Public Private Partnerships (Kuwait)

Economic significance

Research Note

November 2010

ResearchM

KAMCO Research

Introduction ........................................................................................................... 1

What is a Public Private Partnership (PPP) ? ..................................................... 2

PPP's Model Structure & Flow of Funds ............................................................ 3

Legal Developments .............................................................................................. 4

The PPP Law ................................................................................................ 4

Project Financing .................................................................................................. 5

Benefits of PPP's ................................................................................................... 6

Obtain Capital Financing and Reduce Public Capital Investment ............... 6

Optimizing the Value of Funds ...................................................................... 7

Risk Allocation .............................................................................................. 7

Effects on Local Market (Banking Sector) .................................................... 8

Privatization Law .................................................................................................. 8

Conclusion ............................................................................................................. 9

Table of Contents

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I- Introduction Regional governments, including Kuwait, are turning to new financing strategies to fund crucial infrastructure projects with Public-Private Partnerships (PPPs) being an increasingly popular model in the region. After a challenging year in 2009, in which the value of project finance deals plummeted to USD 20 billion from more than double that figure in 2008, investors are more optimistic about the prospects of the coming couple of years. This optimism springs from the list of large projects expected to be executed during the period. The lending power of some of the major banks may have been affected by the global financial crisis, but the infrastructure needs of Kuwait and the region are still present.

During February of this year, the new economic development plan received its final approval from the Kuwaiti Parliament. This bill has great significance to the Kuwaiti economy since it is the first development plan to be approved since 1986. This new plan includes developments on some new projects such as the Kuwait City metro and railway and some long awaited projects such as the multi-billion dollars Silk City business hub project, Boubyan port, the Subiya causeway, as well as improving education, health-care, power and transportation systems. The final cost estimate of the bill was reduced to KD 30 billion (US 110 billion) from KD 37 billion, with the government and the private sector contributing roughly equal portions.

Creation of durable and high quality infrastructure is a prerequisite for rapid economic development and requires sustained investments supported by technological innovation, a skilled workforce and excellent project management. The task of pooling together all these resources often proves to be a burden far too heavy for the government to carry alone. This realization has brought together the public and the private sector in a mutually beneficial relationship in the form of Public-Private Partnerships (PPPs) to execute not only infrastructure projects but also engender innovative strategies for social development.

The basic intent of a PPP is to encourage the private sector to capitalize on its capacity to raise capital and its ability to complete projects on time and to budget, for the welfare of the community, without having to compromise on its profit-seeking motive. At the same time, the public sector would retain its responsibility to provide goods and services to the public at affordable rates. For Kuwait, this will enhance the private sector’s expertise and increase its production capacity.

 

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II- What is a Public-Private Partnership (PPP)? According to Kuwait’s Partnerships Technical Bureau (PTB), PPP’s are “means for the state to introduce private-sector capital and expertise in sectors traditionally under public control without losing its supervision of output quality and tariff levels”. PPP’s describe a government service or private business venture which is funded and operated through a partnership of government and one or more private sector companies. It involves a contract between a public sector authority and a private party, in which the private party provides a public service or project and assumes substantial financial, technical and operational risk in the project. In projects that are aimed at creating public goods like in the infrastructure sector, the government may provide a capital subsidy in the form of a one-time grant, so as to make it more attractive to the private investors. In some other cases, the government may support the project by providing revenue subsidies or by providing guaranteed annual revenues for a fixed period.

Typically, a private-sector consortium creates a company called a "special purpose vehicle" (SPV) to develop, build, maintain and operate the asset for the contracted period. In cases where the government has invested in the project, it is typically allotted an equity share in the SPV. The consortium is usually made up of a building contractor, a maintenance company and lenders. It is the SPV that signs the contract with the government and with subcontractors to build the facility and then maintain it. A typical PPP example would be a hospital building financed and constructed by a private developer and then leased to the hospital authority. The private developer then acts as landlord, providing housekeeping and other non-medical services while the hospital itself provides medical services.

