When the EIB director for Portugal announces the first EIB subordinated/mezzanine debt programme through its new Structured Finance Facility (SFF), and then concludes that Portugal (which has received some serious EIB backing of late) is unlikely to benefit because the current project process is too inflexible, it is time for the Portuguese government to reconsider its position on a range of project issues.

That EIB announcement came on October 26 at the Project Portugal 2001 roundtable in Lisbon ? the Portuguese government has had what is probably its last gentle alarm call. The next one could be when a deal fails ? too late.

At the heart of the Portuguese project debate is the bidding process. As Felipe Cartaxo, EIB director and chairman at Project Portugal 2001, says, ?all agree there is room for improvement in the bidding process ? but no-one seems to agree on what.?

The fundamental hurdle is that the Portuguese government continues to demand irrevocable financial commitments at best-and-final-offer stage (BAFO) ? a stance steeped in the pricing experience on at least one of the earlier deals. Co-extensively, it does not, according to the banks, allow enough time for due diligence, lengthens the time until syndication, and has no time for developing a refinancing market in the form of project bonds ? in effect there is no backup support to the demands of the BAFO system.

General consensus among banks (international and domestic) and sponsors, if not government advisors, is that the system is too inflexible, too expensive and does not ultimately produce value for money for the government. As Teodora Cardosa, advisor at BPI, says, ?we need to clarify value for money ? the politicians need to be better informed about what is going on.?

Portuguese PPP is not a choice ? it is an inevitability. The economy is predicted to slow down, annual government debt increases are forecast to fall from Eu1.7 billion in 2001 to Eu0.4 billion in 2004. In effect, Portugal simply cannot support its predicted spend over the next five years and reduce its debt without strong PPP input.

Concurrent with tight budgets for the next four years, Portugal is also going to be competing for international, and possibly even domestic bank cash, across Europe. Domestic project arrangers are already looking to Ireland's National Roads Agency (NRA) for mandates (at worst arranger roles and possibly lead). And even if the domestic banks do not start investing in foreign deals, there is no way Portugal can fully fund its development plans without international bank support.

In simple terms ? if deals are more appetizing outside Portugal, that is where the cash will go. On the three major Portuguese infrastructure deals already closed, oversubscription rates have consistently fallen. In 1999 the West Toll (real toll road) closed 72.9% oversubscribed. The Beira Interior (shadow toll) dropped to 56.4% in September 2000 and the Tagus Bridge refinancing only managed 26.4% in October. The Costa de Prata shadow SCUT is due out next and appetite could well be around the Tagus mark again.

Accepted ? they are all different deals with different pricing and different timing. But the drop in international bank interest is nevertheless a fact ? albeit new, smaller regional banks with UK PPP experience are now looking at the market.

The perceived lack of international interest is already taking its toll on relations between the Portuguese and international banks. According to Daniel Amaral, assistant director at CGD, ?in most cases there is no real commitment from the international banks. Strong interest is often given at the beginning of a project but it does not materialise into support during the negotiations. To date, no Portuguese project has achieved financial close with the same banking group that started negotiations.?

Again the problem is rooted in the bidding process and BAFO. Portuguese banks do not manage portfolios with a syndications approach. They can't. The initial assessment of bids is lengthy (up to 18 months), followed by a very short time-scale (imposed by the government) between the shortlisting of two preferred bidders and the due diligence for BAFO. And the syndications market can change dramatically between BAFO and final syndication ? particularly if a non-selected bidder challenges the decision. Consequently syndication risk and interest rate risk is high on the international banking agenda.

Amaral counters that the consequent syndication risk, ?is not always a function of the market ? it is simply used as an excuse to raise pricing. Projects should be measured on their own merits, not syndication risk.?

But the problem goes deeper. From the international banking perspective Portuguese banks are perceived as cabalistic in their relationships with Portuguese sponsors. The internationals question how the same bank can be both adviser and arranger (and sometimes even hold an equity stake in a concessionaire) without taking one side on pricing.

The Portuguese banks argue it is not a problem. It is ? as long as international banks continue to perceive it to be and Portugal needs their coffers.

International perceptions of past deals are also causing problems. The Beira Interior deal is held up as a benchmark ? but the concession agreement will never be repeated. The internationals have failed to acknowledge that, as Pedro Leite Alves notes, ?the risk matrix on the last four concessions has ? except for one change in delays in construction clauses tested on Interior Norte ? been the same.?

While many in the market place the problems ? directly or indirectly ? at the feet of the Portuguese government, in fairness it has demonstrated the will to renegotiate post BAFO ? post-deal in fact. Syndication for the Tagus Bridge refinancing ? arranged by SG, BNP Paribas, BCPA and Caixa ? closed in September after prolonged renegotiation between government and the concessionaire Lusoponte. As a banker close to the deal puts it, ?refinancing served as a way to settle the bulk of seemingly intractable issues, largely spawned by the original deal, between the government and concessionaire.?

The deal for the Tagus river crossing originally signed in 1997, with construction completed in time for Expo98. But Lusoponte then put in a claim for the cost overruns incurred as a result of legislative, planning and tolling changes.

