China must put the 'private' into PPP

Public-private partnerships are not trendy in China anymore. The authorities in recent months have canceled about 2,500 PPPs, worth around 2.39 trillion yuan ($376 billion) in aggregate, after Beijing concluded that local governments were abusing the infrastructure financing arrangement to circumvent controls on their borrowing, adding to a worrisome growth in public debt. The halted projects represent about 18% of those in the official pipeline.

I recently published a piece in Nikkei Asian Review on the outlook for PPP in China (click here).

It is critical that China not give up on PPPs simply because of the misbehavior of some local governments. Beijing should instead use the current cleanup to establish clear standards for evaluating PPP bids and bidders while improving its own capabilities to conduct such analysis. The authorities should make clear that the "private" side of PPP will be genuinely open to private companies, including foreign ones, rather than allow PPPs to be limited to a closed club of government-owned entities.

PPP to fuel China's infrastructure build-out

Even with the many highways, airports and bridges that have been built in China in recent years, there remains much to be done. The Asian Development Bank last year estimated China's annual infrastructure investment need through 2020 at $753 billion while projecting an expected average shortfall of $68 billion a year. If properly administered, PPPs can be a critical tool for bringing in private-sector skills and financing to fill this gap.

Chinese officials began to adopt the PPP model only in 2014. In under four years, about 14,000 projects, valued at over 20 trillion yuan, had been initiated, a staggering amount even by Chinese standards.

More than 60% of the companies involved are state-owned entities, according to analysis of a sample of 572 projects by the Ministry of Finance's China Public Private Partnerships Center. The center found that just 4% of PPP participating companies came from Hong Kong, Macau or Taiwan, with another 2% coming from other countries. The balance of participants were Chinese private companies.

The issue for Beijing however was that some local governments structured their PPPs as a de facto borrowing arrangement. In these cases, the PPP partner was promised a fixed return at regular intervals from land sale revenues -- comparable to loan interest -- and a guarantee that the local authority would buy out the partner's equity stake in the project at a set time, effectively repaying the loan principal. This quasi-borrowing, again often involving state-owned companies, was not recorded as debt on the local authorities' books.

Circular 92: the PPP purge

As the Chinese Ministry of Finance grew concerned with the ramifications of runaway PPPs late last year, provincial finance bureaus were tasked with canceling improper projects by March 31. They were told to look out for PPPs where officials had failed to evaluate potential investment returns or conduct fiscal stress tests; where progress had been poor or information transparency lacking; where spending had gone over budget; or where company debts had been illegally guaranteed.

The number of cancelled projects represents a sizeable share of the total number of PPP projects around China. The situation differs significantly between provinces: provinces with the largest number of rescinded projects have a share of projects cancelled as high as 30%. The overall average is around 15%.

The cancellation of PPP projects has created the dilemma of how to deal with those projects for which agreements have been executed and funds put in place. For example, if everyone sustains losses during the initial period, how are the costs divided? To establish this we need to look at the original PPP contract, and who bears policy risk.  Usually this is borne by the government, in order to make it easier for private capital to be withdraw.

The PPP purge, which is likely to continue, may actually not be a bad thing for China Inc. A significant number of enthusiastic Chinese players moved into PPPs without any clear understanding of the potential risks and limited relevant operational experience.

Consider some of the Chinese companies making their debut in infrastructure with PPPs. Conglomerate Fosun International, known for its operations in insurance, resorts and pharmaceuticals, became the first private company to invest in a Chinese high-speed rail project, the $6.9 billion Hangzhou-Taizhou line. Sichuan Yibin Yili Group, a munitions manufacturer and distributor, was awarded a PPP contract to build and operate a 130km expressway in Sichuan Province.

Do these companies really know what they are getting themselves into? Their expertise in insurance and explosives does not necessarily translate into designing, constructing, financing and operating a train line or highway. Each step in the value chain comes with a unique set of skills and capabilities which are quite distinct from each other. Think manufacturing vs financing vs construction vs operations.

Lessons from the field

As a business consultant I had an opportunity to help the Chairman one of China’s largest engineering consulting firms in developing it’s long term growth plan. Moving into PPP was high on the priority list of the senior management team, without fully understanding the risk-return trade-offs and required expertise of such a move. 

