Leveraging Private Capital for Infrastructure Renewal (2019)

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1 Public–private partnerships (P3s) can provide solutions to the project delivery chal- lenges faced by state departments of transportation (DOTs) and local transportation agencies in delivering surface transportation infrastructure by aligning risks and rewards between public and private sectors, accelerating project delivery, improving operations and asset management, realizing construction and operational cost savings, and attracting private-sector equity investment. As interest in P3s grows, U.S. transportation agencies and stakeholders evaluating the potential benefits of P3s have raised issues relating to the role of private equity in these transactions. Recognizing the complexity and challenges of structuring a highway or bridge P3 com- pared to a conventional procurement, the objective of this synthesis is to help fill the knowledge gaps regarding the role of private equity in P3 design–build–finance–operate– maintain (DBFOM) transactions for highway and bridge projects and to address the factors affecting private-sector investment from both a public and private perspective. The P3 industry in the United States is nascent and, at the time of this synthesis, only 12 states and Puerto Rico had successfully closed highway and bridge P3 transactions. This synthe- sis highlights results of an extensive literature review, review of U.S. P3 project data, and interviews with state DOT officials whose agencies have served as the public-sector sponsor (public sponsor) of highway and bridge projects delivered via P3. An important component of P3s is that project risks are taken on by the party that is best able to manage them. The P3 model enables the public sector to benefit from private-sector discipline and innovation throughout the project life cycle. P3 equity investors have further incentive to ensure strong project performance when compared to debt lenders. Equity investors are in a first-loss position should the project underperform; they accept the highest level of risk among sources of financing. While P3 design–build–finance (DBF) transactions contain a finance element, they typically do not include an equity component. Therefore, this synthesis focuses on P3 DBFOM transactions. In a DBFOM transaction, a single contract is awarded to a P3 developer, a private-sector consortium, for the design, construction, financing, operations, and routine and major maintenance of the asset for a fixed contract period. The P3 developer generally sets up a special-purpose vehicle (SPV; project company or concessionaire) to carry out the project, and the public sponsor enters into this single contract with the SPV. The P3 developer makes its equity investment in the SPV by providing a capital investment and in turn re- ceives an ownership position in the SPV. The SPV may also arrange a debt financing and borrow limited-recourse or nonrecourse debt, where lenders/debt investors rely on the creditworthiness of the SPV itself for repayment of such debt. This type of limited-recourse or nonrecourse debt is known as project finance. (In contrast, full-recourse debt financing S U M M A R Y Leveraging Private Capital for Infrastructure Renewal

2 Leveraging Private Capital for Infrastructure Renewal occurs when the P3 developer is fully responsible for repaying project debt throughout the term of the loan if the SPV underperforms and is unable to pay.) The SPV relies on this private financing through equity and debt, which is often subsidized by sources of public- sector capital, to construct the project. The timing of equity investment into the SPV varies from project to project. In some cases, equity is drawn first for use toward construction costs, prior to debt being drawn. In other projects, equity and debt are each drawn pro rata as construction progresses. In all cases, the structure and timing of equity injections and debt draws during construction affect the cost of capital for the SPV, and this is generally a negotiated item among the P3 developer, debt provider (lender or bond investor), and the public sponsor. The interviews for this synthesis were designed to gather information from public spon- sors regarding the structure and responsibilities of their offices, evaluation of private- equity investment in transportation infrastructure, practices in managing returns of the private sector, and mitigating and sharing risks with respect to project outcomes. Fifteen agen- cies with experience procuring P3 transactions (DBF, DBFOM, and concessions) were invited to participate in interviews. Nine agencies accepted the interview invitations; six declined or provided no response, resulting in a 60% overall response rate. The entities interviewed were the following: • California Department of Transportation (Caltrans) P3 Office, • Colorado High Performance Transportation Enterprise (HPTE), • Florida Department of Transportation (FDOT) Project Finance Office, • North Carolina Department of Transportation (NCDOT) P3 Office, • Ohio Department of Transportation (ODOT) P3 Office, • Pennsylvania Department of Transportation (PennDOT) P3 Office, • Port Authority of New York and New Jersey (PANYNJ), • Texas Department of Transportation (TxDOT) P3 Office, and • Virginia Department of Transportation (VDOT) Office of Public–Private Partnerships. All the P3 offices interviewed noted that, during procurement, their offices conduct some sort of analysis prior to procuring a project via a P3, whether its value-for-money or another financial analysis, to assess whether the project is in the public’s best interest. Com- parison of the responses revealed that the methodology of the analysis, the transparency of the results of the analysis, and the consistency in reporting varied between entities. Concerns also exist surrounding transaction costs related to P3s from both the public and private perspective. Due to the technical and commercial complexity of P3 transactions and the length of time that a P3 procurement typically requires, both the public and private sectors incur significant transaction costs by investing time and resources in P3 procurements over the course of the procurement, which can last 2 years or more. In some cases, this acts as a barrier to entry for equity investors in pursuing P3 projects, which may inhibit competition and drive up the cost of equity. P3 projects are technically and commercially complex, and they require the allocation of all project risks up front. As a result, it is important to spend ample time during the procurement process to ensure that all documents and terms in the P3 agreement fairly and effectively protect the interests of all parties. While equity returns often take up much of the public debate surrounding P3s, the P3 offices interviewed revealed that while all the agencies required financial model submit- tals from bidders during the procurement process, none of them used the equity returns projected by bidders as a direct factor in selecting among bidders. All the P3 offices used a best-value approach as part of their evaluation process, which is in part derived from cost as well as well as technical factors.

Summary 3 One concern the public may have regarding the use of P3s is that the benefits of public infrastructure may be compromised because of private ownership and investment. The existing assumption is that because the private sector is mainly motivated by profit, any transaction or partnership arrangement would come at the expense of the general pub- lic. The incentives that drive the private sector to develop and maintain a project in the most efficient way possible also may incentivize other decisions, such as pricing, that are not in the public interest. In practice, public sponsors balance these profit motives by setting toll prices (or price caps) and establishing other contractual terms during the procurement process. A main public perception and concern is that the cost of capital in P3 transactions is higher than for traditional procurement projects, presumably resulting in huge gains for the private sector at a cost to taxpayers. However, as mentioned, one of the primary ben- efits of P3 transactions is the transfer of risks to the party that is best able to manage those risks. A major misconception in assessing equity returns is rationalizing the returns after the fact, thus discounting the risk that was taken on by the private-sector partner at the outset of the transaction. This issue remains important for state DOTs to manage. The P3 offices interviewed monitored project performance ex post (after financial close), generally, as opposed to SPV profits alone, which was in alignment with international prac- tices on project monitoring. P3 offices are aware that there are cases where private-sector partners have received windfall gains where actual project revenues exceeded projections or as a result of a refinancing or sale of equity shares on secondary markets. In response, the P3 offices interviewed used several different tools to limit the potential for outsized equity returns or to share risks/rewards with P3 developers. These could generally be categorized as either excess-revenue sharing mechanisms or as gainsharing mechanisms in financial restructuring. Potential areas for future research include ex-post equity return monitoring and reporting, implications of transaction costs in P3 procurement, standardization in ex-post and ex-ante project reporting, and operational reporting of U.S. highway and bridge P3s, particularly regarding risk-sharing mechanisms.