Leveraging Private Capital for Infrastructure Renewal (2019)

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40 C H A P T E R 6 6.1 Study Objectives The objective of this study was to review the implications of the use of private equity in highway P3s in the United States using a literature review, individual project information, and interviews with staff at state DOT P3 offices. A review was conducted of the state of the highway P3 industry in general and the particular role that equity has played in transportation projects. Important areas for investigation included the assessment of return on equity by P3 offices, the projected and actual equity returns for highway P3s, and the methods P3 offices used in procure- ment to manage or track equity returns. More broadly, the purpose of this study was to identify the changes that the use of private equity necessitates for highway P3 projects, any issues associ- ated with the use of equity, and best practices from public sponsors. 6.2 Findings The following findings were identified over the course of the study. 6.2.1 The Use of Equity in P3s Changes the Incentives and Requirements of Parties in a P3 Transaction Fundamentally, the use of a P3 structure with private equity changes the incentives of the parties involved in a project. The owners of highway projects are always the taxpayers, repre- sented by their DOT. Under traditional procurement, the public sponsor uses multiple cost- based contracts to procure the many tasks required to develop a project and must manage the interfaces between those contracts and the project phases. Under a P3, the project company has a life-cycle contract and is thus incentivized to deliver and maintain the project while minimiz- ing all the project costs, as opposed to those associated with one particular phase of the project. The incorporation of equity provides a strong incentive to innovate to minimize costs and to manage the project efficiently. However, the same profit incentives that drive efficiency for P3s may also encourage deci- sions that are not in the best interests of taxpayers, and thus those incentives must be managed by public agencies. Many of the tools P3 offices use to manage those incentives have been noted in this synthesis, including fixed or capped toll pricing schedules for toll roads, performance maintenance specifications, transparency and reporting requirements of project costs and rev- enues, ERS mechanisms to share revenue risk, and procedures to review or share the proceeds of refinancing or secondary equity sales. Above all, maintaining competition throughout the procurement process enables public agencies to ensure that taxpayers receive the best VfM in a P3 procurement. P3s are a useful procurement tool for public agencies to transfer some of the Conclusions and Identified Research Needs

Conclusions and Identified Research Needs 41 risks of infrastructure development and management to a private partner, but they also intro- duce a new set of incentives that public sponsors must manage in procurement. 6.2.2 Ex-Post Equity Return Projections Are Not Used to Evaluate P3 Proposals None of the agencies surveyed for this study evaluated project proposals based on the expected profits of the bidders competing for the contract. Rather, expected returns for equity investors were just one component of the total costs to taxpayers to develop and maintain a project, and this was primarily what public agencies used to assess proposals. This was an expected outcome. Projected returns on equity are just that—projections. They are not agreed-upon rates of return for capital like interest rates for debt instruments and are wholly dependent on the investor’s other estimates for project costs and revenue being met. Projected equity returns are thus mostly representative of the risks that investors anticipate taking in being awarded a P3 project. The variable nature of equity returns and the flexibility companies have in accounting for project costs and thus profits render public programs to limit, share, or even monitor equity returns extremely difficult to implement in practice. Just as few attempts have been made to monitor contractor profitability in other forms of contracting outside of P3s, none of the agencies interviewed in this study reported having programs to monitor contractor profits in traditional infrastructure procurement. The international studies reviewed in this report that attempted to measure or estimate equity returns for P3s illustrate the challenges in doing so. Instead, public sponsors predominantly use objective metrics, such as project revenue or a reduction in interest rates in the event of a refinancing, for monitoring profits or gainsharing provisions. 