Collateral thinking

Despite the accelerated economic growth of Brazil over the past two decades, a great deal of infrastructure investment is still required for the country to reach its full potential. For example, Brazil's strong agricultural sector struggles due to the poor quality and congestion of highways, railways and ports. Moreover, weaknesses in public education, water and sanitation, health and housing remain huge barriers to social inclusion.

Available government funding in Brazil is not sufficient to support significant improvement in all of the areas listed above, and the question of how Brazil will financially manage the growth of its public services does not allow for simple solutions. One answer, however, could be found in Brazil's public-private partnerships (PPPs).

PPPs are arrangements wherein the financing of a project is shared between public and private entities and are alternatives to traditional models of financing in which the entirety of the cost and risk of a project remains with either the public or private sector. Such traditional structures may lead to unstable levels of public debt or private party insolvency. 

A PPP is a public investment in which the government contracts with a private party for the rendering of a public service or of a service to the government itself. PPPs have a wide range of applications, such as the financing of roads, ports, and sanitation systems and of public health and education facilities.  

WHY SO FEW?

The Brazilian federal law establishing PPPs was enacted in 2004, but only around 70 projects have been commissioned under the PPP law during its 10 years of existence. Considering the demand for infrastructure projects, the question should be posed as to why only a small number of projects in Brazil have been financed through a PPP structure. 

Private contractors in PPP projects typically demand protection from the risk that the government cannot meet its obligations to contribute due to, for example, revenue shortfalls or a currency crisis, or simply refuses to do so following political change. Therefore, a security package, in order to guarantee payment from the government, plays a key role in the financing of the project.

The Brazilian government is not accustomed to providing governmental property as collateral and private parties often request the kind of collateral packages used in project finance deals, which can put severe restrictions on the collateral. As such the selection of, and covenants pertaining to, collateral is one of the most challenging issues in PPP projects. 

It is important to understand what public assets can become collateral under the current Brazilian framework and which of those assets can most feasibly be expected to serve as collateral. Under the Brazilian constitution, certain public revenues (including most kinds of tax revenues) cannot be pledged or otherwise encumbered in connection with a specific project or transaction, including a PPP project.

The principle behind this rule is protection against one government effectively controlling the use of revenues by a future government. Further, security over public assets, such as government-owned land or infrastructure, has, for political and judicial reasons, unpredictable value.

Additionally, enforcement of security on public assets tends to be very slow, as certain procedural rules allowing for acceleration of enforcement of security are often not available when a public asset is involved. 

WATERFALLS 

Alternative structures must be found therefore for use in PPP projects. One possibility which can be seen to balance the public and private interests is the granting of public revenues under a cash waterfall structure. The government, as guarantor to the public party in the PPP, agrees to direct certain public revenues through an escrow account specifically tied to the PPP. Such revenues may, according to law, include dividends of public companies, certain tax receivables, royalties, and revenues arising from the use of public assets.

A waterfall structure gives to the private party an enforceable security. In the case of a default by the public party, the private party has the right to block the related escrow account. After the escrow account is blocked, the monies in the escrow account can be used to satisfy the public party's debts related to the PPP instead of being released to the government for use at its discretion. 

When the escrow account is blocked in connection with a default, payments from the account are made according to a hierarchy, with the private entity in the PPP on top and the government at the bottom. This is a cash “waterfall” because, in a default scenario, the government can only receive money after it flows through the escrow account. 

This structure works well in PPPs because the public entity does not make its entire investment up front, but instead can spread the payments made to the private entity over a long period. Payment is made to the private partner throughout the effectiveness of the PPP contract, at the end of each assessment period (monthly, quarterly or any other period). 

Thus, even if the public entity does not make a payment at the end of an assessment period, the receivables available in the escrow account might, after a relatively short period of time, be enough to cover the amount due. Under non-default circumstances, the cash in the escrow account can flow periodically to an unrestricted account, over which the government has the right of use in its sole discretion.  

VALUE LOSS

This mechanism is also good for the government, as the revenues remain available and liquid in a non-default scenario. Other security structures involving public property can, in practice, create inflexibilities so that public property loses its value to the government during the entire life of the project.

A cash waterfall collateral structure was implemented for the first time in 2014. Notwithstanding that these enforcement provisions have not been tested yet, this project has inspired the commencement of several PPPs using cash waterfall structures. Brazil's infrastructure requires work of a massive scale. However, PPPs with cash waterfall structures can bring Brazil many steps closer to its goals.