Minimum Revenue Guarantee

Minimum Revenue Guarantee

 

Infrastructure Public-Private Partnership projects can be very risky due to high initial investment costs and construction risks, high operating and maintenance costs and long-term concession periods when private partners need to gain enough revenue for the repayment of all costs and for their profit. In addition, in 20 to 30 years, which is a usual concession period, a lot of things can change or go wrong, and for that reason these projects do not appeal to private partners and will not be successful at public tenders. In order to make them more attractive and feasible, governments (or any other public partner in a Public-Private Partnership) can grant a subsidy or some sort of incentive to private partners.

The Minimum Revenue Guarantee Concept (MRG) presents one of the most attractive solutions for risky infrastructure Public-Private Partnership projects, where the private partner’s revenues are based on the usage of a built infrastructure. A typical example is a toll-road where after the completion of the project the private partner gains income from charging a toll to the toll-road users, but the Minimum Revenue Guarantee can be used in any other project where built infrastructure produces an income for the private partner. The main risk, namely, is how many users of a newly built infrastructure the private partner can expect and, as a consequence, what future income will be. This question is even more intriguing in states with a high volatility of GDP, traffic, users or any other unstable variable that is crucial for the determination of future income.

According to the Minimum Revenue Guarantee Concept a government grants to a private partner a minimum level of revenues for a concession period. Yearly government payment is defined as the difference between the predetermined level of traffic income as defined in negotiations between the partners and the actual traffic income. In practice that means that whenever a private partner does not reach the predetermined level of income, the government will pay him the difference between the predetermined level and the actual income. The sum of the present values of paid guarantees throughout the concession period presents the cumulative government’s obligation for respective infrastructure Public-Private Partnership project. That way the public partner increases the project’s cash flow, making the project less risky and more attractive to private partners. We have to emphasise that the Minimum Revenue Guarantee can have a lot of variations and that a benchmark for guarantee calculation can be anything that is agreed between partners like actual traffic income, number of vehicles, EBITDA, EBIT, profit or loss, operating or maintenance costs, etc.

Here we are presenting three main modifications of the Minimum Revenue Guarantee, which are subsequently upgraded:

  • A variation where the government grants the private partner the payment of the amount defined as the difference between the predetermined level of traffic income and actual traffic income (the put option of the private partner);
  • A variation where the government grants the private partner the payment of the amount defined as the difference between the predetermined level of traffic income and actual traffic income and in reverse the private partner grants to pay the government all the revenues that exceed some predetermined level (the put option of the private partner and the call option of the public partner);
  • A variation where the government grants the private partner the payment of the amount defined as the difference between the predetermined level of traffic income and actual traffic income and in reverse the private partner grants to pay the government all the revenues that will some predetermined level, whereby both partners are entitled only to some percentage of the determined lack of income or income surplus  (the put option of the private partner with limitation and the call option of public partner with limitation).

 

1. THE PUT OPTION OF THE PRIVATE PARTNER

In the first variation of the Minimum Revenue Guarantee the government grants the private partner to pay the amount defined as the difference between the predetermined level of traffic income and actual traffic income. In Figure 1 we have the private partner’s traffic income on the x-axis and the public partner’s guarantee obligation on the y-axis. The area framed with 1, 1’ and 2’ presents the cases when the actual income will be lower than the predetermined one and when the government’s guarantee will have to be paid. From point 2’ onwards the private partner’s income increases without limitation. The level of the private partner’s income is therefore defined with line 1’, 2’ and 3’.

 Figure 1: The put option of the private partner

Graph for the put option of the private partner

  Source: Based on L. Shan, M. J. Garvin and R. Kumar, Collar options to manage revenue risks in real toll public – private partnership transportation projects, 2010.

The government’s guarantee as a real option has from the view of the private partner all the features of a put option. The private partner will execute his put option whenever the underlying assets’ actual income will be lower than the strike price, here presented as the predetermined level of the income agreed in the concession agreement. The government’s guarantee increases the value of the project as it guarantees the minimum level of revenues.

