Public-Private Partnership (PPP) – Understanding Various Models

 

A public-private partnership (PPP) is a contractual agreement between the public and the private sectors, whereby the private operator commits to provide public services that have traditionally been supplied or financed by public institutions. The ultimate goal of PPPs is to obtain more “value for money” than traditional public procurement options would deliver. When correctly implemented, PPPs are said to produce reduced life-cycle costs, better risk allocation, faster implementation of public works and services, improved service quality and additional revenue streams.

The core principle of PPPs lies in the risk allocation between the two parties. A well designed PPP redistributes the risk to the party that is best suited to manage it and to do it with the least cost. The PPP models vary from short-term simple management contracts (with or without investment requirements) to long-term and very complex BOT form to divestiture.

Introduction

The significance of Public-Private Partnership (PPP) model has been gaining increased thrust of late as the double whammy of rising urbanization (a combination of rural-to-urban migration and population growth) on one hand and fund crunch on the other put severe pressure on our cities’ already crumbling infrastructure. Besides, an unprecedented rise in prices of commodities, across the board, over the last few years too has hit the ever-constrained finances of urban local bodies hard. These make the task of developing new infrastructure really hard for ULBs, unless there is a strong financial support coming from the central/state government or other agencies like World Bank.

However, given India’s huge infrastructure deficit, the country requires massive investment to build and develop infrastructure like highways, healthcare, ports, airports, and even education. This makes the role of the private sector quite crucial for the two simple reasons – first, private sector participants can bring in the funding at such large scale, provided such investments have the potential to fetch good returns; second, private sector brings with it the required technical and managerial skills and also experience, which the public sector may be lacking in. Besides, private sector is viewed as being more productive and efficient as compared to their public sector counterparts. Aside, this (PPP) also enables the government to liberate and hence allocate vital resources to other activities for public good. According to Wikipedia, “Public-private partnership (PPP) describes a government service or private business venture which is funded and operated through a partnership of government and one or more private sector companies.”

The Government of India’s renewed thrust on bringing private sector investment in building and upgrading its infrastructure is slowly yielding the results. According to the Economic Survey 2007-08, “India has witnessed a rapid increase in private investment in infrastructure over the last five years.” Not only that India even betters other BRIC nations like China and Brazil (the other being Russia) when it comes to bringing in private sector participation in infrastructure development. In 2006, commitments to Indian infrastructure projects with private participation were around double that of Brazil and China, making India the leader amongst the middle and low income countries.

Given that, the Public-Private Partnership has emerged as a viable model for developing countries like India to give a boost to the infrastructure development. However, to reap the true benefits of private sector participation requires meticulous planning, on part of the government and governmental bodies like ULBs, which includes among others things like identify the objectives clearly, proper evaluation of the costs and sources of funding, setting up of a monitoring and coordinating body, and realistic estimates of the return. Also, it is equally important to select the proper mode of the PPP. The main defining feature of PPPs is the degree of private control over and involvement in financing. The next section discusses some of the major types of PPP models.

Types of PPPs

There are five major categories of public-private partnerships; some of these categories also contain several variants. ‘These models vary mainly by Ownership of capital assets, Responsibility for investment, Assumption of risks, and Duration of contract.

Types of PPP Schemes – At a Glance

Schemes Modalities

Service contracts The private party procures, operates and maintains an asset for

a short period of time. The public sector bears financial and

management risks

Operation and management The private sector operates and manages a public owned

contracts asset. Revenues for the private party are linked to performance

targets. The public sector bears financial and investment risks

Leasing-type contracts The private sector buys or leases an existing asset from the

• Buy-build-operate (BBO) government, renovates, modernizes, and/or expands it, and

• Lease-develop-operate (LDO) then operates the asset, again with no obligation to transfer

• Wrap-around addition (WAA) ownership back to the government

Build-operate-transfer (BOT) The private sector designs and builds an asset, operates it, and

• Build-own-operate-transfer (BOOT) then transfers it to the government when the operating contract

• Build-rent-own-transfer (BROT) ends, or at some other pre-specified time. The private partner

• Build-lease-operate-transfer (BLOT) may subsequently rent or lease the asset from the government.

• Build-transfer-operate (BTO)

Design-Build-Finance-Operate (DBFO) The private sector designs, builds, owns, develops, operates

• Build-own-operate (BOO) and manages an asset with no obligation to transfer ownership

• Build-develop-operate (BDO) to the government. These are variants of design-build-finance-

• Design-construct-manage-finance (DCMF) operate (DBFO) schemes.

