Viability Gap Funding: Public-Sector Support in Project Finance

Published: June 26, 2026

Article by Ryan O'Connell, CFA, FRM

Viability gap funding and other public-sector support mechanisms are essential tools in infrastructure finance. Many large projects — toll roads, power plants, airports — cannot generate sufficient returns to attract private capital on purely commercial terms. Governments bridge this gap through grants, guarantees, and subsidized loans that make otherwise unbankable projects financeable. This guide explains the key forms of public-sector support, when each is appropriate, and the risks of overreliance on government backing.

What is Public-Sector Support in Project Finance?

Public-sector support refers to financial assistance from governments or public entities that helps make infrastructure projects viable for project finance. This support can take many forms, from direct capital contributions to revenue guarantees to subsidized lending.

Why is such support needed? Infrastructure projects often face a fundamental tension: the returns required by private investors exceed what projects can generate from user fees or contract payments alone. This gap may exist because:

• Social benefits exceed private returns — a rural road creates economic development but cannot charge tolls high enough to cover costs
• Financial markets are constrained — insufficient long-term capital is available from commercial banks
• Political or regulatory risks — private investors require risk premiums that make projects unaffordable
• Startup uncertainty — traffic or demand projections are too uncertain for lenders to accept

Public-sector support addresses these gaps by reducing risks, lowering financing costs, or directly subsidizing capital costs. However, such support must be carefully structured to preserve the benefits of private-sector discipline — particularly lender due diligence and ongoing monitoring.

Types of Public-Sector Support

Public-sector support for infrastructure projects can be classified into four main categories, each carrying different risk profiles for the government:

The government’s risk position determines how much “skin in the game” private-sector participants retain. From lowest to highest government risk:

• No project risk — Government provides funding but takes no project risk (e.g., credit guarantee finance where private parties guarantee the debt)
• Second-loss (underpinning) — Private equity and senior debt must be lost before government loses anything
• Pari-passu — Government shares losses proportionally with senior lenders
• First-loss — Government’s commitment is lost before senior lenders suffer any loss
• Revenue support — Government may pay before any default occurs

Viability Gap Funding

Viability Gap Funding (VGF) is a capital grant provided to concession-based projects where user revenues alone cannot support the required private financing. VGF bridges the gap between what the project can generate and what it needs to be financially viable.

How VGF Works

In a competitive procurement, bidders submit proposals including their required level of VGF. The contract is typically awarded to the bidder requiring the lowest VGF — ensuring competition drives down the subsidy needed. Key features include:

• One-time payment — VGF is typically paid at or after project completion, not ongoing
• Non-repayable — Unlike loans, VGF does not need to be repaid by the project company
• Limited percentage — VGF is usually capped (e.g., 40-50% of capital cost) to ensure private capital remains at risk
• Upside sharing — If the project significantly exceeds revenue projections, excess revenues above a threshold are shared with the government

Minimum Revenue Guarantees

A Minimum Revenue Guarantee (MRG) provides a floor on project revenues from users. If actual revenues fall below the guaranteed minimum, the government pays the difference. Unlike VGF (which is paid upfront), MRG creates an ongoing contingent liability that may be called upon throughout the project’s life.

When MRG is Appropriate

MRG is designed to address uncertainty about future revenues, not to subsidize projects where revenues are certain to be inadequate. If a project is fundamentally unviable — meaning revenues will almost certainly fall short — VGF or mezzanine finance is more appropriate than MRG.

MRG should be structured with several safeguards:

• Minimum threshold — No MRG payment if revenues fall below a floor (e.g., 50% of projections), preventing moral hazard on wildly optimistic bids
• Upside sharing — Government shares in revenues above a ceiling (e.g., 110-120% of projections)
• Tapering — Guarantee level reduces over time as traffic patterns become established
• Time limit — MRG expires after the ramp-up period (e.g., 10-15 years)

Credit Guarantees

Debt guarantees allow governments to backstop project debt, reducing lender risk and lowering borrowing costs. The structure of the guarantee determines how much risk remains with private lenders — and therefore how much due diligence discipline is preserved.

