PCGF Structure

Financing Agreement Domestic

Capital Market

Sub-National Government

IFI/bilateral

Government Guarantee Agreement

Undertaking Agreement

Counterguarantee

broadening the range of available securities for diversification of institutional investors’

portfolios.

For SNG risks that are closer to investment grade, a Partial Credit Guarantee Facility without counter-guarantee from the Governmentcould be envisaged (PCGF2). Such Facility would take the form of a SPV, and would enhance bonds issued by SNGs on the domestic market. PCGF2 would be backed by a guarantee facility provided by an IFI, either directly or through a special IFI Facility. PCGF2 would complement the role of the guaranteed Facility by providing enhancement for a narrower band of SNGs risks.

Public-Private Partnership Model. For SNGs that chose to finance these investments through Public-Private Partnerships (PPPs), the main challenge is to create the conditions to attract equity investors in these transactions. In this model, SNGs would seek the partic-ipation of the private sector in infrastructure through various Public-Private Partnerships (PPPs) such as management contracts, leases, concessions, BOOs, BOTs and divestiture.

The first objective of PPPs is to achieve improve value for money, or improved services for the same amount of money as the public sector would spend to deliver a similar project. In countries facing limited headroom for financing of infrastructure investments through the public finance model, a second objective of PPPs is to finance infrastructure investments without increasing general government debt (see Box 2.1 above).

The key challenge facing SNGs in establishing PPPs is to attract equity investors in these transactions. Attracting private investors in PPP transactions requires overcoming a number of critical constraints that are encountered across emerging markets in all regions. These include:

■ Increasing reluctance of traditional investor/operators to commit equity in PPI transactions, especially at the sub-sovereign level;

■ Lack of social sustainability of tariff adjustments to cost-recovery levels, leading to contract failure and/or renegotiations;

■ Lack of confidence of private investors in the capacity of local contract resolution and court procedures to protect their rights in case of breach of contract, especially at the sub-sovereign level; and

■ Weakness of national institutions responsible for regulating PPPs.

To overcome these constraints, an improved PPP framework could be structured around a number of mutually-reinforcing instruments.

■ To address the equity constraint two complementary instruments could be envisaged:

● a first round Infrastructure Fund (IF) that would take equity positions in state-owned utility companies, and exit at a three to five year horizon, and would be financed through domestic bond issues and through lending from IFIs. Convert-ible bonds would be issued to a private sponsor who would run the utility through a management contract (See Sirtaine, Sophie and Luis de la Plata, op.cit).

● a second-round Local Infrastructure Investment Trust (LIIT) that would buy-out equity positions from first-round investors, including from the Infrastructure Fund, would hold these equity positions for the long-term, and be marketed to domestic and international institutional investors and to IFIs.

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■ To address the tariff social sustainability constraint, an Output-Based Aid (OBA) system could be implemented to smooth the transition to cost-recovery tariff for low-income households until efficiency improvements resulting from the turn-around of the utility work their way into the tariff structure.

■ To address weaknesses in contract enforcement, a Political Risk Insurance (PRI) and/or Partial Risk Guarantee (PRG) Facility could be implemented to protect pri-vate investors in local utilities against sub-national breach of contract risk First-Round Infrastructure Fund:²⁴The Infrastructure Fund (IF) is a first round equity fund that takes equity participations in greenfield infrastructure projects or in utility companies to be privatized or concessioned over a interim period until strengthening of the legal and regulatory framework enables a direct equity participation by the private sponsor. The IF would be financed through bond issues on the domestic market, and would benefit from an IFI guarantee to enhance its bond issues on the domestic market.

The project or company would be tendered to a strategic private project sponsor under a management contract agreement. The IF could also issue convertible bonds to project sponsors.

