Leveraging Private Capital for Infrastructure Renewal (2019)

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26 C H A P T E R 4 There are many considerations for public sponsors to address when they use an alternative procurement model such as P3s to deliver infrastructure projects, including several pertaining to the use of private equity in a project’s capital structure. In this chapter, several of these con- siderations are addressed, and lessons from U.S. transportation and international programs are drawn upon. Private-sector equity investors and P3 developers have a significant profit motive on highway and bridge P3s. Public sponsors can implement solutions and contract provisions to ensure that the profit motive of private partners is channeled to provide the public benefits that are identified. The drivers of project company equity profits and issues around negative public perceptions of these profits are described by specifically drawing on international studies of project equity returns. These international studies are particularly useful in the U.S. context, where the P3 industry is significantly less mature than in other developed economies, and similar U.S. studies have not yet been completed. In addition, risk-sharing mechanisms that public sponsors have used in the United States and internationally to mitigate any public perception issues around potential future equity profits are identified and described. 4.1 Balancing Profit Motives and Public Objectives in P3s One concern with the use of P3s is that the wider economic and societal benefits of infrastruc- ture may be compromised because of private ownership and investment. Because the private sec- tor is mainly motivated by profit, the concern is that any transaction or partnership arrangement would come at the expense of the general public. This debate centers around the fact that infra- structure is considered a public good and should therefore be offered to the public in an efficient and equitable way. Two of the issues that have surfaced in transportation P3 transactions thus far are whether implementing the project as a P3 brings sufficient value (as compared with the tra- ditional procurement model) for the public, and whether the contractual provisions in place for the P3 allow for the project to be delivered to the public in a cost-effective, fair, and equitable way. 4.1.1 Potential Issues with the Profit Motive in P3s Since P3s involve a private-sector equity ownership of the SPV or project company, they introduce a new set of incentives for public sponsors to manage in procuring the project. These are centered around the profit motive that equity investors have in allocating risks to the party best able to manage those risks and in operating the project. Incentives that drive equity inves- tors to develop and maintain a project in the most efficient way possible may also incentivize other decisions that are not in the public interest, and these incentives must be addressed by public sponsors in procurement. Considerations for Using Private Equity in Public–Private Partnerships

Considerations for Using Private Equity in Public–Private Partnerships 27 These incentives are manifest in projects in several ways. The first, and perhaps simplest, is in the pricing decisions of revenue risk projects. Many infrastructure assets are quasi- monopolies in operations. Once a SPV operator develops a toll road, for example, with complete pricing authority, the SPV may price tolls, or user fees, at a level to maximize profit as opposed to throughput. Here the developer would not necessarily be aligned with the public sponsor. Therefore, for most P3s, the public sponsor specifies toll prices (or at least price caps). User-fee pricing incentives may also change under a P3 with respect to public-use decisions. In the case of the P3, these decisions are generally made based on an explicit cost rather than a forgone revenue. For example, should a public sponsor choose to remove or reduce tolls on a road (temporarily in response to an emergency or permanently due to a change in public opinion), under a P3 the public sponsor would likely be required to compensate the private partner for the change. Under a traditionally procured public toll road, this decision would simply lead to forgoing future public revenue. In either case, the costs to the public would be the same, but the P3 makes these costs explicit, and this may limit public flexibility or, as in the past, lead to some citizen backlash. 4.1.2 The Chicago Parking Meter Concession A high-profile U.S. example where these issues came to bear is the Chicago parking meter concession, which involved the lease of existing assets. This case specifically highlights some important considerations associated with public perception of private-equity participation in transportation P3s. In December 2008, Chicago Parking Meters LLC won a 75-year conces- sion to control and operate approximately 36,000 parking meters throughout Chicago in return for a $1.16-billion lump-sum payment. The concession required the company to install new multi-space kiosks for parking payments and to accept credit cards. The concessionaire also was empowered to write parking tickets, although Chicago retained the revenue. The city retained advertising and naming rights over the meters. Chicago also agreed to a noncompete clause that prohibited it from opening off-street parking lots that would compete with the meters unless the rates in the lots were at least three times the meter rate in the area (Renn 2016). The city council approved the concession on December 4, 2008. The deal closed in early 2009 but almost immediately sparked