Pricing the Deal as a Quadruple Trade-off

Nov 21, 2009 — Neil Boyle

The pricing of deals is often a two dimensional (finance on technical) trade-off between price and a series of financial and technical considerations. Because these considerations are geared toward securing project revenue streams (cash flows) for the comfort of creditors, finance issues tend to dominate the contracting action. Securing lender comfort is necessary given the high levels of non-recourse debt finance that are involved in PPP infrastructure projects. Unfortunately, a narrow focus on financial closure limits the scope of pricing out unrelieved contract hazards, restricts the capacity of contracts to adapt to the unforeseen events that are caused by hazardous incentives in the intertemporal process and interfirm market exchange venues of PPP infrastructure.  Furthermore, focus on financial closure tends to minimize the human factor of contracting, and is indifferent to the signaling of confidence to the various constituencies of the deal, except one. An example of signaling confidence is government expressly saying it will protect equity investments against expropriation and takes action by passing a law that asserts as much and puts in-place an organizational capacity to enforce it. Comfort levels of lenders should not be trivialized, but neither should project completion be compromised in the process.

A more powerful and effective protocol is a four way multi-dimensional negotiation that simultaneously involves price, cash flow security, technology, and safeguards where each are traded-off with the others for net gains; all are interactive. The reason for cash flow security is the positive scope it affords for negotiating governance closure—there is a net positive price adjustment on top of financial closure that can be achieved due to more effective alignment and contract stability.  Cash flow security is the comfort sought by lenders so it is a tradeable asset.  The reason for technology negotiation is that asset specificity poses adaptation needs for complex incentive structures ex-ante and ex-post because of  the hazardous incentives that occur throughout the project cycle. Failing to address either of these needs causes technology to be traded-off for a simpler or a more complex version depending on the degree of credible commitment that can be harnessed; and shifting technology to another level of asset specificity may or may not be desirable. The reasons for safeguards are for the added security features that are introduced into a contract that reduces hazards (due mainly to asset specificity but not exclusively) and that create confidence. Safeguards can be penalties, information disclosure, verification procedures, bilateral hostage arrangements, reciprocal trading, a reduction in incentive intensity, upfront investments by government in measures that attenuate equity expropriation hazards, specialized dispute settlement procedures, and/or more fully developed private ordering apparatus to deal with contingencies; among others.

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