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Financial Structuring and Assessment for Public-Private Partnerships: A Primer

October 1, 2012


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Chapter 2 - Project Financing through Public-Private Partnerships

Traditionally, public agencies have funded transportation infrastructure on a pay-as-you-go basis through receipts from State and local taxes or Federal-aid grants. Occasionally, they issue bonds to raise the funds needed to pay for planned projects.

The pay-as-you-go approach has the benefit of simplicity and allows public agencies to avoid costs associated with borrowing. However, major projects often have to wait until sufficient funds are accumulated, or be completed in smaller sections. Thus the benefits of improved mobility and economic development that come from transportation projects may be postponed. Also, building a project in sections can be less efficient than building a project all at once, and in times of high inflation, delays in project delivery can lead to higher costs when the project is eventually built.

Financing Through Bonds

Many public agencies issue bonds to raise the capital needed to pay for projects. Bond issuance can help to accelerate the delivery of projects. The interest on most bonds issued by public agencies is tax-exempt, keeping interest rates low. However, excessive bonding can constrain future infrastructure investment by obligating future funding streams to prior projects to the point where it is difficult to undertake new projects. In addition, public agencies may be limited in the amount of bonds they can issue for various legal, political, and financial reasons.

Debt financing has long been recognized as both an effective and an equitable technique for acquiring or constructing long-term assets, since it frees a project’s delivery schedule from the constraint of currently available revenues. By accelerating construction or acquisition, it reduces exposure to cost inflation and brings transportation improvements and the associated public benefits on-line sooner. At the same time, debt financing is equitable because it allocates the capital cost between current and future beneficiaries through annual debt service payments.

However, depending on the level of interest rates and the term of the borrowing, the financing cost (annual interest payments) can significantly increase a project’s resource needs in nominal terms. Note, however, that the present value of the debt service on a bond issue discounted at the effective borrowing rate by definition equals the par amount borrowed. (Discounting is discussed in Chapter 7). Stated differently, the effective cost of debt financing (in financial terms) is the same as paying for the project with cash on hand.

Table 2-1 below illustrates how the financing cost over the term of the bond issue increases the nominal expense as a percent of project cost. For example, for a 30-year bond issue of $100 with a 5% interest cost and a level debt service pattern, the annual payment factor would be $6.51/ per year. The sum of those 30 annual payments equals $195.20, comprised of $100 of principal and $95.20 of interest; hence the 95.2% "additional nominal cost".

Table 2-1. Additional Nominal Cost of Interest Expense on Long-Term Borrowing
(for a face amount of $100 borrowed)
  Term of Borrowing
Interest Rate 20 Years 25 years 30 years 35 Years
3 % $34.3 $43.6 $53.1 $62.9
4 % $47.2 $60.0 $73.5 $87.5
5 % $60.5 $77.3 $95.2 $113.8
6 % $74.4 $95.6 $118.0 $141.4
7 % $88.8 $114.5 $141.8 $170.3

Therefore, the funding strategy can complicate comparisons of different projects in nominal dollar terms. Consider two identical projects of $100 construction cost; one is funded on a pay-as-you-go basis from federal grants and state match. Another is entirely debt financed at 5% over 30 years. The latter may appear to be nearly twice as "expensive" due to the impact of financing cost.

Financing through Public-Private Partnerships

Public-private partnerships (P3s) allow public agencies to access private equity capital to finance projects. This may be particularly helpful when a toll-based revenue stream is considered by lenders to be too risky to support the full amount of the upfront investment required. P3s can accelerate the delivery of necessary projects by helping public agencies raise the upfront capital necessary to construct a major infrastructure project all at once, rather than in stages. In some cases, private capital can mean the difference between delivering a project and having no project at all, i.e., the "no build" alternative.

While accessing private capital to finance transportation projects may help a public agency deliver needed transportation projects, it does not come without cost. The capital generated from private finance must be paid back with commitments of a long-term revenue stream to repay lenders and private investors, who typically demand a higher rate of return than the interest rates that satisfy investors in tax-exempt municipal bonds due to the higher risks they bear as well as the taxable nature of the dividends paid to equity investors and (often) the interest on debt. Therefore, the cost of private financing is generally greater than that of public financing.

With a form of highway P3 called a "concession," or DBFOM (Design-Build-Finance-Operate-Maintain) a concessionaire invests its own funds (known as "equity") and borrows additional funds (known as "debt") to pay for construction of a highway project. The concessionaire maintains and operates the project for a specified period and expects to be repaid for its investment in the project over the period of the concession. If the facility is already constructed (i.e., a "brownfield" project such as an existing toll road) the concessionaire uses the combination of equity and debt to pay the public agency for the right to operate the facility for a specified period of time and collect tolls.