controversy. Following the transaction, the investment group increased parking rates in the Loop, the core of Chicago’s central business district, by 17% (and parking rates would rise from $3.50 per hour in 2009 to $6.50 per hour in 2013). The group also doubled parking rates in other parts of the central business district almost immediately and raised them even higher elsewhere in the city (Renn 2016). The higher parking rates provoked public outrage. Meters broke as they overflowed with quarters before the new credit card reading kiosks were installed. Several parking meters were vandalized. Councilors were frustrated when they could no longer adjust parking policy in their wards because doing so would trigger hundreds of thousands of dollars in penalty payments. In June 2009, Chicago’s independent inspector general issued a report stating that the park- ing meters had been leased for only about half of what they were worth. The report provided a number of lessons for future similar P3s. First, it was acknowledged that the review process was fraught with a lack of transparency and conducted in haste. An important lesson was that the review process should enable the legislative body enough time to properly deliberate and con- sider alternatives before approving a long-term lease of significant public assets. In the case of the Chicago Parking Meter P3, the critical time to study and assess the P3 would have been after the administration had decided on the concession terms but before companies placed their bids. In general, ample time should be given to assess the decision before bids are accepted so as not to

28 Leveraging Private Capital for Infrastructure Renewal slow down the process once the private companies actually submit the bids. The review period before accepting bids for a P3 involving leasing of existing assets such as this could be up to 60 days and should include an independent analysis of the costs and benefits of leasing the asset, hearings to get the opinions from outside experts and the public, and debate (by the council or relevant committee) on the issue and a vote on whether the asset should be leased under appro- priate terms and what those terms should be. The short vetting period in the Chicago example can be contrasted with that used by the state of Indiana for the long-term concession of the ITR, which was a brownfield project involving the lease of existing assets, in 2006. The state received $3.85 billion for a 75-year concession on the toll road, and this has widely been considered a success for the public sector. The review period, once the concession was announced by the governor, allowed 2 months for political debate and for the public to voice their concerns before it was approved by the assembly. While a longer vetting process does not guarantee that the final transaction will be better, the process allows complex deals to be explained thoroughly to the public. This enables the process to be deemed legitimate despite there being differing opinions on the transaction. Another lesson from the Chicago example came from the fact that proceeds from the con- cession to the city were included in the city’s annual budget even though the transaction had not yet been approved by the city council. Putting potential revenue in a budget from a large P3 transaction that has not yet occurred (and might not occur) complicates the possibility of proper deliberation. Furthermore, it is important that the transition from public to private operation be managed smoothly. In the Chicago example, parking meter rates were increased significantly following the transaction. This was coupled with poor management of the meters, including meters break- ing due to overflowing from quarters because of the meters’ incompatibility with credit cards. The initial negative experience of the transition was difficult to overcome. This case illustrates that the budgetary implications from a P3 arrangement need to be thor- oughly considered. In Chicago, prior to the P3, the parking meters had contributed $16 million to $17 million in annual net revenue to the city’s corporate fund. Following the concession, this was lost as the company was entitled to 100% of the meter revenue. The impacts of future revenue streams in P3 transactions and up-front compensation payments in P3 transactions are important points for governments to understand. Compensation payments to concessionaires also need be well thought out and scrutinized. In Indiana, as one example, compensation payments were made by the state when extreme flooding on a nearby road forced commuters onto the toll road. The state was required to compensate the concessionaire in this case to allow those affected by the flood to travel on the road. In the Chicago case, by contrast, compensation payments were to be made for disabled parking provi- sions, road closures due to road construction, street fairs, and special events, the frequency of which was far greater than the extreme events in the Indiana case. This led to far higher payments from the city than anticipated. In summary, while the Chicago parking meters case is a little different in nature from a typi- cal highway or road P3, it does highlight important lessons for addressing public perception of equity returns with transportation P3s: • Ensure that enough time is given for deliberation, including inviting public debate. • Ensure prospective proceeds from the P3 transaction are not included in an annual budget before the transaction has been concluded. • Ensure full budgetary implications from P3 transactions are transparent and well considered, including the extent of likely compensation payments to the concessionaire.

