Public-private partnerships in the US - outlook for 2012

April 2012 | TALKINGPOINT | FINANCE & INVESTMENT

financierworldwide.com

FW moderates an online discussion focusing on public-private partnerships (PPPs) in the US between John D. O’Neill at Hunton & Williams LLP, Joe Colagiovanni at SNR Denton, and Adam Sherman at Sumitomo Mitsui Banking Corporation.

FW: What factors are driving the increase in appetite for public-private partnerships in the US?

O’Neill: While there remains some scepticism about PPPs, much progress has been made in recent years in the areas of statutory reform and education of the public, including governmental entities, about their inherent advantages. PPPs are now widely appreciated by the federal government and by a number of states as a sensible tool in allocating risks between the private and public sectors, allowing some important projects to go forward when there was no other feasible alternative. With tremendous infrastructure needs due both to obsolescence of existing facilities and a growing population requiring new facilities, the impact of the recent economic downturn on federal, state and local governments, coupled with a continuing resistance to tax increases, including gas taxes, has driven home the fact that we are all in this together. This is fuelling more interest in PPPs as a creative way to address infrastructure needs.

Colagiovanni: The most significant influence is the budget deficit. All levels and all agencies of government – federal, state and local – are under significant financial stress, especially in areas like transportation and social services where public-private-partnerships have a proven track record of success outside the US. This is exacerbated by the aging condition of US infrastructure which is in need of substantial repair and replacement. The last truly significant effort to upgrade and maintain US infrastructure was more than 50 years ago. The combination of such a severe need and limited traditional funding options has created an environment where PPP approaches are now being considered more seriously.

Sherman: We are seeing a renewed interest by state and local governments in PPP projects in the US. As opposed to the early PPP monetisation of several years ago, American projects are focused on green field or new construction initiatives. In addition, we do continue to see interest in outsourcing certain assets such as parking facilities. The main drivers are the pressing need to quickly replace worn out infrastructure and the strained financial ability of states and localities to finance major projects with increasing levels of public debt. Another major driver is the decreased expectations of funding at the federal level from the delayed highway bill. Finally, state and local governments are increasingly aware of the benefits of risk transfer and risk allocation inherent in PPP structures. To illustrate this renewed interest, more than 36 states have legislative authorisation to engage in PPPs for infrastructure. Armed with these new powers, more and more states are beginning to analyse privately financed PPPs alongside the traditional municipal bond financed approach. A fascinating example of this dichotomy is the decision by the states of Indiana and Kentucky to partner up in the construction of two new bridges across the Ohio River. After careful analysis, Kentucky decided to procure and finance one bridge using a standard municipal bond approach. After its own analysis, Indiana decided on an approach involving private equity and a design build finance and maintain approach. When considering that each state is undertaking opposing approaches for like-sized bridges over the same time period, it’s no wonder that this project will be closely watched and compared by stakeholders in every sphere of US infrastructure.

FW: Which sectors seem to be generating the most opportunities for PPP deals?

Colagiovanni: Transportation is one. It has a ready source of revenue – tolling – and at least some historical tolerance for PPP projects. The other is water treatment and distribution. Again, most end-users in the US already directly pay for this service, unlike other typical government provided services. In addition, these projects are smaller in size and frequently contained within one political jurisdiction, which makes it easier to obtain the necessary support and approvals. While there has been recent activity with respect to courthouses and other public building facilities, it has been fairly limited.

Sherman: Transport is leading the charge for this resurgence in PPPs. Some notable road deals have been transacted in the past couple of years. Apart from the recent Ohio bridges deal, examples include the Denver Fastracks light rail deal as well as several managed-lane toll roads in Texas. More recently, we have seen announcements by New York and New Jersey state authorities to demolish and rebuild the heavily trafficked Goethals and Tappan Zee bridges. These are multi-billion dollar undertakings that, for safety reasons alone, can no longer be deferred. California has also been relatively active with its construction of the Presidio Parkway in San Francisco and its continued pursuit of a huge state-wide high-speed rail network. There have also been some social infrastructure deals, most notably the Long Beach Court House deal supported by appropriations through the State of California. In 2012 a new court house in Austin, Texas is expected to borrow from this precedent. Finally, the City of Yonkers, New York has recently retained a financial adviser to assist it in its consideration of school construction and maintenance on a PPP.