 

2. THE PUT OPTION OF THE PRIVATE PARTNER AND THE CALL OPTION OF THE PUBLIC PARTNER

In the second variation of the Minimum Revenue Guarantee the government grants private partner to pay the amount defined as the difference between the predetermined level of traffic income and actual traffic income but in reverse the private partner pays the government all the revenues that exceed some predetermined level. In Figure 2 we have the private partner’s traffic income on the x-axis and the public partner’s guarantee obligation on the y-axis. The area framed with 1, 1’ and 2’ presents the cases when the actual income will be lower than the predetermined one and when the government’s guarantee will have to be paid. However, in contrast to variation 1 where the private partner’s income was not capped, here there exists a limitation in the form of the government’s call option. In Figure 2 we see it as the area framed with 3’, 4’ and an ongoing income line. The level of the private partner’s income is therefore defined with line 1’, 2’, 3’ and 4’.

 Figure 2: The put option of the private partner and the call option of the government

Graph for the put and the call option

 Source: Based on L. Shan, M. J. Garvin and R. Kumar, Collar options to manage revenue risks in real toll public – private partnership transportation projects, 2010.

The private partner’s obligation to transfer to the government all revenue surpluses has from the view of the government all the features of a call option. The government will execute its call option whenever the underlying assets’ actual income will be higher than the strike price, here presented as the upward limit of the income agreed in the concession agreement.

 

3. THE PUT OPTION OF THE PRIVATE PARTNER WITH LIMITATION AND THE CALL OPTION OF THE PUBLIC PARTNER WITH LIMITATION

The main drawback of the second variation is that when the private partner has a lower income than the predetermined level, he is not encouraged to increase revenues as in any case the government will fully refund him the loss of income difference. On the other side, he will not be interested in a high increase of revenues, as he has to pay the government all the revenues that exceed some predetermined level.

In the third variation of the Minimum Revenue Guarantee the government grants the private partner to pay the amount defined as the difference between the predetermined level of traffic income and actual traffic income and in reverse the private partner pays the government all the revenues that exceed some predetermined level, whereby both partners are entitled only to some percentage of the determined lack of income or income surplus.

Consequently, the public partner does not let the private partner lie back, but pushes him towards achieving higher toll-incomes. The public partner is obliged to reimburse the private partner any time when the actual income falls short of the predetermined income, but only in some predetermined percentage. If for instance the government grants to reimburse 40% of the missing shortfall between the predetermined income and the actual income that means that when the actual income reaches 90% of the predetermined income, the private partner still lacks 6% of the predetermined income. The fact that the government does not fully repay the private partner’s shortfall, motivates the latter to improve his management of infrastructure or to accept some other measures with the purpose of increasing operating income.

In addition, the private partner is obliged to transfer to the government only some predetermined percentage of revenue surpluses, which furthermore motivates the private partner to increase his revenues.

In Figure 3 we have the private partner’s traffic income on the x-axis and the public partner’s guarantee obligation on the y-axis. The area framed with 1, 1’ and 2’ presents the cases when the actual income will be lower than the predetermined one, whereby only shaded area 1, 5 and 2’ presents the amount of the government’s obligation. Area 5, 1’ and 2 presents the income loss of the private partner, which is not reimbursed by the government. In case of surplus revenues only shaded area 3’, 6 and 7 has to be paid to the government, while area 3’, 4’ and 6 presents the exceeded income that remains with the private partner. The level of the private partner’s income is therefore defined with line 5, 2’, 3’ and 6.

Figure 3: The put option of the private partner with limitation and the call option of the government with limitation

Graph for the put and the call option with limitation

 Source: Based on L. Shan, M. J. Garvin and R. Kumar, Collar options to manage revenue risks in real toll public – private partnership transportation projects, 2010.

CONCLUSION

With the Minimum Revenue Guarantee the government steps in to provide a sweetener of the project to the private partner as its guarantee lowers the riskiness of the project. On the one hand, such a guarantee improves the risk-return profile of the project and in the first place encourages private partners to enter into a Public-Private Partnership, but on the other hand it imposes a potential burden on taxpayers. Infrastructure Public-Private Partnership projects are typically huge with substantial financial consequences for both parties and it is of great importance that such a governmental support is calculated consistently and accurately. The experience of the last decade teaches us that granting governmental support without appropriate calculations may lead even to the bankruptcy of public partners.

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