Project Finance: Incentives and Governance of the Deal

Dec 29, 2009 — Neil Boyle


 The traditional approach to PPP infrastructure finance comes from a financial engineering risk-return paradigm. PPPs are often financed with high or even aggressive debt/equity ratios ranging from 80:20 and occasionally reaching the mid 90s.

As a minimum condition for lending, creditors require that project cash flows be extraordinarily stable and resilient to market and business risks. In addition, creditors require strong debt equity cushions and the availability of strong cash collateral to support priority loans in the face of difficult or even threatening post-default scenarios as part of a deal. Creditors are keen to match long-lived assets with long tenor stable debt structures to produce stable credit profiles to smooth potential volatility caused by financial markets and the investment itself. Loan commitments are therefore conditional and borrowers are dependent on creditors for waivers to avert default due to the tight structure and preemptive nature of default clauses. The dependency of borrowers on creditors generated by these credit requirements is often concerning for equity owner-investors in these borrowing firms.

An important issue is the cost of preemptive security that owner-investors are willing to pay for obtaining debt financing. Preemption costs operate on a sliding scale; the higher the debt financing, the higher the cost and more rigorous the preemptive security demanded by commercial bankers. At high levels of debt-equity ratios, the preemptive claims of creditors afford them limited protection due to the non-redeployable nature of the firm’s basic investments, which are sunk costs and not easily or costlessly monetized. To get around the limited protection problem and to assuage lenders fears, borrowers offer the redeployable potential of cash flows rather than rely on the firm’s non-redeployable basic assets; hence, the switch to seek access to debt financing through the redeployable financial assets of cash flows. However, although acquisition of debt financing is facilitated, reliance on cash flows creates other risks.


The agreement of financial terms is a necessary condition for negotiating efficient PPP infrastructure agreements, but it is not a sufficient condition;  negotiating governance terms is also necessary.[1] The trade-off of cash flow dependency for debt financing leads to suboptimal agreements during negotiations and implementation in three ways:

  1. Traditional project finance fails to factor in the costs of the hazard-embedded institution of debt financing. The result is owner-management maladaptation, a condition of conflict between control and management of the project assets caused by the potential for mismanagement by uninformed commercial lenders who have taken over managerial rights from owner-investors in exchange for debt financing. The special purpose hybrid governance structures of PPP infrastructure transactions pose adaptive needs for active management of the project.Nonetheless, these needs go unmet because of misalignment with the competencies of the financial governance structures of debt.  Debt and equity governance structures for financial transactions are analogous to market and hierarchy governance structures for generic transactions, both have unique costs and competencies.  For financial transactions, costs and competencies vary according to debt and equity shares; for example, equity has few if not zero contractual constraints while debt has many; security is preemptive for debt but residual claimant for equity owners; and active management is nil for debt but extensive for equity.  Higher shares of debt financing lead to an increased number of contractual constraints and an increased sensitivity of creditors to terminate a project; together, these hazards are indicative of misaligned financial governance incentives.
  2. Traditional project finance also fails to factor in the costs of the commonly employed risk mitigating institutions and mechanisms that accompany debt financing. [2] The result is contract price instability, a maladaptation that leads to the projected breakeven supply price exceeding the contracted price. Price instability arise ex-post because farsighted traders who fail to price out hazards during negotiations have strong incentives to price them in during implementation as these hidden risks become apparent or relevant to gain advantage. Farsighted traders keep this in mind when the opportunity arises to negotiate a price adjustment that results in a private gain to themselves.
  3. When cash flows are substituted for the basic specialized investments of the firm, both the basic and prospective risk mitigating assets are compromised. The incentive structure created by the substitution reduces the level of asset specificities of the risk mitigating investments. Mindful that these incremental investments serve specific expost risk mitigation purposes but impact on all of the firm’s assets, reversion to lower levels of asset specificity can be costly and diminishes the value of the overall asset. Substitution of cash flows creates strong incentives for aggressive leveraging of debt and signals little or no confidence in the regulatory regime of the state. The resulting increase in lenders demand for preemptive security increases the likelihood that private investors will hedge the degree of asset specificities of both their basic investment assets and risk mitigating assets. Reversion to lower levels of asset specificity appears in ex-ante and ex-post trade-off decisions where governance issues are at play.