Considerations for Using Private Equity in Public–Private Partnerships 29 • Ensure a smooth transition of the asset to the concessionaire (i.e., not increasing tolls straight away and ensuring that efficient service is maintained through change of management). • Consider whether the up-front payment may be efficiently used for other much-needed projects that the public can see (e.g., asset recycling). The sections that follow provide specific details on various mechanisms that can be used to help balance the sometimes competing objectives of the private and public sector. 4.2 Public Perception Issues with P3 Equity Returns – Transaction Costs, Competition, and Ex-Post Cost of Capital Studies In addition to managing the new incentives created by equity investments in P3s, public sponsors must contend with other issues around the cost of equity capital and public percep- tions of it. On the surface, P3 projects may have a higher cost of capital than their traditional procurement alternatives; ideally, however, the incremental increase in cost of capital is in pro- portion to the risk transferred from taxpayers to the private partner. Decision making on the use of P3s is thus similar to decision making for purchasing some form of insurance: additional costs for reduced risk. In practice, though, there are other factors that influence the cost of equity in P3s; these are driven by transaction costs and whether risks are properly transferred to the party that is best able to manage them. P3 procurements involve high transaction costs due to their technical and commercial com- plexity and the fact that they can take a long time to complete—in many cases 2 years or more. P3 procurements require the allocation of all project risks up front, and studies of P3 schedule performance have indicated that they tend to take longer than expected during procurement (through contract award) while not experiencing significant delays between contract award and the completion of construction (Duffield et al. 2008; Allen Consulting Group and the University of Melbourne 2007). During this procurement period, multiple bidders are investing time and resources in project proposals; in some cases, each proposer is spending millions of dollars in the hopes of winning the final P3 contract award. These transaction costs effectively act as a barrier to entry for equity investors in pursuing P3 projects and may inhibit competi- tion, thus driving up costs of equity. While many public sponsors provide stipends to bidders that complete a full proposal but are not selected for the project, these stipends are far lower than the actual transaction costs required to complete a full P3 proposal. Concerns around the cost of equity capital for P3s have been raised internationally, and some international studies of P3 equity returns are included here to provide detail on what these transaction costs involve and how they may affect equity returns and the P3 industry generally. 4.2.1 UK Studies of P3 Equity Returns Public concerns regarding equity returns for P3 projects have arisen in international markets with a significantly longer track record of the use of P3s for transportation projects than that in the United States. Perhaps the most comprehensive study of these issues was published by the United Kingdom’s National Audit Office (NAO) in 2012. The United Kingdom has used P3s to finance social and transportation infrastructure projects for decades and thus has a signifi- cantly more developed infrastructure investment market than does the United States. The UK Treasury first launched the Private Finance Initiative (PFI) in 1992, and the industry there has since developed into the largest P3 market in Europe, with more than 700 PFI projects by 2014 (Reeves et al. 2015). The NAO conducted an audit in response to some public concerns over the

30 Leveraging Private Capital for Infrastructure Renewal perception of high returns by infrastructure equity investors following secondary sales of their interests in project companies or debt refinancing (NAO 2012). Since complete equity return data for private companies were not publicly available, the NAO used a variety of approaches in completing its audit. These included some publicly avail- able data, information from local government sponsors, interviews and data from some inves- tors, and three project case studies. The goal of the NAO study was to compare equity returns with the VfM and risks transferred to private investors under P3s. The study produced several conclusions and recommendations. It acknowledged the important role that equity investment plays in the project structure generally and in managing risks. However, the NAO also concluded that the public may be paying more than necessary for the use of equity investment, in part due to inefficient procurement, equity investor’s cost of capital, and lender requirements. The finan- cial analysis of the case studies included some components of the initial equity investor’s ex-post returns that were not accounted for up front. Up front, the investor does not know whether the risk will be successfully overcome or if it will have a serious negative consequence; its impact is unknown, so that is one of the reasons it cannot be accounted for up front. Though this was clarified as not being a definitive analysis, the NAO recommended that the UK Treasury provide guidance to departments in challenging bidders’ proposed equity returns, that local govern- ments better use their authorities to collect equity return data on secondary sales, and that the treasury consider alternative P3 models that could somehow limit equity returns. The NAO analysis and other studies of ex-ante equity return projections in the UK exam- ined the effect of several additional factors on equity returns for PFI projects. The NAO report focused on the secondary market for sales of equity after development and construction risks were retired and the project had proceeded through the riskier development and construction periods. Other cited factors that drove higher equity returns included lender coverage ratio requirements and the use of corporate “hurdle rates” when pricing equity, as opposed to the project’s risks and economics (NAO 2012; Hellowell