Capitalization – The Financing Structure of P3s
by Gerry Stoughton, SRF 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.
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.