Strategies for Successful Public Private Projects
by Gerry Stoughton,
SFRF Public-Private Infrastructure Advisor
Part of a series highlighting strategies for successful Public Private Partnerships. In this series P3 expert Gerry Stoughton offers insights gained while orchestrating funding for major infrastructure projects for the Port Authority of New York New Jersey.
Read Gerry’s Full Bio
Bank Debt: Less Public Sector Involvement – More Private Control
The third primary source of US P3 project debt in addition to TIFIA (Transportation, Infrastructure, Finance and Innovation Act) and PABs (Private Activity Bonds) is bank debt. Outside the U.S. bank debt is generally the primary – and sometimes only – form of project debt. And while 2008’s financial downturn and subsequent increased focus on bank balance sheet strength led to tighter controls and more rigid borrowing terms, bank debt remains a valuable source for P3 project financing.
Without the lengthy application or allocation process associated with TIFIA and PABs, securing bank debt takes much less time. In addition, many private developers and construction firms have existing relationships with lenders which can make for an easier and faster process to finalize loan details. These existing relationships also allow the lender to better understand the borrower’s business structure and to be more familiar with the type of projects they tend to work on.
Bank debt is particularly valuable on smaller scale projects. TIFIA requires a $50 million minimum project cost to be loan eligible. And bond issuance costs for small projects are proportionately much higher than they are for larger bond deals. While there have not been many small scale P3s, bank debt offers an effective financing source for those projects.
For the larger projects, banks are also still important. With TIFIA covering only 33% of project costs, remaining financing comes from PABs, bank debt, or a combination of the two. Up until financial close, most P3 transactions will keep both bank debt and PABs available as options to see which will offer the best overall rate. During the period up to financial close, should the private borrower want to modify the terms of either instrument the bank debt is typically easier to adjust.
The most significant limitation concerning bank debt has been the maximum term length. TIFIA and PABs provide terms up to 30 years and beyond with rate certainty. Banks will not lend out for that long a period. Long term projects will have future refinancing risk, which can still be hedged but can often make the bank option less competitive.
On the other hand, bank debt provides very competitive rates in the shorter term. Depending on the nature of the project (construction period, commencement of revenue streams, etc.), and with take-out financing coming from another source, banks can still be a valuable element of a long term financing.
Capitalization – The Financing Structure of P3s
With P3s being applied to a growing variety of projects, it is increasingly important to find financing structures best suited to each. In assessing the merits of different structures, some fundamental considerations should be: 1) how much public funding to provide, 2) the desired amount of private equity, and 3) the level of complexity in the mix of financing sources.
P3s can involve various methods of public sector contributions to the project. Sometimes the project involves a defined public component, such as a series of approach roads, which would be entirely funded by the public party. In other cases, the public sector will fund a percentage of the overall P3 project cost. These public funds could come from federal/state/local grants or other sources available to the public entity – including their own financing through tax-exempt debt.
The amount of public funding for the project can depend on several factors. These include how the P3 project relates to the public entity’s capital planning priorities and how much debt capacity is available for the project under associated debt issuance limitations. Depending on the nature of the project and form of the public entity, a certain amount of public investment might be legally required. There are also non-financial considerations for the public party in terms of how they want to show their commitment to the project. Larger contributions often grab larger headlines. There are no set rules with regard to the public party’s financial participation in a P3 project; each project is its own unique situation.
Most public agencies advancing a P3 projects want to make sure that the private developer has a stake in the project’s long-term success. They want the developer to have some “skin in the game” by contributing equity. But there is a flip-side to having more developer equity. The developer’s equity rate of return will be higher than the rates associated with the rest of the financing package they bring to the table. The more developer “skin in the game,” the higher the cost of the overall project financing.
The public entity, as the procuring party, needs to determine what minimum developer equity contribution is needed (generally between 8 – 10%). Prior successful similar P3 transactions can often serve as a guide. Of course, developers can elect to exceed this minimum. Typically, however, they do not in order to submit the least costly financing plan. Occasionally the public side gets the best of both worlds. One developer team provides the highest equity amount and their total cost to design, build, finance, operate and maintain the project is still the lowest.
The primary funding source for the private developer will come in the form of debt. This debt mix should be based on characteristics of the project such as: the length and spending profile of the design and construction phase; the time until commencement of facility revenue operations or payments to the developer; and the projected operation and maintenance costs post-construction. Typically bank debt will offer the most attractive short-term rates, while bonds and private placements will fill in the longer financing troughs and be used to refinance expiring short-term bank loans. Depending on the types of debt instruments, a tiered debt structure can evolve where some debt has higher priority than others. This is common when a TIFIA loan is one of the financing sources.
With a myriad of available instruments and varying maturities, the financing structure should not be unnecessarily complicated. The more parties involved, the more inter-creditor agreements and legal costs. There will also be more time required for all aspects of advancing the project. While a large mix of financing sources might yield the lowest effective rate, a P3 is ultimately a project delivery model with associated financing benefits, not merely a financing solution.
A P3 Does Not Make A Bad Project Good; A Difficult Project Easy; Or An Unfinanceable Project Financeable
Public entities, when confronting challenges to fund and deliver large infrastructure projects, turn to public-private partnerships (P3s) as the best solution. While the use of a public-private partnership structure for the procurement, financing, and delivery of a project often results in time savings, financing efficiencies, and other project benefits, it is very important for public sector entities to understand that a P3 structure by itself does not guarantee a project’s success.
Delivering infrastructure projects is often complex and time consuming. Land acquisition, environmental matters, coordination among project stakeholders, design, and construction all involve certain degrees of risk and uncertainty. P3 projects are most successful and benefit both parties when project elements can be clearly and cleanly assigned to each side based on who can perform those elements best and assume the corresponding risk.
In a P3, the private partner would likely be more familiar with cutting-edge technology, design and engineering approaches to construct a new facility and take on the associated risks. The public partner, on the other hand, would be better able to navigate through an environmental review process involving federal, state, and local officials on the location of the project. Depending on the nature and degree of project risks, a P3 will not necessarily enhance project delivery or save costs and time.
Facility demand can also impact a project’s success – especially when its revenues directly support the financing. P3 structures can transfer revenue risk to the private party or the public side can opt to maintain it – most common when those revenues also support (either directly or indirectly) the public entity’s existing debt. When the public side retains the revenue risk with very questionable demand, the use of a P3 will not solve the problem.
In times of constrained public budgets, P3s can seem to be very appealing. P3 project payments from the public entity to the private developer generally escalate over time. This makes state/local budgets look good in the short term, but can mask the long term financial impacts. In effect, this just kicks the problem further down the road.
Public entities nearing their statutory debt issuance limits could also look to using P3s. Rather than using state or local debt, a P3 will use a variety of other financing sources. However, the project will still require revenues to pay for these P3 financing sources. The simple truth is that no matter how it is funded – be it a pay-as-you-go, state/local debt, federal funds, or with a P3 – a viable infrastructure project requires a secure and ongoing revenue source.
In the end, the fundamentals of the infrastructure project will determine its success. The P3 structure should be seen as an enhancement to the project allowing the private sector to add value beyond what is typically available from the public side. P3s also benefit projects by providing a risk-sharing framework and a basket of financing tools that can be tailored to specific project needs. Each of these will be discussed in future segments of this series.