Source: http://www.europarl.europa.eu/comarl/imco/studies/studies/0602_ppp_briefingnote_en.en.pdf

The major categories of PPP model are:

• Service Contracts,

• Operations and Management Contracts,

• Leases,

• Build-Operate-Transfer (BOT) Contract and its Variants, and

• Concession Agreements.

• Service Contracts

In service contracts, the private party is entrusted with the task of performing non-core activities in lieu of fees. This type of contract is also sometimes referred to as outsourcing. In this form of PPP, the private sector participant is entrusted with the task of procurement, operations and maintenance, while the government retains the ownership. Service contracts have a short duration, ranging from six months to a few years. The private party has to bear the financial and residual value risk.

The main objective in this type of PPP is to benefit from the operational efficiency and technical expertise of the private sector. In other words, the government benefits from the operational efficiency of the private sector without having to transfer the control over the quality of outputs. This mode is more suitable for projects like toll collection services, for the provision and maintenance of vehicles or other technical activities. Examples include cafeteria, security services etc. at government establishments. This form of PPP is suitable in cases where there is a wider opposition from common public about privatization of public (utility) services such as water or in cases where there is a need for the government to reduce its role and improve service efficiency.

Operations and Management Contracts

In this form of PPP, the onus of asset operation and management is on the private party while the ownership rests with the government. The duration of such contracts may range from three to five years, however, the same may be extended, depending on the nature and complexities of the projects. The investment and financial risk is borne by the government. The main objective of this type of contract is to benefit from the efficiency gains and technological know-how of

the private sector. Such contracts can also be useful in the transition stage leading to total divestiture or privatization.

Management contracts are useful options in preparing for PPP where

• The regulatory framework needs to be upgraded;

• Tariffs are too low and government needs time to develop a system of subsidies;

• Stakeholders have not yet agreed to long-term involvement of the private sector; or

• The country has no record of experience of public-private partnerships.

How they Compare?

Leases

In this model, ‘the private party purchases the income streams generated by publicly-owned assets in exchange for a fixed lease payment and the obligation to operate and maintain the asset.’ While the responsibility of planning and raising new investments rests on the government, the private party bears the commercial and demand risks. Therefore, in this type of PPP, the private party has every incentive to reduce the overall costs and improve operational efficiency. Leasing Agreements are appropriate for services such as public utilities like urban transport which can generate independent revenue streams.

Build-Operate-Transfer (BOT) Contracts and Variants

Also called Turnkey Procurement, in this type of PPP, the private sector participant owes the responsibility of designing, building and operations of the asset. Once again the ownership lies with the public sector while the private party bears the commercial risk. The BOT model has several stripped down/stepped up versions like BOOT (Build-Own-Operate-Transfer), BROT (Build-Rehabilitate-Operate-Transfer), BLOT (Build, Lease, Operate, Transfer) and BTO (Build, Transfer, Operate).

This model is best suited for projects which require massive funding and also involve building new infrastructure. These projects are also essentially of long gestation period. This kind of PPP model is generally used in public utilities such as building new power plants, drinking water supply, waste water treatment plants etc. Once again, the private operator has to meet the guidelines/specifications set by the public entity. However, a major drawback of this model

is that ‘the length and complexity of BOTs make these contracts difficult to design, a fact that often negates the positive effects of the initial competition.’

Concessions

Under concession contracts, a private operator is given a contractual right to use existing infrastructure assets to supply customers and to finance and manage all capital extensions and upgrades to the existing services supplied. The duration of this type of PPP is much longer than that in case of leasing agreement model.

A major characteristic of this model is that the private party bears the responsibility of both investment as well as operations and maintenance of the asset. However, the ownership once again, like in case of other models, rests with the public entity. The governments wrest the control of the asset back after the expiry of the concessions agreement period. Concessions model differs from the Leases model in the sense that in the latter the funding responsibility lies with the public sector or the government.

Outlook

By 2021, the share of India’s urban population will jump from the present 28% (of the overall population) to 40%, according to the ES 2007-08. That means by that time all the basic civic services like water supply, sanitation, solid waste, urban transport would have to accordingly be scaled up to meet with the jump in demand for such services. But are our ULBs equipped and geared up to meet these challenges? Definitely not. Against this backdrop, there is no denying the fact that the PPP model is the need of the hour, especially in the case of the developing economies. In case of geographically vast countries like India the challenges before the governments are all the more enormous. However, at the same time, this also presents immense opportunities for the private sector. For instance, according to the Economic Survey (ES) 2007-08, “The Eleventh Five Year Plan envisages total investment in physical infrastructure (electricity, railways, roads, ports, airports, irrigation, urban and rural water supply and sanitation) to increase from around 5 per cent of GDP in 2006-07 to 9 per cent of GDP by the end of the plan period if the targeted rate of growth of 9 per cent for the Eleventh Five Year Plan period (2007-12) is to be achieved.” Further, total investment in creating physical infrastructures such as roads, railways, ports, power, electricity, sanitation etc., would alone require a massive Rs.2,000,000 crore (or approx. $400 bn) during the said plan, as per the ES. The private sector’s investment is projected at one-third of the overall investment envisaged.