and Vecchi 2013). Several studies, includ- ing the NAO study, attempted to break down expected equity returns based on estimates of construction risk or the Capital Asset Pricing Model (CAPM) and found that some component of actual ex-post equity returns was unaccounted for. This was cited as an indication that the public has been paying too much for equity. As discussed previously, there are two ways in which the equity investors in revenue risk P3s can accelerate returns once certain project life-cycle stages, such as the riskier development, construction, and ramp-up stages, have been successfully completed. Equity investors can refinance the project’s debt once risks are retired (either because the risks have not transpired or the risks have been sufficiently mitigated or managed) since the now less-risky project, post ramp-up, may be able to generate additional cash flow for equity by taking on debt at better terms or more debt, potentially creating a profit windfall for equity. Equity investors can also sell part of their project shares to other equity investors on the secondary market, which may purchase the shares at a lower expected return (because risks have been retired), thus increas- ing returns to the initial investor. At the time of the NAO study, profit windfalls from debt refinancing had been partially addressed by the PFI program by requiring some return (or refinancing gain) sharing with the sponsoring government in the event of a debt refinancing. Thus, the NAO study focused on secondary markets for equity, using some public and investor- provided data to estimate the secondary market’s expected rates of return for projects over time. These were combined with some conservative estimates of the premium for construction risk (using contractor default data from Moody’s) and bid costs to determine the unaccounted for components of the equity returns for the case studies. The finding of an excess return aligned with the other studies using CAPM to estimate expected return, which also found excess returns in the projects they studied.

Considerations for Using Private Equity in Public–Private Partnerships 31 These studies of equity returns in the PFI area highlight many issues that reduce competi- tion and drive up the risks of infrastructure procurement. They also show (and were motivated by) higher-than-expected equity returns for investors in P3 projects that experienced consider- able positive events that contributed to higher-than-projected return on equity, which, in turn, presented a public perception and political challenge. This can be exacerbated when returns for primary investors are accelerated via a refinancing or sale of equity shares on a secondary market, which the NAO pointed out. The NAO also identified some ways to reduce transaction costs and procurement times, which should enhance industry competition. The following sec- tion addresses other mechanisms that governments can use to address the public perception/ political risk of higher-than-expected equity returns ex-post and those mechanisms’ relative benefits and costs. 4.3 Procurement Tools to Address Public Perception of Ex-Post Equity Returns The primary benefit to governments of P3s as a procurement model is the appropriate trans- fer of project risks from the public sector to the project company, which should be better able to manage certain risks. Still, issues with public perceptions commonly manifest (on both the upside and the downside) when those risks emerge for projects. In those transportation projects in which risks manifest negatively for investors, losses or bankruptcy are often cited as signs of a fault in the procurement model; however, technically, this indicates that risks were effectively transferred from taxpayers to the project company. When risks manifest positively, and rev- enues or profits are higher than expected, there is still potential for negative public perception. Higher-than-expected profits often cause public observers and taxpayers to complete an ex-post rationalization of the project that discounts the risks associated with the project at the outset that were transferred to the SPV. In other words, public observers may ignore the risks that were transferred and successfully overcome. If these risks that have been overcome or retired are then removed from the analysis, observers might assume that the public overpaid for the project based on its equity returns. Ex-post rationalization of infrastructure projects once risks are retired is, of course, funda- mentally flawed as an analytical exercise. As described, a principal benefit of P3s as a procure- ment model involves the transfer of project risks from taxpayers to the SPV and the improved project management through the efficient risk allocation. If this risk transfer (and its impact on the higher target equity return required by the P3 developer) is ignored or discounted up front in the comparative analysis between a P3 and its traditional counterpart, the analysis would conclude that the P3 is not the best procurement option in the first place. This would especially be the case in those instances in which project risks, due to either good fortune or effective risk management, do not manifest negatively for the project. In that case, an analysis based after the fact would conclude that the equity investors in the P3, which bore those project risks, were overcompensated. The logical inconsistency of ex-post project analysis has done little to inhibit the reexamina- tion of P3s once risks have been successfully overcome and retired. For detractors of the pro- curement model, it can also be an attractive line of reasoning to argue that successful P3s are too costly. In this way the added benefit of increased transparency from using P3s may be a liability for the procurement model because it may attract undue public opinion. Because P3s involve the creation of an SPV to implement the project, the profits or losses can be measured or observed as the project finances are isolated within the SPV, in some cases making them more easily mea- sured or observed than under the traditional procurement model. In turn, the data may be more easily studied and scrutinized by the public sector and research organizations.

