Private Partnership is by no means a new concept.
Its origins can be found in early government concessions in China, granted for
salt and iron mining about 2,000 years ago, according to the author, Gernet
(1982). However, the phenomenon was only formalized in as late as the 18th
century in France by the Public Works Concession (Concession de Travaux
Publiques). Subsequently, it became a turn-to solution for large infrastructure
projects for several succeeding governments in Western Europe, America and
Asia.
However, despite the relative popularity of the
Public-Private Partnerships, their arrival in Italy has been relatively recent.
Rossi and Civitillo (2013) contend that these projects were first formalized in
Italy in 1994 through what has become known as the Merloni Law. Since then as
Figure 1 below illustrates, the popularity of Public-Private Partnerships has
been on a general upward trend, both in terms of the number or projects
undertaken and the collective annual outlay on these projects.
Figure 1. Italian Public-Private Partnerships, 2002-2012
Source: As noted on graph.
As noted above, Public-Private Partnerships, despite their
ongoing popularity as a means of financing public infrastructure projects, are
a relatively late arrival to the scene in Italy, having existed elsewhere for
several decades. The reasons for the late arrival of the concept in Italy are
difficult to ascertain. It is possible that one factor in the 20th
century at least, was the frequency at which governments changed in Italy
during the same century but the cost of government debt undoubtedly also played
a role.
Figure 2 below depicts the trend of the cost of Italian debt
since 1950. For the majority of the second half of the 20th century
in Italy, real interest rates (that is, interest after inflation) were
negative, effectively providing an incentive for successive governments to
invest in public infrastructure rather than issue private contracts to do so.
However, as the cost of issuing debt reached its apex in 1994 at the time that
Public Private Partnerships were beginning in Italy, it’s reasonable to make an
assumption that the cost of debt was a major factor here.
Figure 2. Italian Interest Rates, 1950-2012
Source: Banco d’Italia
In fact, the cost of debt is of the utmost relevance to this
paper. Most Public-Private Partnerships are only around 10-15% funded by the
SPV, which leaves a large proportion of the money to be made up by financial
institutions such as banks – the focus of this paper. In particular, the paper
will analyse how debt issued by banks (especially senior debt) is affected by
the following variables:
-
Size of
the Main Partner
-
Length of
concession period
-
Interest
rates on date of financial close
-
Solidity
of the Main Partner
The paper will thereafter make a number of reasonable
assumptions about how these variables usually affect the provision of debt for
the Public Private Partnership.
At the outset, it is worth noting that the scale of the
projects undertaken by Public-Private Partnerships are generally large enough to
attract the attention of international financial institutions and not just
Italian banks and financiers. This is also one of the tenets of the European
Union - that all public projects are put to tender on an EU-wide basis. In
theory at least, this ensures competition and transparency in the union and
arguably creating a more efficient marketplace for infrastructure projects.
The implications for the EU-wide tender go beyond competition,
efficiency and transparency, however. From an Italian perspective, it means
that, on the government side (the “Public” in the Public-Private” equation),
the Italian government at the time of the project in question is effectively
competing with other countries’ infrastructure projects. In other words, when
the NHS is looking for VFM (“value for money”) in its projects in the UK
(Broadbent and Laughlin, 2003), this too has consequences for projects seeking
financing in Italy.
Regarding the financial aspect of Public-Private Projects,
Rossi and Civitillo (2013) note, “the funding of public-private partnership
projects in Italy is generally granted by banks and rarely by capital market by
selling bonds or shares to investors. Using such a kind of funding gives
disadvantages in comparison with other countries: the interest rate is about
10-11%, while in the UK, for instance, the spread on the risk-free rate is
about 0.75 – 1%.” The authors also note that Italian banks tend to ask for
traditional guarantees for the financing.
The authors go on to note that the Italian government doesn’t
use VFM as the UK government prescribes, but rather an “Economic-Financial
Plan” – a financial model put together by the private side. This suggests that
the process isn’t as transparent as it should be in Italy and that
considerations beyond the size of the tender bid by the private (financing
side) are potentially being given too much weight but the issue of transparency
is not within the scope of this paper.
