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Challenges and Opportunities Series: Public Private Partnerships in Transportation Delivery

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3. Financial Considerations


  • Private financing of transportation projects can also help to facilitate the financing of projects that cross multiple jurisdictions, reduce cost and schedule uncertainties, better allocate risk, and create incentives to better manage the life cycle costs of a project.
  • P3s are not a source of revenue; in fact, to be financially feasible they require a stable revenue source. However, they can be used to free up existing revenue, increase the certainty of project lifecycle costs, and protect general revenue from revenue shortfalls.
  • In recent experience, most P3s in the U.S. have not been exclusively privately financed. Most P3s have required public sector financial support in the form of up-front capital contributions or credit assistance to attract private investment.
  • Availability payments, where the public sector retains demand risk, represent one way public agencies have structured P3 contracts to attract more bids that are competitive and keep financing costs down.


Public private partnerships (P3s) allow public agencies to access private equity capital to finance projects. This can help public agencies achieve their goals in a number of ways. 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 developing a project and having no project at all. Private financing of transportation projects can also help to facilitate the financing of projects that cross multiple jurisdictions, reduce cost and schedule uncertainties, better allocate risk, and create incentives to better manage the life cycle costs of a project.

While accessing private capital to finance transportation projects may help a public agency deliver needed transportation projects, it does not come without cost. As with any financing, the capital generated from private finance must be paid back with future revenue. P3 agreements often involve the commitment of a long-term revenue stream to pay back lenders and private investors. Private lenders and investors typically demand a higher rate of return than investors in tax-exempt municipal bonds; so, the cost of private financing is generally greater than that of public financing. Public agencies must carefully analyze these and other tradeoffs when deciding whether to pursue private financing of transportation projects.

This chapter explains why public agencies may choose to use private sector capital to deliver projects and the requirements that private financial markets may impose on such projects. It explains the basic concepts of project finance and explores the incentives and capabilities of various sources of private capital. Since P3s require revenue to pay back investors, this chapter describes the various types of revenue that can be used to support P3s. It then describes how private investors and public agencies may determine the value of public private partnership opportunities and come to an agreement regarding the price of transferred risks. Finally it discusses the advantages and disadvantages of private finance and how P3 deals can be structured to incentivize private investment and optimize risk transfer.

Advantages and Disadvantages of Public Financing of Projects

Traditionally, public agencies have funded transportation infrastructure through State and local taxes, Federal aid grants, and municipal bonds. In some States, transportation projects are funded primarily on a "pay-as-you-go" basis, while other States issue bonds to raise the capital needed to pay for planned projects. Both approaches have advantages and disadvantages.

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

Many public agencies issue bonds to raise the capital needed to pay for projects. Bonding can help to accelerate the delivery of needed projects. The interest on most bonds issued by public agencies is tax-exempt, keeping interest rates low. However, bonds must be paid back with future revenue. Excessive bonding can constrain future infrastructure investment by obligating future funding streams to past 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.

Structuring Equity-Financed P3s

In a P3 project, the responsibilities for designing, building, financing, and operating are bundled together and transferred to private sector partners. P3 projects are either partly or wholly financed by debt that leverages revenue streams dedicated to the project. Structuring effective partnerships requires an understanding of the advantages, disadvantages, interests, and capabilities of various sources of financing such as public agency bond issuances, private activity bonds (PABs), special governmental credit issuers (such as the Federal TIFIA Program), private equity investors, and commercial loans. Each source of financing varies in both cost and capacity to assemble sufficient amounts of capital. Equity-financed P3s may use each of these sources to assemble the capital necessary to meet the terms of the agreement.

A public agency undertaking a P3 can leverage anticipated future revenues by issuing bonds or attracting private investors that provide funds for capital and project development costs in return for a stake in profits derived from the project. Direct user fees (tolls) are the most common revenue source, but other revenue options are available, ranging from lease payments to shadow tolls and vehicle registration fees. These revenues may be supplemented by public sector grants in the form of money or contributions in kind, such as right of way. Figure 3-1 shows a basic P3 financing structure under a P3 arrangement.

The critical private investor is the concessionaire, the partner who bids for the project and is responsible for delivering it. To facilitate financing, the concessionaire typically establishes a special purpose vehicle (SPV), a legal entity organized to limit the liability of investors. Typically, the SPV has no assets or liabilities other than those related to the project. Investors in an SPV are sheltered from claims on their revenues or assets outside of those directly related to the project.

Revenue from the transportation project is channeled through the SPV. 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 3-2). 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 3-1. Simple P3 Financing Structure

Figure 1. Simple p3 Financing Structure

Figure 3-2. Typical Cash Flow Waterfall

Figure 2. Typical Cash Flow Waterfall

Sources of Private Funds in a P3 Finance Transaction

Private project sponsors usually seek investment partners to optimize the capital structure of P3 project financing and maximize their return on investment. The partners to a project include public project sponsor(s), equity investors, subcontractors, private lenders, and, oftentimes, public lenders. Each partner has distinct interests and capabilities. Public project sponsors may make upfront capital contributions, ongoing payments, or credit assistance to a P3 project. Equity investors assume the highest risks but may also receive the highest returns. Subcontractors, who sign contracts with the private project sponsor to perform specific services such as the construction, operation, and maintenance of the project, may or may not contribute an equity stake as well. Lenders to a project make loans to the SPV that will be reimbursed through future cash flows. Lenders may provide senior debt, which has the first claim on the SPV's net cash flows, or subordinate debt. Lenders may come from the private or the public sector.

Equity Investors

Equity investors provide upfront capital, which can be repaid with dividends if the project is financially successful. Equity typically accounts for less than 30 percent of the investment in a project and may be provided by project sponsors or by third party investors. Equity plays an important role in strengthening incentives for the private sector to perform efficiently and effectively and can be vital in attracting private lenders to a project.

Equity investors are typically willing to take on greater financial risks than private lenders or public agencies in return for a competitive risk-adjusted return on investment. Equity investors are exposed to greater financial risk because project revenues typically must be used to pay operational costs and repay lenders before equity. If a project does not generate sufficient anticipated revenues, equity investors may lose some or all of their investment. Equity investment also has a potential upside, as surplus net revenue from higher than expected revenues or efficient management of costs is captured in dividends to investors (though they may be subject to revenue sharing provisions with the public sector). As a result of the risks that equity investors take, the expected rate of return on equity may be significantly higher than the expected rate of return on debt.