Partnerships are now an increasingly relevant and globally popular public policy option, and the methodology is evolving. For the private sector, organizational and fundamental risk management analysis is a key to their successful partnership and operation of the public project.

 

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III- PPPs Model Structure & the Flow of Funds There is no set form of PPP structure and there are differences of opinion as to what is a true PPP structure. Essentially, the term reflects the relationship between the government and the private sector, ranging from total project outsourcing, to a maintenance contract whereby the parties have a shared equity interest. The structure of a PPP will vary depending on the project and the amount of risk allocated to the private sector.

Chart 1: PPP Model Money Flow

Source: KAMCO Research

Exhibit A represents the flow of funds during the ‘Planning, Design & Construction’ Phases where the project company receives funds from Investors in the form of equity and from banks in the form of loans or bonds. Funds are then directed to the Design & Construction Consortium, of which, the sponsor company has to be a Kuwaiti entity.

Exhibit B represents the period following the construction phase which is the ‘Operation and Maintenance’ phase where the project company distributes project proceeds to investors in the form of dividends and to banks in the form of loan repayments and interest on the loans. It also pays an operation and maintenance company for overseeing the project over its operational period.

 

  Equity 

Loans 

Payments for D&C

Exhibit A

Project Company 

Financial Institutions 

Shareholders / Investors 

Design & Construction Consortium 

Project Revenues Exhibit B

Dividends 

Loan payments & Interest 

Project Company

Financial Institutions

Shareholders / Investors 

Operation & Maintenance Company 

Payments for O&M

 

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IV- Legal Developments Created under Article 12 of Law No.7 of 2008, which was established for the regulation of Build, Operate, and Transfer (BOT) projects and similar operations, the Partnerships Technical Bureau (PTB) represents the focal point agency of the PPP program, where it is involved in all phases of the Project, from inception to financial termination.

The PPP Law The PPP Law established a legislative framework to promote and facilitate PPP’s in public infrastructure and land-based development projects in the State of Kuwait. According to the newly passed law, no government body is allowed to enter into a PPP agreement, which involves government owned land without obtaining the approval of the new Supreme Committee. However, it is important to point out that PPP projects that were awarded prior to the ratification of the law cannot be amended, extended or renewed.

A significant aspect of the new law is the lifespan of PPP projects, which has been amended to 30 years. After this, the project is to be handed back to the government without any considerations or compensations. However, in certain cases, the committee could approve a lifespan extension of a project up to 40 years. If the project’s term is not specified within the project’s bid documents, then the lifespan of the project is assumed to be 25 years.

In terms of the cost, if the total cost of a project exceeds KD 60 million, a special purpose vehicle (SPV), such as a Kuwaiti joint stock company needs to be set up. Furthermore, two approved appraisers are to value the project, one of which should include the market value of the land, and the lower of the two will be assumed as the value of the project. As for the PPP Project Company’s share capital, it will consist of the following:

1. 40% of the shares are offered in a public auction to companies listed on the Kuwait Stock Exchange or approved by the Supreme Committee. Shares will be allocated to the highest bidder;

2. 10% will be sold off to the company that will implement the project at a share price that is 50% less than the share price accepted by the highest bidder;

3. The remaining 50% will be offered for public subscription by Kuwaiti citizens.

The recent legal developments in terms of supporting the Public Private Partnerships emphasizes the significant role that the private sector is expected to play in the post financial crisis era.

 

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V- Project Financing Assuming that the government will fund 50% of the planned projects, private banks will be needed to fill the gap and fund the remaining portion of required capital. An assessment of local banks in Kuwait leads us to conclude that the sector’s ability to fund such projects is limited, and the need for innovation to make sure these projects get funded is immense.

