By Kimberly J. Heimert | Niki Amalu and Ali Hassanali contributed to this article
The World Bank estimates that sub-Saharan Africa (SSA) has an annual infrastructure investment deficit of approximately $93 billion.
Its April 2017, Africa’s Pulse report reveals that SSA lags other developing regions in virtually all infrastructure performance metrics. For example, only 35% of the population has access to electricity, and the region has the lowest road and railroad densities among developing regions.
The African Development Bank (AfDB) estimates that SSA countries lose as much as 2.1% of GDP annually due to inadequate infrastructure, which in turn, constrains sustainable development in the region.
Although data on infrastructure spending by SSA governments is limited, estimates by the International Monetary Fund (IMF) suggest that national budget spending constitutes the major source of funding for infrastructure across the African continent generally, accounting for approximately two-thirds of total infrastructure spending.
A 2015 Brookings Institution study on financing infrastructure in SSA concluded that, as of 2012, over 97% of external infrastructure financing came from three main sources:
(1) development finance institutions (DFIs), export credit agencies (ECAs) and other multilateral institutions (Official Development Financing), representing 35% of all external financing;
(2) private sector participants, constituting approximately 50% of all external investments (although over two-thirds of such investments have traditionally been concentrated in the telecom sector, growth in the energy sector, and particularly, power generation, is increasing); and
(3) China, in the form of public lending (requiring the incurred debt by SSA countries) from China’s Export Import Bank, primarily targeting the transport and energy sectors.
Like most emerging economies, limited national budgets and constraints on the ability of the governments of SSA to raise external financing significantly limit the availability of internal funds for infrastructure development. Therefore, private sector investment is vital to closing the infrastructure gap.
Although the SSA infrastructure gap represents an opportunity for investors, private sector capital investment into SSA has not kept pace with the level of investment required.
This does not reflect a lack of interest in deploying capital in SSA infrastructure. Instead, it reflects the fact that there are relatively few bankable infrastructure projects for private sector investors to pursue.
Therefore, the best way for African governments to encourage more private sector infrastructure investment is to ensure that the priority infrastructure projects are bankable.
Determining whether a project is bankable is a complex process with many variables. At its most fundamental, however, a project is bankable when it is structured in a manner that is likely to provide debt and equity providers with returns that are commensurate with the risk they are taking.
Bankability is so important to successful private sector infrastructure development that a number of government agencies have issued publications on just this issue, including the Overseas Private Investment Corporation (OPIC) and several other U.S. government agencies (Ten Bankable PPA Features) and the U.S. government’s Commercial Law Development Program (CLDP Understanding PPAs), both of which focus on power projects, but are applicable to many other infrastructure projects.
There are many components to creating a bankable project that a government can directly influence, including ensuring that projects have sufficient, reliable, and predictable revenue streams, creating a stable legal and tax system, and understanding project financing and various equity structures so that governments can properly allocate risks among the government and private sector investors.
A central component of bankability is a revenue stream from a credit-worthy party. First, that revenue stream must be sufficient to operate the project, repay project financed debt, and provide a risk-adjusted return to the equity.
Second, the provider of that revenue stream (often called the 'offtaker') must be required to purchase the project’s output, with few (if any) exceptions.
There are some instances in which projects that sell their products into the market (on a 'merchant' basis) can be project financed, but those projects are fairly sector-specific and are more challenging for project lenders. Third, the offtaker must be credit-worthy.
For example, if a state owned enterprise (SOE) is the offtaker for the project, that SOE must have operations, a balance sheet, and a track record that evidence its ability to satisfy its payment obligations. If it does not, the lenders and equity providers will require that another entity (such as the sovereign government) guarantee such SOE’s obligations.
Creation of a stable legal and tax system
Ideally, the track record of a country’s legal system should provide comfort to private sector investors that the country’s legal and tax systems are stable and predictable.