The paper will begin with a discussion surrounding some of
the main theories of the use of debt in project financing – with a focus on
Public-Private Partnerships. This is an area of the academic field which is
still relatively new but is growing in line with the industry itself. This will
be followed by analysis of what role the variables mentioned above (size,
solidity, duration of concession period and interest rates) play in the
issuance of debt for Public-Private Partnerships in Italy.
The Role of Banks in Italian Public-Private
Partnerships
Banking institutions are the predominant form of finance for
Public-Private Partnerships in Italy. It is somewhat difficult to ascertain why
this is the case, given that the Italian debt market is the third largest of
its kind in the world.[1]
This could be related to the flexibility of bank financing relative to that of
bond financing, its low cost and importantly to some SPVs, its low disclosure
requirements (whereas Bond financing requires a public listing and much higher
disclosure).
The predominant use of bank financing for Italian
Public-Private Partnerships at least means, that for the purpose of research,
the form of financing Italian Public-Private Partnerships can practically be
simplified to banking institutions. Akintoye and Chinyio (2001) suggest the
following structure for PFI (Public Finance Initiatives) – type projects.
Figure 3. PFI Model Structure (Akintoye and
Chinyio, 2001)
It’s important to note here that the bank is
the senior debt provider. This is generally the case but not always. This is an
important point to remember with these projects, which are often not as liquid
as smaller investments which might be part-funded by banks. Collateral in the
form of a bridge or road project, for example, might not be attractive to banks
which have provided funding for the project in question.
The nature of Italian Public-Private
Partnerships (small population of projects relative to other countries,
infrequent use of capital markets for financing, lack of transparency in the tender
process) means that the task of analysing how debt is issued by banks is made
more difficult. Nonetheless, this paper will put forward several justifiable
theories as to what factors underlie the process. In turn, the factors to be
analysed are: risk, firm size, the length of concession period and the interest
rates on date of financial close.
Firm
Size as a Factor in Banks’ Willingness to Issue Debt for PPP
In a sample of 75 Public-Private Partnerships (see appendix
1), what is notable how large the firms’ are in terms of market size. The
reasons for this could be manifold, including existing relationships between
banks and these firms, a long track record of large infrastructure projects
having been delivered by these firms, the criteria of the project demanding
larger private partners or just a lack of smaller firms competing for the
tenders of the Public-Private Partnership projects in the sample.
In the 75 projects sample mentioned above, the average firm
was several billion euro in terms of market capital (where some firms were the
main private partner on more than one project). This would comfortably put
these firms in the top decile of firms in the European Union and would suggest
that firm size is a highly important factor when banks are deciding whether to
issue debt for the project. Particularly given that some of the project sizes
could feasibly be taken on by much smaller firms.
Regarding how smaller firms could take on many of the
projects in the sample; this is confirmed by running a correlation between the
main partner firm size and the debt required for each project. There is
virtually no correlation at all between the two.This would seem to give further
weight to the theory that banking institutions prefer when the main partner is
a large company.
The sample of 75 projects is almost entirely populated by
projects where the main partner is an Italian firm. There are some exceptions,
however. These are provided by Barclays Bank, the Sunpower Corporation and the
Foresight Group. While the Foresight Group is estimated to have a shareholder
equity value of €60m, Barclays and Sunpower Corporation are among the largest
firms on the list, suggesting that when banks do look to foreign partners, the
size of those foreign partners is a major consideration.
Likewise, Akintoye et al (2001) note that “the credit risk
associated with the borrower is of little importance and the finance must be
judged almost entirely on the basis of the risks that may threaten the project
completion and operation.” This would suggest that, where funding banks are
concerned, a track record is highly important. Larger firms, all things being
equal, will tend to have longer track records than smaller firms, thus
providing further inclination for banks to provide debt to them over smaller
firms.
