Analyzing the Impact of PPP Financing Model on Governance and Optimality

Bilateral Lending versus Dis-intermediated Financing in Infrastructure finance

The needs and benefits of developing Lebanon’s infrastructure and more specifically its energy sector have been abundantly analyzed and widely researched. Even bankability requirements are -to a large extent- known and understood by all the stakeholders. While papers on the risks aspect of bankability abound, very few have actually covered assessing the impact of the financing model retained (as defined hereinafter) on the stakeholders. This paper explores the impact of two financing models for infrastructure: (the bilateral financing approach and the dis-intermediated financing approach) on governance specifically and more broadly on the overall economy.

The questions we are trying to answer include: is the financing model retained for a given infrastructure project “neutral” to the various stakeholders and to the economy? Would one specific financing model create more wealth than the other? Alternatively, does the retained financing model impact the allocation of the wealth created (if any) between the various stakeholders and to whose advantage? Is there a relationship between the financing model of the infrastructure project and the Pareto optimality?

As indicated above, we will compare two financing models. The first one -referred to as “bilateral”, covers instances where the project is financed by the sponsor’s equity and his chosen lenders. It is not unusual to have the sponsors and the lenders being related to each other either publicly or in a more subtle and concealed way. The main feature of the bilateral lending model is to enable the senior lenders and the equity partners to speak in one voice. Even in duress, they will protect each other’s interests. Because of the entangled relationships, senior lenders and subordinated investors have aligned interests. It is common to have instances where on different transactions (or even on personal basis) the sponsor(s) or its owners being obligated towards/debtor of the lender(s). Which means that any loss hitting the sponsor or the equity of the infrastructure project would equally hit the senior lender or at least weaken the implicit security package. At a project level this alignment of interest between the sponsor and the senior lender is undoubtedly a strength, at least from a negotiating standpoint and from a governance perspective. This strength enable the sponsor to extract more “value”, in other words negotiate better terms and sometimes impose higher tariffs. This strength enables a disproportionate risk sharing equation where most of the risks are kept with the government or the general public and the returns, almost always secured and/or guaranteed, are passed on to the sponsor. Being stronger is the negotiation game is not unlawful in itself. Nor is it morally reprehensible. But in the Lebanese context, it is conducive to corruption. Having a bilaterally structured financing allows the sponsor to conceal the conflicts of interest, to hide the unlawful operating efficiencies or to modify the nature of the deliverables. The absence of independent oversight allows the sponsors to direct the supplemental margins extracted from the higher tariffs applied to consumers or taxpayers to fund political parties. We can also turn this sentence around by saying that the pre-agreement to fund political parties is precisely the reason why the sponsor was awarded the utility at a higher tariff than his peers. And the bilateral funding nature of the project enables the concealment of such a scheme.

The second financing model -referred to as “dis-intermediated”- include instances where the sponsor calls upon capital from unrelated third parties whose sole interest vests in the investment being made and who have no other ties to the sponsor (other than their involvement in this specific infrastructure project). This will be referred to herein as unrelated capital. The investors’ investment decisions -and required returns- are solely based on the disclosed merits of the specific investment case. No other relationships –transparent or concealed- interfere with the decisions of the unrelated investor. Nowhere is it stated or implied that the dis-intermediated model has to cover or encompass the entire capital structure. The dis-intermediated model does not assume or insinuate that the entire capital structure has to be entirely funded from “un-related” parties. To the contrary, the dis-intermediated model assumes that only a minute portion of the capital structure is raised from “unrelated” parties. The balance being financed “as usual” from local or global lenders either related or unrelated to the sponsor. We would like to make the case –and eventually prove- that a tiny dose of “unrelated” money (small as a percentage of the entire capital structure, more substantial when measured as a portion of equity or mezzanine) is sufficient to instil a totally different type of behavior which in fine leads to Pareto optimality.