However, many SSA countries do not yet have a sufficient track record for investors to rely on that alone. In those countries, private sector investors take a great deal of comfort in stabilisation clauses, which are either statutory provisions or contractual obligations of the government to guarantee that any change in law (including tax law) that has an adverse impact on the project either will not apply to the project (be 'grandfathered') or the project will otherwise be 'made whole' by the government.
Although these clauses are sometimes controversial, as they could be seen as restricting a government’s ability to positively develop its legal and tax regime, they are fundamentally important for private sector investment in markets where the legal and tax systems are perceived as potentially unpredictable.
Understanding project financing and equity structures to properly allocate risk
There are some project sponsors that can finance some projects 'on a balance sheet.' That is, they provide all of the costs of developing and constructing the project themselves, without recourse to the debt markets or the private equity markets for the particular project.
However, outside of the oil and gas sector, this financing structure is relatively rare in developing markets.
The most common structure for most infrastructure projects that involve the private sector is project financing.
Project finance is a structure in which lenders rely on the cash flow from the project to repay the debt, instead of the balance sheet of a 'deep-pocket' corporate entity. Typically, debt in a project financing structure will cover between 50%-80% of the project’s costs.
The remaining portion of the project costs are funded with equity. The equity provider in a classic project financing is a corporate entity/developer that intends to develop, construct, and operate the project and has a balance sheet sufficient to fund the equity.
Many variations on this classic structure exist. Each of the structures present different advantages and different challenges, and all require different allocations of risk.
A relatively new variation is the entrance into the market of private equity investors, often in the form of investment funds. According to the 2016 Kudos Africa Report on trends in SSA investment, these private equity investors have shown increasing interest in infrastructure projects, including in SSA, over the past several years.
Private equity investors typically raise funds from financial investors (investors without particular knowledge or interest in a particular sector that simply bring money to the table) and generally will not take development risk.
At the same time, different types of projects present different risks that are more or less appropriate for the various financing structures.
For example, certain equity investors are often more willing to take development risk in certain types of projects, such as power projects and transmission lines, expansions of existing infrastructure and projects in the manufacturing, hospitality, and other service industries.
However, few equity investors are willing to take development risk for projects that involve a greater variable of unknowns and associated risks (such as greenfield port, freight rail and urban rail projects and major highway development projects). In those cases, governments should consider absorbing some of the development risk before bringing in private sector investors.
However, in order for governments to properly determine how to allocate risk – based on the sector, financing structure, and other variables, it is imperative that the government retain financial and legal advisors with substantial expertise in project financing, private equity (if relevant), and the relevant sector.
The type of expertise necessary to properly structure these transactions is gained only with many years of experience that very few government officials (regardless of the country) have.
Those advisors may be paid for by the governments, by various facilities provided by development institutions (such as the African Legal Support Facility from the African Development Bank), or by the project sponsors. Regardless of who picks up the bill, their involvement is essential to the success of any project financed infrastructure project, especially those that involve private equity investors.
African infrastructure investment
Africa is widely heralded as the continent of the future. However, to realise its potential, SSA countries need to reduce the infrastructure deficit. The current shortage of private sector infrastructure investment in SSA is not caused by a lack of interest or a lack of funds. It is caused by a lack of bankable projects.
African infrastructure projects are competing with infrastructure projects all over the world for private sector investment. SSA governments must focus on designing and marketing bankable infrastructure projects that will compete, on a risk-adjusted return basis, with projects elsewhere in the world. Read more...
To do this, governments must approach infrastructure development with the private sector by marketing bankable projects, which requires them to understand the risks from the private sector perspective, properly allocate those risks, and provide appropriate risk-adjusted returns.
Countries that are able to take these steps and proffer bankable infrastructure projects are the countries in which private sector infrastructure investors will be more likely to spend time and money.
About the author
Kimberly J. Heimert is counsel in the Project Development and Finance practice of Shearman & Sterling LLP, based in their Washington, D.C. office.
Kimberly recently joined the firm after serving in President Obama’s administration as General Counsel of the Overseas Private Investment Corporation (OPIC), the U.S. government’s development finance institution.
Niki Amalu and Ali Hassanali of Shearman & Sterling also contributed to this article.
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