Leveraging Private Capital for Infrastructure Renewal (2019)

Below is the uncorrected machine-read text of this chapter, intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text of each book. Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.

4 C H A P T E R 1 In today’s constrained fiscal environment, public–private partnerships (P3s) are becoming an increasingly important option for delivering critical improvements to U.S. highway and bridge infrastructure. This chapter provides an overview of the purpose and objectives of this synthesis, background and recent history on the use of P3s and their characteristics, and infor- mation on the approach of this synthesis study. 1.1 Background This synthesis focuses on the use of private capital to advance highway and bridge projects through the P3 structure. Specifically, it focuses on the use of design–build–finance–operate– maintain (DBFOM) as a project delivery mechanism, how private-equity participation differs between projects and jurisdictions, and how contractual mechanisms and other improvements may facilitate further private investment in highway and bridge infrastructure in the United States. Information in this synthesis was obtained from a literature review, P3 project data, and interviews with department of transportation (DOT) officials whose agencies have served as public sponsors of highway and bridge projects that have used DBFOM. P3 delivery is typically reserved for complex, capital-intensive projects. The objectives of public sponsors of P3s include accelerating project delivery using private capital and injecting private-sector discipline and innovation into the project’s delivery. Public sponsors in P3 projects greatly rely on the use of private capital (equity and debt) to pay for construction and other costs associated with delivering and, in some cases, operating the project in question. Many P3 alternative project delivery methods (including DBFOM and some of its variants discussed later in this report) are commonly used internationally. The United States is at a nascent stage regarding the use of P3 alternative delivery methods, with a limited sample size of highway and bridge P3 projects available to review. Internationally, the United Kingdom, France, Spain, Canada, Chile, Argentina, Australia, and others have used P3 delivery for the procurement of a wide variety of transportation projects. In 2015, the U.S. Department of the Treasury conducted a market survey that indicated large amounts of private capital were available to be used for P3s in the United States. The survey indicated that an important challenge to tapping that significant source of capital is generat- ing enough cost savings through whole life-cycle infrastructure management, such as through a DBFOM, to outweigh the lower cost of the U.S. tax-advantaged municipal bond market (U.S. Department of the Treasury 2015). Although P3s have been used less frequently in the United States than abroad, several sophis- ticated U.S. public sponsors, including DOTs and regional transportation agencies, have used Introduction

Introduction 5 P3 procurements for large and complex tunnel, bridge, and roadway projects. One of the reasons that P3s have not been widely used is that P3s have not had widespread statutory authorization throughout the country (Rall 2010). At the time of this writing, 39 states and other jurisdictions (including Washington, D.C., and Puerto Rico) in the United States had some form of active P3-enabling legislation (see Figure 1). Of those 39 states and jurisdictions, 32 had passed transportation-related P3 legislation. (Addi- tional information on the P3 policies of the projects covered in this report can be found in Section 5.1: P3 Policies.) A central element in any form of project delivery is the identification, understanding, and management of risk. Optimal risk transfer occurs in a P3 when public and private partners reach an agreement on allocated risks that meets both parties’ risk/reward tolerance and where risks are allocated to the party best able to manage those risks. This generally allows risk to be priced most efficiently and creates proper incentives for strong performance. The FHWA Office of Innovative Program Delivery defines risk allocation and risk transfer as follows: • Risk allocation: The process of assigning operational and financial responsibility for specific risks to parties involved in the provision of services under P3. • Risk transfer: The process of moving the responsibility for the financial consequences of a risk from the public to the private sector (FHWA 2012). Source: National Conference of State Legislatures (2018). Figure 1. P3 enabling legislation in the United States.

6 Leveraging Private Capital for Infrastructure Renewal Despite transferring a great amount of risk to the private sector, P3 projects never achieve 100% risk transfer, nor are they intended to. The public sponsor is always exposed to some project risks and generally retains the risks that the private sector cannot control or effectively price to achieve optimal risk transfer. Transfer of risk to the private sector provides an incen- tive for the private partner to bring innovation and private-sector discipline to the project. Examples of private-sector innovation include solving design and logistics problems beyond the experience of public-sector entities, incorporating more advanced technologies in proj- ects, and employing experimental operational strategies. This risk transfer is also a driver of value-for-money (VfM) for the public sector through opportunities for greater efficiency in managing a risk. The appropriate ratio of debt to capital (debt plus equity) or debt to equity for a project is a direct function of the project’s level of risk. This attribute of the project is sometimes referred to as “gearing” or “leverage.” All else being equal, projects with a low level of risk [i.e., with more stable cash flows like those receiving an availability payment (AP) or with a stable revenue stream] can generally tolerate higher leverage. Based on data on AP-based P3s studied by Giglio and Friar (2017), the debt-to-equity ratio could reach as much as 90% debt and 10% equity (90:10) in the current market. Revenue risk projects tend to be riskier than AP projects, with less certain cash-flow streams, and they generally require more equity financing and may feature debt-to-equity ratios in the range of 70:30 or 60:40 (Giglio and Friar 2017). Further, nearly all U.S. highway and bridge P3 projects feature some form of public funding support or subsidy in addition to the private-sector capital that the P3 developer brings. Debt providers (lenders or bond investors) in P3 projects impose discipline on the special- purpose vehicle (SPV) borrower through contractual arrangements. Examples of these are legal covenants requiring the SPV to maintain certain debt service coverage ratios (DSCR; cash avail- able for debt service divided by required principal and interest debt service payments); limita- tions on distributions to equity investors until certain DSCR, reserve fund level, or other targets are met; SPV reporting requirements; and lender and lender technical advisor oversight during construction and operations. P3 equity investors have further incentive to ensure strong project performance because equity investors are in a first-loss position should the project under- perform; they accept the highest level of risk among sources of financing. Equity investors in a P3 typically receive distributions only if there is cash remaining after payments of all higher priority categories of the “cash-flow waterfall” (the priority of payments in a P3) are made. While equity investors may have target rates of return, the amount and timing of their returns are generally not certain, particularly at financial close. This is before the project has progressed through its riskiest period—construction and early operations while the project is establishing itself and level of cash flow generation. Further, because of their first-loss position, equity investors are taking a higher risk of loss in a bankruptcy situation; they are less likely to recover their investment, as compared to debt providers, should a bankruptcy occur. These are important differences between debt and equity financing. As a result, equity investors require a higher target return than lenders. While equity investors are in a first-loss position, they also seek to insulate themselves from losses and to transfer and mitigate risks. P3 developers typically attempt to pass many project risks on to subcontractors (e.g., construction, operations and maintenance) up to negotiated limits to protect their equity investment in the SPV. As an example, P3 developers may attempt to pass construction schedule risk to the construction contractor(s) through the construction contract(s). For example, the construction contractor may be required to pay liquidated damages to the P3 developer if it is late in achieving project completion. This compensates the P3 devel- oper, which generally does not receive revenue related to project until operations commence.