Equity investors have an interest in maximizing the return on their investment by borrowing funds from private lenders. Because of its place in the cash flow waterfall, equity investment provides a cushion for lenders to the project and helps to attract private finance. The greater the ratio of debt to equity, the higher the potential return on equity will be (see Table 3-1.) However, lenders will typically expect larger equity contributions for riskier projects. If equity investors are able to achieve higher lender participation, they may be able to accept lower revenues and still make similar returns on a percentage basis.

Table 3-1 illustrates the effect of higher leverage on equity return. For a $1 billion project that achieves $75 million in revenue over the life of an investment, greater leverage - that is, higher levels of debt - lowers the amount of equity that investors must contribute to the project up front. If the investors only have to contribute $100 million, with $900 million covered by debt, they will realize $12 million in profit once the revenue has been realized and interest is paid. That represents a 12 percent return on their investment. By contrast, if the equity investors have to contribute $400 million, they will have lower interest costs due to more robust debt service coverage, but the profit of $39 million will only represent a 10 percent return on their investment.

Table 3-1 Illustrative Example of Effect of Leverage on Returns on Equity

  High Leverage Low Leverage
Debt (in millions) $900 $600
Equity (in millions) $100 $400
Revenue (in millions) $75 $75
Interest Rate on Debt 7% 6%
Interest Payable (in millions) $63 $36
Interest Coverage 1.19 2.08
Profit (in millions) $12 $39
Return on Equity 12% 10%

Adapted from E.R. Yescombe, Public-Private Partnerships: Principles of Policy and Finance

Equity investors may also receive tax benefits from their investment. The tax benefits of equity investment (depreciation and amortization deductions shielding other taxable income) may account for 10 percent or more of the project's value to the investor. These tax benefits vary over the period of the agreement and can be factored into the bids of project sponsors.

There are different types of equity investors. Each has different preferences for projects based on their capacity to manage different types of risk:

  • International toll road companies. As a result of their technical skills and experience with other projects, these companies are well positioned to evaluate and manage construction and operations and maintenance risks. They typically serve as the concessionaire on a project. By investing their own funds in a project, they may create business opportunities, attract other private capital, and participate in any upside gains from higher than expected net revenues. They are also more exposed to risk, should a project fail. As a result, they have a strong incentive to conduct due diligence before investing in a project and managing a project so that it is positioned for success.
  • Major infrastructure construction firms. These companies specialize in construction, project management, and operations and maintenance of infrastructure projects. They may participate in a concession as a concessionaire or as a subcontractor to the concessionaire.
  • Financial equity funds. These financial institutions have access to large amounts of capital and are skilled at assessing financial risks. They tend to act as shareholders to a project and may bring specific sector expertise.
  • Public pension funds are interested in investments that may offer stable long-term returns.
Private Lenders

Private lenders are often investment or commercial banks that specialize in project finance. They tend to be more conservative and have a lower risk tolerance than equity investors. They require lower rates of return than equity investors, but they seek to structure deals that minimize their risk by ensuring that they have first call on the net cash flows of a project.

Lenders assess the risks of a project to determine if it is a good credit risk. They want to see that there is a reasonable expectation that the project can be completed on time and on budget; that the revenues and expenditures are relatively predictable; and that projected net cash flows are adequate to cover interest payments. If lenders perceive that a project is less risky, they may be willing to lend more. If lenders perceive more risk, they will demand greater investment of equity, thereby raising the overall cost of the project.

Lenders maintain oversight responsibilities throughout the term of their loan and may retain "step-in" rights that allow them to take over a project that is not meeting expectations. Private lenders have an interest in being paid back as quickly as possible and often structure loans to encourage refinancing after an initial period of project ramp up. As a result, equity investors often seek to refinance their loans after seven to 10 years. Prior to the 2007/2008 financial crisis, refinancing of loans at lower rates and shorter terms often led to substantial increases in rates of return for equity investors. Today, due to uncertainty in the financial markets, refinancing represents more of a downside risk to equity investors.


The proceeds from bonds sold to investors in the capital markets may also be used to fund a project. Bond buyers are typically institutional investors such as insurance companies and pension funds looking for a predictable long-term return on investment. Bonds offer advantages over commercial loans such as greater capacity, lower costs, and longer terms; however, they can be less flexible instruments.

Municipal Bonds

Bonds issued by the state or local governments are termed "municipal bonds." Bond investors are often willing to accept lower interest rates on municipal bonds than other types because they are generally exempt from Federal income tax and most State and local taxes. There are many different kinds of municipal bonds that can be issued to help finance transportation projects including general obligation bonds, revenue bonds, and grant anticipation notes. In addition to project revenues, municipal bonds can be repaid from revenue sources including State gas taxes and other transportation-related revenues; Federal-aid funds; tolls; and State and local sales taxes.

The interest rates that must be paid on bonds are determined by market demand. That demand is heavily influenced by the project's credit ratings as determined by rating agencies (if the bond will be repaid through project revenues) or by the issuing government's credit history and financial circumstances. Rating agencies evaluate a wide variety of potential risks associated with the bond issuer and the project's projected costs and revenues before applying a credit rating. Figure 3-3 shows an example of how different credit ratings may influence the interest rates, or yields, demanded by the market. Typically, the longer the term of the bond and the lower the credit rating of the project, the higher the interest rate demanded by the market.

Project Finance Bonds and Private Activity Bonds

An SPV may issue taxable project bonds or seek to use private activity bonds (PABs) issued by a public sector conduit issuer. Because project finance bonds issued by the private sector are taxable and financially riskier, buyers typically demand a higher rate of return. Project finance bonds typically receive much lower ratings from ratings agencies than general obligation municipal bonds do. This is because project finance bonds offer no recourse beyond project cash flows. If a project fails to produce sufficient revenues, bond holders may not get paid. Project finance bonds often struggle to achieve investment grade ratings from ratings agencies and private project sponsors often must adjust a project's capital structure to reach investment grade. Prior to the 2007/2008 financial crisis, default insurance could be purchased to make the issuance of project finance bonds more attractive to buyers. The collapse of the bond insurance market has made it more difficult to finance projects through project finance bonds.

