Leveraging Private Capital for Infrastructure Renewal (2019)

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36 C H A P T E R 5 To further study the perspectives of public-sector managers and procurement officers on their approach to using private-sector equity and P3s, the research team conducted a series of interviews with transportation infrastructure P3 offices and departments. Fifteen agencies were invited to participate in interviews. Nine agencies accepted the interview invitation. The inter- view group consisted of most of the states that have procured P3s, with equity investments, in the United States to date. The complete list of offices interviewed is as follows: • Caltrans P3 Office, • Colorado HPTE, • FDOT Project Finance Office, • NCDOT P3 Office, • Ohio Department of Transportation (ODOT) P3 Office, • PennDOT P3 Office, • Port Authority of New York and New Jersey (PANYNJ), • TxDOT P3 Office, and • VDOT Office of P3s. Together these organizations have procured the majority of highway and bridge P3s in the United States—by both number of projects and amount of private capital attracted. Each agency answered a series of questions based on its policies, procurement practices, specific functions that pertain to procurement, proposal evaluation methods, procurement transparency, and specific project outcomes. As private equity was the focus of the study, agencies also answered questions specific to the use of equity in P3s, how it is perceived, and how equity returns are formally evaluated. Agencies described contractual provisions or other practices that limit or monitor equity returns for P3s and whether equity returns for P3s had (in their opinion) created any public perception issues with stakeholders on any of their projects. The sections that follow discuss some of the questions and responses. 5.1 P3 Policies The majority of P3 programs involved in the interviews were governed by some sort of enabling legislation by their state that authorized them to use P3s as a procurement model. The state of New York was the exception here in that it has no enabling legislation for P3s, but the PANYNJ has still used the procurement model for several projects, determining that its mandate gave it the legal authority to do so. Some states (e.g., California and Texas) enacted P3 enabling legislation that has since lapsed. While some states did have limitations on the use of P3s, either by number of projects or by authorizing only specific projects, none of the states constrained the use of private equity for P3s in any way. Public Sponsor Perspectives on the Use of Private Equity and Optimal Contract Mechanisms

Public Sponsor Perspectives on the Use of Private Equity and Optimal Contract Mechanisms 37 Two states (Florida and Pennsylvania) included a requirement for some form of an evaluation by the department before procuring a project as a P3, although the specific evaluation process was not specified in the legislation. Instead the legislation includes only a general requirement for best value in procurement. As detailed in the following, most states have developed an evalu- ation process for determining whether a project would be best procured as a P3 irrespective of whether it was required by legislation. In terms of limiting or monitoring private-equity returns, the enabling legislation in North Carolina is unique in that it requires some form of ERS agreement for revenue risk P3s pro- cured within the state. This was used on the only highway P3 procured in the state to date, the I-77 project, which was discussed in Chapter 4. 5.2 P3 Office Structure, Authority, and Responsibility The P3 offices differed somewhat in their roles and responsibilities during procurement, although most were integrated into the DOT in some way and eventually reported to the head of that department. HPTE was somewhat different in this respect because it is governed by a board and is technically independent from the DOT, although three members of its board are appointed by the department, and the department retains significant authority over the agen- cy’s activities, including project selection. PANYNJ is also different in that it was created as an interjurisdictional infrastructure agency and is thus uniquely suited as a relatively independent procurer of large, multiparty projects. Each P3 office provided the specific responsibilities it has during procurement. This included its role in market sounding and advertising projects, in the development of P3 specifications, in evaluating qualifications and proposals and managing the procurement process, in financial analysis or VfM studies to assess procurement decisions, and in transparency or reporting on P3 projects. All the P3 offices interviewed were involved in or led many of the procurement respon- sibilities to implement a P3, with some variation on specific tasks. While all the agencies per- formed some sort of assessment to evaluate whether the winning P3 proposal was in the public interest, not all agencies specifically performed VfM studies, and there was also some variation as to whether their analyses were simply used internally or resulted in a public report. While all the P3 offices were actively involved in many tasks in the procurement process, they differed somewhat in their degree of centralization. As examples, Florida and Texas reported that many of the tasks such as project specification and RFP development were led by the districts or a line office within the department with P3 office participation. PANYNJ also described a more decentralized procurement process within the agency, with the project finance office focusing on review and analysis of each step. 5.3 Private-Equity Evaluation and Monitoring The P3 offices further discussed their practices in evaluating ex-ante equity returns in bidder financial proposals and monitoring equity returns ex post. Practices were fairly uni- form in assessing the ex-ante returns. While all the agencies required financial model submit- tals from bidders during the procurement process, none used the equity returns projected by bidders as a direct factor in selecting bidders. All the agencies used a best-value or lowest-cost assessment as part of their evaluation process, which is in part derived from equity returns in addition to all other project costs. This is in line with most procurement evaluation practices globally. None of the agencies reported setting a target ex-ante equity return requirement in