The IFI would support the Infrastructure Fund in three ways:

■ As a lender, through unsecured loans to the project company, or through a loan to the Government to finance part of the project’ investments, to the maximum extent in local currency;

■ As an intermediary capable of raising local capital market debt:through the Infra-structure Fund, the IFI would issue bonds on the local capital market in domestic currency. These bonds would be placed with institutional investors and possibly with project sponsors; and

■ As a passive equity investor through the Infrastructure Fund, and using the proceeds of bonds issued on the domestic capital market, the IFI would acquire an equity stake in the project or utility company, and the Government would acquire the remain-ing part of project equity. The equity risk carried by the IF would be passed back to the Government through a total return equity swap (TRES), thereby shielding the IFI from equity risk. The TRES is an arrangement between the Government and the Infrastructure Fund whereby the host government commits to purchase the under-lying shares back from the Infrastructure Fund at maturity of the structure at market value and whereby in return, the Infrastructure Fund commits to pass on to the Gov-ernment 100 percent of any equity appreciation or depreciation in the value of the underlying infrastructure project’s share during the life of the financing structure.

The Infrastructure Fund would transfer its voting rights to the government, less a veto right.

The Development of Non-bank Financial Institutions in Ukraine 85

24. This Section draws heavily, with the permission of the authors, from the paper by Sirtaine, Sophie and Luis de la Plaza: New Approaches to attract and Finance Private Sector Participation in Infrastructure, World Bank mimeo, May 2004.

This structure aligns the interest of the government, the project sponsor and the Infra-structure Fund behind a successful project outcome or turnaround of the utility company:

■ Because the government keeps the equity risk, it has an interest in a successful pro-ject outcome, that is, a successful placement of the underlying equity at the highest possible price, and therefore in strengthening the legal and regulatory framework to make such placement possible;

■ Because it holds convertible bonds, the project sponsor also has an interest in max-imizing shareholder value of the project or of the utility company;

■ Furthermore, through WBIF, the Bank would keep a veto right so that it could oppose any action that could threaten the success of the project or of the company turnaround.

The project sponsor would initially operate the project company under a management contract and would engage as debt investor via WBIF. This debt investment would be con-verted into equity once the project has matured and regulatory ambiguities have been lifted.

At that time, the company would be privatized. The project sponsor could convert its debt into equity or other equity investors could be encouraged to participate. A sale to private equity investors could be envisaged, for example to a second-round Local Infrastructure Investment Trust.

This structure would encourage the entry of private investors in infrastructure pro-jects or utility companies in the interim period until the legal and regulatory framework is improved to the point where they or other investors can commit.

Local Infrastructure Investment Trust (LIIT): The Local Infrastructure Investment Trust (LIIT) is a second-round investment fund that invests in a mixed portfolio of trade-able securities and of long-term equity positions in local utility corporations. The LIIT raises resources through equity, quasi-equity and debt issues on the domestic and international market. The LIIT would buy equity positions in local utility companies from first-round investors, including from the first-round Infrastructure Fund, and would sell its shares and issue bonds to institutional investors, including insurance companies, pension funds and mutual funds (funds-of-funds) both domestically and abroad. The LIIT would be managed by a recognized private fund management company.

The LIIT would be listed on multiple securities exchanges, both domestic and abroad, including potential US or EU host exchanges. With this reach, both foreign and domestic retail and institutional investors could buy shares in the LIIT. Moreover, as the chart above shows, International Financial Institutions (IFIs) could participate through equity as well as through quasi-equity or debt instruments in order to provide leverage and, therefore, enhance the expected investment return scenario. Investments in local infrastructure util-ities would be made and monitored by the LIIT. While these underlying investments would span 15 to 20 years, the mixed structure would ensure that investors could trade in and out of the trust more readily, thus assuring the necessary liquidity.

Key issues in structuring a LIIT include:

■ Redemption requirements to facilitate liquidity. Similar to a real estate investment trust (REIT), a LIIT offers investors liquidity in otherwise illiquid real asset investments.

To achieve this objective, the trust must be able to liquidate its portfolio to meet 86 World Bank Working Paper

The Development of Non-bank Financial Institutions in Ukraine 87