As a final consideration, it is more difficult to ascertain
the importance of this particular measure (firm size) in banks’ decisions to
fund the Public-Private Partnership without access to competing bids (i.e.
those that bid but did not win the tender). The true measure of the importance
of firm size in banks’ decisions to provide debt or not would require the full
list of applicant firms for each project, along with their estimated firm size.
Length
of Concession Period as a Factor in Banks’ Willingness to Issue Debt for PPP
Although the length of the concession period is technically
part of the risk profile of each project, there is more at play from a banks’
perspective than just risk when it is being considered. There are potential
agency problems, issues about capital ratios and considerations to be made on
how they view the long term interest rate curve. In fact, the interest rate
curve has to be a major decision for banks in looking at the length of the
concession period for each project.
The interest rate curve can tell banks a lot about which
medium- to longer-term (as projects in Public-Private Partnerships tend to be).
The interest rate curve at any particular time should offer a good indicator of
whether banks will offer for longer-term projects or not. Typically, they would
face an upward facing interest rate curve (that is, interest rates in the
longer term are normal) whereas at times – such as during the recent global
financial crisis – they will face a flat interest curve, indicating ongoing
uncertainty in the financial industry and probably some reluctance to become
involved in projects with longer concession periods.
From a banking perspective, the disadvantage of many
Public-Private Partnership projects it that the length of the concession period
can potentially create agency problems that might not otherwise appear in
shorter-term projects. These are the same agency problems that are created by
mortgages; bank management often do not have the time in office that it takes
for the projects to be realized, so there is some misalignment between the
duration of management and that of the debt being issued.
The concession period of a bank’s existing stock of loans
should also be a factor in their decision to provide debt or not. Banks don’t
want to be over-loaded with long-term loans, given potential liquidity problems
that can be created in such a scenario. Therefore, as a general rule, they
attempt to balance the concession periods of their loans. On this basis, every
time a project is being analysed, it is also being analysed (or at least,
should be) in conjunction with existing loans on the bank’s balance sheet.
Interest
Rates as a Factor of Banks’ Willingness to Issue Debt for PPP
Interest Rates in the European Union have been set by the
European Central Bank since the mid-1990s. As Figure 2 above illustrates, these
have been at historically low levels for almost five years, meaning banks have
had access to increased liquidity and perhaps some incentive to provide
value-creating loans during the same period. In fact, when one considers how
the Public Private Partnerships projects held up during the past number of
years next to the economy, this would seem to hold true.
When banks are considering the interest rates as a factor to
accept to fund a project or not, other projects’ interest rates are also a
factor that should be considered. When two projects are deemed similar but one
has a higher interest rate than the other, it doesn’t necessarily mean that the
higher interest rate project will be funded over its competitor. The bank will
also figure how likely the project is to maintain payments at higher interest
rates over the concession period.
The interbank rate is a fundamental factor in how banks made
lending decisions. As Figure 4 which follows illustrates, since the onset of
Public-Private Partnerships in Italy, 3-month interbank exchange rates in Italy
have been on a fairly consistent downward trajectory. This suggests several
elements are at play but primarily that Italian banks have more access to
liquidity than they did in the time before PPP (and thus can take on illiquid
projects such as those of project finance).
Furthermore, should the interbank interest rate be relevant
to the issuance of debt for project finance, one would expect the number of PPP
deals to fall to some extent as the rate rises. That is to say, the two have a
negative relationship: one tends to rise as the other falls and vice versa. This
is broadly consistent with what seems to be happening when Figure 4 is compared
with Figure 1 from previously. In particular, it is notable how PPP plateaus in
2009 as interbank rates rise.
Figure 4. Historical Italian 3-month Interbank
RatesSource: Banco d’Italia
Inflation rates also play a factor. These are accounted for
by the real interest rates in Figure 2, but nevertheless, a graph is
indicative. Figure 5 below illustrates historical Italian inflation rates from
1995 to 2013. Most Central Banks target an inflation rate in the region of 2%
annually and Italy has been very close to the target since PPP projects began
in 1994. Given that Italy’s average inflation from 1958 to 2014 was 6.58%[2],
it could well be that the low-inflation, low-interest environment has combined
to make a set of circumstances which are amenable to project financing. This is
what economic logic would lead us to believe.