Figure 3-3. Illustrative Tax-Exempt Yield Curves (Interest Costs)

Figure 3. Illustrative Tax-Exempt Yield Curves (Interest Costs)

Federal Assistance

In recent years, most P3s in the United States involving private financing have been supported by Federal government programs such as credit assistance from the Transportation Infrastructure Finance and Investment Act (TIFIA) and allocation of Private Activity Bonds. The TIFIA program can issue long-term subordinate debt to revenue-financed projects of national significance. TIFIA credit assistance can lower the amount of private sector financing needed and the costs of that financing by assuming a subordinate position in the cash flow waterfall of a project. This means that TIFIA interest costs are paid only after the interest on private debt is paid. Private Activity Bond allocations allow State and local governments to issue tax-exempt bonds on behalf of infrastructure projects with significant private involvement.

Potential Revenue Sources for P3s

Project revenues for P3s can come from various sources. The most common source of revenue for a P3 project is project tolls. In many P3 projects, the revenues for a project come exclusively from tolls. Toll-based P3 projects may be undertaken with minimal financial contributions from the public sector. The private sector may agree to design, build, operate and maintain a project in exchange for the future revenues derived exclusively from the project itself. Future toll levels are typically established to in the P3 agreement. The public sector effectively transfers demand risk - the risk that facility demand will be less than expected - to the private sector. If demand for a facility does not materialize private investors stand to lose their investment.

In recent years, potential project investors have been more reluctant to accept a high degree of demand risk. Many P3 agreements in the United States now include revenue sharing agreements and a mix of public and private financing. Some P3 agreements use availability payments, where the public sector pays the private sector an agreed upon annual or monthly fee for meeting performance standards set in the agreement.

Public agency contributions to a P3 agreement can be derived from various revenue sources. Typical revenue sources include State and local gas and sales taxes, as well as Federal aid funds. P3s may also be structured to take advantage of non-traditional revenue sources such as local option taxes, parking and other fees, tax increment financing, and tax assessment districts. However, nontraditional revenues may be viewed by potential investors as less stable sources of revenue and, as a result, may be more difficult to leverage. As a rule of thumb, the broader the base from which a revenue source is derived, the more stable the revenue source. For example, statewide sales taxes and gas taxes are generally considered more stable than local property taxes. See Table 3-2, for a more detailed explanation of typical P3 revenue sources.

Table 3-2: Typical P3 Revenue Sources

Revenue Source Advantages Disadvantages

Direct user fee, may create stronger performance incentives for a facility operator.

Revenue risk can be transferred to the private sector.

Tolling structure may include market pricing mechanisms that create economic benefits.

Traffic and revenue forecasts can fall short of actual revenues.

Use of additional toll revenues may be constrained within pre-defined limits of the corridor to address geographic equity concerns. Few facilities can be fully financed on toll revenues alone; recent experience shows that most projects will require a combination of revenue sources to work.

Costs of collection may be higher than other revenue sources.

State fuel taxes

Indirect user fee.

Revenues are not directly associated with the use of a specific project, but related to general use of highway network, therefor they may be relatively stable.

Low cost of collection.

Yield declining over time since they typically do not increase in line with inflation and improved fuel efficiency and introduction/growth of alternative fuels lead to lower fuel usage.

Significant demand from competing priorities/interests.

Federal-aid highway funds and discretionary funds Derived from federal fuel taxes - a relatively stable revenue source and an indirect user fee.

Yield declining over time, see above.

Federal funds are generally linked to regulations and contracting requirements (e.g., NEPA, Davis-Bacon, etc.) that may be more demanding than the requirements of other revenue sources.

Once obligated or awarded, Federal funds, grants and earmarks must be used within a specific timeframe (generally three years).

Sales taxes Relatively stable revenue source, though subject to influence of economic growth and recession.

May create market distortions because it is not aligned with the "user pays" concept.

Some of the local option taxes or those dedicated for specific uses may have a "sunset" date that may or may not be aligned with the length of the P3 agreement.

Value capture
Impact fees
Special assessments
Tax increments
Development contributions Joint development /development rights

May capture economic value created through infrastructure improvements that is not captured by other sources.

Value capture options can be chosen based on regional/local conditions and project needs.

Subject to the volatility of the real estate market. Rated low by bond rating agencies.

Yield may be low for major projects; likelihood of requiring other revenue sources is higher.

There can be concerns about the public sector being a "landlord."

Policy issues related to eminent domain takings (if any required for the project) being turned over to the private sector for profit.

Ancillary revenues
Rest stops
Utility/fiber optics on highway right-of-way
Air rights
Encourage private sector to optimize potential revenue options, reducing the need for limited public resources Yield is relatively low; cannot be considered as standalone funding sources, but as part of the "revenue portfolio."

None of these revenue sources is exclusive to P3s, but the information regarding the advantages and disadvantages is presented from that perspective. It is also important to note that this list represents some of the revenue sources available today, and it may change over time. For example, fuel taxes are the main revenue source for highway and transportation investments, yet given their declining yield due to the introduction of more fuel efficient and alternative fuels, some practitioners are exploring revenue options, such as mileage-based user fees to replace fuel taxes over the long term.

Notice that the table above does not include two items that are sometimes counted as revenue in public discourse: debt and equity. Oftentimes, debt is used to help fund a project or program of projects, and when looking at the project financial pro forma, debt shows up in the "revenue" category. This is true from the perspective of the project's upfront funding, but debt cannot be considered a long term revenue stream that supports the repayment of lenders and bondholders. Similarly, investors may put up equity at the front end of a project, thereby providing the funds needed to build the project earlier. That equity, however, is offered in anticipation of earning a return on investment over time.

