This is the second in our series of articles on Covid-19 and its impact on the PPP projects’ market in the Gulf. In this article, we explore the design of a stimulus package specifically directed at the Gulf PPP market at a time when high corporate debt levels are encouraging developers to retain cash rather than deploy it.
Whilst social distancing measures remain in place, it is inevitable that there will be a slow down in the PPP projects market. Most procurers, developers, bankers and advisers have already factored this in. What is less certain is the financial impact of the crisis on developers, particularly foreign developers, in the medium to long term. What, if anything, can be done at this early stage to stave off a slow down in the market once social distancing measures have come to an end?
At least in the near term, a debt liquidity crisis seems unlikely. Governments around the world have been quick to announce stimulus packages. The monetary measures in Saudi Arabia and the UAE are noteworthy. In Saudi Arabia, the Saudi Arabian Monetary Authority has announced a US$13.3 billion package to support the private sector, partly by encouraging banks to increase lending to businesses. In the UAE, the Central Bank has unveiled a US$27 billion package, including zero-interest rate collateralized loans to banks.
The view of commentators on the equity side is less optimistic. At a time of heavy corporate indebtedness, there will be a temptation amongst PPP developers to retain cash rather than deploy it – even though many government stimulus packages, including in the Gulf, are specifically designed at deferring debt repayments and generally easing the burden of corporate indebtedness.
To address the prospect of a PPP equity crunch, the following are measures to be considered.
· Reduction of Minimum Equity Thresholds: procurers typically stipulate that sponsors must make a minimum equity contribution of 20% of total project costs. This is good practice and incentivizes developers to perform well. Given the extraordinary times, the amount could be reduced to 15%. As lenders also impose minimum equity contributions, they would have to be encouraged to buy into the relaxed requirements.
· Promoting Use of Mezzanine Debt as Equity: Mezzanine debt is often found in leveraged buyouts. A company may pursue the purchase of shares in a company for $100 million with debt, but the banks may be unwilling to lend more than 80% of the value. The purchaser may be unable or unwilling to contribute US$20 million of its own money and raises US$5 million from a mezzanine lender. The lender may be a bank or some other form of lender. The debt can be converted to equity once the relevant conditions have been met.
If the sponsors of a PPP project are required to make an equity contribution of 15% (see above), but with say five percent by way of mezzanine debt, the effective equity contribution is reduced to only ten percent.
Mezzanine debt is not inexpensive and the cost would have to be passed through into the tariff or unitary charge.
· Government Shareholding: If the sponsors’ equity contribution is to be reduced to only 15%, with five percent of that amount coming from mezzanine debt providers, there will be a shortfall of five percent against the conventional model. This amount could be made up through government/quasi-government shareholding in the project company. The shareholder could be taken by the procurer or off-taker as most procurers and off-takers in the region are government owned. Where this approach is already taken, for example in Abu Dhabi, the government shareholding could be increased, provided adequate minority protection is given through the project company shareholders’ agreement.
· Minimum Equity Return: perhaps most controversial of all would be a minimum equity return to the shareholders of the project company, calculated at the time of financial close, but subject to the risks associated with construction.
This, more than anything else, is likely to maintain the interest of both domestic and foreign developers in the Gulf PPP market. There is certainly precedent for the approach. For example, in the Shuaibah III IWPP, the first independent power and water project in Saudi Arabia, the procurer stipulated that there would be a minimum internal rate of return.
It may be that in some jurisdictions, not all of these measures would be needed. If the shareholding of a procurer or off-taker is larger than suggested above, mezzanine debt may not be needed. If there is no procurer or off-taking shareholding, mezzanine debt may become more important.
A PPP stimulus package in the form described in this article would clearly come at a cost, but it would be on the understanding that the measures would remain in place for a limited period of time – perhaps 12 months - providing a boost at a time when social distancing has come to an end, but the after affects of Covid-19 linger on.
The next article in our series on Covid-19 and the PPP sector will be published shorty.