P3s: Potential Profit or Pitfall

P3s: Potential Profit or Pitfall

March 13, 2013

By Dean B. Thomson

Public Private Partnerships (P3s) are being more frequently used to address the shortfall of public funding available for necessary public projects.  This month’s Briefing Paper explores some of the risks and rewards of P3s and provides recommendations that will increase the chances that P3s will be a potential profit center rather than a pitfall.

The Demand

Traditionally, public construction has been procured through a design-bid-build solicitation funded 100 percent by public appropriations.  The amount of public dollars available for public projects, however, has been steadily decreasing.  As an example, the percentage of California’s budget for infrastructure has decreased from 30% in the 1960s to 3% today.  In 2009, the American Society of Civil Engineers found that the average public school is over 40 years old; in 2011, a White House report noted that nationwide, school districts have an estimated $271 billion of deferred building maintenance. Yet, despite the evident lack of public funds to pay for them, the demand for new public projects (and repair of deteriorating infrastructure) continues unabated.  As a result, public entities have turned to private sector partners to provide funding solutions to pay for needed public construction.

Broadly speaking, the goal of the P3 process is to seek “value for money” – i.e., the public receives value for the money received by the private sector.  There are typically two categories of P3s – “Greenfield Projects” involving a newly constructed asset and “Brownfield Projects” where an existing asset with ongoing operation and maintenance (O&M) is upgraded and transferred to the private sector for management.  Over the last decade, governments at all levels have increasingly turned to P3s to fund development of public assets such as roads, bridges, tunnels, hospitals, schools, prisons, courthouses, and wastewater treatment facilities.

While the private sector can easily form joint ventures to address private needs, there are statutes and regulations that regulate how public and private entities can form a “partnership” and especially how public entities can award public projects to those P3 entities.  Thus, the first step in exploring P3s opportunities is determining whether they are allowed under the statutes in your jurisdiction.  Frequently, special legislation has been created to allow P3 opportunities and create special exemptions from the typical public bidding requirements.  In many states, including Minnesota, there has been a trend in the law toward allowing procurement awards based on a “best value” determination and not just on low bid.  Part of a “best value” analysis could be the private financing package provided to fund the project.

The details of the private funding packages offered by various P3 proposers will likely vary greatly, a fact which makes award of these projects under traditional procurement methods difficult.  Because of the demands placed on the structure of the deal by private investors, it typically takes a long time to negotiate the deal points, and the original proposal often changes as interest rates and other business terms fluctuate.  This is why it is useful to have special P3 legislation authorizing extended competitive negotiations and ensuring the confidentiality of proposals so that the competitive advantages of various proposals are not lost during the negotiation phase. These statutes should also address other unique issues in P3 arrangements such as whether the asset is public (and as a result requires public project payment and performance bonds) or whether it is private (and therefore subject to mechanics’ liens). [2]

Canada’s federal government and the Provinces of Ontario, British Columbia, and Quebec have established special agencies in order to develop the specialized expertise needed to assess “value for money” P3 opportunities.  These agencies have established efficient procurement processes and standardized project agreements that have created a widely accepted risk allocation model and reduced the timeline from RFP to award.  Many think the U.S. should follow a similar model as there is a concern that public entities that infrequently use a P3 process are ill-equipped to negotiate with private project financing experts.  As an example, the agency must be able to do sophisticated life-cycle costing to evaluate the relative competitiveness of the contractor’s operating fee and both estimate and negotiate appropriate security for potential default.

The Structure of the Deal

There are a great variety of P3 structures ranging from active public participation and involvement throughout the life of the project to an almost wholesale, “turn key” delegation of responsibility to the P3.  Typically, however, in order to control their risk (and secure their reward), the P3 entity will want to perform on a design-build basis so it can control both the design and construction of the project, as design is one of the main factors impacting cost and completion risk.  In addition, the P3 will often operate and maintain the project for anywhere from 20 to 50 years in order to control revenues and maintenance expenses.  During the project’s operation, the consortium of entities that form the private part of the P3 receives a stream of payments as compensation intended to be sufficient to repay the initial investment (capex) and the operation and maintenance of the project (opex).  Depending on the type of project, the stream of income comes from user fees (e.g. toll roads) or from government payments (e.g. jails).

The fact that the P3 is responsible for decades of O&M is attractive to the public entity as it usually assures the public that the design and construction will be high quality; otherwise, the private side of the P3 will have to pay for needed repairs that will impair its profit stream.  When bidders are responsible for enforceable O&M obligations, they have an incentive to consider them when designing the project.  If the project is “built to last” with a low life cycle cost, it should also have residual value after it is transferred back to the public entity at the end of the P3’s duration.