The bridge was designed to relieve congestion on the 25th April Bridge (also a Lusoponte concession). And under the original arrangement, tolls on both bridges were set at Esc350. But the government allowed free tolls on 25th April Bridge, with a final toll set at Esc200. Motorist protests killed any idea of raising the 25th April tariff to the Esc350 level.

The government has been compensating Lusoponte for having reduced the 25th April tariffs, but under the refinancing the concessionaire receives a one-off payment. Similarly, under the initial arrangement, the project was due to revert to the government after a certain number of cars had crossed the bridge. The concession length has now been fixed at 35 years and Lusoponte has been given Esc65 billion over 19 years to settle the construction claim on the project.

The deal is good but not exceptional news for sponsors, many of which are as rattled by inflexibility and the expense of the BAFO process as the banks: in the SCUTS auction Lafarge went to the expense of bidding for four and only won one. If nothing else the Tagus deal means the Portuguese government is willing to listen and compromise, but the creation of a project bond market would make refinancing easier and pricing on the original deals less dangerous for al concerned.

Beyond the BAFO battle, the legal environment for Portuguese deals is neither clear nor project friendly. Public works, withholding tax, project bonds, security, tribunal de contas, accounting practices and securitization laws ? all need ammending, according to Eduardo Carinena, director at Scutivias, ? for the sake of both public and private sectors.?

In public works legislation, whether or not Decree Laws DL 405/93 of December 10 and DL59/99 of March 2 apply to construction contracts or not needs clarifying. Both provide for majeure in more detail than civil law and hence more comfort.

International banks lending into project financing also need automatic withholding tax exemption. As legislation stands, the Minister of Finance can extend corporate income tax exemption to interest on loans from abroad that fund public services, provided that lenders are resident outside Portugal. But that exemption cannot automatically be extended to banks on syndication as the tax exemption is granted on a name-by-name basis and not to all the banks participating at any given time. New banks therefore have to file for a new exemption, which normally takes three to four months to materialise. That may create an additional cost of between 10-20% to the project company due to the gross up clause.

The development of a project bonds market is similarly stifled by law. 20% withholding tax ? reduceable to 10% ? is payable. But more importantly any bond issuer in Portugal must be registered (at a maximum cost of Eu75,000) with the companies registrar for 2 years minimum, must have two balance sheets regularly approved, and cannot issue more live bonds than its existing and paid up share capital.

All the rules can be waived on a case-by-case basis ? by joint order of the Ministers of Finance and Justice ? on projects of national interest. So why have them at all? As Francisco Sa Carneiro, partner at Vasconcelos, F Sa Carneiro, Fontes & Associados, suggests, it would be simpler, and still include a form of safety mechanism, to ?waive the company code conditions if the issuer gets an A rating.?

The absence of project bonds has implications for the pricing of projects overall. Portugal has no easy way of refinancing ? the Tagus deal for example. Consequently any given project must get good pricing at the original syndication ? and good pricing that is going to stay good for years to come (the ?crystal ball' school of economics).

Furthermore, refinancing with another debt deal means paying registration costs and stamp duty again. The only way round that is to alter existing loan documentation, but because Portugal does not recognise the concept of trust, new or renegotiated banks have to be brought in.

As for securitization as an alternative solution ? the new rules approved in 1999 are simply too tight. And, as Ferial Hamid, subdirector of project finance at BCP, notes ?the potential for a subordinated debt market (quasi equity) and specialised investment fund equity is again made difficult by BAFO.?

All this is constructive criticism Portugal cannot afford to ignore. The Operational Programme for Transportation and Accessibilty (OPTA) alone is looking at Eu3.4 billion total investment to meet Portugal's public transport needs ? Eu1.4 billion from the state budget; Eu1.4 billion from FEDER and Eu 600 million self finance from project companies ? between 2000 and 2006. And the total Transport Sector Investment Plan (TSIP) in the same period is Eu20 billion of which project finance is expected to account for Eu6.1 billion.

Even the Ministry of Defence is looking at the PPP/PFI options available and is considering a range of proposals ? joint ventures between European defence companies and the armed forces, tax leasing of submarines and helicopters. The army is set to grow by 10,000 by 2003 and according to Jose Mourato, secretary of state for defence,?we are open to revolutionary ideas when we are short of money.?

But Portugal needs to be clearer about what PPP means, how it will be funded, and to avoid ideological traps. On the one hand, there is the fondly held view that PPP will place public administration in a limbo. On the other ?private is good ? public is bad.? And a recycled role for the state in the development of PPP for smaller projects is a must. The government needs to act as a central body for the bundling of smaller regional deals to achieve economy of scale ? as in the UK.

Solutions to the Portuguese conundrum are numerous. Get rid of BAFO and create a more flexible bidding process. Keep BAFO but give the final bidders more time for due diligence and facilitate syndication post-award in weeks instead of months. Create a project bond market. Clarify accountancy and legal treatment. Accept that the PPP market across Europe is changing and change with it. But most of all, as Antonio Correis de Campos, president of the INA, says ?the government must not paralyse us for the mistakes of past administrations.?