The growth and spread of PPPs around the world is closely linked to the development of project finance, a financial technique that helps to borrow against the cash flow of a project that is legally and economically self-contained. The typical financial arrangement for a PPP, described in Section 5.1, has two characteristics. First, all financing is run through a so-called special purpose vehicle (SPV) – a stand-alone firm created for the sole purpose of developing the project. This firm is managed by the sponsor, who is an equity investor responsible for bidding, developing, and managing the project. Second, the sources of finance change over the project’s life cycle. During construction, expenses are financed with sponsor equity (which may be complemented with bridge loans and subordinated or mezzanine debt) and bank loans. In some cases, the project may receive subsidies or minimum revenue guarantees from the government. Once the PPP project becomes operational, in many cases long-term bonds replace bank loans, and the sponsor’s equity may be bought out by a facility operator or even by passive third-party investors, usually institutional investors.

The changing sources of finance match the evolving pattern of risks and incentives over the life cycle of PPP projects. Most changes to the specifications of such projects occur during construction. Yescombe notes that banks exercise control over all changes of the PPP contract and tightly constrain the project company’s behavior (2007, p. 141). They are thus well suited for lending during construction. By contrast, bondholders only have control (through the bond covenants) over issues that may significantly affect the security of cash flows; they cannot monitor the details of borrower behavior because of transaction costs. Consequently, they are better suited to finance the project during its operational phase, when there are fewer unforeseen events such as major project modifications.