We challenged them with a series of questions: Do they understand all the risk associated with a PPP project and do they have the discipline to price their bids accordingly?  Is the commercial case sufficiently attractive, especially in the Chinese context where infrastructure projects are supporting public services which need to be priced sufficiently low to be affordable to the masses?  

In my experience, Chinese companies have jumped on the PPP bandwagon much the same way they embraced international M&A over the last couple of years.  Full of enthusiasm and bravado but without a clear plan or a complete understanding of what they are getting themselves into. 

This ‘build it and they will come’ approach has proved to be a strategy that can work quite well for China as a country overall. Think about the high-speed rail network where few expected to see a commercial return when China embarked on this project over 10 years ago.  Some lines are now turning a modest profit.

But the stakes are so much bigger for individual companies that are expected to take huge financial, construction and commercial risks for relatively modest returns. One or two bad PPP bets could easily send a business into ruin and with it thousands of workers and shareholders.  

The history of PPP in Western countries is littered with casualties. The bankruptcy of Carillion in the UK earlier this year left 43,000 employees in limbo and government officials scratching their heads how vital government services would be delivered. It serves as another reminder that companies in China should tread the PPP path with utmost caution and explains why the Chinese government has stepped in, to tighten the ground rules. 

PPP Alignment

It’s critical there is alignment on the objectives of the PPP between the private and public stakeholders. This includes recognising that a PPP should result in a reasonable financial return to private sector sponsors over the life of the project. One reasons why relatively few foreign players are active in China’s PPP sector is a misalignment of the objectives if the government versus private sector investors.  

For instance, several years ago I led a project for the China Aviation Authority of China to understand why relatively few international players had taken the opportunity to invest in Chinese airports, something the authorities had allowed more than 15 years ago. The number one issue that was flagged was quite clearly the expected misalignment between shareholders on the objective of the business: whereas international players are looking for favourable economic returns, local government are more concerned about building the biggest and most grand airport terminal to showcase their city to the wider world.  This, coupled with stringent price controls from the government, deterred most international players from committing major resources to China’s airport sector, despite the booming local demand for air travel.        

What's next for China's PPP model?

To help create a credible PPP sector, Beijing must become stricter in evaluating bids and bidders. This will require the government to upgrade its screening capabilities to help weed out sweetheart favors. PPP projects should be evaluated on the soundness of the business case and executed by a consortium of companies which have the right experience and knowhow across all relevant technical, financial and operational dimensions of the project.

All the risks need to be understood upfront and priced in accordingly. There needs to be a realistic financial forecast including volume projections and future maintenance and capital expenditure requirements. Tools and frameworks need to be adopted that allow for transparent evaluation and decision-making. This expertise needs to reside both with the bidders and the respective government agencies tasked with evaluating and awarding projects.

This has been a major issue in the past where parties on both sides jumped onto the PPP bandwagon without the relevant ability to prepare or evaluate these projects on their financial impact over a 20 year period. Unless this is addressed we will start to see a lot of examples where PPP projects are going to blow up and the government will then likely put in more stringent constraints or even put the PPP structure in the ban again.

If bidders are overly aggressive, they will not be able to generate the revenues they expect and service their debts. The government may then have to step in to salvage their projects, so it is in the authorities' interests to ensure that forecasting is credibly done.

If the authorities lack the capability to properly evaluate bids or run a true competitive bidding process then they may leave too much money on the table. This would be a bad deal for taxpayers and run counter to what the government should be aiming for with PPPs, namely getting better value from its infrastructure projects.

PPPs can offer China better value and an alternate source of funding and innovation. However, it is critical that projects be awarded based on sound business cases to parties with the right knowhow and experience to ensure success.

This will require a dramatic upgrade in the capabilities of both bidders and government officials tasked with awarding and evaluating bids. A balanced, multidisciplinary approach is essential for PPPs to be of long-term value to China's infrastructure buildout.

Michel Brekelmans is Managing Director at SCP/Asia, a consulting firm that supports business executives and investors in business intelligence, growth planning, M&A support and organisational performance improvement across the Asia Pacific region. With over 20 years experience in strategy consulting, and based in China and Singapore since 2002, he is highly experienced in solving complex management decisions regarding the growth path of their business and major investments. www.scpartnersasia.com