When looking at PPPs and infrastructure projects one can assume the stakeholders to be: equity investors, lenders, government, O&M, EPC, taxpayers, users, and the general public at large. In assessing Pareto optimality to stakeholders within the contact of choice of suitable financing model, the following issues will need to be explored:

1. Would bilateral lending result in lower tariffs/cost to users/consumers than dis-intermediated financing?
2. Would bilateral lending result in a lower cost to the general public than dis-intermediated financing?
3. Would bilaterally funded projects have stronger or weaker bargaining power than dis-intermediately funded ones?
4. Which financing scheme/model (bilateral versus dis-intermediated) take us closer to a Pareto optimal?
5. Given the importance of FDIs to the Lebanese economy, is bilateral lending a better mechanism to attract FDIs than dis-intermediated financing?
6. Who is more likely to win an infrastructure bid: a bilaterally funded bidder or a dis-intermediately funded bidder? Or is the financing model neutral to the government?
7. Does the retained financial model impact the negotiating behavior of the bidding consortium?
8. What is the impact of bilateral lending on (i) the on the pre-bidding disclosures and (ii) the post-bidding transparency and reporting? Is the impact neutral?
9. Conversely, what is the impact of dis-intermediated financing on (i) the on the pre-bidding disclosures and (ii) the post-bidding transparency and reporting? Is the impact neutral?

The above questions hint to the possible interdependence between the retained financing model and certain conflict of interests, governance issues, public finance sub-optimality, tariffs (overcharged cost of the utility), sub-optimal wealth distribution, social (in) justice, and corruption. In the present document, we will try to shed some light on such relationships while trying to qualitatively (and maybe sometimes subjectively) assess their contribution to optimal well-being.

I- Conflict of Interest

As per law, the licensee in any infrastructure project/PPP has to be a Lebanese Joint Stock Company (SAL). Lebanese Joint Stock Companies are controlled, in fine, by their majority shareholders. The majority shareholders, via the elected board, are the effective ultimate decision-makers on all managerial decisions including the appointment and/or removal of the operator, the selection of EPC, etc…. In the Lebanese context, it is also often the case that the suppliers of the bidding company (O&M operators, EPC contractors,…) be, themselves, the shareholders in the biding company or a part thereof. As such, it is common for these shareholders to be conflicted in their corporate governance decisions including transfer pricing and other related party transactions. In case of conflict, the matter usually ends up in legal battles and the company governance system is blocked.

A dis-intermediated model (using structured finance investment vehicles under Lebanese law, without necessarily any public or private offering of shares or units or bonds) effectively de-links the management of the “company” from the operations of the asset and from the “equity beneficial interest” therein, thus resolving the inherent conflict of interest between asset owner, asset controller and operator and ultimate beneficiary. Traditionally, in a joint stock company, with risk and reward comes control. He who takes the most risk, gets the highest return and makes the decisions. Using structured finance, the control gets stripped from the risk and reward which the sponsor retains to himself. The shares are in effect “silenced” or stripped of their voting rights while retaining risks and rewards. The powers over crucial decisions (mainly related to the appointment and or the removal of contracting parties, which are often related parties) is shifted towards the most senior lender then outstanding. In reverting to a dis-intermediated financing model, the ability to remove and/or replace any supplier (be it the operator or anyone else) becomes possible even when this supplier is himself is an “equity” investor (even if majority or sole shareholder) in the asset-owning and license-holding entity. And this outside of the court system and without legal battles and seamlessly.

One could argue that this is achievable in the bilateral lending model through contractual covenants and other legal provisions. This is partially true, but comes with serious caveats. Firstly, shareholders rights are “d’ordre public” and any shareholder can argue he is being stripped of his rights. The inability for any consul to issue strongly worded legal opinion on the matter puts any project in a legal limbo and uncertainty which would ultimately be reflected in the price and hence, all other things being equal, a sub-optimality. Secondly, the lender could be perceived as a “gestionnaire de fait” (or de facto manager) which would requalify the entire structure and result in the same additional legal risk commanding an additional premium and hence another layer of sub-optimality. Thirdly, the legal construct in a bilateral lending structure is so specific and tailored to a lender that it can hardly be transferred to any other senior lender or new beneficial owner. How would these protection flow through from one senior lender to another seamlessly in a 25-years project, in case of natural waterfall or in case of transfer/assignment or sale of the exposure? How would these rights seamlessly shift down to him? Lastly, and maybe most importantly, the enforcement of these rights would still require a lengthy legal battle.