Project Finance

"Project finance" is a specific type of financing through which an expected future revenue stream generated from users of a project or committed by a public agency is the primary means for repaying the upfront investment needed to fund it. Project financing is also known as non-recourse financing because, unlike other types of financing (e.g., corporate financing), the project’s lenders have no recourse or only limited recourse to the shareholders of the concessionaire in the event of a default on the debt. Private firms often use non-recourse project financing for large, high-risk projects because it can help to insulate them from financial risks associated with the project.

Figure 2-1 depicts the financing structure for P3 projects. Although a single company may bid on and develop a project, generally several companies form a consortium to develop the project. In order to make a clear separation between the members of the P3 consortium and the project itself, a Special Purpose Vehicle (SPV) or project company known as the "concessionaire" is created after the public agency has awarded the project. The members of the consortium then become the shareholders of the SPV and their liability is limited to the amount of shared capital they have invested in the new company.

Figure 2-1

Figure 2-1. Simple P3 Financing Structure

The concessionaire enters into a P3 agreement with the public agency to implement and operate the project. Using project financing, it structures and raises funds from investors and lenders based on the project’s future net revenue stream or net "cash flows." The project’s projected net cash flow (after deducting operating costs and tax payments) must be sufficient to service debt and provide a return to equity. Public agencies may provide direct funding or financing support, guarantees or other risk mitigation measures.

Revenue from the transportation project is typically channeled through the concessionaire. The cash flow is structured so that accounts for project costs and reserve funds, as well as accounts to repay lenders and investors are sequentially funded. This is commonly referred to as a "cash flow waterfall" (Figure 2-2). The cash flow waterfall defines the order of priority for project cash flows as established under the loan and financing documents. In a typical cash flow waterfall, dedicated revenues are used to pay for project costs and debt repayments before other parties derive benefits from the project. This ensures that project debt and maintenance are covered before surplus revenues are used to pay back investors or shared with the public sector.

Figure 2-2

Figure 2-2. Typical Cash Flow Waterfall

Project finance is a useful tool for companies who wish to avoid issuing a corporate repayment guarantee and prefer to finance the project off their balance sheets. Although project finance can be used for all types and sizes of projects, it is primarily used to finance more capital-intensive projects, such as major highway projects. The transaction costs related to implementing project finance structures are high, making the use of this type of financing inappropriate for smaller scale projects.

Cash Flows for Life-cycle and Financing costs

Life-cycle costs are the sum of all project elements (including costs of risks) anticipated throughout a project’s life. This means accounting for not only a project’s construction or capital expenditures (known as "Capex"), but also the costs associated with operating and maintaining (known as "Opex") it for the term of the concession. Costs for project development (including procurement costs) are also included.

A new project is characterized not only by large-scale capital costs, but by a variety of other expenses over the decades of its useful life. Maintaining a facility throughout that time presents significant costs which will be incurred as part of the concession agreement. These and other expenses can be difficult to quantify with certainty.

The financial model must include estimates of all of the life-cycle costs, including financing costs. Table 2-2 lists some of the items that are included in the project’s cash flow analysis.

Table 2-2. Cash Flow Elements for Life Cycle and Financing Costs
Cost Item Description
Capital Costs Referred to as the Capex, it includes costs for development of the project, including planning, environmental documents, design and procurement, right-of-way purchase and construction costs. These costs are incurred in the first few years of the concession period (or term of the contract).
Operations Costs Day-to-day costs of operating the project such as snow and ice removal.
Maintenance Costs Items such as replacement of lighting.
Reconstruction and Rehabilitation Items such as bridge or pavement replacement, which are included as Capex.
Overhead Costs Items such as administrative costs, office space, supplies, employee salaries, etc.
Financing Costs Costs associated with the interest charged on public or private debt, returns to private equity, as well as other costs, such as arrangement fees and commitment fees

Cash Flows for Payments to Concessionaires

P3s are commonly classified by their payment mechanism. The three most common compensation arrangements in P3 concessions are:

  • Toll concessions, where the concessionaire receives compensation by obtaining the right to collect the tolls on a facility;
  • Shadow toll concessions, where the concessionaire receives a set payment from the public agency called a "shadow toll" for each vehicle that uses the facility; and
  • Availability payment concessions, where the concessionaire receives a periodic "availability" payment from the public agency based on the availability of the facility at the specified performance level.

