How much additional rigour does private finance actually provide?
In previous articles, I argued that many of the benefits traditionally attributed to privately financed Public–Private Partnerships (PPPs) can be achieved without private finance. Performance-based service payments, output specifications, lifecycle integration, handback requirements and whole-of-life optimisation can all be replicated under owner-funded delivery models. I also explored two alternative procurement structures that seek to preserve those benefits without requiring a privately financed SPV.
This article examines what may be the last major pillar supporting the case for private finance:
The argument that debt financiers and equity investors bring additional financial rigour that governments and private project owners cannot replicate themselves.
This proposition is repeated so often that it is rarely challenged.
But how much additional rigour does private finance actually provide?
And perhaps more importantly:
What risks are lenders and equity investors really scrutinising?
The answers may be more nuanced than many PPP proponents suggest.
The traditional argument
The conventional PPP narrative is familiar.
Because lenders and equity investors have capital at risk, they undertake rigorous due diligence before committing to a project.
This scrutiny is said to improve outcomes by:
challenging optimistic assumptions;
identifying poorly allocated risks;
stress-testing engineering solutions;
examining contractual structures;
monitoring financial performance;
identifying emerging problems early; and
forcing parties to be realistic about costs and timeframes.
At a conceptual level, this argument is difficult to dispute.
People are generally more diligent when they are risking their own money than when they are spending somebody else's.
The more interesting question is whether this proposition still holds true in modern Australian PPPs.
What risks are debt and equity actually exposed to?
Consider a typical availability-based PPP.
The SPV enters into:
a Project Deed with government;
a D&C Contract;
an O&M Contract;
Equity Subscription Agreements; and
Debt Financing Documents including associated security arrangements.
The SPV then seeks to pass virtually all project risks to its contractors.
The D&C contractor assumes design and construction risks.
The O&M contractor assumes operation and maintenance risks.
Government retains the risk of Relief Events and Compensation Events.
Demand risk is usually retained by government because service payments are largely independent of patronage.
Which raises an obvious question.
If the SPV has transferred most of its risks downstream and government has retained many of the remaining risks upstream, what risks are lenders and equity investors actually assessing?
In many modern availability-based PPPs, debt and equity are not primarily assessing whether the project will succeed. They are assessing whether the SPV will survive if things go wrong.
The answer is often narrower than commonly assumed.
Many risks exist only because the SPV exists
A surprising number of the risks scrutinised by debt and equity arise solely because the SPV has been inserted into the contractual structure.
For example, financiers may examine:
whether subcontractor liability caps are lower than the SPV's liabilities to government;
whether the SPV's insurance arrangements are effective;
whether any gaps exist in the flow-down of the SPV's DBOM obligations;
whether the SPV might incur liabilities that have not been fully flowed down to its subcontractors; and
whether the SPV's rights, security and contractual remedies are sufficient to protect it against contractor default.
These are genuine risks.
But they are often risks that only arise because the SPV exists.
Under a conventional owner-funded delivery model, there may be no intermediary vehicle sitting between the owner and the contractors.
The owner contracts directly with the parties performing the work.
The owner is therefore not paying debt and equity to absorb risks that would otherwise sit with the owner.
Rather, the owner is paying debt and equity to manage risks created by the insertion of the SPV into the structure.
That distinction is often overlooked.
Do lenders really stress-test the engineering?
It is frequently asserted that lenders undertake extensive technical due diligence.
There is undoubtedly some truth in this.
Technical advisers are engaged.
Independent reports are produced.
Engineering models are reviewed.
Supply chains are examined.
The more difficult question is whether lenders are genuinely relying upon those analyses when making lending decisions.
Or whether they are primarily asking a much simpler question:
Has the SPV fully transferred its risks to contractors with balance sheets capable of absorbing them?
In most Australian PPPs, the lender's primary protection is not the engineering model.
It is the D&C contractor.
Likewise, the lender's primary protection against O&M risk is not usually its confidence in the maintenance regime.
It is the O&M contractor.
This is not intended as criticism. It is simply how project finance works.
The lender typically does not intend to assume construction or maintenance risks. Rather, it intends to ensure that those risks have been allocated to contractors capable of bearing and managing them.
The distinction matters because a properly advised owner can undertake exactly the same assessment.
An owner can examine:
contractor capability;
balance sheet strength;
parent company support;
security arrangements;
insurance programmes; and
risk allocations.