II- Governance issues

Utilities, unlike normal commercial entities, come with a lower operational complexity but a higher governance complexity. Firstly, utilities are usually special purpose entities, in the sense that their purpose and hence their activity is restricted to a single specific line of business. When using joint stock companies, limitation of purpose cannot be properly achieved through contractual agreements: it is impossible to limit the powers of the general assembly by law. To be convinced, ask any international legal counsel to give you a clean bankruptcy remoteness opinion on an incorporated company especially under civil law. It is virtually impossible. More so when the entity (the joint stock company) is not structured as an orphan subsidiary. Note that the concept of orphan subsidiary is totally alien to civil law countries where the legislator favored creating un-incorporated legal entities (like SPV under law 705 in Lebanon or Law 88 in France). The government usually addresses that concern by taking controlling ownership stake or a golden share. Secondly, utilities and other PPP entities are constrained by the necessity to continue the public service they provide (continuité du service public) even if operating at loss or if they are entangled in their own internal infightings. Thirdly, utilities are usually not in control of the price at which they sell their services. All three points mentioned above stress the importance of governance in PPP/Utilities and highlights the far reaching consequences of the lack thereof. Poor governance resulting in conflicts will surely impact the investors and lenders but also the government, the GDP, the taxpayers, more broadly the general public.

III- Attracting diaspora and DFI

Reaching out to the diaspora to attract “off shore” money into infrastructure finance (equity or debt) would be much easier if the money raised is made against delivery of a “euroclearable” instrument materialized as a marketable security as opposed to some type of direct local company common equity (share in a Lebanese SAL) or direct debt instrument for the following reasons:

1. The physical remoteness of the investor and the lack of oversight make it virtually impossible for the diaspora investor to partner with “strangers” especially given the notoriously low governance standards of Lebanese corporations. Chances of realistically succeeding in raising diaspora money in bilateral funding model are virtually nil.
2. Bond issuances are strictly capped to two times the capital (as per Code of Commerce). So it is either (a) the debt raised is below the quantum needed to financial close and therefore more debt need to be piled on top of the bonds which would de facto make them “senior subordinated” or (b) the paid up capital has to constitute no less than 32% of the project capex which reduces the leveraging profile and lowers IRR.
3. It is difficult to get a “retail” party into a loan agreement and syndication is complicated and not designed for smaller tickets.

In conclusion, raising “diaspora” FDIs (debt and or equity) in a bilateral financing model is cumbersome, limited in size and improbable. On the other hand, attracting offshore money (diaspora money or institutional lenders money), into a dis-intermediated financing model designed for this purpose, is a much simpler exercise, unconstrained in quantum and maturity.

Taping into the diaspora investor base to fund infrastructure projects will require using structured finance to pool the widest investor base possible and channel investments into these projects, giving remote investors equal transparent access to these investment opportunities via a regulated, supervised and professionally organized investment vehicle.

IV- Tariffs

Most of the tendering processes, provide that the terms are negotiated prior to bid award. Debit amortization pattern is pre-scheduled and the return on equity is known with a fair degree of certainty. Both investors and lenders have set their required returns and priced their services accordingly. If we make the assumption that the market pricing of the required returns is the correct price and any other price bilaterally negotiated is either inflated or deflated for the risk being effectively incurred, one would conclude that the tariffs set based on bilaterally computed required returns are also either inflated or deflated, which results in overcharging (or undercharging) the consumers and the users of such service. And if the tariff is subsidized or simply covered by government, in this case the taxpayers are supporting an overpricing burden and hence over taxed (or under taxed) for the service rendered. This result in a sub-optimal situation when considering the overall stakeholders.

V- Equal investment opportunity

Opening the door for the general public to transparently participate in a portion of the equity and/or debt of the infrastructure projects allows such general public to reap-back the benefits from lucrative projects which -as a taxpayer and/or as a user- the general public is contributing to finance. Paying for using a toll road can be better stomached if one is a toll road shareholder. The wealth created and the profit generated are distributed in a way that allows small and large investors to contribute to -and benefit from- such investment. The equal investment opportunity concept is extremely powerful and goes a long way in addressing possible social unrest impulses. The case for dis-intermediated financing is here easier to make and comes clear-cut, as opposed to bilateral funding which keeps wealth within the “one-hand” circle of related parties sponsors and lenders.