To ensure smooth function and success of the PPP model in the country, the government has already initiated several measures which are expected to give a big boost to the Public Private Partnership model in the days to come. To conclude, surely, this presents huge opportunities for the private sector to play and benefit by participating in the economic development process of the nation.

N Janardhan Rao, Lead Economist.

US Bond Market - Meltdown in the offing?

 

After Nuclear disaster, is it now turn for a meltdown in Bond market? Investors are now bothering about another critical impending meltdown - grossly overvalued bonds, the most dangerous of all.

After the tech bubble in 1990s, followed by housing bubble in 2000s, it now seems to the turn of the bond market collapse, which when happens could be the most dangerous of all. If the bond market bubble busts, the unavoidable and direct consequence is that interest rates will surge — not only on bonds, but also on mortgages, auto loans, business loans, and nearly every kind of financing possible.

A recent report, from the research firm headed by New York-based University Professor Nouriel Roubini who rightly predicted the sub-prime housing bust and subsequent financial crisis, predicts that debt defaults of local and state government (grossly overvalued bonds in the US) could rise 650% in 2011. Moreover, the dreadful disaster that has just hit Japan fades the shaky US Treasury Bond market moderately as it holds a major chunk of US bonds. Analysts anticipate that quake-hit Japanese economy will not only bring to a standstill the US treasury bond purchases by Japan, but it will also force the authorities to make substantial sales of a significant portion of their reserves of the US treasury bond to finance the enormous cost of stabilization, reconstruction and restoration of the economy.

The US government fiscal situation is worsening as deficits have topped $1 trillion, the highest levels when measured since World War II. It is too big for the current bond market and there are hardly enough investors to purchase the ever growing US government debt. This is the reason why the US Federal Reserve recently purchased $600 billion of debt to keep interest rates on the debt at a reasonable level. If not, the US debt would become more toxic and less attractive to the investors who still hold the US t-bonds. The PIMCO Total Return Fund, top mutual fund decided (prior to the earthquake) to sell off all of its US Treasury holdings in exchange for corporate bonds as yields on treasury bonds are too low, especially with the risk of inflation growing each day.

Roubini doesn't think that defaults in the municipal market will lead to any of systemic problems for the US economy that happened when the sub-prime mortgage market meltdown. According to Dr Doom, many of the bonds that go bad won't be worthless and local governments will make good on around 65% of their bad debts. The unrated bonds that could default are generally smaller issue bonds that back specific projects like roads or water treatment centers. Though defaults on this type of bonds are not common but in the past there were many instances of defaults.

The bottom line

Investors are worried that amidst unparalleled spending by the US government, the Federal Reserve will inevitably increase interest rates which in turn reduce the value of existing treasury securities (generally bond prices fall when interest rates rise and increase when rates drop). The billion dollar question that investors are debating is – is the end of a treasury bull market that began in the early 1980s around? With inadequate investors to fund the growing deficit, the US will have no choice but to cut hundreds of billions of dollars from federal spending in 2011, or else it may run out of money very soon which would in turn trigger bond market to crash.

 

N Janardhan Rao, Senior Economist.

 

Microfinance in India: What Led to the Crisis?

A recent spate of unfortunate incidents of farmers’ suicides linked to their microfinance debts (aggravated by MFIs’ exorbitant interest rates and brutal recovery methods of their recovery agents) in Andhra Pradesh, in particular, and crackdown by the government, in response, has, however, put a big question mark over the very existence of the microfinance industry in India.

If you want to do a quick health check on India’s Microfinance sector, look no further than the stock price of SKS Microfinance. The Hyderabad-headquartered firm became the only publicly-listed micro-lender (who provides loans to poor people who either do not have access to/aren’t eligible for loan from a bank) in India when it listed its shares on BSE (and NSE) in a dream debut on August 16, last year, logging a listing gain of a hefty 18% and soon went on to touch its all-time high of Rs. 1490.70 (as against the IPO price of Rs.985). The stock closed at Rs. 638 on January 6, down nearly 35% amidst growing concerns about the popular (read also: political) backlash, possible regulatory tightening (already recent AP government’s Ordinance has nailed the sector down) and shakeout, which looks more or less inevitable.