32 Leveraging Private Capital for Infrastructure Renewal Under traditional public procurement, in which construction firms compete to submit low- cost bids for public works projects, companies also earn a profit, as do other consultants and design firms that compete in the industry. Even when those companies are public, however, profits are only reported in aggregate, and there is little public interest in or ability to deter- mine how much contractors profit from traditional procurement. Presumably this is due to the general understanding that the forces of competition will drive down costs and ensure that any profit earned by contractors is a function of the risks they bore in completing the project. That same consideration is often not afforded to P3 projects ex post. The following sections review several contract mechanisms that may help address the public perception of high ex-post equity profits should they occur. 4.3.1 Excess-Revenue Sharing Mechanisms Excess-revenue sharing (ERS) mechanisms are an effective way to mitigate public percep- tion issues for P3 projects (such as toll roads or bridges where the SPV receives user fees and its revenue) with demand or revenue risk. Under an ERS structure, should traffic and revenue for the project exceed predefined levels, a percentage of the excess revenue would be shared with the public sponsor. The percentage shared with the public sponsor generally increases as excess revenue increases. ERS mechanisms are sometimes paired with minimum revenue guarantees (MRGs) to create a blended risk-sharing profile between the public sponsor and the private partner. The ben- efits of a combined ERS/MRG structure are thus twofold. First, in the event that revenue for the project is much higher than expected, some of the revenue comes back to the public, and thus the potential for excess private profits (and public perception issues associated with them) is considerably mitigated. Even though profitability will be higher than originally forecast, an increasing share of the benefits will accrue to the public sector. This generally mitigates concerns that the private partner is benefiting too much. Second, depending on the structure of the MRG and where it is set, the guarantee could enable the SPV to get lower-cost debt or increase the project’s leverage due to public support (by reducing project revenue risk), thus reducing the cost of financing for the project (Liu e al. 2017). A balanced risk-sharing profile provided by an ERS/MRG mechanism is not cost free. Naturally, the MRG provided by the public sponsor exposes it to some degree of risk should demand, and thus revenues, be lower than forecast for the project. In that scenario, the public sponsor could face a similar public perception problem when it needs to make payments to compensate the SPV for lower-than-expected revenues. It should also be noted that the mechanisms described here share risk based on levels of demand or revenue as opposed to attempting to share profit directly. This is an important dis- tinction. The predominant use of revenue metrics, as opposed to profit-based metrics, is likely because a metric based on revenue more directly shares demand risk and is also significantly more measurable and less open to manipulation than a similar metric based on profit. Metrics based on profit also have the potential to distort incentives for the private partner. For example, a metric for sharing SPV profits could dilute the incentive that the private partner has in oper- ating and maintaining the asset efficiently because an increase in profits from more effi- cient operations would be shared. Furthermore, as many studies of corporate tax avoidance have indicated, companies have a variety of tools to limit profitability through investments or leverage even if the public sponsor somehow requires profitability reporting for the SPVs. For many P3s, parent and affiliated companies often have contractual relationships with the SPV, for instance. In those cases, equity investors in the SPV may have some flexibility in adding or reducing costs or altering their investment decisions to adjust the profitability of the SPV if that

Considerations for Using Private Equity in Public–Private Partnerships 33 profit is measured or limited in some way. Metrics based on project revenues compared to a baseline forecast avoid many of these issues. Table 2 presents types of mechanisms available for use in different states. Case Example: North Carolina DOT I-77 HOT Lanes Perhaps the most notable example of an ERS/MRG mechanism in a U.S. transportation P3 was developed for the I-77 HOT-lanes project in North Carolina. The project will add 26 miles of HOT lanes along I-77 north of Charlotte. The lanes are dynamically priced based on traffic congestion, giving drivers the choice to use the toll lanes, which alleviates traffic on the free lanes of I-77. The SPV is carrying revenue risk according to the pricing mechanism established in the P3 agreement. The P3 agreement between the public sponsor, North Carolina DOT (NCDOT), and the SPV included an ERS/MRG mechanism to share the risk. Should project revenues exceed the