Introduction 7 Public sponsors need to use contractual mechanisms that enable and incentivize P3 developers to innovate and meet project objectives. Given that target and/or actual return on equity for the P3 developer may be significantly higher than the public sponsor’s cost of borrowing, the general public may wonder if its inter- est was truly served and whether the private sector was overpaid for the service provided. For revenue risk projects, where the P3 developer receives as compensation the revenue generated by the project (such as tolls), public sponsors have put in place revenue risk-sharing mechanisms. These mechanisms ensure that the public sector shares in the benefit of higher-than-expected revenue generated by the project and can limit the P3 developer’s return to some extent. As an example, returns to the equity investor from high revenue generation may be capped by a type of pre-agreed revenue ceiling. Conversely, lower than forecast revenue risk may be mitigated by a type of pre-agreed revenue floor. The I-495 high-occupancy toll (HOT) lanes serve as a useful example of a highway P3 that has worked well for all parties. The I-495 HOT lanes are 13.7-mile-long high-occupancy lanes that operate on the Capital Beltway, the major thoroughfare circling the city of Washington, D.C. The dual lanes run between the Springfield interchange to north of the Dulles Toll Road and connect to the I-95 Express Lanes. In 2007, the Virginia Department of Transportation (VDOT) finalized a long-term partnership agreement with Capital Beltway Express, LLC—a consortium led by Transurban—that would design, build, finance, operate, and maintain the $2 billion HOT lanes project via a DBFOM P3 over 75 years of operations. Transurban and its part- ners provided a substantial up-front equity commitment to help fund construction and financed the rest of the project through private-activity bonds (PABs) and a Transportation Infrastruc- ture Finance and Innovation Act (TIFIA) loan. As a result of the transaction, the private sector assumed the long-term financial risk for the project, including full responsibility to pay back all project debt. Construction, managed by Fluor-Lane, began in 2008, and the new lanes opened for traffic in 2012 (U.S. Department of Transportation 2014). Due to lower-than-expected toll revenues during the first 2 years of operations, Trans- urban invested an additional $280 million of equity in 2014 and used $150 million in existing reserves to reduce the PABs and restructure the project’s debt. In 2013, the I-495 HOT lanes lost $51.6 million. By fiscal year (FY) 2017, the traffic demand on the I-495 HOT lanes increased the average toll pricing 21% over the prior year, and the mobility improvements facilitated the neighboring state of Maryland to explore adding P3 express lanes in the Beltway. 1.2 Study Approach For this synthesis study, public reports, individual project information, interviews with staff at state DOTs and local transportation agencies, and other literature, as referenced in the bibli- ography, were used. These include: • Published reports from national, state, and local agencies, in the United States and internationally; • FHWA P3 publications, including the Guidebook on Financing of Highway Public–Private Partnership Projects (U.S. Department of Transportation 2016); • State P3 authorizing legislation; and • P3 agreements from closed U.S. highway and bridge projects. In gathering the public-sector responses compiled for this synthesis, the research team devel- oped an interview guide (Appendix A) and held interviews with officials of state DOTs and local transportation agencies that closed highway and bridge P3s (list of interviewed parties in Appendix B). Additionally, P3 project-level data were used.

8 Leveraging Private Capital for Infrastructure Renewal Following this introductory chapter, the report is organized as follows: • Chapter 2 provides an overview of the basic principles of a P3 as well as different P3 structures and their respective general risks and other attributes. The chapter includes a discussion on the use of P3s by DOTs in the United States. • Chapter 3 discusses the general role that private equity plays in P3s and the differences between equity and debt in P3s. To provide additional context, it discusses the implementa- tion of certain P3s with project financing without equity, as well as the consequences of that debt-only structure, and explores the nature of equity investors and their motivations for participating in P3s. • Chapter 4 focuses on important considerations for private equity in P3s, discusses the balance between the profit motive and public interest inherent in P3s, the issues regarding public perception of P3 equity, and mechanisms to mitigate these issues. • Chapter 5 contains a discussion of the DOT and local transportation agencies interview responses. It also focuses more specifically on the contractual mechanisms that different agencies use to mitigate certain risks and concerns related to the use of private equity in projects. It includes examples provided by interviewees to demonstrate their practices when facing common private-sector equity issues in P3 infrastructure projects. • Chapter 6 provides a summary of the findings and considerations for additional research topics that could be conducted to fill remaining knowledge gaps pertaining to this topic.