Are Public Private Transaction the Future Infrastructure Finance

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Public Works Management & Policy

DOI: 10.1177/1087724X07303680

2007; 12; 320Public Works Management PolicyKathleen Brown

Are PublicPrivate Transactions the Future of Infrastructure Finance?

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ARE PUBLICPRIVATETRANSACTIONS THE FUTURE OF

INFRASTRUCTURE FINANCE?

KATHLEEN BROWN

Goldman, Sachs & Co., Los Angeles, California

Demand for infrastructure in the United States continues to grow dramatically

while governments at all levels struggle to balance their budgets. As a result,

state and local governments are looking more to nontraditional sources of financ-

ing for their capital and operating needs. Public Private Partnerships (PPP) are

financing strategies that are widely used around the world but are still relatively

new in the United States. Under these agreements, state and local governments

maintain ownership and control of the assets but receive financial compensation

to contract with a private operator who provides operating, maintenance, and/orconstruction expertise for large-scale infrastructure projects.

Keywords: public private partnerships; PPP; P-3; infrastructure finance; inno-

vative financing concession

Demand for infrastructure in the United States continues to grow dramatically while gov-

ernments at all levels struggle to balance their budgets. As a result, state and local govern-

ments are looking more and more to nontraditional sources of financing for their capital and

operating needs. Publicprivate partnerships (PPPs) are financing strategies that are widely

used around the world but are still relatively new in the United States. Under these agree-ments, state and local governments maintain ownership and control of the assets but receive

financial compensation to contract with a private operator who provides operating, mainte-

nance and/or construction expertise for large-scale infrastructure projects.

This market for PPPs is being fueled by the enormous amounts of cash that pension funds

and insurance companies need to invest in steady, predictable long-term cash flows. For

example, when PPPs are used to finance toll roads, the future traffic volume and toll revenues

can be monetized to provide dependable returns to the private investor while future operating

and capital expenditure risk is minimized for the public sector. As a result, in many overseas

markets, the PPP has become the primary source of infrastructure funding for government

transportation agencies. There are various ways to structure a PPP concession, and the result-

ing benefits may vary from a substantial upfront payment, an ongoing annuity, or both. Initial

construction and/or expansion programs can be accommodated under any of these models.

With the successful completion of major PPP transactions in Chicago and in Indiana, with aninvestor class with a strong interest in infrastructure assets, and with a growing understand-

ing and acceptance of the PPP concept in states and local governments, PPPs are emerging as

a key part of the new frontier of infrastructure finance.

320

PUBLIC WORKS MANAGEMENT & POLICY, Vol. 12 No. 1, July 2007 320-324

DOI: 10.1177/1087724X07303680

2007 Sage Publications

Kathleen Brown is head of

public finance for the West

Region at Goldman, Sachs

& Co. and was treasurer of

the State of California from

1991 to 1995, during which

time she was responsible for

managing the states $24

billion investment portfolio

and overseeing all debt

issues for the state.

This market for PPPs is

being fueled by the

enormous amounts of

cash that pension

funds and insurance

companies need to

invest in steady,

predictable long-term

cash flows.

COMMENTARY

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Brown / PUBLICPRIVATE TRANSACTIONS 321

Market Overview

The United States is at a crossroads in its transportation infrastructure lifecycle. Large cap-

ital investments, critical to sustaining our economic growth and quality of life, have been

identified across the nation. Traditional funding sources such as gas tax revenues have not

kept pace with these needs, thereby requiring local governments to search for alternative and

increasingly innovative financing approaches to deliver capital projects. Given the magnitudeof the major capital needs looming on the horizon, state and local governments have been

forced to consider alternative means of financing them, including the significant resources

that can be provided by the emerging global infrastructure market for PPPs.

Although it has been customary for local municipalities to provide the funding for

improvement and maintenance of their infrastructure, they face constraints on traditional rev-

enue sources and are limited in the alternative approaches they can take to finance these

assets. Many states, cities, and public authorities have already amassed millions, if not bil-

lions, of dollars of debt associated with past construction and improvements which limits their

ability to return to the tax-exempt bond market. In addition, the tax-exempt market imposes

strict limitations on the amounts of financial leverage that can be layered onto each asset as

well as other restrictive requirements and fiscal tests.