forecast, excess revenues will be shared with NCDOT in a range of between 0% and 75%, with the share for NCDOT increasing as excess revenues increase. Should revenues fall below the forecast, the MRG provided by NCDOT is structured specifically to support the SPV’s debt service. The P3 agreement specifies a developer ratio adjustment mechanism (DRAM) in which NCDOT will make a supplemental payment to the SPV should the debt service coverage ratio for the project fall below 1.0x in any given year. The P3 agreement also specifies that NCDOT’s payments under the DRAM will not exceed $12 million in any given year or $175 million over the life of the concession. While the ERS mechanism reduces the profitability of the project company in an upside scenario, the DRAM shares demand risk with the public sponsor in a downside scenario. The project is still in development, so actual demand is not yet known (Mercator Advisors LLC 2017). 4.3.2 Transaction Approvals, Reporting Requirements, and Gainsharing Public sponsors also commonly require regular reporting of SPV revenues, costs, and profit- ability or require a review and approval by the public sponsor should the SPV undergo some types of financial restructuring. These contractual provisions generally allow the public spon- sor to monitor for windfall profits due to unplanned project refinancing or equity sales on the secondary market. A secondary market equity sale is a transaction in which an equity owner in the SPV sells all or a portion of its shares to another party. Transaction approvals can also be State APs MRG ERS California X X X Colorado X X X Florida X X X New York/New Jersey X X North Carolina X X Ohio X X X Pennsylvania X X X Texas X Virginia X Note: Notations indicate that the particular mechanism is not prohibited by the state’s enabling legislation, not that it is used for all projects within that state. Table 2. Mechanisms in use in selected states.

34 Leveraging Private Capital for Infrastructure Renewal used to protect taxpayers’ interests in a proposed change in ownership of the project company before the P3 agreement ends. Transaction approval requirements for P3 projects vary widely within the United States and abroad. Many in the United States are focused primarily on the potential for sales of an equity interest in the SPV. The Indiana Finance Authority (IFA), for instance, included provisions in the P3 agreement for the ITR that required approval by the IFA should an equity owner wish to sell its interests to another party—provisions that were exercised when the original con- sortium did in fact sell its equity interest in the SPV (while in bankruptcy) in 2015. The IFA’s review was primarily focused on the capability and reputation of the new owner as a long-term partner and its ability to successfully manage the project throughout the P3 agreement term. Similarly, TxDOT includes language in its P3 agreements requiring public sponsor approvals of or limitations on ownership sales. The P3 agreement for SH-130 Segments 5 and 6, for instance, limits any change of majority ownership in the SPV before 2 years of project operations have been completed, with approval at the sole discretion of TxDOT. After that period, TxDOT still requires approval of majority ownership sales subject to a reasonable review of the new owner’s capability to successfully manage the project for the term of the P3 agreement. For secondary equity transactions, the I-595 concession in Florida requires approvals similar to those used by TxDOT. Sales of equity shares by investors are not permitted until 2 years after the project commences operations. Between 2 and 6 years into project operations, equity sales or transfers are allowed as long as the majority share ownership in the SPV does not change. After 6 years of operation, majority share ownership transfers are permitted subject to a review by FDOT. For debt refinancing, the I-595 P3 agreement has provisions that require a sharing of project refinancing gains. Here the SPV is required to submit financial models showing pre- and forecast post-refinancing results to FDOT prior to the refinancing to determine the excess equity returns that the refinancing would generate. The increase in equity returns as a result of the refinancing are compared with those of both the project without refinancing just before the refinancing and the original equity returns projected in the original proposal. This refinancing gain is then split 50/50 between FDOT and the SPV, with FDOT receiving its portion of the excess return by either a reduction in APs or a lump-sum payment immediately following the refinancing. This provision was implemented when the SPV for I-595 eventually refinanced the project during operations, resulting in a net benefit to FDOT (in the form of reduced APs) of more than $75 million in nominal dollars over the remaining life of the P3 agreement. Financial reporting provisions are commonly included in transportation P3 transactions in the United States. These may include requirements that the SPV provide the public sponsor with unaudited financial statements every 6 months, or requirements to simply