6.2.3 Public Perception of Equity Returns Remain an Important Issue for State DOTs to Manage The use of equity in a P3 does more than align incentives. It also enables the SPV to absorb the risks it is taking on for the P3 project. The outcomes of those risks thus determine the equity investor’s returns, which may be far below or far greater than the returns it projected at the out- set of the project. This is a fundamental part of risk transfer—the costs to taxpayers to transfer risks are effectively fixed when the P3 agreement is signed. This does not mean that the actual ex-ante returns of equity investors are irrelevant to public sponsors. They may create public perception issues when an extreme outcome occurs, either on the downside (a project company bankruptcy) or on the upside (large profits for investors). Project company bankruptcies are often cited in public discourse as indicators of a bad procure- ment, even though, technically, a bankruptcy indicates that risks were effectively transferred from taxpayers to the project company. Large or windfall profits from project companies often lead stakeholders to question why risks were transferred in the first place—the project, after all, turned out fine. This makes project ex-ante equity returns, or at least the perception of them, an important issue for public sponsors to manage, and they have a wide range of tools with which to do so. This study grouped these tools into several categories, including risk-sharing mechanisms and gainsharing or transaction approval mechanisms for refinancing or secondary equity sales. 6.2.4 State DOTs Use Risk-Sharing Mechanisms to Limit the Potential for Outsized Returns on High-Risk Projects While none of the public sponsors interviewed for this study used equity return monitoring or limitations in their P3 agreements, many used other risk-sharing mechanisms to limit the

42 Leveraging Private Capital for Infrastructure Renewal potential for an extreme outcome or the public perception of one. These mechanisms are most relevant to demand risk projects since these projects entail greater risk in the highway sector. ERS was one such mechanism, and while those programs varied across states, they generally involved garnering a portion of project revenue should traffic demand exceed expectations. For most ERS mechanisms, the portion of revenue returned to the public sponsor was in part a function of the degree to which demand exceeded the forecast, with the public receiving a larger share as rev- enues increased. These ERS mechanisms are, in some cases but not always, paired with MRGs, which creates a symmetrical risk profile for the project and provides some protections for part of the project’s capital structure (mainly lenders) while still transferring some demand risk to equity investors in the SPV. These risk-sharing mechanisms are based on project revenues (as opposed to equity inves- tor profits) relative to a forecast for reasons similar to those that cause public sponsors to not base procurement decisions on forecast equity returns, monitor those returns explicitly, or monitor contractor profits in other forms of contracting. In addition, any risk-sharing mecha- nism based on project company profits could effectively reduce the incentives the P3 developer has to manage the project efficiently and reduce operating costs, or even to allocate additional parent company costs to the project. This is likely why objective and verifiable metrics like proj- ect revenue (as opposed to profits) are used in risk-sharing mechanisms. 6.2.5 State DOTs Use a Variety of Tools to Limit Equity Returns in a Refinancing or Secondary Sale Programs to limit or at least approve of equity returns in the event a refinancing or, to a lesser extent, the secondary sale of equity shares are also common in the P3 offices interviewed for this study and in U.S. highway P3s generally. In the event of a refinancing of a project’s debt, equity investors have the potential to generate a profit windfall should the project perform better than originally forecast. There are several drivers of increased profits in the event of a refinancing. The project could be performing more profitably than originally forecast, or, even if the project is not, it could obtain better debt terms because project risks have been retired and the project is already built and operational. In addition, macroeconomic conditions could have caused interest rates to decrease since the project was originally financed. A refinancing essentially captures these gains for project equity investors. The gainsharing mechanisms used for U.S. highway projects require some of the gains of a refinancing to be shared with the public sponsor without limiting the P3 developer’s incentives to refinance the project at better terms. They can be based on several different metrics, including the total gain from refinancing; however, they are often based on the gains from the refinancing using a baseline of the project’s cash flows immediately prior to the refinancing as opposed to the P3 developer’s original forecast. This allows the SPV and its equity investors to capture the refinancing gains from better project performance and thus preserves their incentives to operate the project efficiently while requiring them to share gains from refinancing due to changes in the project risk profile or macroeconomic conditions. Most U.S. highway projects also include a requirement for the public sponsor to review and approve a secondary sale of equity interest in the project company, at least up to a certain point in the project life cycle. The sale of equity interest to new investors may also increase equity returns to the original investors in the SPV if the value of the project company has significantly increased. However, none of the projects reviewed in this study included a requirement to share some of those proceeds with the public sponsor. Instead, public sponsors retained the authority to review and approve of these transactions mainly to protect their interests should a proposed

