# **1. Introduction**

Since the 1990s public private partnerships (PPPs) and concession contracts have been widely used to develop major infrastructure projects. Although the mechanics of financing such projects are now well understood, less clear is the motivation behind these financing choices. A significant barrier to progress has been the scarcity of available data. Indeed, the development of project finance – and the creation of special purpose vehicles (SPVs) or “project companies” – has meant that the firms of interest are almost always unlisted and so assembling data is a challenge. In many countries regulatory agencies do not regularly monitor the accounts of such firms, and when they do they often remain confidential. There are political motives behind this decision; given the continued controversy over the use of private capital to provide public goods, details regarding firm profitability, debt and other indicators may not be well received by the public.

Researchers interested in the financing of PPPs and concessions have typically relied on the snapshot information available at “financial close”. Given the high leverage of project companies, the predominant view is that debt is preferred to equity.<sup>1</sup> Indeed, the World Bank’s (2012) PPP Reference Guide states that “because equity is regarded as more expensive than debt, project sponsors often try to use a high proportion of debt to finance the project” (p.46). Yescombe (2007) echoes this view but notes that “leverage is dictated largely by the lenders’ requirements for a cash-flow cushion” (p.120). In essence then, investors prefer as much debt as possible but an upper limit is imposed by the increasing threat of bankruptcy.<sup>2</sup> Such arguments are clearly analogous to the static trade-off theory of capital structure. All else equal, less risky projects will have higher proportions of debt in the capital structure.

In the context of the United States in particular (Spiegel & Spulber 1994, Dasgupta & Nanda 1993, Taggart 1981) and Europe more recently (Bortolotti et al 2011, Cambini & Spiegel 2011), there is a view that infrastructure providers use leverage to influence regulatory outcomes. If the regulator is averse to bankruptcy, it may announce higher prices when leverage is high. The regulator may fear service disruption for example (Ehrhardt & Irwin 2004), or wish to avoid sending negative signals to potential investors. Knowing this, firms can extract higher prices and maximise profits by increasing leverage.

In this paper we extend such models to an emerging market context. We show that the firm’s ability to influence regulated prices is determined by the design of regulation. Under high-powered regulation, such as price cap, prices are unresponsive to the probability of bankruptcy; this reduces the firm’s incentive to use leverage. Our model therefore predicts that firms operating under high-powered regulation will have lower leverage than others, all else equal.

1 We define leverage as the ratio of liabilities to assets.

2 Similar arguments have been made by others in the field. Klein (2012, p.27) states that “without market risk, investors are often willing to provide high levels of debt... when there is market risk, financiers tend to require significantly higher equity cushions”. Engel et al (2010, p.49) argue that “leverage depends on the volatility of revenues and when these are very volatile, the project may not be bankable. Governments sometimes provide revenue insurance to improve the bankability of a project. Better alternatives allowing for high levels of leverage are, for example, PVR and availability contracts”.

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