Key Considerations Associated with P3s and Revenues

Revenue from Programmed Toll Increases

Toll facilities typically require periodic toll increases to cover operations and maintenance costs which tend to increase over time. Toll increases for publicly operated toll facilities often get caught up in political debate, so it can be difficult for public toll operators to raise tolls when they need to. In a P3 concession (where toll collection is transferred to the private sector), toll increases are typically defined in the contract and are often tied to inflation. Publicly financed toll facilities may also commit to future toll increases through bond indentures or other means, however, ratings agency typically have more confidence in the ability of privately operated toll facilities to raise tolls as needed. This is because privately operated facilities have stronger incentives to raise tolls and may be more insulated from political influence than publicly operated facilities.

What about the upfront payments from long-term leases?

The long-term leases of the Chicago Skyway and the Indiana Toll Road generated large upfront payments ($1.8 billion and $3.8 billion, respectively). Some may argue that these upfront payments can be considered revenues generated through P3s, especially if those revenues are used to advance other transportation projects, such as it was done in Indiana. In reality, however, the upfront payments are similar to cash advances; the concessionaires will continue to collect tolls over the concession in return for the cash advance. The use of upfront payment revenues is important in that when used to advance other transportation investments, it helps with cash flow issues and can accelerate economic benefits that may not be realized without these investments.

Periodic increases in toll rates for a P3 project do not necessarily mean that there are additional revenues to invest in transportation. In a toll-based P3 agreement, toll revenues are used to pay for debt service, return on investment (ROI) to equity investors, and operating and maintenance expenditures on the facility. If a P3 agreement includes a revenue sharing agreement than a public agency may share in the remaining net revenues once the payments identified above have been made. Only then can additional revenues be realized by the public. In the availability payment model, toll revenues derived from a project are retained by the public agency and the public agency pays the private partner an agreed upon periodic fee. If toll revenues are in excess of the required availability payment than the public agency may choose to reinvest that income in the transportation system or lower tolls on the facility.

Freeing up Revenue for Other Projects

If private equity or debt is used as part of a project funding plan, it could mean that less money is needed from public sources in the short term. This means that the unused money could be used on other projects that may not be attractive for P3 delivery, but that are considered important to meet the transportation demands of the public. As noted before, however, ultimately, the private contribution will need to be paid back by the public, either from tax or toll sources, so what may appear to be increased revenue is really just a matter of adjusting the timing of the revenue.

Obligating Future Revenue on a Specific Project

A P3 that uses availability payments may dedicate public funds for decades on an individual project. The availability payment model obligates the private partner to maintain certain performance standards, which will encourage them to make timely investments in the facility's upkeep. This kind of asset management should reduce the life cycle cost of the project, and ensure that the facility remains in acceptable operating condition.

The implication of an availability payment agreement, however, is that the projects that are subject to these agreements will receive top-notch care (if the performance measures are written in that manner), while others may suffer from neglect. With contractual obligations to make availability payments, government loses the flexibility to allocate revenue where it may be most needed. This can impact the overall revenue picture for the entire highway program in a region.

Stability of P3 Revenue Sources and Need for Multiple Revenue Sources

Revenue sources must be stable and have an adequate yield over the long term to repay P3 debt and equity. Tolls and taxes are usually stable revenue sources, and tend to be rated higher by credit rating agencies. Ancillary revenues, such as revenue generated from right of way leases, rest stop concessions, or the sale of advertising or air rights, tend to have relatively low yields, and value capture revenues are typically volatile, thus are best when combined with other revenue sources as part of the P3 debt/equity repayment plan. Therefore, not all revenue sources are equal, and some are of higher quality than others.

In most cases, several financing and funding sources are combined to provide capital for the initial construction of a project, and several revenue sources are bundled to repay debt and equity in a P3. It is rare that a project can be "self-financed" through tolls, without requiring any form of up-front contribution from the public sector. In many cases, more than one revenue source (e.g., ancillary revenues in addition to tolls) is required repay all of the investment over time. However, this is not unique to P3s. On both P3 and traditional project development models, project sponsors have to use a mix of approaches to develop a plan that meets all the needs of a project.

Restrictions on Uses of Revenue

P3 legislation in most States allow public and private sector funds to be combined, although legislation in some States does not include explicit provisions that allow it (e.g., Alabama, Maryland, Minnesota, Missouri and South Carolina).

Some revenue sources have a shelf-life. Grants and discretionary funds may have time limitations, and some State/local revenue sources (such as sales taxes) may expire after a certain date, requiring voter approval to be extended beyond that period. For a P3 project using availability payments, the revenues dedicated to make the annual payments must have a life span that extends through the concession period. Those revenue sources with a shorter shelf-life can be used to make payments in the early stages or be used as backstop during period of high risk (e.g., construction, and ramp up period for toll roads).

Another concern with availability payments is whether these payments are contingent upon annual appropriation. For instance, the Florida statutes on P3s allow FDOT to use availability payments but include the following two provisions:

  • "The annual payments under such agreement shall be included in the department's tentative work program... and the long-range transportation plan for the applicable metropolitan planning organization... The department shall ensure that annual payments on multiyear public-private partnership agreements are prioritized ahead of new capacity projects in the development and updating of the tentative work program"
  • "The annual payments are subject to annual appropriation by the Legislature as provided in the General Appropriations Act in support of the first year of the tentative work program." Although availability payments are prioritized in the agency's work program, there is a risk to the concessionaire associated with the State's annual budgeting process.
Restrictions on the Use of Federal Funds Related to P3

Federal funds come with some restrictions that may affect their applicability for P3s, such as specific criteria for the types of eligible projects and activities that can be funded with Federal-aid highway programs. For example, Interstate Maintenance funds are for capital investments associated with resurfacing, restoring, rehabilitating, and reconstructing Interstate highways. Projects eligible for Congestion Mitigation and Air Quality (CMAQ) funds must demonstrate air quality benefits and be located within nonattainment areas, among other factors. There are similar restrictions with other Federal-aid highway programs. In some cases, even after flexing of Federal-aid highway funds is considered, States may find it difficult to align the available funds with their priorities. Federal funds also have matching requirements. Title 23 regulates what can be used as match, including flexible match (i.e., other Federal funds, or third party donations). In addition, any project funded with Federal money must meet specific requirements (e.g., NEPA, Davis-Bacon, DBE, Buy America, etc.) that can add to the complexity of administering a project or otherwise increase project costs.