Figure 5. Historical Italian Inflation Rates.
Source: Banco d’Italia
Solidity
as a Factor in Banks’ Willingness to Issue Debt for PPP
The solidity of the main partner – which is the current
equity position of the main partner – can be used as a proxy for the risk
position of the firm. It follows that firms with more solidity should be
willing to take on further debt. Or at least, they should be in a position to
take on more debt if the occasion arises; whether or not management of the main
partner are willing to take on the debt, is a matter of discretion.
Nowadays banks have proprietary risk-measurement tools (as
permitted by the Basel III Accord), which means that each banks attributes
different weights to different factors when measuring risk. Given that the weights
behind these proprietary models are not disclosed, it is difficult to say too
much about banks’ appetite for risk. It is suffice to say that they wish to
minimize the risk. Maximizing their equity – four the purposes of this paper,
the solidity – is one way of doing so.
Grimsey and Lewis (2002) note that PPP projects are
characterized by all downside risks for banks, with very little to compensate
on the upside: “the facilities often do not have a capital worth, in terms of a
wide market, to which lenders would attribute value.” The authors seem to be
suggesting that PPP is characterized by large liquidity risks, which would be
another reason to opt for larger (more solid) SPVs. This view of risks taken by
the banks is surely another reason for them to be reluctant to hold equity in
the projects.
Akintoye et al (2001), note, “financial companies are
involved in a rigorous process of project’s risks evaluation and subsequently
they refine the terms and conditions of
their commitment…During this process, the finance companies utilize a range of
tools to ensure effective fund provision, contract enforcement, sharing their
market information and risk management skills.” In light of this, it would seem
that banks are highly aware of the risks inherent in providing funding to PPP
projects.
As the number of Public-Private Partnerships increases in
Italy and as they become a mainstay on the Italian banking industry’s funding
horizon, experience would suggest that banks will expose themselves to further
risk with these projects. There is a marked tendency to take on more risk where
one hasn’t been burned before.
Conclusions
As the recent global financial crisis illustrated in stark
terms, banks are not immune to making irrational funding decisions. Given how
low interest rates are currently set, many banks (although not all), for the
moment at least, can make loans they wouldn’t otherwise make should interest
rates be at traditional more higher levels. The potential for banks to make
irrational funding decisions correspondingly becomes easier in such an
environment where money is cheaper.
Italy didn’t escape the global financial crisis but did
become one of the notorious PIGS[3]
group, which were dogged by high public debts. These high public debts in Italy
might also have contributed to a slow-down in projected infrastructure
development by the government and on the private side, a reluctance to invest
in projects where the partner was – by some predictions, at least – due to go
bankrupt in the near future. In this environment, reading too much into
Public-Private Partnerships in Italy can be unwise.
Nevertheless, the advent of Public-Private Partnerships in
Italy in the 1990s offered a new avenue for Italian public projects on one side
and an avenue to diversify funding opportunities for Italian financial
institutions on the other. On the basis of financial theory, the initiative
made the funding of Italian public projects more efficient. Likewise, judging
by the growth in the industry in the intervening period, it is fair to say that
the initiative has been well-received so far.
This study has put forward some theories about the decisions
banks take while funding those same projects. Without data into the projects
that don’t become funded and greater transparency in general on Italy’s
Public-Private Partnerships, the research remains largely theoretical, rather
than empirical. However, the small data sample did provide some insight into
where funding decisions are being made by banks for Italian PPP. These data
seem to suggest the following:
-
Italian
firms are preferred as the main partner for funding.
-
Larger
firms are preferred for funding.
-
There is
no virtually no correlation at all between major partner size and project size.
Bibliography
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