O’Neill: Transportation, in particular surface transportation, remains the most prominent infrastructure sector for PPP projects in the US. It is the most mature of PPP activity in the US, and projects in this space are of a scale that justifies the deployment of private capital and human resources to pursue PPP arrangements. But just as with other countries, there is movement into other economic and social infrastructure sectors. The most notable are water and other municipally owned utility enterprises. While obsolescence in these facilities is not as visible to the public as deteriorating roads and bridges, they represent good prospects for PPP arrangements because of the significant development and operation experience private entities possess. PPP arrangements in the social infrastructure sectors remain in a nascent phase. However, often as an ancillary undertaking of adjacent private development, we are seeing a growth in PPP arrangements for public parks, schools and recreational facilities.

FW: In your opinion, what benefits can PPPs bring to stakeholders, and the broader community?

Sherman: Across the complete life cycle of an infrastructure project, PPPs confer multiple benefits as they introduce private sector discipline, expertise, and efficiencies to participating governments. If new construction is involved, studies have shown that a PPP procurement can save a significant amount of time as well as cost by selecting a single design build contractor. By requiring fixed-priced, date-certain, design-build construction contracts, PPPs also fully transfer construction risk, particularly the cost overrun risk to private contractors, equity sponsors and lenders. With respect to facility management, PPPs can also transfer staffing costs to private operators. When considering the heavy burden of health care and pension costs on strapped government financials, this is a significant benefit over time. Lastly, the PPP model transfers the full life cycle risk to private parties who risk losing their concessions if facilities are not sufficiently maintained.

O’Neill: For public sector stakeholders, the principal benefit of PPPs is the delivery of infrastructure assets in a shorter period of time, at a more efficient price and with a better level of service. This occurs because private entities bring specific expertise to the undertaking, expertise that is not usually possessed by public sector entities. And because it is driven by profit motives and the prospect of other PPP arrangements, private entities are motivated to perform well. For private entity stakeholders, including investors, the major benefit of PPPs is the ability to earn a long-term, inflation based return on an investment that typically has a risk profile in the low to moderate range. Moreover, given the scope of US infrastructure needs and the large size of projects, PPPs give private sector stakeholders economies of scale that produce operational cost benefits that enhance investment returns.

Colagiovanni: For everyone involved the clearest advantage is more efficient delivery. From conception to operation, a PPP approach will generally be developed faster and more cost-effectively than a traditionally procured government project. For the community as a whole, the most significant advantage is the transfer of the entire life cycle obligation, and maintenance and operation risk to the private sector. This creates a significant incentive for delivery of a high quality, long lasting asset or service. The fact that this risk currently resides with the public entity is a large reason for the present US infrastructure condition.

FW: Why has the PPP structure historically struggled to gain full traction and acceptance in the US?

O’Neill: There exists, and probably should always exist, a fundamental difference in the ways public and private sectors think about cooperative arrangements with one another. The private sector’s objective is to tackle and resolve challenging projects that benefit the public, but at a profit. Governmental entities, by nature – and sometimes with good reason – mistrust the profit motive and are concerned almost exclusively with the benefits to the public and constituents. Large PPP projects often become entangled in state and local politics, where polarisation along party lines exists and seems to be getting worse. Again, much progress has been made, helped by successful negotiations of a healthy number of high-profile PPP arrangements between sophisticated parties with top quality financial and legal advisers. But the jury is still out on whether these long-term projects will ultimately turn out to be successes or failures. Only time will tell.

Colagiovanni: There are two main reasons, each of which reflects the same basic concern. First, the American people are inherently distrustful of private sector involvement in the provision of public services. Going back to the Teapot Dome Scandal, the essential tenor of US government procurement policy has been to prevent the private sector from abusing public trust. Second, the political class in the US see themselves as the stewards of this policy. Politically, public-private-partnerships mean that public officials have less control over what government delivers and this makes them very cautious toward PPP proposals. Also, there is not yet a full appreciation for the economies of scale that can be achieved with the implementation of a broad PPP structure, which has inhibited public support for the PPP approach.