As of September 2010, Kuwaiti banks had total deposits of KD 36.6 billion, of which, KD 28.7 billion were already extended in loans and other advances representing 78.3% of deposits. Given the 85% ceiling on loans that can be extended in Kuwait, we find that the whole sector has KD 2.44 billion in available funds with National Bank of Kuwait (NBK) representing 40.1% of that amount.

Chart 2: Aggregate Kuwaiti Banks Free Funds to Loan Projects (KD Billions)

10.6 13.117.1

23.127.2 28.5 28.7

15.117.8

23.7

32.336.1 36.6 36.6

2.31 2.05

3.06

4.36

3.43 2.652.44

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

2004 2005 2006 2007 2008 2009 Sep‐10

Net Loans and Advances (KD Blns) Total Deposits Free Funds  to Loan

Source: KAMCO Research & Banks’ financial statements

The banking sector, while proving resilient during the global financial crisis, remains exposed to bad debt and depreciating asset prices. Meanwhile, borrowers, already burdened with debt, are nervous about taking on more debt. Governments in the region and globally are working hard to institute stronger financial regulations, but it will take time for the banks’ recovery to be sustainable. In that regard, the government of Kuwait has recently committed to providing KD 10 billion (USD 34.9 billion) in the form of bank guarantees to fund these projects either through a financial portfolio, bonds, or long-term deposits with tenures that could reach 20 years. As of November 24th 2010, the government had outstanding public debt (including treasury bills & bonds) maturing

 

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before the end of 2011 of KD 3.38 billion, held mainly by local banks. In addition, and serving as an added buffer for funding, banks currently have on their balance sheets cash and deposits with other Financial Institutions in the value of KD 3.54 billion and KD 2.37 billion, respectively.

Foreign banks like HSBC, Al-Rajhi Bank and Citi Bank, among others, have already expressed their interest in filling the liquidity gap through participating in the financing of some of these projects. In Kuwait, foreign banks are only allowed to practice private banking, wealth management and lending. With the former two activities’ stalling since the intensification of the global financing crisis, the option of lending to projects that are deemed to have some government backing seems to be a critical window of opportunity and the only breather for them in the Kuwaiti market.

Given the need from local banks to engineer innovative solutions in order to fund these projects, we may look at some regional experience post the financial crisis to learn about possible ways to fund large scale projects in such economic and liquidity conditions. For example, the USD 2.1 billion raised during June of last year for Bahrain’s Addur Independent Water and Power Project (IWPP) used the ‘mini-perm project finance structure’ which involves using smaller, short term loans that will be refinanced at a later stage of the project. Banks have also tapped into less familiar areas of financing to ensure that deals get done.

VI- Benefits of PPPs PPPs give the private sector access to secure long-term investment opportunities; they can generate business with the relative certainty and security of a government contract reducing the implications of market uncertainty.

• Obtain Project Financing and Reduce Public Capital Investment One of the most important benefits of these partnerships is splitting the spending between the government and the private sector. In theory, the government only has to come up with a certain percentage of the planned spending providing additional flexibility for increasing the amount of spending on projects.

Currently, and including the KD 30 billion planned spending according to the development plan, Kuwait has a total of KD 68 billion (USD 239 billion) of planned projects as reported by MEED Projects Index on August 19th, 2010 representing 10.42% of the total planned project in the GCC region. This figure is in comparison with United

 

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Arab Emirate’s whopping USD 940 billion and Saudi Arabia’s USD 697 billion representing 41% and 30.4% of total GCC projects, respectively.

Chart 3: GCC Projects Index- August-10 (USD Billion)

UAE, USD 940 Bn

Saudi Arabia, USD 697 Bn

Qatar, USD 249 Bn

Kuwait, USD 239 Bn Oman, 

USD 94 Bn

Bahrain, USD 76 Bn

Source: KAMCO Research & MEED Projects

• Optimizing the Value of Funds The increased participation of the private sector brings along access to expertise and technological advances which potentially can increase the value of money spent and increase efficiency in carrying out these projects. This will improve service delivery by allowing both sectors to do what they do best. Government’s core business is to set policies and procedures to govern these contracts, while the private sector takes responsibility for technical aspects of project delivery. Furthermore, by taking advantage of private sector innovation, experience and flexibility, PPPs can often deliver services more cost-effectively than traditional approaches, while the resulting savings can then be used to fund other needed services or projects. In addition, private sector companies have a financial motivation to use facilities to their full extent, and to make the most of commercial opportunities to maximize returns on their investments. This can result in higher levels of service, and reduced costs for the government.