VI- Social (in)justice

It is also a matter of social justice to “give access” to tax payers to such investments. In fact, the general public should claim a “preemptive right” over the equity of such projects (or at least a reserved portion). It is taxpayers money who is being mobilized for the payment of the utility/infrastructure and therefore, it is only natural that tax payers be allowing into the deals most lucrative positions. Furthermore, dis-intermediated financing results in substantial additional benefits. By opening such investment to the wider community especially the Lebanese diaspora, Lebanon could dramatically boost its chances of winning the race towards economic transformation and development. Pooling the financial resources of the Lebanese diaspora and giving them equal access to infrastructure investment opportunities in Lebanon would go a long way towards raising the profile of Lebanese transparency and governance of public utilities, let alone developing deep and liquid capital markets (which even in Europe was only possible when fuelled by massive infrastructure or privatizations waves – see France 1980 and 1990 privatizations and the surge of the Bourse de Paris).

VII- Bargaining powers

Let us consider two features:

a)    In a bilateral model lenders and sponsors negotiate together. Because of the “step in rights” and the highly leverage nature of PPP funded on a project finance basis (limited recourse), the lenders tend to wish to ensure that their seniority in protected in the documentation. They therefore participate in, and sometimes lead, the negotiations. On the other end of the table, sits the government/civil servants. In that context, and given that government is usually indebted to those same lenders, the bargaining position of the bidding party (sponsor + lender) becomes more powerful than otherwise and specifically when the sponsor is negotiating on his own as typically is the case with dis-intermediately funded scenario. This involvement of the lender in the negotiations is a feature of the bilaterally funded companies (due to the “one hand” approach) when negotiating bids. One can conclude that bilaterally funded sponsors are in a more powerful bargaining situation than dis-intermediately funded ones. In a dis-intermediated model the sponsor is alone negotiating with government.

b)    Let us also assumed (or so we believe or try to demonstrate) that a project funded under a dis-intermediated model leads to a Pareto optimal situation. Each stakeholder is compensation in perfect commensuration to the risk he undertook.

We are making the assumption that dis-intermediately funded projects result in (i) a sponsor with weaker bargaining powers and (ii) optimal tariffs and distribution of risk/reward and (iii) a stronger overall governance and finally (iv) a better check over corruption. Given the above one could reasonably believe that government would be inclined to favor or even incentivize the dis-intermediately funded sponsors. The economic agents rational behavior theory being assumed, one would expect government (as a rational agent) to favor a weaker beginning counterparty, with stronger governance controls, optimally allocating risks between stakeholders.

Oddly enough, historical evidenced of Lebanese PPP over the past 50 years tend to indicate that the exact opposite use to occur. Government preference for a stronger counterparty to negotiate with rather than weaker ones. At the same time government repeatedly selected sponsors charging abnormally high rates/tariffs on users/taxpayers. How is this possible and why is it so? The answer to this could be found in a classical agency problem. The interest of the government as representing the “collective will” and seeking the “common good” (i.e. naturally leaning towards a weaker counterparty and opting for solution which shares wealth optimally) conflicts with the private personal interest of the person in charge of executing such mission i.e. the ministry or the authority. The civil servant wants first and foremost to be able to negotiate in a closed room without the threat of unpredictable “loose cannon” behavior of unrelated investors. To achieve the “closed room” negotiation public servants will favor skewed wealth distribution over economic optimality, conflicted structures over sound governance, opacity over transparency, higher ones over lower ones. And this can only be achieved with bilaterally funded sponsors.

VIII- Corruption and perception thereof

The general public investment in any project (even in a minute portion as we have indicated above) somewhat limits the ability of the project sponsor to act in concealment. Oversight, scrutiny and disclosure are much higher when capital is open to the public or when “unrelated parties” are invested in any project. Furthermore, utility applying abnormally high tariffs (as is often the case in Lebanese PPP including water, electricity, phone, waste management, airport, transportation, internet) delivers to its shareholders abnormally high returns way in excess of the required return commensurate to the risks taken. Allowing for the general public to become a shareholders neutralizes the public opinion propensity to claim and prosecute effective or perceived corruption. On the other hand, the incentive to price abnormal high tariffs is somewhat toned down when the entire benefits and returns are not concentrated in one hand but rather are shared by a large granular community of investors. In conclusion, the dis-intermediated model induces various behavioral changes of which (i) reduction of the incentive for corruption, (ii) redistributing the excess profits extracted from a corrupted bid and (iii) increases the oversight and scrutiny.

