IN THE CURRENT economic environment, infrastructure funds have seen an increase in capital commitments as investors look to diversify their portfolios and secure stable rates of return. State legislation enabling Public-Private Partnerships (PPPs), as well as recent proclamations of renewed commitment to infrastructure at the federal level, have contributed to an increased interest by sponsors in infrastructure assets, particularly related to existing, or “Brownfield”, infrastructure assets. The most common PPP structure utilised in the United States for Brownfield assets has been the Long Term Lease Concession. Lease Concession transactions offer private equity sponsors the opportunity to secure long term economic rights, in some cases for as long as 99 years, to a valuable public asset with a stable revenue stream, such as a toll road, airport, stadium, lottery or parking concession.
Such transactions, however, present several issues that may be problematic for private equity sponsors. Lease Concession transactions impose service level requirements over the life of the concession that expose sponsors to significant risk regarding future operating costs and may hamper a sponsor’s ability to react to changes in consumer preferences. Contractual or regulatory restrictions on price changes may negatively impact a sponsor’s ability to maximise profits. Finally, limitations on transfer and change of control imposed by governmental authorities create significant risk for a sponsors’ exit strategy. All of these issues are exacerbated by the long term nature of the concession and the importance of such assets to the public interest, and must be carefully analysed by any sponsor pursuing an investment in this sector.
SERVICE REQUIREMENTS AND RELATED COSTS
Lease Concessions provide for an investment by a private equity fund in exchange for the rights to the revenue streams generated by an infrastructure asset owned by a governmental entity. The governmental entity transfers the operational and maintenance obligations of the asset in exchange for a lump sum payment, or concession, by the private equity sponsor. The private equity concessionaire has the opportunity to realise a return on its investment through the collection of fees and tolls. This deal structure transfers both economic and operational risks from the governmental entity to the private equity sponsor. The governmental entity transferring the infrastructure asset, nevertheless, has a vested political interest in ensuring that the operational obligations of the asset are fulfilled. Accordingly, the governmental partner will require, through contract or state regulation, that the private concessionaire provide the same level of service as the governmental operator. This shifts the risk of unforeseen increases in the cost structure to the private equity sponsor. Unexpected increases in maintenance or service costs could impact long term financial projections, rendering potential exit opportunities untenable due to lower profitability.
The regulation of service maintenance and operational performance through inflexible state regulations is problematic in light of the extended duration of the Lease Concession. For Brownfield developments, the life of the investment often runs far in excess of customary private equity investments or, for that matter, the life of the fund. For example, the Lease Concession in the transaction for the Chicago Skyway was for 99 years; the recent Lease Concession transaction in which the City of Chicago relinquished control of the operations of its municipal parking meter system contained a 75-year term. During such an extended period of time, it can be reasonably expected that significant, if not drastic, shifts in technology and efficiency will occur, having a substantial impact on the operational cost structure of the underlying infrastructure asset.
Moreover, the changes in underlying costs can occur without any change to the basic service components. Consider a state regulation that requires a roadway subject to a Lease Concession to be resurfaced every X years. One only need look at the recent volatility in oil prices and its resulting impact on the cost of asphalt to appreciate the severity of potential shifts in underlying cost components. While a prudent investor would reasonably foresee the cost volatility in such a basic raw material and would likely hedge for this volatility, there are other influences on the underlying cost structure that are not as predictable – for example, changes in technology and evolving consumer tastes.
During the past 20 years we have seen dramatic changes in the level of service demanded by consumers and made possible by new technology: tolls are collected electronically; cashless and paperless transactions are the norm; threats to security are more technologically advanced and difficult to predict and healthy and environmentally friendly alternatives are
increasingly being demanded by the public. One can only imagine the possible changes in service level demand and consumer preferences that may occur during the next 99 years. The governmental partner in a Lease Concession needs to be responsive to these change over time, and cannot be restricted in its role as protector of the public interest.