Conclusions and Identified Research Needs 43 equity sale change the control of the SPV. These approval requirements were generally strict during the early stages of the concession (especially during construction) and became more flex- ible as operations progressed. 6.2.6 Procurement Transaction Costs May Have an Outsized Impact on Equity Return Requirements P3s entail high transaction costs for public sponsors and equity investors. These costs include those to manage the procurement process, to draft and negotiate project contracts, to complete necessary planning and environmental studies, and, for investors, to develop proposals and compete for the contract award above and beyond any stipends provided by the public sponsor. The transaction costs borne by investors may have an outsized impact on the required equity returns for P3 projects. While the equity investments that concessionaires make to develop a project bear the project’s risks, the funds they invest to pursue contracts bear the added risk that they will not, in the end, win the contract. In procurement, this is limited by the fact that gener- ally only two to four qualified bidders will develop full proposals for a given P3 transaction. In markets where procurements are commonly cancelled before contract award, the risk associated with these precontract investments increases significantly. These transaction costs further act as a barrier to entry that prohibits the competition for P3 projects that is necessary to compress required equity returns for the industry. However, govern- ments have tools to limit the transaction costs’ impact. Stipends for proposals cover some of the costs of investors in competing for projects, and while they do not necessarily reduce transaction costs, they limit the high-risk investments that companies must make to pursue contracts and thus foster competition. The development of P3 offices and dedicated programs also addresses this issue to some extent since they allow governments to develop a track record and standard- ized procurement processes to reduce the risk that projects will be cancelled mid-procurement. 6.3 Areas for Future Research In furthering the understanding of state, local, and federal DOTs on the role of equity in P3s, several areas for future research were considered and are discussed in the following. 6.3.1 Ex-Post Equity Return Monitoring and Reporting International studies have called for requirements to report or monitor the equity returns from P3 project companies to support additional research on the industry. While potentially beneficial, this form of aggregate profit reporting would be extremely difficult to implement for the same reasons contractor profits are not actively monitored in other forms of infrastructure procurement. In other forms of contracting, public agencies simply maximize competition to reduce excess profits for each procurement rather than try to manage or control profits directly, and the same basic principles apply to P3 procurement. Measuring or requiring reports of project company ex-post returns is difficult in part because of the flexibility parent companies have in their allocation of project costs in determining the net income of multiple subsidiaries. It is also problematic because many of the companies involved in a transaction have multiple relationships (as owners or service providers) with the project company. Parent companies that own part of and also provide services to the project company would have some flexibility in their allocation of costs. This makes any program to monitor or limit equity returns for a project company difficult to implement in practice, and such programs may also introduce undue incentives for the companies involved in projects. In order to be

44 Leveraging Private Capital for Infrastructure Renewal comprehensive, such a program would need to monitor the profits of every entity involved in a given project as service providers or parent companies, and this is simply not feasible. 6.3.2 Implications of Transaction Costs in P3 Procurement Additional research could examine the degree to which transaction costs drive up required equity returns and create barriers to entry for the P3 industry. The actual investments that con- cessionaires make to pursue projects are naturally proprietary information, and while industry surveys could shed some light on the scale of their transaction costs, those data would also not be objectively verifiable. Some aspects of procurement risk could be objectively measured though, such as a comparison of the number of proposals completed by investors (for completed and cancelled procurements) compared with the number of contracts actually awarded in the sector. This would give a broad indication of the risks associated with investor pursuit costs. A survey of bid stipends in the highway P3 sector could also compare procurements with low or no stipends with those that have higher stipends to assess the degree to which stipends foster competition for a concession. Another study to measure the impact of transaction costs could analyze secondary sales of project equity between financial close and the start of construction or during construction. When an initial equity investor sells its shares during this period, few if any actual project risks have been retired, but the risk of procurement cancellation or not winning the procurement has. Thus, the differences between the equity return projections of the initial investors and the new investors may accurately measure the procurement risk associated with that project separately from the other project risks. The problem, though, is that secondary equity sales soon after the concession is awarded are fairly rare, and in a P3 market as small as that in the United States, such a study would likely not yield enough examples to draw findings. The study could be viable in a larger market such as in the United Kingdom, other parts of Europe, or Australia. 