• Risk Allocation Proper risk allocation represents one of the major challenges in the implementation of the PPP model. The efficiency of the PPP contract depends on the effective transfer of

30.4%

10.9% 10.4%

4.1%

3.3%

41%

 

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some risks to the private sector. Private entities are more efficient in the management of a project if they have money at stake, and if they face risks that they can manage. If project risk has not been allocated to the private sector appropriately, private entities could realize that it is more profitable to try to shift risks to the government rather than managing those risks.

• Effects on Local Market (Banking Sector) Given the steady rise in the Banking Sector Index since the beginning of the year, investors will remain cautious as to whether the government spending spree will happen and to how these new projects will affect the social developments of the State of Kuwait. Furthermore, financing these projects is seen as a long term safe investment that has some government support; it should also help stimulate loan growth momentum after being flush with liquidity. In addition, appending such high quality loans to the loan portfolio of Kuwaiti bank will help improve the overall loan quality which has been a significant issue since the beginning of the global financial crisis.

Table 1: P/E Multiple for GCC Banking Sector as of November 23rd, 2010

P/E (X) Kuwait Saudi Arabia

Dubai Abu

Dhabi Bahrain Qatar Oman

25.98 16.10 10.22 11.44 20.10 13.94 15.83 Source: KAMCO Research

Despite the positive impact that the spending plan is expected to have on the banking sector, local banks are already trading at high multiples in comparison with other GCC banks, which increases the resistance for their share prices to go up much further. In addition, the plan will not solve all the banks problems, as the sector still faces liquidity issues, along with the deteriorated quality of its loans portfolio.

VII- Privatization Law The new privatization law passed during May 2010 is seen as a testimony to the new political and economic reality in the State of Kuwait. The contents of the newly issued law stipulated a foundation for the privatization of public services with the exception of some sectors such as oil, health-care and education. The law provided grounds for privatization through a public shareholding company in which Kuwaiti citizens would be offered 40% of the shares through an initial public offering, another 5% would be

 

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distributed to Kuwaiti employees, 20% will be held by the government, while the remaining 35% stake would go to private investors.

However, strong opposition to this law has emerged after it was passed and managed to win great concessions in terms of sector-based exemptions for the oil industry and social services, as well as a government “golden share” which would allow it to veto any decision made by the newly established entity to regulate privatization. Given these concessions, the bill is still regarded as highly controversial as many MP’s considered that the efforts were aimed at stripping the country from its wealth, while others considered it biased towards serving the interest of the wealthy minority. It is worth noting that privatization efforts in various other countries, such as in Eastern or Western Europe, during the 1990’s lead to conflicting opinions about the concept of privatization and its effects on the economy. But it has, nonetheless, proved to increase the output efficiency of privatized industries as well as competitiveness in the local and global economies. As for Kuwait, it is estimated that approximately half a million Kuwaiti citizens would enter the work force over the next 16 years, which would make it extremely challenging for the government to create enough jobs to employ them all.

VIII- Conclusion For Kuwait, PPP is a strategic option that should be regulated and enforced to provide the government with an added flexible option to expand its services to the wider community, especially in key areas such as the oil, health-care and education. Furthermore, PPP’s can provide financing and investment opportunities to channel Kuwaiti private sector liquidity into core projects and away from speculative stock trading investments. In addition, Projects operated under PPP will add substance to many local companies and create stability in the market.

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Public Private Partnerships (Kuwait)

Economic significance

Research Note

November 2010

ResearchM

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