Guarantee Structures

Second-loss structures (debt underpinning) are generally preferred because they preserve lender incentives. If lenders know they will be made whole regardless of project performance, they have little reason to conduct thorough due diligence or monitor the project actively.

For cross-border projects, similar guarantee functions are provided by export credit agencies and development finance institutions, which also offer political risk insurance.

Policy Banks

Policy banks are state-owned financial institutions established to provide long-term financing to specific sectors of the economy. They fill gaps where commercial banks are unwilling or unable to lend — particularly for infrastructure projects requiring 15-30 year loan tenors.

Why Policy Banks Exist

In many countries, commercial banks prefer short-term lending because:

• High interest rates make short-term loans more profitable relative to risk
• Banks lack expertise in long-term project finance
• No government bond market exists to establish long-term pricing benchmarks
• Regulatory capital requirements discourage long-dated assets

Policy banks address these gaps by providing long-term infrastructure loans, often on terms below market rates or with extended tenors.

Public-Sector Support vs. Private Financing

The decision to provide public-sector support involves trade-offs between project viability, cost to taxpayers, and preservation of private-sector discipline.

Public-sector support is typically justified when:

• Financial markets are constrained — Insufficient long-term capital available from commercial sources
• Projects are not viable on commercial terms — Social benefits justify public subsidy
• Cost reduction is needed — Lower financing costs reduce user fees or government payments
• Political risk mitigation — Government participation provides comfort to foreign investors (common for cross-border projects involving political risk)

Common Mistakes

Public-sector support programs can fail to achieve their objectives — or create unintended problems — when poorly structured:

1. Providing 100% debt guarantees. Full guarantees eliminate lender due diligence incentives. Lenders with no capital at risk have little reason to scrutinize project viability or monitor ongoing performance. Similarly, the Korean MRG experience (90% revenue guarantees) showed how excessive revenue support creates one-way bets for private investors — though that is a revenue guarantee rather than a debt guarantee.

2. Setting MRG levels too high. Guaranteeing 80-90% of projected revenues leaves minimal risk with the private sector. If traffic falls short, the government pays; if traffic exceeds projections, investors keep the upside. Always require upside sharing and set minimum thresholds below which no MRG payment is made.

3. Using VGF as a substitute for equity. When VGF approaches 100% of capital cost, investors have no meaningful capital at risk. Equity should remain substantial enough to ensure investor commitment to project success.

4. No upside sharing. Governments that provide support without claiming a share of project success are subsidizing private returns. Excess-revenue sharing (at say 110-120% of projections) ensures taxpayers benefit when projects outperform.

5. Using MRG when VGF is more appropriate. MRG addresses revenue uncertainty, not fundamental unviability. If a project cannot generate adequate revenues under any realistic scenario, up-front VGF or mezzanine finance is more appropriate than ongoing revenue guarantees.

Limitations of Public-Sector Support

While public-sector support can make valuable infrastructure projects possible, it carries significant limitations and risks:

Moral hazard. Excessive support erodes private-sector incentives. If investors and lenders know they will be protected from losses, they have less reason to ensure projects are well-designed and efficiently operated. Maintaining meaningful capital at risk is essential.

Political vulnerability. Ongoing subsidies (MRG payments, tariff support) are visible and subject to political criticism. One-time grants (VGF, capital contributions) are less conspicuous. Projects that repeatedly call on revenue guarantees may face public backlash.

Credibility concerns. In developing countries, long-term government guarantees may lack credibility. Will a future government honor commitments made today? Guarantee funds (like Indonesia’s IIGF or Korea’s guarantee fund) can address this by ring-fencing resources to meet obligations.

Coordination complexity. Projects with both public and private components create interface risks. If the government builds connecting infrastructure (roads, utilities) but delivers late, the private project company suffers — leading to compensation claims and disputes. Clear allocation of responsibilities and strong project agreements are essential.

For information on cross-border support mechanisms, see our article on export credit agencies and development finance institutions.