Sherman: PPPs have struggled to gain acceptance for two primary reasons. First the US has a very large and highly efficient municipal bond market which has historically financed infrastructure through thousands of rated state and municipal authorities. That market is now $3.7 trillion dollars in size, with over $300bn issued in 2011 alone. The US government also does not tax the interest on most municipal bonds conferring a below market rate advantage to most municipalities. Many entrenched government officials can’t get beyond the interest cost savings of municipal bonds without ever considering the advantages of PPPs in terms of procurement, construction, operating and life cycle risk allocation, and cost savings. The other primary obstacle is the ‘populism’ of many American officials and voters who are suspicious of private ‘ownership’ of public assets. The fact that the initial PPPs in the US were the monetisation of existing toll roads probably coloured the views of many Americans.

FW: What legal challenges surround PPP deals, such as gaining approvals at the federal and state levels and overcoming political fragmentation?

Colagiovanni: The biggest challenge is also the most significant benefit of the US governmental structure – the nature of our democratic process. The sheer number of different jurisdictions and the related number of associated agencies involved in a typical public project – including a PPP – means that there is a substantial lag between the initial identification of a need and the final approval to move forward. This is less an issue of fragmentation in terms of substantive differences – although that does occur – and more a matter of time, which has a resulting impact on financing.

Sherman: The US market has had a number of prominent last-minute turn downs including some large turnpikes and, last year, a parking system. It has less to do with legal challenges, though there was one brought by state engineers challenging the Presidio Parkway. It has more to do with ‘populist’ council members or other decision makers who want to score points against Wall Street private equity or foreign ownership. An effective way this has been addressed is by getting full legal authority and approvals in advance of a bid. This was done for the Puerto Rico toll road PPP of 2011 and was successful.

O’Neill: In the US, just under half of states have enacted legislation covering PPP projects generally. This lack of specific legislation means governments must rely on other statutes when considering PPP solutions. When combined with political fragmentation, this gives life to objections to PPPs, driving up costs and driving away potential PPP suitors. But even in those states with progressive PPP legislation, we continue to see opponents of projects exploit the continuing uneasiness with PPP arrangements by threatening and filing litigation that is designed to slow the process in hopes the private sector will move on to other ventures. This places a premium on choosing PPP projects wisely, taking into account the appropriateness of the assets for PPPs and the experience of the private sector partner. States like Texas, Virginia, Florida and Colorado have been at this awhile. Others have not, presenting more risk of failure.

FW: Are there any other major hurdles that frequently surface in US PPPs? How should investors prepare for and manage these issues?

Sherman: The US system of government is a federalist model which delegates powers to 50 different sovereign states. Those states in turn delegate power to home rule cities. Succeeding in the US PPP market requires great political sophistication and great patience.

O’Neill: After political environment and statutory authority considerations, risk allocation and financial feasibility would be at the top of any list. Although there has been movement by governments away from pursing PPPs principally as a means of monetising assets to meet short-term budget woes, it is essential that private sector entities investigate fully the reasons behind a government’s desire to undertake a PPP project. Clear conversation between the parties regarding appropriate risk allocation, financial feasibility and the prospect for a reasonable return on private investment is essential to overcoming these hurdles.

Colagiovanni: There are still some states where statutory impediments exist to PPPs, such as the inability to use design-build or other integrated project delivery methods and restrictions on the ability to make long term budget commitments over the life of a PPP project, which is typically 25 years or more. But the biggest hurdle in my view is the fact that the US insurance and surety market has not yet developed alternatives to traditional insurance and bonding products that fit the PPP model. Without more innovative risk management solutions, the mandate from most public entities to ‘guarantee’ results will make it more challenging to finance some projects.

FW: What is your advice to parties on dealing with the allocation of risk in public-private partnerships?

Colagiovanni: Be as clear and definitive as possible in describing and identifying the nature and extent of each risk. Then allocate it to the party best able to finance, manage, and protect against it. Risks need to be planned for as early as possible – not simply postponed until they arise. This means that each project needs to be evaluated in relation to its unique rewards, attributes, liabilities and benefits. Formulaic approaches will not be sufficient and the retention of experienced and knowledgeable consultants is critical.

Sherman: I would advise utilising professionals experienced in the US market, great persistence and intelligent deal selection. In addition, I would urge governments considering a PPP to utilise a comprehensive and transparent process to make the business and financial case for alternative procurement vehicles. This concept of ‘value for money’ has proven effective in other countries at producing PPP decisions that have lasting public and political support.

