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Meeting the Challenge of Public Private Partnerships and Project Infrastructure Construction. Roger D. Stark Partner, K&L Gates 1601 K Street N.W. Washington DC 20006-1600 [email protected] 202/778-9435. Cynthia M. Weed Partner, K&L Gates 925 Fourth Avenue, Suite 2900

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Meeting the Challenge of Public Private Partnerships and Project Infrastructure Construction

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Meeting the challenge of public private partnerships and project infrastructure construction

Meeting the Challenge of Public Private Partnerships and Project Infrastructure Construction

Roger D. Stark

Partner, K&L Gates

1601 K Street N.W.

Washington DC 20006-1600

[email protected]

202/778-9435

Cynthia M. Weed

Partner, K&L Gates

925 Fourth Avenue, Suite 2900

Seattle, WA 98104-1158

[email protected]

206.370.7801

DC-#1010156 v1


Overview

OVERVIEW


Summary of presentation

Summary of Presentation

  • Background on P3, public finance and key paradigms

  • Project finance/public finance Structures

  • Legal constraints on P3s

  • Elements of successful P3s

  • Conclusions


Background on p3s public finance and key paradigms

Background on P3s, Public Financeand Key Paradigms


What are p3s

What are P3s?

Public-private partnerships (P3s) :

  • Combine private sector capital with public sector commitments (and, sometimes, capital)

  • Procure plant and equipment, improve public services and/or improve the management of public sector assets

  • Focus on public service results, and thereby offer a more cost-effective approach to public sector risk management


What are p3s cont d

What are P3s? (cont’d)

  • Infrastructure Project Need

    • Will be used in whole or in part by the general public or a public agency

  • Public Participant – State or state agency/local government

  • Private Participant – joint venture/domestic/foreign

  • Is it a partnership?

    • Not in the traditional legal sense

    • More likely a joint venture or in the alternative a lease or franchise arrangement


Combination of public and private finance components

Combination of public and private finance components

  • A formula for success – due to the unique contributions available from each participant

    • Governmental power

      • Eminent domain

      • Taxing power

      • Access to tax-exempt financing

    • Private strengths

      • Construction expertise

      • Equity investor

      • Private procurement

      • Private management


Key elements of a p3

Key Elements of a P3

  • Contracts awarded based on “value for money,” not lowest bid

  • Capital or capital-equivalents provided by public and private parties

  • Reliable, long-term commitments

  • Flexibility in structuring contractual arrangements to best suit the economic, operational and policy goals of the parties

  • Assets with relatively high residual value


Key elements of a p3 cont d

Key Elements of a P3 (cont’d)

  • Government support in the form of credit commitment, concession or other facilitation

  • Private capital contributed to the venture earns returns that may vary based on project risks, project performance and/or government regulation

  • Documentation that commits the government and the private entities to various project rights and obligations

  • A sustainable “win/win” relationship between government and private parties


Vocabulary perceptions reality

Vocabulary/Perceptions/Reality

  • Private participants financing goal

    • Return on investment

  • Public participants financing goal

    • Obtain asset at lowest cost

    • Avoidance of debt limits

    • Avoidance of public procurement requirements

  • Reality is that the cost or the risks involved have the potential to reduce or eliminate the perceived benefits to each side


Traditional finance paradigms

“Traditional” Finance Paradigms

  • In the corporate world, capital is raised through equity as well as debt offerings

  • In the public sector, capital is raised primarily through the issuance of long term debt – bonds – in order to accomplish specific projects. Most public sector debt has an amortization term of 20-30 years; most debt is amortizing – often on a level payment basis


Recent developments

Recent Developments

  • Increased Budget Constraints at the Federal, State and local level

  • Mistrust of merchant projects/market projections

  • Degradation of municipal credit quality

  • Heightened attention to regulatory and political risks


Structural paradigms

Structural Paradigms


Municipal finance

Municipal Finance

  • General Obligation Municipal Bonds (tax exempt, indenture trustee)