However, only until a few months back it was not so. The sector was once touted as one among the sunrise industries in India by analysts and industry experts alike. Lured by the promise of quick and hefty returns, investors (mostly private equity firms) came in hordes from India as well as overseas; many of the investors in MFIs include several high-profile US-based PEs. In the run up to and soon after the spectacular launch of SKS’s IPO, stories of how CEOs and top brass of these MFIs earned 7-digit salaries and bonuses flooded the market, vindicating investors’ faith in India’s microfinance success story.

                                                

                                             Top Players

The issues behind…

Ingredients are common such as lack of (or lax) regulatory oversight, which in turn increased greed, opaque often unethical business practices, high commissions etc., which are generally found in every crisis. So, it is no different this time as well. More specifically, though, the answer to the above question has been best described By Dr. Y V Reddy, the former Governor of Reserve Bank of India who is credited with successfully shielding Indian economy from the global financial crisis in 2008. “They (MFIs) are no better than money lenders,” said the ex-Guv of the country’s apex bank in an interview. “If you look at it, the resource is leveraged. It is not just money-lending business. The moneylender normally lends out his own money, whereas here the MFI is actually borrowing money from depositors and lending the money. So fundamentally, he is a moneylender, but a leveraged moneylender,” he added further. Emphasizing on the need for regulating the sector, Dr. Reddy said, “Micro finance is a respectable area, and the impressive profitability of our profit-seeking MFIs has attracted investments from private equity funds globally. There may therefore be merit in a detailed analysis in a sort of supervisory review, to check any incipient tendency towards irresponsible usurious lending by such profit-seeking MFIs.”

Andhra Pradesh (AP), which accounts for about 30% of India's $6.7 billion in microfinance loans, is at the epicenter of the current crisis gripping the microfinance industry in India as the State’s average outstanding microfinance debt per household is Rs. 65,000 as compared to national average of Rs.7,700. Critics observe that the high growth and high profits of the industry has resulted in abuses and greed into micro-lending, which exceeds the number of borrower accounts served by the Regional Rural Banks by as much as 50% and represents 40% of the total number of micro-borrower accounts in the entire financial system in the country. Besides, other factors like the practice of giving multiple loans to a single borrower and the fact that in majority case these loans were given for consumption purpose and not for starting a new business or improving productivity too are blamed for the current crisis at India’s Rs. 25,000 crore MFI sector (see chart: Consumption-driven).

The fallout

In the aftermath of SKS controversy, there was a conflux of woes for the sector when the AP government came up with legislation aimed at curbing MFIs’ operations. Besides, banks also pulled back on lending fearing wide-scale defaults from MFIs. Banks such as SBI, ICICI Bank and Axis Bank are estimated to have lent Rs 16,000 crore to micro-lenders. According to data from CARE, the credit rating agency, ICICI’s lending is at Rs 2,000 crore, SBI’s at more than Rs 1,000 crore and Sidbi’s at Rs 4,000 crore. Experts say that even if a single microloan defaults, it might have a trickle-down effect on the entire sector. According to N Srinivasan, who consults on the industry for the World Bank, around 70% the 260 MFIs are likely to collapse in coming months, as banks halt lending to them to curb risks. MFIs with stronger net worth have a possibility of survival for a period of time. Srinivasan is of the view that collapse of MFI would have a devastating effect on the poorest borrowers in remote regions. A slump in microfinance loans might trigger a chain reaction of defaults by borrowers with multiple debts. He compares the condition just like managing juggling balls, if we remove a ball, the right in the middle of it; suddenly there is no ball to throw. A lack of microfinance loans might force borrowers to turn again to moneylenders, who operate outside the formal credit-delivery system and charge usurious interest rates. In words of Dipak Gupta, Executive Director, Kotak Mahindra Bank, “Money has stopped and a borrower is used to getting that money and circulating it. If you don’t create an alternate system or don’t allow the system to rotate, he will go back to the moneylender.”

According to Dilip Mookherjee, Professor of Economics, Boston University, “Institutions need to be more diligent in their lending – but politicians also need to be wary. In taking aim at the occasional overstep, they may inadvertently destroy microfinance itself. That would be a disservice to the world’s poor, and their hopes of climbing out of poverty.” C Dr. Rangarajan, the former Governor of RBI and currently the Chairman of the Prime Minister’s economic Advisory Council, has asked microfinance institutions (MFIs) to overhaul their ‘flawed’ business model for sustainability. He has suggested that MFIs should lend more for productive purposes and not just for consumption-related expenses, adding that the bulk of the current MFI lending was for consumption.