Toll Concessions: In a toll concession, the concessionaire collects tolls on the facilities. Toll revenues are used to pay for project expenses and returns to equity. The toll rate that the concessionaire is allowed to charge is typically defined in the P3 agreement – the agreement often caps the amount by which a toll rate can be increased over time. In the case of congestion-priced facilities, where toll rates are often tied to mobility performance targets and may not be restricted, P3 agreements will typically limit the potential for excess profits to the private sector through revenue sharing mechanisms.

Toll concessions are often referred to as "revenue risk" concessions because the concessionaire accepts both the downside and upside risks of uncertain revenues. Forecasting demand on new toll roads or lanes is difficult and revenue projections are very uncertain. More speculative investors may be attracted to the potential for extra profits to be gained if demand for a facility is higher than anticipated. Recently, however, investors have been less willing to take on revenue risk. To address their concerns, the availability payment approach (discussed below) has been used.

Innovative contract arrangements have been used in other countries to enable sharing between the public and private partner of the risks associated with uncertain future toll revenues. They include "dynamic concession terms" and "revenue bands." With dynamic concession terms, the term of the concession ends when a specified net present value (NPV) of the toll revenue stream is reached. (The calculation of the present value of future cash flows is discussed in Chapter 7). With the revenue band approach, upper and lower bounds of the expected toll revenue stream are set contractually. If toll revenue is below the lower bound, the public agency may provide a subsidy to make up a portion of or the entire shortfall, depending on the terms of the agreement. Revenues in excess of the upper bound are shared with or turned over entirely to the public agency. Both approaches reduce the exposure of the concessionaire to revenue risk.

Very few projects have revenue streams that are sufficient to repay the capital investment. As a result, the public sector may need to provide financial support to the project by participating in the initial funding for construction or by supplementing the project revenue stream during the operational phase using its own tax-based resources. Public sector participation in the initial funding could involve providing capital grants to fund parts of the project, providing subsidized or "subordinated" loans (i.e., loans whose debt service is paid only after the debt service of "senior" debt is paid), or providing tax advantages including tax-exempt debt. These are discussed further in Chapter 4.

Shadow Toll Concessions: Under this form of concession the concessionaire receives a set payment for each vehicle using the facility, known as a "shadow toll." In a shadow toll concession, the public sector transfers traffic risk to the concessionaire, so that the concessionaire still has strong incentives to provide high quality service-levels that attract traffic. Shadow toll payments may be adjusted based on performance or based on pre-established floors and ceilings. Shadow toll concessions have been extensively used in the U.K. In the U.S., they have been used in Texas in "public-public" partnerships (under the term "pass through tolls") to repay local agencies for their up-front investments in a project. The advantage over real tolls is that traffic diversion to non-tolled facilities is avoided, since motorists themselves do not pay tolls. The disadvantage is that revenue to repay the concessionaire’s investment must come from other public sources, which may be constrained. Also, the public agency loses cost certainty. However, the upper bound of the public agency’s cost is usually known since most shadow toll agreements cap payments.

Availability Payments : With this approach, the public agency provides periodic payments to the concessionaire on condition that the facility meets defined performance specifications. Revenues received by the concessionaire are not dependent on tolls. If the project is a tolled facility, the public agency may retain revenues from tolls.

Availability payments may be used if the public sector wishes to retain traffic risk to attract more bids, or because the private sector would otherwise demand a high risk premium. To determine the amount of the availability payment, private entities submit bids based on the annual payment they would require in order to design, build, finance, operate and maintain the facility. Availability payments may also be used in cases where tolling is infeasible. If this is the case, the public sector will have to identify an alternative source of revenue to make the payments.

On toll-based projects, availability payments eliminate the public relations risk related to a private firm potentially reaping windfall profits if toll revenues are higher than anticipated. (As discussed earlier, this risk can also be mitigated through revenue sharing provisions that come into play if toll revenues exceed pre-defined thresholds.) In the case of tolled managed lanes, public agencies may choose to use availability payments to retain the ability to dynamically manage toll rates to optimize traffic flow on both the managed lanes as well as the adjacent free lanes. However, while toll revenues will offset the obligations for availability payments, lower than expected revenues may limit the public agency’s future financial flexibility.

Performance-based availability payments and traffic dependent payments (i.e., shadow tolls) in effect allow public agencies to use the P3 as an alternative to direct government borrowing. However, use of such P3 arrangements affects their credit capacities less than direct borrowing. The impacts on the public sector’s credit rating will be minimal or non-existent when project-based revenues (e.g., tolls) are the sole source of repayment with or without public operational subsidies.


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