  • “Private Activity” Revenue Bonds

  • Lease Purchase

  • Certificates of Participation (“non-appropriation risk,” “essential services”)


Tax exempt financing

Tax-Exempt Financing

  • Debt issued at lower interest rates, because the recipient does not include the interest in federal gross income

  • The structure of the debt is limited primarily by state law. Debt may be fixed rate, variable rate, auction rate, credit enhanced, un-credit enhanced, senior or subordinate lien

  • Bond insurance used to be a major factor in project financing and public private partnerships


Tax exempt lease purchases

Tax-exempt lease purchases

  • Public partner enters into a long term agreement:

    • Providing for payments over time

      • (if the lease is securitized, payments will generally be semiannual, with annual principal payments)

    • Public participant has management of and control over the asset during the term of the lease

    • At the end of the lease term, public partner may acquire title to the property

    • Title may be in the form of a condominium ownership interest


Conduit financing

Investors

Government Issuer

Bonds

Bond proceeds

Trust agreement

Bond Repayments

Proceeds to pay cost

Project

Trustee

Revenues from project

Conduit Financing

  • The public partner may participate as an issuer of debt solely to provide access to tax exempt financing

  • Public partner does not provide any direct financial support (i.e. taxes, revenues other than project revenues) to the project


Conduit financing1

Conduit Financing

  • Risks

    • Construction Risk

    • Revenue Risk

    • Acts of God

  • Mitigating Factors

    • Private Partner Guarantee

    • Bond insurer (used to be)

    • Contingent Guaranties

      • Letter of credit

      • Surety Bonds

      • Government contingent guaranty


Partnership financing

Investors

Government Issuer

Bonds

Govt. revenues

Bond proceeds

Trust agreement

Proceeds to pay cost

Bond Repayments

Project

Trustee

Revenues from project (may be secondary or absent)

Partnership Financing

  • The public partner may participate not only as an issuer, but also with a source of governmental revenues – governmentally imposed

    • Special excise taxes

    • Customer facility charges

    • Incremental tax revenues

    • Utility revenues (special revenues)


Partnership financing1

Partnership Financing

  • Risks

    • Security of Govt. Revenue Source (how critical)

  • Mitigating Factors

    • Back up Guaranty from govt. entity


Project finance

Project Finance

  • Firm, long-term revenues

  • Mitigation of market and regulatory risks

  • Fixed price, on-time, at-spec EPC to mitigate construction risks

  • O&M Agreement to mitigate operating risks


63 20 financing option

63-20 Financing Option

What it is: A mechanism created under federal tax law (Rev.Rul. 63-20; Rev. Proc. 82-26) that permits nonprofit corporations to issue tax-exempt debt

How it works: Nonprofit corporation established under state law issues tax exempt bonds; proceeds used for a desired project; the nonprofit corporation is obligated to repay the debt from identified and pledged sources

Applications: Unlimited, but particularly helpful in the P3 context


Privatization models

Privatization Models

  • Concession of public services

  • Build/Own/Transfer

  • Sale/Leaseback

  • “Contracting Out”


Uk private finance initiative pfi

UK Private Finance Initiative (“PFI”)

  • Project Company/“OpCo”/D&B Contractor

  • Project Agreement defines construction/operation results and pushes various commercial and financial risks down to private sector participants

  • “Private consortia, usually involving large construction firms, are contracted to design, build, and in some cases manage new projects. Contracts typically last for 30 years, during which time the building is leased by a public authority.”

    UK Dept. of Health Website: http://www.dh.gov.uk/ProcurementAndProposals/PublicPrivatePartnership/PrivateFinanceInitiative/fs/en


Meeting the challenge of public private partnerships and project infrastructure construction

Sponsors

Senior Lenders

Term Notes

-Banks -Public -Institutional Investors

Bank Revolver/LC Facility

Subordinated Lenders

CollateralAgent

Legal Counsel

Independent Engineer

Guarantees or

Support

Market Consultants

Equity InvestmentShareholders Agreement

PayingAgent

Funding Company

Insurance Consultant

Passive EquityInvestors

Parent Guarantor

WarrantiesPerformance Guarantees

Insurers

EPC Contractor

Project Company

Fixed Price

EPC Contract

Project Input Contract

Equipment and Material Suppliers

Parent Guarantor

Subcontractors

Supplier

Parent

Guarantor

Legal Counsel

Design Engineer

Offtake

Purchaser(s)