O’Neill: The essence of PPP risk allocation places risks with the party that can most efficiently manage them at the lowest cost. Ideally, each party should retain risks within its control and not accept risks outside its control. Applying these principles to PPPs is made more difficult by their size and complexity. There is no ‘one size fits all’ solution to risk allocation. It is critical that each side identify early in the process the various risks and take steps to mitigate those within their control. This will create a transparent process that builds trust consistent with a true partnership. For public sector entities, employing experienced PPP advisors, whether through a PPP unit or the engagement of outside advisers, is essential to managing risk allocation. There is no substitute for experience in identifying and mitigating transaction risks. Private sector participants have it. Public sector participants must have it as well.

FW: Looking ahead, what are your predictions for the PPP market through 2012 and beyond?

Sherman: I am optimistic that the US PPP market will grow this year. There are some very high profile transport projects which, if successful, can set a very positive tone for the market. And infrastructure needs are too great, and public debt levels too high, for public officials and their financial advisors to ignore the PPP business model. That being said, infrastructure will continue to be mostly financed in the traditional way in the municipal bond market. However, there is a municipal bond solution for PPPs. Post-crisis there was Congressional legislation which authorised Private Activity Bonds for major infrastructure projects which utilise the private participants. I would also add that one can take comfort that Canada endured many of the same challenges but that market has proven to be robust and generally accepted over time.

O’Neill: In the immediate future, with a presidential election later this year, there is not likely to be much in the way of federal leadership in solving the country’s infrastructure needs. As a result, it will be left to the individual states. Those with more seasoned PPP experience, such as Virginia, Florida and Texas, will continue to push forward with a number of needed and interesting projects. But for those states whose PPP experience remains in its infancy, we do not expect much movement. Beyond 2012, with the presidential election settled, we hold some optimism for an increase in PPP activity. The deterioration of our infrastructure is not abating, nor are the continuing deficits being borne by state and local governments. PPPs have become a regular part of the conversation around solutions, and that should portend their greater use in the next several years.

Colagiovanni: I think 2012 will see only modest PPP activity. The fact that it is an election year is a big factor, and we are still awaiting some final indication of public policy on tools such as infrastructure banks. Beyond this, however, the magnitude of the need for new infrastructure investment alone means that we will eventually see the US embrace PPPs, likely in a somewhat sudden and massive fashion, as seems to be the American way.

John D. O’Neill, Jr. is the managing partner of Hunton & Williams’ Richmond office and co-head of its public finance practice group. His practice focuses on public finance, public-private infrastructure development, capital finance and complex commercial lending. He has substantial experience with a broad range of public and private infrastructure projects, including airports, roads and highways, convention and conference centres, government administrative facilities, and water and wastewater facilities. Nationally recognised by his peers, he was recently elected as a Fellow of the American College of Bond Counsel. He can be contacted on +1 804 788 8406 or by email: joneill@hunton.com.

Joe Colagiovanni is a partner at SNR Denton and chair of the firm’s Construction practice. Mr Colagiovanni’s practice centres on construction, architectural engineering and development law, including related finance. He has been involved in a number of US PPP projects and in major construction projects of all types, including utility and infrastructure systems; bridges and roadways; water treatment and distribution facilities; industrial and manufacturing facilities; hospitals; sports arenas and convention centres; hotel and resort developments; power plants; renovation and rehabilitation of historic structures; research facilities; casinos; museums; and entertainment complexes. He can be contacted on +1 314 705 2413 or by email: joseph.colagiovanni@snrdenton.com.

Adam Sherman is an executive director at Sumitomo Mitsui Banking Corporation. He is group head of the bank’s Public and Infrastructure Finance group for North America, which is devoted to providing direct loans and other credit facilities to the government finance and the PPP/PFI project finance sectors in the US and Canada. The Group coordinates its sponsor relationships and financing activities with its infrastructure counterparts serving the UK, European and Australian PFI markets globally. Mr Sherman can be contacted on +1 212 224 4859 or by email: asherman@smbclf.com.

THE PANELLISTS

John D. O’Neill

Hunton & Williams LLP

Joe Colagiovanni

SNR Denton

Adam Sherman

Sumitomo Mitsui Banking Corporation