In summary, the project companies of PPP infrastructure projects operate in a maladapted owner-management and price stability environment weakened by fault lines of hazard-embedded institutions


Once traders recognize that harmonizing the contractual interface to enable adaptability and continuity is the source of real economic value, sustainable solutions are feasible. After recognizing this, negotiating governance closure is necessary. Then, the following safeguards are posed:

  1. Contractual integrity is restored by strengthening legal protection of equity investment and by signaling confidence to equity markets.   
  2. Equity ownership is strengthened by improving the balance between the contractual constraint competencies of debt and the active management competencies of equity.
  3. Organization and oversight functions of the board of directors are clarified. As a benefit of equity financing, share ownership and a board of directors ensure active and intensive monitoring and supervision of project management. 

The important question faced by farsighted investors is how much debt the project company can absorb without jeopardizing the owner-management and price stability integrities of the transaction and the values of the risk mitigating investments. Per [A]TCE analysis, debt financing should cease when production and governance cost differences between buying and making the firm’s products cancel each other, or when the preemptive security of creditors starts to interfere with the active management and private ordering discretion of equity owners. Although this exact point is difficult to discern, the tools provided by [A]TCE, can provide approximation skills to the negotiator; the more skilled the negotiator, the better the quality of trade-offs, the closer the approximation.  

Harmonization of the contractual interface to effect adaptability and continuity of the contract parties involves:

  1. Private ordering. [3]
  2. Credible commitment of both parties. 
  3. A project company that specializes in farsighted procurement, project and contract management, and hazard mitigation.
  4. Project finance expertise that recognizes there are high costs due to an absence of parity or near-parity in the general capacity of government counterparties to negotiate public private partnerships (PPP)s. By general capacity is meant the requisite knowledge and skill that is necessary to negotiate an efficacious autonomous bilateral relationship between the parties based on credible commitments and private ordering.

Often, an absence of parity occurs when a developing country negotiates with a large well-funded private corporation from a developed country. Developing country naiveté leads to expropriation of unowned assets by developed country negotiators. Expropriation is a common practice as foreign investors often assume a level playing field where costless appropriability is available on all margins.[4]  Farsighted investors are sensitive to opportunities to signal credible commitment and confidence to the other party in asymmetrical capacity situations between parties planning to engage in a public private partnership.



  1. Failure to safeguard against hazards is due to transaction hazards (even before mismanagement arises). Transaction hazards tend to lurk in the background as potentiating forces or incentives that either inhibit or promote action; in the case at hand, transaction hazards act to inhibit the introduction of mitigating mechanisms. Once mismanagement becomes overt due to those transaction hazards becoming transaction costs, production costs increase. As costs increase, the value of the Project Company and markets suffer.
  2. The standard inventory of risk mitigating institutions and mechanisms, which PPPs have relied on or turned to in the past is embedded with unrelieved hazards. These institutions and mechanisms are: pay for performance payment systems; franchise procurement; unitary structured project company; comprehensive contingency contracting; reliance on legal counsel and court ordering; insiders; rigid financial covenants; constant price-supply performance constraints; strategic disclosure; zero sum counterpart relations; semi-credible commitments and residual rights; obfuscation; regulation; and government guarantees, among others.
  3. Private ordering and credible commitment are explained elsewhere. Private ordering and credible commitment help to change the benefit-cost calculus of the parties involved in PPP projects, which help attract equity investment, thus relieving the hazards of misaligned incentives caused by excessive debt finance.
  4. An unowned asset is not privately owned. Property rights economists refer to these kinds of assets as common property, i.e., property owned in common by the public and thereby open to capture through various means (e.g., stealth, theft, fraud, threat, power, and potential for violence, among others). 

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