Lastly, Federal funds can only be used on capital expenditures; States are responsible of operating and maintenance (O&M) expenses of any Federally-funded project, including P3s. Therefore, for a project delivered under the availability payment model of P3s, Federal funds cannot be dedicated to make the annual payments to the concessionaire, unless it pays for 4R expenses, or a clear distinction is made that the Federal funds are being used to pay debt associated with the initial capital investment.

Pricing Financial Risk

Whether revenues are derived from tolls or other sources, public agencies seek to structure a P3 agreement that achieves public benefits and can attract private financial resources. Potential private project sponsors determine whether and how much to invest or lend to a project based on an evaluation of projected project cash flows and associated risks. Both equity investors and lenders assess the extent and likelihood of project risks and price those risks. To the extent that investors and lenders perceive risks to projected net revenues, investors will demand a higher rate of return and lenders will demand a higher interest rate.

To determine the value of a P3 agreement, the public agency and private investors each develop a financial model that forecasts cash flows and project costs and assesses project risks. The financial model may include projections and assumptions related to constructions costs; operations and maintenance costs; capital expenditures; debt schedules and financing costs; tariff schedules, usage rates and toll and non-toll revenues; and inflation and tax rates. The results of the model illustrate project cash flow under different assumptions.

Investors are interested in the project's internal rate of return or return on equity. If investors decide that there is a good chance that they can meet a defined internal rate of return (IRR) or "hurdle rate" then they will make a bid. The IRR calculation is a measure of how well an investment pays off over time, and allows investors to compare different types of investments to decide where to invest their capital. Different investors have different hurdle rates. Lenders are primarily concerned with the projected debt service coverage ratio, or the amount of annual cash flow available to meet debt service payments in a given year, and the quality of the analysis that led to the project. Lenders generally expect a minimum of debt service coverage ratio of 1.2 or higher.

The financial model reflects assumptions made about risks, the allocation of risks, and the value of money over time. It enables decisionmakers to make informed choices about how to structure the agreement, set tariff and subsidy levels, and allocate and mitigate risks. Investors factor risk into their valuation of an agreement by identifying risks, estimating the extent of each risk, the timing of each risk, and the probability of each risk occurring. Since risks to a project vary over time, these risks may be applied to projected project cash flows at different levels over the period of the project. The value of a P3 is ultimately arranged along a probabilistic curve that states the estimated probability of achieving a certain value.

Since risks have costs associated with them, the private sector will not take on risk unless it expects to benefit. Therefore, the private sector will attach a risk premium, or higher cost, in order for it to take on and manage a particular risk. The private sector does not decide upon risk allocation and risk premiums lightly and relies on extensive analysis. It is up to the public sector to decide whether to pay that risk premium or retain the risk. The amount of risk premium may be an indicator to the public sector of the magnitude of the risk, which will help them make a more informed decision. However, it can be difficult for the public sector to determine which project elements have led to a higher risk premium on a project. It is also important to note that the public sponsor cannot know the risk premium in advance with any certainty. It can be difficult to design a procurement process that allows them to choose which risks to transfer - a so-called "cafeteria plan."

How an investor values future cash flows is reflected in the discount rate applied to future cash flows. Variation in the discount rate can have a major effect on an investor's valuation of a project. Despite the discounting of revenues in the later years of an agreement, longer-term agreements may be more attractive to investors due to potential tax benefits of anticipated depreciation, amortization, and interest rate deductions. In addition, equity investors may anticipate refinancing a project on more favorable terms once construction is complete and the project has been fully operational for several years, when the uncertainties associated with the project are significantly less. Often, however, the concession agreement will stipulate that any savings from refinancing need to be shared with the public sponsor.

The public sector will develop its own financial model and apply its own evaluation process to help shape appropriate agreement structures and determine acceptable bids (for a detailed discussion of public sector project evaluation processes see Chapter 2, Decisionmaking.) The public sector may use cost benefit analysis or Value for Money (VfM) tests to determine whether to go ahead with a P3 approach, evaluate bids, and set an acceptable level of subsidy. VfM tests use a public sector comparator to determine whether a P3 would be better than more traditional public sector delivery methods. Using a public sector comparator, the public agency models the net present value of a project using traditional project delivery methods versus a P3 delivery. Qualitative factors are also considered in conducting the analysis. Procurements based on VfM tests help achieve a best value selection of a bidder, rather than the traditional low-bid selection. VfM analysis can help a public agency better understand project risks and determine the optimal allocation of those risks.

Potential Advantages and Disadvantages of Equity-Financed P3s

This subsection contrasts the advantages and disadvantages of the P3 approach from the perspective of financial considerations. Table 3-3 provides a summary of the considerations.

Table 3-3. Financial Advantages and Disadvantages of Traditional and P3 Financing

Financing Approach Advantages Disadvantages
  • Generally cheaper
  • Smaller or no "learning curve"
  • Quicker, less complex transactions
  • Funding may be inadequate or permit only a piecemeal approach
  • Government retains all financial risk
  • Short-term budget process limits resources and options for life-cycle cost management
  • Debt capacity is limited by law and policy
  • Leverages more up-front capital resources
  • Transfers financial risk from public sector (for a price)
  • Provides incentives for early, on-budget completion and better life-cycle cost management
  • Debt owed by private parties does not count against the government's debt limit
  • Standalone project financing can insulate government from bad investments (though non-recourse municipal debt can do the same).
  • More rigorous analysis of costs, benefits and risks
  • Typically higher cost of capital, although the additional cost may be offset by the risk transfer
  • Complex and lengthy transaction
  • Potential for greater public controversy
  • Higher management and oversight costs
  • Potential for lost residual revenues (unless adequately dealt with in contracts)
  • Availability payments obligate government to future payments, thereby limiting its flexibility in allocating revenue to projects.
Potential Financial Advantages of P3s

Florida's Limitations on P3 Obligations

When Florida authorized the use of P3s, it explicitly limited the amount of funding that can be obligated for future payments to 15 percent of its five-year work program. This is one potential mechanism to prevent public agencies from over-committing future resources to P3 projects.