maintain updated financial reports for the SPV and make them available to the public sponsor with reasonable notice. In most cases, these provisions also include language ensuring that these financial reports will be treated as private records to protect intellectual property or confidentiality. As mentioned previously, P3 agreements often include the requirement to share some of the gains of financial restructuring between the public and private partners and contain certain related refinancing approval provisions. As an example, the transaction approval provisions used by the FDOT align fairly closely with the requirements for gainsharing from refinancing used in the United Kingdom under the PFI program. In both cases, these gainsharing provi- sions apply to debt refinancing as opposed to sales of equity. The transaction approval require- ments for the I-595 AP P3 provide a good example of the use of these provisions. As background on specifically which gains may be captured, if a P3 is refinanced at a gain after operations have begun, that increased value must be from three distinct sources—changes to project cash flows, changes in the risk of those cash flows, or changes in market conditions that

Considerations for Using Private Equity in Public–Private Partnerships 35 lower market interest rates generally. First, the project’s actual cash flows may be different dur- ing operations than originally forecast. This could be due to higher-than-expected revenues for a toll concession or, in the case of an AP concession such as I-595, lower-than-expected operations and maintenance costs. Second, even if the project cash flows are precisely the same as those forecast during procurement, they are more valuable during operations; with operating history, they are now less risky—they are no longer a forecast, but actual, operat- ing cash flows. Thus, if they are refinanced, all else being equal, lenders should be willing to provide debt at a lower interest rate as compared to that at the time of financial close. Third, debt financing rates are always partially based on general market conditions. If lending rates are lower in general, at the time of a project refinancing, this could contribute to some of the gain from refinancing. The gainsharing provision example in FDOT’s I-595 project appears to target gains from the second and third driver of refinancing gains, but not the first. This maintains the con- cessionaire’s incentive to maximize project cash flows and also protects the concessionaire’s baseline returns if cash flows are lower than forecast but the now de-risked project can still be refinanced at a gain due to the second and third drivers. It also retains some of the incentive for the concessionaire to pursue lower-cost financing in operations since it still gets to retain half of the gain. These are all factors that P3 developers use to price their proposals when competing for P3 projects (and that may increase bid price) but that, to some extent, may reduce some of the issues around public perceptions of refinancing gains ex post. The Pennsylvania Department of Transportation (PennDOT) used a similar mechanism with a slightly different calculation in its P3 agreement for Rapid Bridge replacement project. Like the provision in the I-595 concession, the gainsharing mechanism was applied to the refinancing of the project’s debt. In the case of the Rapid Bridge replacement project, the SPV is required to get PennDOT’s approval for any debt refinancing that results in an increase in equity returns above the base-case equity IRR, as calculated in the bid for the project. If the SPV refinances the project and achieves a gain, it is required to share 50% of that gain with PennDOT, either in the form of a lump-sum payment or as a reduction in the project AP over time. Prior to the approval of the refinancing, the SPV is required to provide PennDOT with an updated financial model reflecting the increased IRR for the project. The refinancing gain in this case is calculated by using the project’s base-case IRR to calculate the net present value (NPV) of the project’s cash flows with the proposed refinancing and subtracting the same NPV for the project without the refinancing. The gainshare calculation also includes a provision to adjust the refinancing gain to bring the project pre-refinancing IRR back up to the base-case IRR in the concessionaire’s bid for the project. The calculation in the Rapid Bridge replacement P3 agreement functions similarly to the I-595 mechanism in that it requires sharing of the refinancing gains that result from either improved macroeconomic conditions or the retirement of project risks, but it allows the conces- sionaire to retain all the gains due to the improvement of the project cash flows beyond those forecast during procurement. The provision to adjust a refinancing gain to meet the base-case IRR provides an added protection for the SPV. If the project is underperforming its forecast IRR during operations, but the SPV can still refinance the project at a gain, those gains would be fully captured by the SPV until they exceeded the base-case IRR forecast for the project.