These are not exclusive project-finance skills.
The optimism bias argument
Perhaps the strongest argument in favour of private finance is that lenders and investors help eliminate optimism bias.
The theory is that governments often underestimate costs and overestimate benefits, whereas financiers take a more disciplined approach because their money is at risk.
It is a powerful argument.
Yet it deserves closer examination.
Over three decades of PPP transactions, I cannot recall seeing a lender insist that a D&C contractor's price was unrealistically low and should be increased.
Lenders may require additional contingencies.
They may require stronger security packages.
They may require larger reserve accounts.
But their principal concern is generally whether the SPV can absorb adverse outcomes if they occur.
The lender's focus is often SPV resilience rather than repricing.
Private finance may therefore not eliminate optimism bias in the way many assume.
Rather, it may seek to ensure that its borrower – the SPV – remains resilient if optimistic assumptions prove wrong.
That is not quite the same thing.
The demand risk exception
One area where private finance can unquestionably provide additional discipline is demand risk.
Where lenders and equity investors are genuinely exposed to toll revenue, patronage revenue or other user-charge income, their incentives are materially different from those in an availability-based PPP.
Demand forecasting becomes critically important.
Traffic forecasts matter.
Revenue assumptions matter.
Market behaviour matters.
In those circumstances, lender scrutiny can provide genuine additional value.
But such projects have become increasingly rare in Australia.
Most contemporary PPPs are service-payment PPPs.
The key demand risk remains with government.
As demand risk disappears, one of the strongest traditional arguments for private finance becomes less significant.
What does the evidence really show?
Supporters of PPPs frequently point to studies showing better cost and time outcomes for the construction phase than traditional procurement.
The work undertaken by Professor Duffield is often cited.
The reported statistics are impressive.
The difficult question, however, is identifying the cause.
Are improved outcomes primarily attributable to private finance?
Or are they attributable to different contractual risk allocations?
Traditional procurement models have often included:
broader extension of time and relief entitlements; and
broader compensation entitlements.
PPP D&C contracts have generally adopted tighter regimes.
A contractor bearing more risk should be expected to deliver greater price and programme certainty.
That does not necessarily prove that debt finance was the cause.
It may simply demonstrate the consequences of transferring risk to contractors.
The distinction is important.
Correlation should not automatically be mistaken for causation.
North East Link and the changing reality
Recent projects illustrate this evolution.
The North East Link PPP's reimbursable Incentivised Target Cost arrangements demonstrate that traditionally accepted notions of "bankability" continue to evolve.
Historically, project financiers sought fixed-price, fixed-time construction arrangements supported by extensive risk transfer.
Increasingly, contractors have refused to accept risks that cannot be efficiently priced and project owners have agreed to share those risks.
The result has been a gradual movement towards more collaborative risk-sharing structures.
If the project owner ultimately bears the cost consequences of many external events, financiers have less risk to monitor than was once the case.
The additional rigour provided by debt and equity correspondingly becomes narrower.
Does private finance still have a role?
Absolutely.
Private finance still provides important benefits.
Debt and equity can:
provide a financial buffer against contractor failure;
create additional monitoring and oversight;
enforce financial discipline during delivery;
facilitate lender step-in rights; and
transfer demand risk where demand risk genuinely exists.
The point is not that these benefits are illusory.
The point is that they are frequently overstated.
Many of the benefits traditionally attributed to private finance are actually delivered by:
performance-based payment regimes;
output specifications;
lifecycle integration;
O&M involvement in design;
handback requirements; and
effective contractual risk allocation.
These benefits can exist with or without private finance.
Conclusion
The PPP debate often asks the wrong question.
The question should not be:
“Does private finance provide additional rigour?”
It almost certainly does.
The more important question is:
“How much additional rigour does private finance provide, and is that additional rigour worth the additional cost?”
For projects involving genuine demand risk, the answer may well be yes.
For many modern availability-based PPPs, however, the answer is less obvious.
Once whole-of-life integration, performance-based payments, output specifications and lifecycle accountability are separated from the use of private finance, the remaining value proposition becomes considerably narrower.
That does not mean privately financed PPPs have no future.
It does mean that advocates of private finance should be careful not to claim credit for benefits that can be achieved equally well without it.
The future of PPPs may depend less on defending familiar arguments and more on clearly articulating the specific risks that debt and equity are genuinely being paid to manage.