However, Prof. H.S. Shylendra of Institute of Rural Management, Anand, Gujarat, believes that there is a need for a structural change. He does not feel the federal state government’s decree will make much of a difference, he was quoted as saying by Radio Netherlands Worldwide. "I believe it’s (ordinance) mainly intended to make the government look good. There are different kinds of MFIs, and there are so many rules and regulations that the federal state can impossibly enforce them all. We have already seen a large number of MFIs change their legal status to a Non-Banking Financial Company to evade state oversight." He reportedly added, "Each year, hundreds of farmers in Andhra Pradesh commit suicide. It’s a structural problem, which has several causes. Most farmers have borrowed from a number of sources before they commit suicide."

While opinions vary, there is no disagreement over one thing. That is, India’s microfinance sector needs a fix or, shall we say, quick fix.

Contingent Convertible bonds: A New Kid on ‘Banking’ Block

 

A proposal by Britain’s Barclays to use CoCo as a remuneration tool is being watched closely by peers.

Don’t confuse it with a new Swiss candy or a soft drink brand. CoCo is a bold, new concept which is being explored by banks in Europe as a revolutionary tool to revamp their compensation mechanism (read: bonus). The British financial giant, Barclays is reportedly looking to issue CoCos, subject to regulatory approval, to its senior employees in a bid to overhaul its compensation strategy that could help it navigate any crisis-like situation, such as the global financial crisis of 2008, better. Crisis-hit big European and US financial institutions (remember AIG) had recently come under scathing attack from the regulators and experts for issuing fat bonuses to their senior management even as they had to be bailed out by their respective governments. Now by using CoCo as a ‘bonus currency’ (as some experts call it), the issuers might hope to buy peace with critics. However, the utility of CoCos goes beyond as a mere compensation tool as several banks in Europe are looking to issue such bonds to recapitalize them to meet tougher Basel III and regulatory norms in their own nations.

CoCos or Contingent Convertible bonds are a kind of hybrid instruments. According to David Bishop, Ethan Zuofei Liu, Patrick Murray and Téa Solomonia of State University of New York, “Contingent Convertible bonds (CoCos) are debt instruments that must transform into shares of equity or are written off upon a triggering event.” The trigger event, they suggest, could be determined either by regulatory assessment or objective bank losses. So, the bonds become effectively worthless if the financial viability (a major trigger) becomes questionable. That means the employees have every incentive to make sure their institution’s remain financially strong. It also serves as an effective recapitalization tool if the issuer’s tier-I capital falls below a threshold or specified limit.

So far, two financial institutions which have issued CoCos include Lloyds Bank and another by Rabobank. In case of Lloyd Bank which issued these bonds in November 2009, the conversion is contingent upon the trigger event of Core Tier 1 leverage ratio falling below five per cent, while in case of Rabobank, in case trigger event happens it would lead to write-off of 25% of the principal amount.

“[They] are interesting as a pay device on two counts,” FT quoted a leading European banker as saying, who further added, “They (CoCos) give an employee downside and don’t incentivize strategies that would ramp the share price in the short term, as equity can. At the same time, they could count towards core capital.”

As regulators and bankers across the globe look for preemptive measures to prevent a repeat of the 2008 financial cataclysm, CoCos appear as a ray of hope. But will they deliver? “An inherent problem within banking finance is the risk of panic: when a bank needs to convert hybrid debt into equity, it sends a clear signal to investors that the bank is in trouble. These investors are then tempted to withdraw their investments, making the initial problem much worse. CoCo bonds are emerging as the most concrete new idea for solving these inherent problems,”

However, CoCos do suffer some drawbacks. A major concern about CoCo’s effectiveness is about the trigger event. According to Prof. Theo Vermaelen of the prestigious INSEAD, France, is that “how should the trigger be set?” “In the case of Lloyds the trigger is based on regulatory capital ratios, which are only computed once every quarter. Such a mechanism will not work in a situation where a bank capital structure deteriorates rapidly,” he writes in his article, “Message to Basel: Another way to avoid bank bailouts,” published in Wall Street Journal. “For example, Citibank had a Tier 1 capital ratio that was measured at 11.8 per cent in December 2008, at the height of the financial crisis. This means debt holders are not likely to get their money back, which makes the bonds very expensive, and reduces their attractiveness as an alternative to simply issuing equity.” He proposes a new framework, Call Option Enhanced Reverse Convertible or COREC in which the trigger is based on market values, and not "old" capital ratios and also, the design protects equity holders against dilution caused by manipulation and/or market panic.

Whatever, European banks, for now, it seems, are liking CoCos.

Amy