Equity-financed P3s have the potential to generate benefits for a project or program of projects by:

  1. Providing an alternative to public sector debt capacity for legal, political or other reasons;
  2. Leveraging greater amounts of upfront capital for the same revenue stream as comparable public sector financing;
  3. Facilitating the financing of projects that cross multiple public jurisdictions;
  4. Allowing the public sector to transfer financial risks, thereby creating stronger incentives for at-risk private partners to conduct due diligence; and
  5. Creating incentives to reduce the long-term life cycle costs of maintaining the asset.
Providing an Alternative to Public Sector Debt Capacity

Legislative, constitutional or policy restrictions on a State's or agency's ability to borrow in the public finance market are often the primary reason why a public agency decides to seek out private financing for a project. In some cases, legal covenants restrict how much of a revenue source can be pledged to debt, the term of the debt that can be assumed, or the overall amount of debt a government can take on. In cases where a public agency is unable to issue sufficient debt through the municipal bond market to raise the capital needed to fund a transportation project, private financing may provide a viable alternative.

It is important to recognize that whereas some P3s transfer future financial risk away from governments, others (particularly those featuring availability payment or shadow toll structures) retain such risks over time. These techniques may still provide benefits, but governments will need to consider the level of future payments that are obligated to such projects as a part of their broader work program.

Leveraging Upfront Capital

Private entities may be willing to take on more financial risk than public agencies by borrowing more against a given revenue stream. Some public agencies may be less willing and less able to issue debt as aggressively as the private sector. A public jurisdiction has numerous demands on its debt issuance capacity. In addition to transportation projects, other capital projects that may require debt financing include schools, hospitals, and water and sewer facilities, as well as other government buildings. Since a default could affect all government operations, not just the single project, governments may be less willing to take on financial risks than private investors.

The private sector may be able to achieve greater financial leverage on a project by being more willing to accept projections of higher revenues or lower costs, or financing projects at lower coverage levels than the public sector. In general, public sector debt issuances have to have a higher ratio of forecast pledged revenues to the debt service requirement. Typical coverage levels for public debt are 1.5 times forecast revenue, while commercial loans can be in the range of 1.2 times. Thus, a given revenue stream will yield less upfront money for the public sector than the private sector. Despite these differences, private investors have become considerably more cautious in recent years as traffic (and revenue) flows have leveled due to the recession of 2007/2008. Their appetite for taking on higher risks may have cooled, and it remains to be seen if that caution is maintained into the future.

Catalyzing Project Debt Issuance for Projects that Involve Multiple Jurisdictions

Many P3 projects involve multiple government jurisdictions, such as counties, cities, States, and toll authorities. For a project that crosses multiple jurisdictions, it may be difficult for one jurisdiction to bear the responsibility of issuing all the debt. At the same time, it is difficult for the other jurisdictions to provide guarantees and pledges to back up the debt of an issuing jurisdiction. Sometimes, this problem can be solved by creation of a special authority that crosses the relevant jurisdictions - but that may just create another level of government solely to carry out a single project.

Private equity finance, by contrast, can allow multiple public jurisdictions to pledge either upfront or ongoing revenues, without taking on the debt issuance risks on behalf of the other jurisdictions. In an equity-financed P3, public and private financing for a project goes to a special purpose vehicle (SPV) set up solely for the purpose of administering the project, which limits exposure to financial risk.

Providing a Financial Incentive for More Robust Due Diligence

In many P3s, private sector participants - both investors and lenders - have capital at risk, so they have financial incentives to ensure that the contracted services are provided. Private sector lenders want to be sure that the project to which they are lending is financially sound throughout the term of the loan. Therefore, they can be expected to conduct due diligence before issuing a loan and independent oversight of a project throughout the period of their involvement. The additional due diligence imposed on privately financed P3s means that risks may be more likely to be identified, assessed, and mitigated than when using traditional delivery methods. Evaluations of projects financed through public bond issuances tend to be done tend to be based more on the credit rating of the issuer than the project.

Protecting General Revenue from Project Revenue Shortfalls

P3s can be one way for governments to make sure that general tax revenues, or the toll revenues from pre-existing toll projects, are not at risk in the event project revenues do not materialize as expected. Non-recourse revenue bonds have been used for decades to achieve this purpose. P3s provide yet another mechanism but one for which governments need to be wary of either contractual or implied promises that weaken this protection. This has not generally been an issue in U.S. public finance, but there are situations abroad where revenue risk was not adequately transferred in the P3 transaction. In fact, there are several cases in the United States of P3 projects where lower than expected revenues led to private sector losses, but, because of the P3 contract the public sector was shielded from losses. For example, the original investors in the Dulles Greenway, a P3 project completed in 1995 in northern Virginia, took substantial losses when initial traffic was less than half of what investors had anticipated. While the private partner was forced to lower its tolls to attract traffic and restructure its debt, the public sector had no funding at risk and lost nothing.

Spanish Concession Program: Unintentionally Retained Risks

Under the Spanish concession program, the private sector was supposed to take the financial risk. However, the contracts were written such that the government owed the concessionaire compensation if the concession terminated early for any reason - including bankruptcy. This meant that the government was on the hook for revenue, regardless of the P3 structure.

Improving Performance and Life Cycle Cost Management

A well-designed P3 agreement can align the incentives of public and private partners in such a way that the private partner has a strong incentive to complete a project on time and to make cost-efficient investments throughout the life of the project. P3 agreements are typically structured so that the public sector pays the private partner only when the facility is complete and performing to agreed-upon standards.

P3 agreements typically involve a commitment on the part of the private project sponsor to operate and maintain a facility at a specified standard for the duration of the agreement. In bidding for a contract that includes long-term O&M private firms factor in the projected long term costs of achieving the stated O&M standards into their bids. Project revenues are dedicated to maintaining the facilities at the stated standards prior to reimbursing creditors or investors. This gives the private participant a strong incentive to minimize long-term maintenance costs by applying the most cost-effective treatments at the appropriate time so that it can maximize its long-term net revenues.

This is in contrast to traditional means of project maintenance by public agencies where funding constraints can thwart efforts to apply both routine maintenance and rehabilitation treatments required on aging roadways, even when such treatments would be the more cost-effective over the long-term. As a result, they end up applying short term treatments that end up costing the public more in the long-term.