6.3.3 Standardization in Ex-Post and Ex-Ante Project Reporting Some standardization in ex-post and ex-ante project reporting between state-level P3 offices could generate useful data for several studies of P3 equity returns in refinancing or secondary transactions and forecast equity returns for selected contracts. A major hurdle to data collection under such a program would be the proprietary nature of project reporting between proposers and public sponsors. In many cases, ex-ante project forecasts and financial models included in P3 proposals are considered proprietary, which makes sharing such data across procure- ment agencies for an aggregate study difficult. Still, if ex-ante equity return forecasts could be aggregated from winning P3 proposals, it would provide a limited indicator of the equity return requirements based on project conditions and would allow for a comparison across projects with different risk profiles and leverage. Conclusions from such a study would be limited in part because equity returns in proposals are only forecasts and are not an accurate measure of all corporate return requirements in a project proposal. A complete review or study of ex-post equity returns across U.S. procurement agencies would likely not be possible, at least for a generation if at all. This is partially because ex-post equity returns for a given project cannot be completely accounted for until the end of the concession. Still, a study of investor gains in the event of a refinancing or secondary sale may be feasible in the United States, in part because most states already require reporting, approvals, or gainsharing in the event of either of these events. If these data were aggregated across P3 offices, a study could yield some interesting findings, including on the relative contributions to refinancing gains from the sources identified in this report—project performance above that originally forecast, the retirement of project risks, or macroeconomic trends that improve financing terms generally.

Conclusions and Identified Research Needs 45 A similar study of secondary equity sales could compare the conditions under which ownership changes occur in the P3 equity market and, potentially, equity return compression across the project life cycle. 6.3.4 Operational Reporting of U.S. Highway P3s Generally and Risk-Sharing Mechanisms in Particular As risk-sharing mechanisms such as MRG and ERS become more prevalent in U.S. highway P3s, a comparative study of their performance and use would be feasible. This study could examine the frequency at which these mechanisms are triggered for projects as well as the ex- post losses or gains for public sponsors. Similarly, a study of project operational performance across states, especially for concessions with revenue risk, could yield general findings on the degree to which actual revenues have exceeded forecasts or not; similar studies have been completed internationally for P3 projects and toll roads under traditional procurement. Another study could examine projects that spe- cifically did not meet traffic forecasts and the degree to which that risk was shared between parties after the fact. This would potentially compare the economic losses shouldered by equity investors, lenders, and public sponsors for those projects. 6.3.5 Comparative Studies of the Impact of Handback and Maintenance Requirements on P3 Bid Prices Stricter maintenance requirements or handback requirements on a concession contract are understood to translate to increased costs for the project, either in the form of higher bids for AP projects or higher toll price bids for revenue risk projects. For many projects, the degree to which stricter maintenance or handback requirements affect project costs may be difficult to measure, especially in cases where one of the project equity owners is self-performing operations and maintenance for the project. For projects in which equity owners contract out project main- tenance to a service provider, these costs may be more directly observed. Comparative studies of the impact of maintenance requirements on bid pricing may be difficult to complete deter- minatively in the highway sector because of the wide array of variables that drive bid prices and equity returns for a complex infrastructure project and the relatively small sample set of projects in the United States. This makes it difficult to isolate the impact that maintenance requirements have on bid prices for projects. Still, additional research on this topic could be useful for proj- ect sponsors in determining the trade-offs between stricter handback requirements and project costs and could better enable them to optimize their contract requirements in procurement.