Historically, most of the PPPs in Lebanon were funded in a bilateral manner (actually all of them except for Solidere). The vast majority of these proved to be overpriced (to consumers and taxpayers) and the awarding thereof was made in an opaque manner with some element of corruption. Attached in appendix C is a list of most Lebanese attempts of public private partnerships. Most of which included corruption at one level or the other. Most of which ended in total disarray leaving the taxpayers paying a huge bill for a below-par service (telecom, electricity, waste management, water treatment, airport concession, transportation and commuting, mecanique etc…). In this context, bilateral finding allows for negotiation/discussion/corruption to remain “covert”. The same resonates well with how government intends to keep matters as expressed in articles 10.5 and article 14 of PPP law 48/2017.

IX- Adverse selection

Adverse selection occurs when market participation is affected by asymmetric information. It is likely that bilaterally funded sponsors will shy away from bidding into those projects evidencing a higher risk profile (commercial risk in a toll road project versus off take in a power plant, etc…). This will force the government to open these projects to the public in an attempt to attract private funding therein. The government will never acknowledge that his decision to call upon “the public” was forced upon him “due to higher risk profile” and given the absence of appetite from the “first circle sponsors” rather government will advertise that such decision was taken in altruistic gesture to promote “equal investment opportunity”. A fair application of the equal investment opportunity concept commands that all projects be open to public investors. And if a selected number was to be opened for dis-intermediated funding, the government would need to explain why and how such selection was made. What are the criteria used and what the risk profile is. Adverse selection is awarding PPP projects will result in the least risky projects awarded to “informed” sponsors usually bilaterally funded precisely to mask the favorable risk/reward equation they are enjoying. Riskier PPP projects would be proposed to the public under the fallacious headline of “equal investment opportunity”.

X- Pareto optimality

It is true that bilaterally funded projects allow infrastructure project to materialize. Yet this comes at a high price to the economy: skewed wealth distribution, low governance, higher tariffs, all of which are designed to ensure excess profits to the winning bidder (in excess of the required return Re commensurate with the risks taken). Dis-intermediately funded projects would upgrade the infrastructure while satisfying optimality in the system: optimal wealth distribution, better governance, lower required returns (Re) to equity investors and hence lower tariff for the utility being deployed. This in turn results in a higher GDP output.

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Situation analysis

I.    Situation analysis

1. Lebanon needs money to finance PPP.
2. Lebanon has limited available liquidity in its banking sector.
3. Lebanese government cannot take on more debt.
4. Lebanon needs foreign money to balance its deficits.

In conclusion: Lebanon needs to raise Private and Fresh Money for PPP projects

II.    In order to attract money and more specifically FDIs, infrastructure projects need to ensure:

1. Higher risk-adjusted returns:
2. Structuring & tranching,
3. Favorable tax treatment,
4. Optimal operation and maintenance expenses

III.    Proper structuring and risk mitigation

1. Ring fencing of the assets away from any claim of any party
2. Segregation of ownership and operation
3. Bankruptcy remoteness
4. Swift ‘out of court’ enforcement process

IV.    Adequate governance/ transparent framework

1. Using properly structured SPVs under Lebanese law
2. “Auto pilot” administration of the assets (gestion liee)
3. No conflict of interest between owner, operator and contractor
4. Reporting obligations to investors required by law

A dis-intermediated financing model achieves the above as well as the below objectives:

• Neutralizing the tenure effect (ie long-term financing) because the instrument is a marketable security
• Ensuring equal investment opportunity to local constituents (the Lebanese population at large)
• Attracting diaspora as the securities channeling the investment to Lebanon are euroclearable
• Addressing the “suspicions of corruption” because investment opportunity is open to the public
• Ensuring the continuity of the “public service” even in case of litigation or disagreement with operator
• Reaching Pareto optimality

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Appendix A: Summary of features Bilateral Funding versus Dis-intermediated Funding

Appendix B: Table Comparing Features of SPV that could be used under Lebanese Law to achieve Pareto optimality

Appendix C: Non-exhaustive list of PPPs over the past 50 years

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