Finance Dilemma Of The Private Sector In Public Procurement

The private sector participation in the financing and delivery of infrastructure services still addresses only a fraction of the demand. Issues that affect the supply of well-prepared projects, rather than the demand of such projects, have been main constraints to mobilizing private sector investment and involvement in public procurement.  Given the difficult environment for long term private investment, the challenge of preparing projects that attract long term private partners is more pronounced. Many factors are involved so that greater realism can be applied to this challenging task.

Many governments turn to the private sector to design, build, finance, and/ or operate new and existing infrastructure facilities in order to improve the delivery of services and the management of facilities hitherto provided by the public sector. Governments are attracted by the benefits of mobilizing private capital.

Private sector financing   consists of a mixture of equity, provided by investors in the project, and third-party debt, provided by banks or through financial instruments such as bonds. The equity investment is “first in, last out”—that is, in principle any losses that the project suffers are borne first by the investors, and lenders begin to suffer only if the equity investment is lost. It follows from this that equity investment has a higher risk than debt, and so equity investors expect a higher return for this risk. Since equity is more expensive than debt, the more debt a project can raise, the lower its overall funding costs will be.

Projects can be financed using corporate finance that is, lenders lend to the construction and operating and maintenance contractors, which in turn fund the project. This may create more flexible structures at a price.

Lenders’ security is normally limited solely to the project, comprising, primarily, the project’s cash flows and the sponsor’s equity that is invested in a company set up especially for the project. This company is ring fenced from the rest of the project sponsor’s business and prohibited from entering into any business outside the project.

Project financing through open tendering allows the competitive process to drive the most efficient funding structure. However, it is important for the public authority to understand clearly the overall capacity and capability of the lending markets when implementing a private program, and there may be steps it can take to encourage the development of such markets.

The identification and allocation of risk between the public authority and the investors are the issue of risk is not just a matter for discussion between the public authority and private sector bidders for a project: the lenders play a major role in this respect.

In certain cases, the assets underlying the project may also provide security for lenders. Banks earn a relatively low return (after allowing for their own funding costs) compared to equity investors, but the corollary to this is that they cannot afford to take high risks, the realization of which could easily wipe out the return they had expected to make. Therefore, when considering risk allocation, the public authority must bear in mind that allocating a high level of risk to the private sector will reduce the amount that lenders are willing to lend to the project, and so increase its cost, since the gap will have to be filled up with much higher priced equity.

The correct allocation and mitigation of risk are major factors in making projects bankable, and the public authority needs to develop a clear understanding of how potential lenders perceive the risks of the project from the early stages of project selection and preparation. This is one of the matters requiring the assistance of a financial adviser.