DBRS Updates PPP Methodology to Refine Its View on Equity Contributions

DBRS has today published an updated methodology for rating Canadian public-private partnerships (PPPs), incorporating new guidelines for equity contributions. The last few years have seen significant growth in the popularity of PPPs in Canada, partly helped by a steady stream of projects, greater understanding among investors of construction risk and these document-intensive transactions and the inclusion of more recently rated transactions in the DEX Universe Bond Index. As part of this maturing process, certain features, such as dynamic lifecycle inspection and reserving mechanisms and true-up clauses for financing structures involving bank and bond debt, have become standard, leading to more robust transactions. However, efforts have also continued among certain market participants to refine financing structures in order to make their proposals more competitive and more efficient for equity providers, creating at times downward pressure on credit metrics. This trend has been particularly noticeable in the gearing assumed in certain project proposals, suggesting it may be time for DBRS to signal to the market the minimum level of equity that it deems adequate for investment-grade design, build, finance, maintain (DBFM) projects of low to moderate complexity.

When PPPs started gaining momentum in Canada a few years ago, projects with a least 10% equity (a gearing of 90:10) at financial close were commonplace. Over the last year or two, however, DBRS has come across an increasing number of proposals with equity contributions accounting for less than 10% of the project’s pro forma capital structure during construction – and sometimes significantly below this level – raising concerns about possible excessive erosion of this metric.

DBRS recognizes that the benefit of equity does not stem from the financial strength or resilience that it brings to a project, since a gearing of 93:7 or 88:12 makes little difference in the ability of the project to weather the replacement of the design-build contractor or a significant shock in the operating and maintenance (O&M) or lifecycle budgets. Nor is equity a source of additional funding for a project during construction, since, with the exception of contingent equity, all funds are fully earmarked at financial close. Instead, equity is viewed as a way to incentivize the equity sponsors during the construction phase and ensure that construction work is performed with a long-term view. As such, DBRS is of the view that to constitute adequate commitment to the project and to incentivize the project proponents, equity in a DBFM project of low to moderate complexity should account for at least 7% of the capital structure at financial close. Establishing a floor is deemed necessary given the importance of keeping the incentives of all major project participants aligned during the relatively short, albeit critical, construction phase. Failure to meet this requirement would be expected to have an adverse effect on the rating.

For design-build-finance (DBF) projects, however, DBRS does not view traditional equity as essential to the capital structure. In such transactions, ProjectCo (i.e., the special-purpose entity undertaking the project and the issuer rated by DBRS) is generally owned by the construction contractor. Therefore, the only key partner on which the project and bondholders rely for success in a DBF project is the construction contractor, which already has the proper incentive given the extent of its financial involvement as reflected in the contract’s liability cap and the parent guarantee, generally amounting to at least 50% of the contract price. Furthermore, the rated bonds generally mature shortly after substantial completion, making long-term considerations irrelevant to the rating.

Nevertheless, the fact that ProjectCo is owned by the construction contractor may raise some concerns with respect to how objective and proactive ProjectCo will be in exercising its rights under the construction contract and dealing with delays. As a result, special attention is given to the role of the lender’s technical advisor (LTA) in the project. In DBRS’s view, a clear and comprehensive mandate entrusted to the LTA, especially with respect to the approval and withholding of progress payments and/or certification of milestones, may be a valid way of mitigating such concerns.

These new guidelines have been incorporated into DBRS’s rating methodology for Canadian PPPs, which is available at www.dbrs.com or by contacting us at info@dbrs.com. DBRS has taken no rating action as a result of this methodology update.