Public-private Partnership as an Effective Mechanism to Attract Investment During the Crisis
According to the latest forecast of the Ministry for Development of Economy, Trade and Agriculture (MDETA), Ukraine’s GDP will decline by 4.2% in 2020, while at the end of 2019, it was expected to grow by 3.2%.
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Ukrainian economy is suffering due to quarantine. According to the latest forecast of the Ministry for Development of Economy, Trade and Agriculture (MDETA), Ukraine’s GDP will decline by 4.2% in 2020, while at the end of 2019, it was expected to grow by 3.2%. The IMF forecast is a 8.2% decline of Ukraine’s economy this year. The situation may get worse if the quarantine measures are intensified or extended in the course of 2020. In January-May, non-execution of the state budget amounted to 10.1% of the plan (according to the Treasury).
It is possible to overcome the economic downturn faster thanks to investments. Although the very idea of the vital need for investment in the Ukrainian economy is not new, what should motivate entrepreneurs to invest during the crisis?
State and business: what is the use of combining capital?
One of the mechanisms to attract investments is a public-private partnership (PPP or P3), including in the form of a concession. Unlike privatization, PPP allows the state to keep its assets (state-owned enterprises, or SOE) and, at the same time, enjoy the benefits of access to private capital. In point of fact, PPP lets the state retain ownership of a facility while using not only financial investments, but also technology and management experience that often “come” to the enterprise together with material resources. All the resources obtained begin to work not only for the private investor, as is the case with privatization, but for the state as well. In comparison with public investment projects, such interaction also allows for risk-sharing in project implementation between the state and private investors. This makes PPP mutually beneficial.
At the beginning of the year, the search for concessionaires for the Kherson Commercial Sea Port (KSCP) and Stevedoring Company Olvia was successful. These were Risoil, a Georgian-Swiss company, and QTerminals from Qatar respectively . PPP in the form of a concession for these ports became the first major infrastructure projects implemented in Ukraine.
A decision between privatization or partnership is made taking into account the benefit for each party of either form of possible economic collaboration. Calculating the projects’ prospects will be discussed in more detail below.
How can SOEs’ profitability be increased?
According to the Reform Support Office, the return on assets (ROA) of state-owned and municipal enterprises in 2019 was 2.09% and 1.76% (excluding the results of Naftogaz), respectively . Following the 2019 results, more than 15% of SOEs have a negative ROA, i.e. they are not profitable. This year, due to quarantine, even a larger number of enterprises run the risk of sliding downward. The probability of regaining lost positions is lower due to weakening market demand, switching to other suppliers, and sometimes a complete liquidation of part of their consumers.
Search for an effective investor for these enterprises / assets can be the best alternative to privatization or liquidation. The PPP mechanism will not only make it possible to obtain additional resources (investments, innovations, management experience, etc.), but also support the development of different industries. It is important to understand that the state retains ownership of these assets, while getting a bonus in increased tax and other revenues to the budgets of all levels.
Working both sides of the street
PPP projects can be implemented in the following forms: concession, property management, joint activities, or under different contracts, including mixed types, as the PPP implementation mechanism is quite flexible. The new Law On Concession (effective from 20.10.2019) introduced clear and transparent procedures of:
- initiation and decision-making on implementing PPP, including in the form of a concession;
- concessionaire selection (concession competition, competitive dialogue); with provisions to involve independent experts in the selection committee, advisers in project preparation, as well as renewed guarantees for all parties and better regulation of ownership of PPP objects;
- modification of lease into concession.
This enables to take into consideration the interests of all stakeholders.
So by what exactly is PPP development currently impeded in Ukraine, if, as we can see, there is the appropriate legal framework, assets to implement projects as well as insufficient SOE financing on the part of the state?
PPP is first and foremost a partnership from which both private investors and the state should benefit. And this gain, of course, should be expressed in monetary terms. Thus, the adequate calculation of the financing model to evaluate the basic assumptions is a key initial step in making a decision on whether a PPP project makes sense. Lack of experience of a SOE staff or property manager at this stage may lead to rejecting a potentially profitable project for all parties.
How should a project’s success be calculated?
Typically, a PPP project and its efficiency calculations are little different from a regular private sector investment project. The main difference lies in calculating the project’s effectiveness for the state as a party to an investment project. Read more about it below. To evaluate a project based on data of latter periods or using an example of market analogues (in case of creating a new product / service), it is necessary to predict the following:
- Revenues from sales of goods and services
- Operating costs (including staff costs)
- Capital costs or other costs associated with the project
- Financing in terms of disbursing, servicing and repaying a loan
The financial model must include a list of all project assumptions that will affect its implementation, including:
- Indexation rates (e.g. the consumer price index (CPI) for wages and the producer price index (PPI) for most revenues and expenditures). These indicators can be predicted based on information from State Statistics Service of Ukraine (SSSU), international organizations’ forecasts or other available sources. The model can also use the management indicators of indexation rates or a deviation from the CPI / PPI.