Highway projects are most typically (and conservatively) financed through motor fuel

taxes, either on a pay-as-you-go basis or to securitize debt. Over the past decade, this revenuestream has been flat or decreasing and is not nearly enough to cover the outstanding mainte-

nance and rehabilitation costs associated with existing infrastructure let alone construct new

facilities. Although these funds can be supplemented by federal programs such as GARVEE1

bonds and TIFIA2 loans, these financing mechanisms, though extremely effective on a project-

by-project basis, are not adequate to address the national infrastructure deficit, nor do they rep-

resent new revenue. They are simply borrowing against future revenue streams. Increasingly, the

public sector is looking to the private sector to finance and operate what has heretofore been

considered public infrastructure projects. Publicprivate partnerships can provide municipalities

with the capital necessary to sustain a healthy transportation system. In addition, PPPs offer

the municipalities a means to monetize the value of selected assets and use this revenue to

accelerate other desperately needed projects.

PPP Overview

PPP TRENDS IN THE UNITED STATES

As this is written, many governments have already used PPPs to meet their capital fund-

ing goals. The State of Indiana found itself faced with a $2.8 billion deficit in its 10-year

transportation plan. After determining that the maximum amount available from tax-exempt

debt financing would be insufficient to fund its plan, Indiana began a PPP concession process,

which concluded with the acceptance of a $3.85 billion bid in exchange for a 75-year lease to

operate and maintain the Indiana Toll Road. The proceeds from the lease will be used to fully

fund the transportation plan and accelerate several other projects to upgrade and enhance

infrastructure in the state. Indirect benefits of this strategy will be a significant increase in new

construction and manufacturing jobs and a reduction in future costs for debt issuance and

interest. In addition to this upfront payment, the private operator expects to spend $4.4 billion

(2006 dollars) to maintain and expand the Indiana Toll Road over the life of the leasefunds

that were not available under the roads previous management structure. Similarly, the City of

Chicago awarded a $1.83 billion concession lease of the Chicago Skyway in 2005. The pro-

ceeds were used to pay down existing debt, establish a $500 million Rainy Day fund, allo-

cate $375 million to the annual operating budget, and fund several social service programs.

In addition, the Citys debt was upgraded fromA toA+.

Given the magnitude of

the major capital needs

looming on the horizon,

states and local govern-

ments have been forced

to consider alternative

means of financing

them, including the

significant resources

that can be provided

by the emerging global

infrastructure market

for PPPs.

Increasingly, the public

sector is looking to the

private sector to finance

and operate what has

heretofore been consid-

ered public infrastruc-

ture projects.



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322 PUBLIC WORKS MANAGEMENT & POLICY / July 2007

Texas recently announced a concession agreement that will provide a $2.1 billion upfront

payment plus $560 million for design and construction of State Highway (SH) 121 in Denton

and Collins Counties. In addition, the successful bidder will pay $700 million in lease pay-

ments over the next 49 years as well as $1.7 billion for operation and maintenance of the toll

road. The SH 121 project will now be completed by 201125 years faster than would have

been possible with traditional gasoline tax revenue. This project is significant for several rea-

sons. It is one of the first greenfield PPPs in the United States, and the Regional Transpor-tation Council of the DallasFort Worth area will largely decide how the upfront funds will

be spent on projects in their region. Furthermore, above certain revenue targets, the Texas

Department of Transportation will share an increasing percentage of the gross revenues in

addition to the upfront payment and guaranteed annual payments.

In light of these transactions, many governments have realized that the combination of steady

annual cash flow that tolls produce, coupled with the ability to depreciate the asset for tax pur-

poses, is of immense value to private operators. One of the key drivers of value in the Indiana

Toll Road, Chicago Skyway, and Texas SH 121 leases was the ability of the concessionaire to

make an upfront payment in return for the future cash flows that the projects would produce.