Investment Banker

Revenue Modeler

Offtake Agreements/Concessions/Project Agreements

Accountants

O&M Provider

O&M Agreement

Rating Agency(ies)

Subsidiary Infrastructure

(e.g., rights-of-way)


Meeting the challenge of public private partnerships and project infrastructure construction

Typical PFI Structure

Lender’s Direct

Agreement

Procuring Authority

Project Agreement

Project Company’sShareholders

Project Company

Project Company’sLenders

Loan and

Security

Documents

Operating

Contractor

D&B

Contractor

Key: = contract

= flow of money


Risk mitigation paradigms

Risk Mitigation Paradigms


Risk mitigation lender goals

Risk Mitigation (Lender Goals)

  • Mitigation of Construction Risk

  • Reliable cash flow/credit quality—off-take and Concession Agreements (non-appropriation risk?)

  • Mitigation of market risks

  • Mitigation of political risk (“essential service”?)

  • Bilateral contracts that integrate market requirements and mitigate market risks


Documentary risk mitigation paradigms

Documentary/Risk Mitigation Paradigms

  • Off-take Agreements

  • Service Contracts (aka “Project Agreements”)

  • Concession Agreements

  • Construction (EPC/Design Build) and O&M Agreements

  • Credit Facility Documentation (“renting money”)


Key p3 objectives

Key P3 Objectives

  • Enhance capital sources for creating new and improving existing infrastructure

  • Promote efficiency in infrastructure development and execution

  • Leverage existing assets and future cash flows to facilitate capital formation and respond to pressing infrastructure needs


P3 risks

P3 Risks

  • Political, regulatory and change of law risk

  • Additional costs of project oversight, documentation and execution may exceed savings from efficiencies

  • Market projections fail to pan out


Transaction risk matrix

Transaction Risk Matrix

GC Entity= Government controlled entity

Project Company= Privately controlled entity


Meeting the challenge of public private partnerships and project infrastructure construction

DesignBuildFinanceOperate(DBFO)

LongTermLease Agreement

Private Contract Fee Services

BuildOperateTransfer(BOT)

Build OwnOperate(BOO)

Design Bid Build

Other InnovativePPPs

Design Build

PUBLIC Responsibility

PRIVATE Responsibility


Legal constraints on p3s

Legal Constraints on P3s


Legal constraints on public private partnerships

Legal Constraints on Public Private Partnerships

  • Legal constraints generally arise as a result of the participation of a “public partner”

  • Why? -- Unlike private enterprise, public agencies are entirely creatures of state law. They have only those powers that are granted by a state constitution and by the state legislature.

    • The power of a state legislature is plenary

    • The state constitution is the citizens’ limitation on the powers of a state legislature

    • As a result, any party dealing with a public agency is required to be aware (to an extent not contemplated in the private sector) of the constraints of state and local law. Any exercise of power by a local government beyond its express grant of authority (or that necessarily implied) is void. Let the private party beware.


Lending of credit

Lending of Credit

  • Most often (but not always) found in a State Constitution.

    • In order to protect the taxpayers from their elected representatives

    • Prohibits gifts of public funds to private parties

    • Prohibits lending of public credit to benefit private parties

    • Prohibits the acquisition of stock

  • Effect of limitation

    • Generally limits the ability of a public agency to be a “partner” with private enterprise

    • Prohibits public agency from guaranteeing the performance of what is essentially a private function

    • The public agency is limited in its ability to participate in the “upside” and the “downside” of a business venture


Procurement rules

Procurement Rules

  • One of the goals of a public private partnership may be to lower the cost of the project that would otherwise be subject to public procurement requirements