Typically, a parent company interested in P3 work will form a private and independent entity to serve as a single purpose vehicle (SPV).  This format reduces the risk to a healthy parent corporation if the project is not successful.  The public entity then gives the SPV either a lease to an existing asset (in the case of a Brownfield) or the land upon which the new asset will be constructed (in the case of a Greenfield).

The SPV will generally have many participants, most notably a sponsor that will provide the initial equity necessary to fund the work and to attract third-party financing.  The source and type of financing changes over the course of the project.  The sponsor’s initial bank loans and mezzanine debt funds design and construction.  Once the project is operational, the bank loans and other initial debt is replaced by long term debt such as bonds.  Sometimes the sponsor’s equity interest is bought out by a facilities operator or concessionaire, or by third-party passive investors.

The P3 “Premium” Cost and How to Reduce It

Due to the tax exempt funding they can supply, public entities typically provide a lower cost alternative to private capital for project financing.  But the RFQ and RFP process for P3 private financing is also made more costly than traditional publicly funded procurement as contractual, performance and financial risks have to be negotiated and those negotiations can consume many months of time.

The process also can cost proposers large sums of money to generate detailed financial and design proposals that they must seek to regain in their proposals if successful.  These proposals are often so expensive that public entities may provide a proposal fee stipend to encourage competition by helping defray the cost of the proposal.  The public sector may also have to absorb pre-development period risks such as environmental reviews, rights of way, community approvals, and permits because the length of time and cost to obtain these development approvals.  Simply put, there is a “premium” cost to P3 financing.

Nevertheless, private financing can greatly accelerate the delivery of a project as compared to public funding.  In addition, if the P3 is structured using a fast-track, design-build delivery method, the public entity can obtain cost certainty and a finished product much sooner than the traditional design-bid-build procurement method.  In any type of P3 procurement, which can entail lengthy and multiple evaluation stages, it is important to develop and apply clear evaluation criteria to ensure the integrity of the process.  Confidentiality rules should also be established so that proposers will not fear their trade secrets and unique proposals will be shared with their competitors.

The private entities providing project financing will expect a return on, and will insist on protection of, their investment as a condition of financing.  A toll road, lock and dam, or light rail transit project provides a few examples.  Repayment of the private financing will largely be provided by user fees such as tolls or fare box revenues.  But user or ridership projections are often over-optimistic, a problem that can lead to a revenue shortfall and debt default.  To protect against this risk, the public entity can promise to make up any user shortfall to ensure the debt is repaid.  Ultimate public responsibility for a fare or user fee shortfall could also help qualify the project to be financed with tax exempt bonds, which could lower the cost of private financing to the public entity.  As an example, a new project managed by Kentucky includes a new I-65 north-bound bridge over the Ohio River and will be financed by tax-exempt debt secured by a gross revenue pledge on toll revenues, backed by a commitment to fund O&M with state road funds if toll revenues are insufficient.

Project funding risk (at least for transportation construction) can be reduced by loans, loan guarantees, and terms of credit from the Transportation Infrastructure Finance and Innovation Act (TIFIA).  Current DOT Secretary Ray LaHood is touting the TIFIA as the largest infrastructure loan program in history.  Any prudent private lender, however, will want to create a risk matrix that identifies all of the project’s many risks and who has financial responsibility for them.  The greater the risk allocated to the P3, the more expensive it becomes to obtain private debt financing, and if large risks reside with the private partner of the P3 (e.g. the risk of the revenue stream), the private lender will require large contingency reserves that could make the price of the P3 bid or project uncompetitive.

Conclusion

As the market for P3 transactions in the United States continues to expand, lenders, contractors, and public entities will need sophisticated advisors experienced in these types of transactions to appropriately allocate risks and rewards.  If a P3 opportunity is on your horizon, our team of experienced attorneys is ready to provide the necessary assistance.

[1] Dean Thomson is a shareholder in the firm’s Construction Department and is involved in negotiating the P3 design and construction agreements for the new “People’s Stadium” that will also be the home of the Minnesota Vikings.  He can be reached at dthomson@fwhtlaw.com or 612-359-7624.

[2] Our firm has drafted model legislation to accomplish this for use by trade associations or public entities.

This discussion is generalized in nature and should not be considered a substitute for professional advice.© 2013 FWH&T

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