Debt markets, which have historically funded public toll roads, rely primarily on historical

growth to determine acceptable borrowing levels. However, because they are not as risk-averse

as the tax-exempt debt market, equity investors in PPP projects are willing to take a more entre-

preneurial view of the future performance and value of established revenue-producing assets.Currently, several other states are investigating similar models to develop alternative fund-

ing streams for infrastructure expansion. Specifically, the state of Texas is assessing the

financing alternatives for new toll roads, including a private concession model and the applic-

ability of Private Activity Bonds and TIFIA loans to be used in combination with a PPP. The

state of Utah also is engaged in determining the appropriate funding technique for a new toll

road project and, in conjunction with this process, recently passed legislation to allow PPPs

to be considered as a viable financing alternative for the project. New Jersey and Pennsylvania

are evaluating the benefits of long-term concessions for their existing toll roads.

BENEFITS OF PPPS FOR THE PUBLIC SECTOR

The growing list of executed concessions serves to demonstrate the multiple benefits to thepublic sector arising from PPPs. These include the following.

Flexibility with use of proceeds. Municipalities can utilize the upfront proceeds to accel-

erate needed transportation or other projects. A significant benefit of the PPP is the flexibil-

ity it provides the public partner to utilize the proceeds for any public purpose. The value of

this flexibility is particularly enhanced when compared to the strict limitations on the use of

proceeds from tax-exempt bonds. For example, the proceeds can be used to address public

needs ranging from accelerating the schedule of planned transportation projects to funding

social service programs for which other revenues are not available. The City of Chicago

placed a portion of the proceeds from the lease of the Skyway into a rainy-day fund that

aided in upgrading the citys debt and will lower future borrowing costs.

Greater upfront proceeds. A PPP allows the municipality to capture greater upfront valueat less cost than a municipal bond transaction because the value is based on the projected

growth of future cash flows as compared to historical data.

Strict operating and maintenance standards. The public partner can carefully craft the terms

of the concession agreement to achieve strict operating and maintenance standards that meet

public policy goals. If the concessionaire does not comply with these standards, the concession

can be terminated and control of the project will revert to the public sector. Both the Indiana Toll

Road and the Chicago Skyway transactions have 300 pages of operating standards that address,

in great detail, the manner in which the roads will be operated and maintained.

. . . many governments

have realized that the

combination of steady

annual cash flow that

tolls produce, coupled

with the ability to

depreciate the asset for

tax purposes, is ofimmense value to

private operators.



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CONSIDERATIONS OF PPPS

Important questions for the public sector to consider when determining whether to pursue

a PPP versus another financing strategy include the following.

What are the public policy implications of retaining ownership but transferring operations

to another entity for a predefined period of time in accordance with a concession agreement?Clearly, public policy issues are a major factor in a PPP and must be addressed very carefully.

Such factors as the rate and magnitude of toll increases, safety and environmental concerns,

and the status of public employees in the new management structure will be major concerns.

Recent positive experience supports the premise that PPP financing can work to satisfy both

public policy needs and the interests of investors.

What authority does the municipality relinquish under the PPP model? The public partner

retains ownership of the asset, which inherently enables it to retain a great degree of control

over ongoing operations and maintenance. Typically, the concession agreement contains a

detailed list of operating standards that the concessionaire is required to follow. The munici-

pality has the right to terminate the lease and take back operation of the facility if the con-

cessionaire fails to meet these standards. This is the publics ultimate control under a PPP.

What is the appropriate term of the concession agreement to maximize benefits to both

parties? The term of the concession must be sufficient to provide the concessionaire with the

tax benefits from depreciation, and this is possibly the least understood aspect of PPP. The

ability to depreciate an asset worth hundreds of millions or billions of dollars, although of

enormous value to the private partner, holds little or no value for the public sector. A longer-

term agreement provides flexibility to depreciate the asset in the most attractive manner

which will be reflected in the amount the private partner is willing to pay for the concession.