  • Incidentally, many public projects are intertwined with private functions. E.g., a public library and city hall amid retail shops; a hotel adjoining a public convention center, a public museum built as an integral part of a bank headquarters


Public procurement requirements

Public Procurement Requirements

  • Traditional public works requirements are primarily set forth as state legislative requirements (or local procurement codes)

    • Design, bid, build –with the emphasis on “bid”

    • The public agency is required to accept the lowest bid

    • The concept of “lowest cost” being attached to lowest bid has been overtaken with

      • Prevailing wages

      • Change orders at the expense of the governmental owner

      • Recognition that the “bid” is not the actual cost to be paid by the owner, as the owner is not able to make design changes in order to keep costs within “budget”


Federal tax constraints

Federal Tax Constraints

  • Tax exemption is a benefit that carries with it certain constraints

    • Unlike a private financing where the lender may have full control with respect to the property/the project pledged, the federal tax rules related to tax exempt financing may require that the “use” of the property be limited to a “permitted tax exempt use”

    • Failure to comply with those federal tax rules will jeopardize the tax status of the project debt – and any action that eliminates the tax exemption will correspondingly eliminate a favorable financing cost

    • The access to or requirement to maintain federal tax exemption will affect project feasibility analysis. A project that is financially viable without regard to the continued maintenance of tax exempt financing is a stronger project from a credit perspective.


Additional federal tax constraints

Additional Federal Tax Constraints

  • The IRC will limit the availability of federal tax benefits

  • Projects that are financed on a tax exempt basis will not be eligible for depreciation entirely, or at a minimum, not on an accelerated basis – on the tax return of the private party

  • Private participants will pay particular attention to all federal tax aspects of their role in a public private partnership. Access to tax-exempt financing may not be financially preferable to other tax benefits.


The role of government

The Role of Government


Checklist for government support arrangements

Determinable Tax Liabilities (“PILOT” Agreements)

Credit Support for Governmental Obligations

Assistance in Obtaining Governmental Permits/Approvals

Mitigation of Change of Law Risks

Mitigation of Uninsurable Force Majeure Risks

Priority or Parity on State-Controlled Transportation Facilities (e.g. port facilities)

Checklist for Government Support Arrangements


Assistance in obtaining governmental permits approvals

Assistance in Obtaining Governmental Permits/Approvals

  • Defining the Scope of Necessary Permits/Approvals/Regulatory Exemptions

  • Government Support to Facilitate Processing of Approvals (e.g., NEPA “lead agency” status)

  • Applicability to Extensions and Renewals

  • Combine with due diligence of procurement rules and Franchise/Concession Requirements


The way forward role of government

The Way Forward: Role of Government

  • Traditional Government Financing

  • Governmental grants/Revolving Funds/“63-20” corporations to attract private capital

  • P3 Structures

  • Transaction-specific innovation


Why do p3s succeed and why do they fail

Why do P3s succeed and why do they fail?

  • Politics/philosophical misunderstandings and differences

  • The public/private universe is comparing Venus to Mars

    • Constituency: Shareholders (or private owners in a non-public owners) vs. the general public

    • Control: State legislature v. shareholders

    • Motivation: General (and often unrelated) political issues (affecting the public partner) v. Internal political issues (affecting the private partner)

  • Sunshine Effect

    • Negotiations with a public partner invite public scrutiny

    • Public records issues

    • Public notice and public hearing requirements

  • Motivations of the parties negotiating may not be different; however, the reward systems are different

  • When parties who are not similarly situated are negotiating, the probability of miscommunication is enhanced and the opportunities for mistrust and negotiation breakdown escalate


Conclusions

Conclusions

  • Estimated infrastructure needs in the hundred of billions of dollars

  • Without suitable mitigation, structural, legal, and regulatory risks may reduce flow of private capital to infrastructure projects

  • Existing paradigms must be adapted to accommodate changes in the market

  • Governmental support central to attracting private investment


Meeting the challenge of public private partnerships and project infrastructure construction

Speaker Bios

[email protected]

+1. [email protected]


Questions

Questions?


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