Potential Financial Disadvantages of P3

The costs of private financing of transportation projects must be taken into account and weighed against the benefits when considering a P3 (see Figure 3-1). The costs and complexities of private financing such as higher transaction costs, higher capital costs, lost revenue opportunities, and hidden risks make using such an approach appropriate only for certain projects.

More Lengthy and Costly Transactions

Private financing can add complexities and costs to the project delivery process and can be difficult to explain to the public. P3 contracts can be lengthy and complex and require more time and resources to develop and monitor than traditional contracts. Due to the complexities of P3 agreements, it is important to acquire or develop the appropriate legal, financial, and technical expertise to execute an efficient agreement. Implementing a P3 procurement process can take several years from the beginning of P3 investigations to financial close. Due to the length and complexities of such transactions, private financing will only be appropriate for large projects, although Canada's experience indicates that as P3 transactions become routine, the costs and timelines should decrease.

Higher Cost of Capital

SR-91 Express Lanes

Completed in 1995, the 10-mile, four-lane section of California State Route 91 (SR-91) known as the SR-91 Express Lanes was constructed with $135 million of private funds under a 35 year concession agreement. It was the first fully automated electronically tolled road in the world. The project was a financial success; however, a clause in the contract that limited improvements to parallel, "competing" infrastructure within the SR-91 Express Lanes corridor proved untenable for the public sector and led to litigation. To alleviate the issue, Orange County Transportation Authority (OCTA) purchased the concession for $207 million in 2003. OCTA now has more control over toll levels and operates the road under a private contractor. The SR-91 Express Lanes remains financially successful and has generated over $150 million in net revenues for OCTA to date.

Private capital tends to be more expensive than public capital because the public sector has the advantage of tax-free municipal bonds. Private debt is not tax-exempt and the private sector also requires greater returns for assuming the greater risks associated with P3 agreements. This "risk premium" is reflected in the higher financing costs of private finance compared to public financing. The interest costs on public bonds may range from 4 to 7 percent, while private financing costs may be 8 percent or higher.

Lost Revenue Opportunities

P3s may commit a dedicated revenue source, typically tolls, to a private project participant for periods typically ranging from 30 to 99 years. These dedicated revenues allow the private firms to cover initial capital and ongoing O&M and financing costs and to profit. Anticipated project revenues as well as costs are reflected in the competitive bids made by private firms. But if actual revenues are much higher than anticipated, a private firm can receive a windfall. Using traditional public financing, any revenues above and beyond project costs would belong to the public sector. Most recent P3s have revenue sharing arrangements in the event of "excess" revenue to eliminate the potential for windfall profits.

Poorly Transferred or Unintentionally Retained Risks

The value of a P3 can hinge on the extent to which certain risks are transferred and on the costs of transferring or retaining those risks. If revenue risk is not adequately transferred to the private sector in a P3 and future revenues do not materialize, the public sector may have to cover the shortfall. That is, the public sector may end up bailing out a failed concession in order to maintain an operational road. Although there are no examples of this in the United State, the concession program in Spain did not adequately insulate the government from the need to step in when concessionaires went bankrupt.

Structuring Agreements to Optimize Risk Transfer

The primary value proposition of the P3 project delivery approach is that it allows for the optimal allocation of project risk. Project risks include, but are not limited to, financial, design, construction, maintenance, operations, demand, regulatory, and asset ownership risks. In structuring a potential P3 agreement the public agency decides which risks to retain, which risks to transfer, and which risks to share. The private partner may in turn transfer risks to subcontractors, insurers, and other parties.

Different types of project delivery agreements transfer different risks. However, risks are not always apparent and the true allocation of risk to various parties may not be known until a negative event occurs. In practice, many project risks are not, or cannot, be wholly transferred to the private sector, and the public partner inevitably retains significant risks.

Risks should be transferred to the party best able to control them at the lowest cost. Where the private partner has limited control over a risk, it may be optimal for the public agency to retain that risk. Risks that private investors may be able to effectively control include: design and construction risks, finance risks, operations risks, and maintenance risks.

Potential project bidders are also concerned with risks associated with the bidding process itself. It can cost millions of dollars to develop a competitive bid for P3 procurement. As a result, bidders will have a strong interest in a procurement process that they believe is fair, open, and transparent and that has a reasonable likelihood of the agreement being completed. Once a project is underway, private investors anticipate the greatest uncertainties in design and construction costs and demand, or facility usage. Operations and maintenance costs are perceived as less of a risk because they are a smaller portion of the overall costs and they occur in later periods of the agreement and are therefore discounted. Facility usage, or demand risk, is often the greatest risk that private investors are asked to take on, but it is a risk over which they have limited control.

For toll projects the projection of toll revenues is central to the evaluation of cash flows. In projects where the primary revenue stream is tolls, how private investors assess the value of a toll-financed project will depend on their projections of potential toll revenues. Forecasting demand on new toll roads and lanes, however, is not a simple task. The uncertainty associated with toll forecasts will be factored into a potential investor's assessment of project risks and their willingness to invest in a project. Investors that are more speculative may be attracted to the potential upside gained from assuming demand risk. If demand for a facility is higher than anticipated, they will be positioned to capture residual revenues, subject to revenue sharing contract provisions.

Availability Payments: A Different Risk Transfer Approach

In recent years, there has been a trend away from P3 projects where private partners assume demand risks. The 2007/2008 financial crisis continues to impact financial markets, making it more difficult and more expensive to assemble private capital. The loss of the bond insurance markets and a newfound conservatism among senior debt lenders has led public agencies to find new ways to structure P3s to mitigate or retain risks that private investors no longer find acceptable. Given the limited capacity of private capital markets to take on risk, publicly subsidized debt mechanisms and credit assistance are more likely to be required to ensure that sufficient capital can be raised to complete P3 agreements. Most recently closed P3 agreements include a mix of public and private capital invest as well as the use of various contract mechanisms that limit the private sector's exposure to risk.

Rather than ask the private sector to rely on tolls for project revenues, public agencies have offered fixed availability payments to the private partners based on performance of the facility to standards. In the availability payment structure, private partner revenues are not dependent on tolls. The public partner commits an annual payment to the private partner for maintaining and operating the facility to a specified standard. If the project is a tolled facility, the public partner retains the revenues from the tolls. To determine the amount of the availability payment, private sector bidders submit bids based on the maximum annual payment they would require. Figure 3-4 provides a comparison between availability payments and toll-based revenue for P3s.

