Public Private Partnership (P3) Financial Hurdles, Budget Constraints & Overcoming Junk Ratings
Updated: Jun 7, 2019
Approaching a Public Private Partnership (P3) starts with analysis of your market. Typically investment grade markets attract low interest, high demand project bids. The ability to thrive in competitive business environment typically tracks funding.
Projects without capital lay dormant, create liability and place strain on public works.
International developing markets often market tax concessions, permitting, legislative support and proper off-take structuring. These same markets lack one key component to forming a successful P3.
Most developing markets lack credit worthiness. The chart below illustrates credit ratings from Standard & Poor's and Moody's.
Most developing markets fall under the BB - C rating for Standard & Poor's and Ba - C rating for Moody's. The standard method for country capitalization for P3 is through debt. Bonds are typically the established medium for investment.
Moody's, Standard & Poor's, and Fitch allocate their ratings with an indicator to show a bond's ranking within a category. Moody's uses a numerical indicator. For example, A1 is better than A2 (but still not as good as Aa). Standard & Poor's and Fitch use a plus or minus indicator. For example, A+ is better than A, and A is better than A-.
Ratings are not perfect. Ratings do not tell you whether or not a P3 investment appreciates or declines in value. Before using ratings as a factor in the P3 selection process, learn about the methodologies. Each methodology establishes a criteria for different sources of financing. It is possible to find some methods more useful than others. Knight Advisory specializes in "below investment grade" ratings.
What this means is below investment grade projects (i.e. Junk Rated P3) focus on different liquidity pools. The liquidity pools for junk rated P3 projects are tied to international policies. These policies range from diplomatic relations (by treaty ratification) to humanitarian considerations. Environmental issues are also a push in today's economic climate. Trade Treaty allocations are also a key focus for Junk Rated P3 projects. Projects below investment grade rating have large institutional support for operating concessions. For instance, HSBC may be granted a license to operate in Venezuela, subject to 1bn RMB investment per annum in road infrastructure.
Investment grade and high yield bonds
Investors typically group bond ratings into 2 major categories:
Investment-grade refers to bonds rated Baa3/BBB- or better. These bonds have low risk of default and command lesser premiums. A sample chart is annotated below.
High-yield (also referred to as "non-investment-grade" or "junk" bonds) pertains to bonds rated Ba1/BB+ and lower. These bonds have a higher chance of default and pay premiums reflective of their risk. A chart of these bond ratings are below:
If you approach a Junk Rated P3 in the private sector a high risk tolerance for high-yield bonds is required. The financial health of an issuer can change—no matter if the issuer is a corporation or a municipality. Stressed financial health means ratings agencies can downgrade or upgrade the rating abruptly. It is important to monitor a bond's rating regularly. If a bond is sold before it reaches maturity, any downgrades or upgrades in the bond's rating can affect the price others are willing to pay for it.
Often this raises concern for private capital. If political instability exists higher chances of failure persist. Private capitalization is difficult without local expertise.
Best Approaches for Junk Rated P3
Public Route. The only exception for high yield bonds that support a +70% success chance, according to Knight Advisory Research, are bonds that deposit as American Depository Receipts (ADRs). These issuers submit to American Regulatory and compliance. Local individuals are held accountable. Typically big name auditors are employed to safeguard against fraud. Local accountability lessens the risk of fraud. Risk mitigation is applied through Risk Transfer methods to insurance underwriters.
An investment grade insurance guarantee is then applied against fraud, omission or deception. This can attract investors who wish to place a certain portion of their portfolio into high risk enterprises to achieve a return differential.
Failure to implement proper risk mitigation and accountability tools in a Junk Rated P3 is typically grounds for high failure odds.
Private Route. Proper P3 structure is required. External Agency License (EAL) should be applied. A standard Memorandum of Understanding (MOU), coupled with legislative letter of appointment should be incorporated. Sovereign Guarantees (SG) that carry junk ratings typically only serve for legal purposes.
A Sovereign Guarantee (SG) is not a monetize eligible instrument and carries restrictions. Therefore no liquidity market or secondary market presence applies.
A Letter of Appointment (LA) is required only to show legal standing. External Agency License (EAL) should be supported by current legislation or bill passage. Once these items are in place the P3 entity formed should incorporate a local company that is owned by the P3 entity. The incorporation should be in the host jurisdiction of the Junk Rated P3.
The EA should be granted to a local entity owned by a parent corporation. The parent corporation should be the Special Purpose Vehicle (SPV) responsible for accepting funds.
The SPV that raises money should be the sole owner of the local corporation. The SPV formed should be the parent corporation. The SPV should list a debt instrument and remain private. The debt instrument is guaranteed by the SPV which will carry a lender / debtor relationship with the SPV. The MOU should be signed by the local corporation and the SPV. The SG should guarantee both the SPV and local corporation.
With this structure in place as long as the following categories are applied institutional support should be found: emerging technology, humanitarian causes (by United Nation Resolution), environmental disaster or prevention (by ratified treaty), infrastructure (roads, water, electricity, bridge).
Reach out to Knight Advisory & Planning today to guide you through below investment grade rating processes.
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Knight Advisory & Planning (KAP) is the only company to primarily focus on Public Private Partnerships (P3) since 2006. KAP operations are spread across countries of the world to serve this need. KAP Network consists of core partners surrounded by interlocking networks of consultants and affiliates in key trading countries and disciplines. We maintain Master Project Manager (MPM) who are American Academy of Project Management (AAPM) certified and are experienced in the following industries: construction, development, finance, technology, FinTech, biotechnology, production, R&D, and manufacturing. With over twenty (20) years of experience let us guide you through the P3 process.