- Exchange rate forecast if a project has imports / exports of products, equipment, etc. This can apply both to investment prices in the case of the planned purchase of equipment over several years, and SOEs’ own exported products or the imported raw materials used to produce them. Forecasting is normally done based on currency parity using the CPI of the two countries of origin.
- Taxation (income tax, VAT, payroll taxes, etc.). When investing from abroad, it is necessary to take into account the income tax for non-residents with a source of origin from Ukraine (repatriation tax). For most income items, the basic repatriation tax rate is 15% in 2020 (except for some other income items or unless otherwise stipulated in international treaties of Ukraine).
- Weighted average cost of capital (WACC). WACC takes into account the cost of borrowed capital and the cost of equity calculated using CAMP (Capital Asset Pricing Model). Despite the complexity of calculating the latter due to its components, namely the market beta and market premium, there is a list of resources that offer free ready-to-use indicators. An example is Aswath Damodaran’s database at the NYU Stern School of Business. However, due to the relatively high cost of equity for Ukraine (according to preliminary data), averages from several resources or in-house calculations are often used if necessary market information is available.
The expected value of a project should be based on several calculation scenarios to verify its margin of safety. Scenarios of revenues reduced by 10-30%, growing operating expenses, an increase in the cost of investment or third-party financing are usually considered. A strong project should have a sufficient margin of safety for its industry. It is often the pessimistic project implementation scenario that is the closest to the final result. Investors usually consider a more pessimistic project approach due to available or hidden risks. A conservative approach is often the most effective in traditional investing practices, unlike e.g. venture projects.
To determine the potential interest of private investors in a particular project, discounted cash flow analysis is carried out, followed by NPV, IRR, DPP and other financial efficiency indicators calculations.
PPP projects – to be or not to be? And what about the state?
The state’s interest in the project is determined by calculating the project’s budget efficiency.
Normally, the state’s main source of income from implementing a PPP project is tax revenues. These are income tax, VAT, payroll taxes, repatriation tax. If the project involves foreign economic activity, the list may include various indirect taxes, including customs duties, excise taxes and fees.
PPP can be implemented on the basis of a profitable or unprofitable enterprise or asset. In the case of current losses, a project may aim to reduce these losses, other things being equal, or help make an enterprise profitable again paying dividends to the state budget.
In the case of profitable activities, it is first necessary to calculate in detail which part of the net profit is generated by the assets that will be the object of a PPP project. Following the calculation, the project may include a utilization payment in favor of the SOE that used to receive certain income prior to the object’s transfer to PPP. The payment can be made over the entire period of project implementation (sometimes including indexation of payments) or, under certain conditions, only for a designated period of time.
It is also necessary to pay attention to profitable SOEs’ dividend policy. Dividend payments in most SOEs in Ukraine amount to 50-90% of net profit. Thus, in the case of implementing a PPP project on the basis of an operating SOE with all assets transferred, the amount of current dividends, as in the case above, can end up as additional payments to the state budget instead of a utilization payment to the SOE’s benefit.
If a PPP project is implemented in the form of a concession, budget efficiency calculations will also include concession payments (CP) that can be fixed or variable. The latter are usually defined as a percentage of the enterprise’s amount of sales or operating profit.
In line with international best practices, upon calculation of all the components of budget efficiency, it is necessary to conduct discounted cash flow analysis for all the budget levels. Instead of the usual discount rate, the public debt value is used (e.g. government bonds with respective tenor).
Each PPP project is unique requiring its own set of assumptions, detailed calculations, preparation time depending on the industry, stakeholders (asset owner(s), consultants, consumers / suppliers), project scope, etc.
PPP projects have their own peculiarities as regards initiation and efficiency calculations to make decisions on their implementation. Normally, they take more time to analyse and launch, due to the state being a party to the project. At the same time, we see that Ukraine already has the legal framework, relevant institutions, established collaboration between main stakeholders and international partners, and successful cases of major infrastructure projects underway. This will support the further development of public-private partnerships, with the current quarantine situation possibly even contributing to this, odd as this may sound. In addition to its negative impact, the crisis can create additional opportunities for development by slightly changing the order of priorities for the parties involved. To reduce operational risks by having the state as a party to the project, it is possible for private capital to agree to lower profitability. Whereas for the state, the current situation can be a good push to start the projects they previously simply “did not get around to” or lacked staff to initiate and do calculations in the projects’ early stages.
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