This difference in perspective also has political implications. For this reason, Indiana ulti-

mately decided to scale back the Toll Road lease from 99 years to 75 years after it was deter-

mined that investor value would not be severely affected.

PROCESS OVERVIEW

Developing a successful PPP is a complex process and dependent on many factors. The

process usually can be completed within 9 to 12 months, and a strong foundation of prelimi-

nary groundwork will contribute heavily to a successful effort. The key steps in the process

are as follows:

Legislative approval

Prepare feasibility study/projections

Obtain any Federal Highway Administration or other federal approvals

Draft concession agreement and operating standards

Solicit bidders and select top quality firms/consortia

Due diligence/negotiation of key agreements

Why the Sudden Emergence of the PPP Market?

Seemingly overnight, a variety of private funds have emerged to pool large amounts of

money solely to invest in infrastructure. For example, Goldman Sachs has created an infra-

structure investment fund of more than $6 billion. Other firms, such as Morgan Stanley, the

Carlyle Group, GE-Credit Suisse First Boston, and JP Morgan have established funds of sim-

ilar magnitude. These funds are driven by the convergence of two mutually supportive trends.

First, as described earlier, the public sector is strapped for revenue just at a time when its need

Brown / PUBLICPRIVATE TRANSACTIONS 323

The ability to

depreciate an asset

worth hundreds of

millions or billions of

dollars, although of

enormous value to the

private partner, holds

little or no value for the

public sector.



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to invest in infrastructure is cresting. Second, investors with large cash holdings and long-

term payout responsibilities such as pension funds and insurance companies are looking for

moderate returns that are stable and predictable and carry a minimum of risk. Other investors

are looking to the infrastructure asset class as an additional means of diversifying their invest-

ment portfolios. The revenue potential of U.S. infrastructure as an asset class is essentially

untapped. The difference in value that can be captured by a private investor in a PPP over and

above what can be realized in the tax-exempt market by the public sector is the main driverof the PPP market. Private investors can realize more value from these assets than the public

sector and are willing to pay for the opportunity to do so. Ultimately, a private investment

group, in conjunction with an experienced facility operator, is highly incentivized to hold

down expenses and manage the asset efficiently and can do so because of economies of scale

and broad experience with similar holdings.

Are PPPs the Future of Infrastructure Finance?

The need for alternative funding to repair and replenish the nations infrastructure has

given rise to the increased interest and application of PPPs in the United States today. There

are enormous pools of private capital that are available for this very purpose. Publicprivate

partnerships can be truly mutually beneficialmunicipalities are able to monetize assets forupfront cash payments to fund future projects or inject additional capital in others while pri-

vate owners, operators, and investors are able to access the steady stream of cash flows pro-

duced by infrastructure assets. The marriage of private operating efficiencies and incentives

with essential public assets can only enhance our nations transportation infrastructure.

As budgets become increasingly constrained and funding sources harder and harder to

come by, it is likely that PPPs will become a prominent fixture in the infrastructure finance

landscape. The recent growth in the PPP market has been exceptionally strong, and there is

every reason to believe that it will continue in the future. Publicprivate partnerships are a

very real and practical solution to many of our local municipalities transportation funding

crises. Although a PPP may not be appropriate for every project or municipality, it provides

a valuable alternative to the current financing options that are available.

Notes

1. Grant Anticipation Revenue Vehicles (GARVEE) can offer states and local governments additional sources of

funds for their infrastructure projects but can be subject to conservative assumptions and a haircut of value because

of the inherent risk of reimbursement.

2. Transportation Infrastructure Finance and Innovation Act (TIFIA) loans are specifically designed to aid pro-

gressive transportation projects by providing low cost funds that offer immense flexibility for new and complex pro-

jects. They can, however, also be quite restrictive.

324 PUBLIC WORKS MANAGEMENT & POLICY / July 2007

Private investors can

realize more value from

these assets than the

public sector and are

willing to pay for the

opportunity to do so.

The marriage of private

operating efficiencies

and incentives with

essential public assets

can only enhance our

nations transportation

infrastructure.


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