38 Leveraging Private Capital for Infrastructure Renewal bidder proposals. Instead, all of the offices evaluated projects and proposals based on total costs to the taxpayer, either in terms of construction costs or, for revenue risk P3 projects, in toll revenues collected by the SPV. This is aligned with international best practices in P3 evaluation and monitoring. Most of the agencies surveyed reported completing some form of sensitivity analysis in evaluating projects and proposals from bidders. Specific practices included an evaluation of a range of traffic outcomes given an investment-grade traffic study and the development of a project risk register early in the procurement process to estimate potential outcomes. These risk registers were often combined with a base cost estimate developed by the agencies to com- pare bidder proposals with a risk-adjusted cost estimate. The terminology used and timing of the assessments varied between projects (in some cases they were termed “sensitivity analysis,” “risk register,” or “shadow bid”), but all of these assessments essentially combined the agency’s estimate of project costs and a risk assessment to forecast project outcomes and compare those with proposals received during procurement. Equity return transparency and ex-post monitoring or reporting practices were somewhat more varied, especially in the degree to which ex-ante equity return projections are publicly available. Florida reported that ex-ante project weighted average costs of capital (WACC) were publicly reported, and other project information was governed by sunshine law requests. Other states, such as California and Texas, required ex-ante returns for their review process but did not make that information publicly available because bidder proposals contain pro- prietary information. Colorado also reported that the pro-forma project WACC was publicly reported. There were more consistent (or nonexistent) practices in the ex-post monitoring of project company returns. None of the agencies interviewed made a regular public report on project profitability, although many concession agreements stipulate that the project company must make financial information available to the public sponsor on request. Each agency was also asked whether it monitored contractor profits in any form of more traditional project contract- ing other than P3s. None of them reported doing so. This may be partially due to the factors that limit the value of such monitoring and reporting, discussed in Chapter 4, such as the common situation of the parent companies of equity investors also having service contracts with project companies, which agencies reported as being fairly common in their highway P3 projects. 5.4 Project Results Pertaining to Private Equity Ex-post monitoring of project performance, as opposed to monitoring of equity profits alone, was reported in all the agencies interviewed, and traffic demand was one factor for those agencies (such as Texas and North Carolina) where ERS was commonly used. This appears to align with international practices on project monitoring, where more readily measurable or veri- fiable performance data (revenue relative to the demand forecast) are used as a metric instead of project company profits. Project company equity returns were commonly reviewed and evaluated by the agencies when project company debt was refinanced. All the agencies reported having a required review process or both refinancings and secondary equity sales. For the sale of equity shares, states reported approval processes that varied over the course of the P3 agreement, with more stringent limitations early in the contract while the project was under construction. Some reported more stringent review requirements when a larger share of the project company equity, generally 50% or more, could change hands since this would neces- sitate a change of control for the project company.

Public Sponsor Perspectives on the Use of Private Equity and Optimal Contract Mechanisms 39 5.5 Private-Equity Return Limitations and Issues The agencies interviewed used several different tools to limit the potential for outsized equity returns or to share risk with P3 developers. These could generally be categorized as either ERS mechanisms or as gainsharing mechanisms in financial restructuring. ERS mechanisms were reported by Texas, which used them for all toll road projects, and North Carolina, which implemented one for the I-77 project. These mechanisms were pri- marily used for revenue risk projects (as opposed to AP P3s) since the added demand risk provides for a wider range of project outcomes. While the I-77 project also incorporated a minimum revenue support payment for a blended risk profile, Texas reported that this was not combined with ERS for its projects. Restructuring gainsharing mechanisms were commonly reported by the agencies, but only in the event of refinancing. None of the agencies reported having implemented a mechanism to share in the project company profits in the event of a secondary sale of project equity shares, although, as discussed previously, they did retain some approval or review authority over those transactions. All the agencies reported a gainsharing calculation if the project company refinances its debt during operations, and although the specific calculations varied among agencies, they gener- ally required a sharing of project company gains from refinancing at lower interest rates due to macroeconomic changes or project revenues beyond those forecast ex ante. Additionally, some P3 transactions include distribution lockups, but these are generally deter- mined by the debt providers, where the equity investor is not allowed to realize any return on the project unless the project is maintaining and projecting certain financial performance metrics. An example of this was in the Central 70 project, which had a distribution lockup of 1.2x debt service coverage ratio—12 months backward-looking and 24 months forward-looking. The Central 70 project is a P3 to redesign and expansion of a 10-mile section of the I-70 highway running through central Denver, CO. The consortium of Kiewit Meridiam Partners LLC was awarded the 30-year concession for the project in August 2017. The consortium raised funds through $116.9 million in long-term private-activity bonds (PABs), a $416 million TIFIA loan, $64 million in equity, and $319 million in substantial completion payments. The two tranches of debt (PABs and a TIFIA loan) have different restrictive covenants. The distribution lockup test is 1.2x for the TIFIA debt and 1.1x for the PABs, creating an average debt service coverage ratio of 1.17x for all debt. In each case, while both tranches of debt are active, the more conservative covenant will apply. These tests are backward 12 months and forward 24 months, with each tranche of debt having a 6-month debt service reserve (Macdonald and Repishti 2017).