Figure 3-4. Characteristics of Availability Payments vs. Toll-based Revenue Risk P3s

Availability Payments Toll-based Revenue Risk P3
  • Payments are made for a fixed amount on a periodic basis
  • Potential concessionaires bid on required payment amount
  • Bid amounts depend on the concessionaire's expected project costs, likelihood of achieving performance standards, and desired return on investment
  • Payments begin when facility is open to traffic (although progress payments can also be included)
  • For toll-based projects, public sector sets toll rates and receives toll revenues
  • Public sector imposes financial penalties for failure to meet performance standards, such as lane availability, exist
  • Private investors may perceive less risk and be more willing to invest
  • Revenues are generated from tolls
  • Potential concessionaires may bid on amount paid to public agency for revenue stream or required payment amount
  • Bid amount depends on estimates of likely costs and revenues and desired return on investment
  • Payments depend on toll rate schedule (usually set in the agreement) and facility demand
  • Concessionaire captures residual revenues, usually subject to maximums
  • Legal and financial recourse is established for failure to meet performance standards

There are a number of reasons why a public agency may choose to use availability payments instead of toll-based payments. Availability payments may be used in cases where tolling is infeasible long-term project costs. If this is the case, the public sector will have to identify an alternative source of revenue to make the payments. Availability payments may also be used if the public sector wishes to retain traffic risk because the private sector demands too high of a risk premium. In the case of Florida I-595, one of the reasons Florida DOT chose to use availability payments was to retain the ability to dynamically manage toll rates to optimize mobility along the corridor. Availability payments may be more attractive to potential private sector investors that are averse to taking on risks outside of their control. This can help to lower project financing costs and overall costs to the public agency.

With the availability payment model, potential private partners no longer assume demand risk. This may make it easier to attract capital and allows the project sponsor to focus on managing risks associated with construction, maintenance and operation of the facility. Whereas the ratio of debt to equity in a demand risk deal may be 80/20; in an availability payment deal the ratio could be 90/10. Whereas a private operator of a toll facility may adopt practices to maximize throughput, there is little the private operator can do to manage demand risk that is largely dependent on exogenous factors such as economic development and the performance of other transportation facilities in the network. With availability payments, private sector bids are more likely to be based on the bidder's ability to manage risks associated with construction costs and operations and maintenance of the facility rather than divergences in traffic modeling assumptions.

It should be noted that the use of availability payments results in the public sector retaining greater risks than in P3 agreements where demand risk is transferred. If project revenues are less than expected it is the public agency that must make up for the shortfall. Alternatively, if demand is greater than expected, the public agency is positioned to capture any windfall. The I-595 Express Toll Lanes is an availability payment project where the public sector is responsible for collecting toll revenue, but relies on other sources as the basis for its long-term responsibility to pay the concessionaire. Availability payments may be paid from the State transportation trust fund and Florida Turnpike Enterprise. Toll revenues offset the obligations from these sources.

Availability payments represent one way to structure P3 contracts where the public sector retains demand risk, the risk that demand for the facility is lower than expected leading to lower than anticipated revenues. This structure may allow the public sector to attract more bids that are competitive and keep financing costs down. In addition, availability payments eliminate the public relations risk of a private firm potentially reaping windfall profits if facility demand is higher than anticipated. Other alternative approaches to P3 contracting, such as dynamic concession terms, can also be used to ease the risks of future revenue for both the public and private partners.

Like public debt, availability payments represent a significant long-term commitment of funds for the maintenance of infrastructure at specified standards that may limit the public agency's financial flexibility in the future. Furthermore, while the public agency may demand, and be willing to pay for, the operations and maintenance of facilities to high standards in an availability payment concession, it may be unable to maintain the rest of the transportation system to such standards due to financial constraints.

Other Ways to Share Risks

If the public agency is uncomfortable retaining all of the demand risk, there are alternative contract mechanisms that can allow it to transfer some portion of the demand risk. For example, the public agency can guarantee an agreed-upon amount of annual revenue to the concessionaire and require sharing profits if the project revenues are greater than expected.

Another alternative contract mechanism allows for a flexible agreement term. The terms can be set so that the concession terminates at a pre-determined level of gross revenue (in present value terms). If projects yield more revenue than expected, the term is shorter; conversely, if there is less revenue, the term is extended. This allows the public agency to offer fair compensation for the equity contribution without affecting general government revenue. In the case of toll projects, however, it will be toll payers carrying the burden for a longer period.


P3s include a potentially powerful suite of financial tools that allow governments to accelerate the delivery of projects and to do so more efficiently. However, P3s are not a financial panacea. Private participation in project finance may allow greater leveraging of future revenue streams than traditional public sector financing, but such participation does not create revenue. Private participation in project financing can create significant benefits for appropriate projects, but private financing can do nothing without the promise of future revenues, whether taxes or tolls.

Research Needs

Additional research may help clarify some of the additional opportunities and challenges associated with P3 financing for long-term concessions. Among the research needs are:

  • What are the realistic public alternatives to compare to P3 concession financing rather than traditional public financing?
  • How much in financial loss has been avoided by the public sector in past domestic P3s? How much future revenue has the public sector foregone?
  • What financial models can be used to estimate financial risks in a P3 transaction (in order to allocate it between public and private parties)? How successful have the models been at predicting outcomes?
  • How can a State compare a "system pledge" with a standalone P3 financing?
  • How has lender behavior changed since the downturn of 2008? How has this affected the current P3 lending market?
  • How have rating agency criteria changed since the downturn of 2008? How has this affected the current P3 lending market? Do criteria differ for public and private borrowers?
  • How do private financial structures differ from those available to public agencies (e.g., greater capacity, higher cost, greater or lesser flexibility, shorter or longer tenure, etc.)? What are the advantages and limitations of each?
  • What is the actual financial advantage of depreciation in a transaction?
  • How does discount rate affect the analysis?
  • How does the market view appropriations risk for availability payment financings? How are future availability payments counted against debt ceilings under statute and by rating agencies? What are some lessons learned from past availability payment financings?


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