Accordingly, careful financial analysis must be undertaken to ensure that the service requirements included in the Lease Concession are balanced to reflect the economic needs of the private fund sponsor, both with respect to the service levels themselves and the underlying cost components. At an optimal level, the Lease Concession could provide flexibility with respect to the cost structure through explicit contractual mechanisms for changes to the service requirements on cost sharing formulas. For example, providing for the establishment of an advisory board to review the service level requirements and underlying costs periodically over the life of the Lease Concession could provide some necessary relief from the burden of volatile cost components. Such a board could be comprised of representatives of the investor/concessionaire, the governmental authority and, perhaps, other elected members of the public, in an attempt to ensure that the views of all constituencies affected by the Lease Concession are considered.
Private equity sponsors have faced the issue of significant shifts in underlying cost structure and consumer preferences before in other investment contexts. In recent years, for example, there have been a number of high-profile sponsor-led transactions focusing on telephone directory businesses, where the right to publish yellow pages is subject to a long term agreement (10-50 years) with the telephone company. The telephone directory business is burdened with specific regulatory requirements governing the format of the business’ sole product (the size, appearance, format and layout of a directory is often prescribed by regulation) in the face of a shift in both technology (the internet) and consumer preferences (a paperless approach through on-line directories). In that investment context, in several cases, cost sharing arrangements and related mechanics accounting for increases in cost and change in preferences were negotiated to help address the issues. The result was a beneficial outcome for the three principal constituencies – the regulated provider, the private equity investor, and the consumer. Similarly, the guiding principle in the Lease Concession model should be to incentivise modernisation for the benefit of all constituents – including the private concessionaire – if the momentum of public-private partnerships is to continue.
RESTRICTIONS ON REVENUE
Another advantage of the Lease Concession model, with respect specifically to existing infrastructure assets, is that historical revenue streams provide guidance to project future revenue streams. This provides a private equity sponsor with quantitative information on which to base its investment decision prior to committing to the Lease Concession. The ability to project future income streams facilitates future transferability of the private equity interest as well, by giving potential transferees – other private equity funds, private investors or a governmental entity – the confidence that they will receive a predictable rate of return. Sponsors may also have the ability, subject to negotiated limits, to accelerate their rates of return through an increase in toll or usage rates, thereby providing attractive benefits to a prospective transferee. The potential adjustment of fees and rates gives prospective investors additional security in relying on long term revenue projections.
However, private equity sponsors should be cautious when considering rosy projections of future revenue based on substantial increases in price or fees associated with the services provided by the concessionaire. Infrastructure transactions by their nature necessitate a continued dialog and relationship with a number of constituent groups, including the public as the consumer of services. Early infrastructure deals granting the concessionaire the unrestricted ability to raise prices were not met with positive public reaction. As a result, established formulas and ceilings setting upper limits for rate increases have become the norm.
Even in recent transactions, however, potential price increases remains a highly sensitive public relations issue. Consider the recent Chicago parking meters transaction, in which Chicago Parking Meters, LLC (an entity majority-owned by a private equity sponsor) entered into an agreement with the City of Chicago for the concession and franchise to “operate, manage, maintain, and rehabilitate” the city’s metered parking system and collect related revenues. A fairly significant rate increase was approved, announced and implemented prior to the consummation of the transaction; it was left to the concessionaire only to reap the increased revenue.
However, public outrage over the rate increase, together with operational issues relating to a transition in technology hampered the overall plan. A changeover from individual metered parking to “pay and display” units was delayed. The result was that Chicagoans were required to carry around bags of quarters to compensate for the increased cost of parking – if, that was, they could find a working meter. Many meters had become clogged with the flood of quarters required under the new rate scheme and the schedule for emptying the meters could not keep up. The situation prompted the following terse summation in an article headline: “Chicago parking deal sparks anger, vandalism, legislation.”1 With the heated rhetoric that typifies Chicago politics, in the wake of the public outcry over the situation, the Chicago aldermen made accusations of “deceptive business practices” and “fraud” on the part of the concessionaire.
Recently, some governmental authorities have been exploring revenue sharing arrangements in the context of Lease Concessions, providing the governmental partner with an interest in the proposed future rate or fee increases. Through this approach, the interests of the sponsor and the governmental partner are arguably better aligned. A revenue sharing structure should also be more palatable to the public constituents/consumers of the services that are the subject of the Lease Concession, based on the knowledge that some portion of the increased rates will benefit the community, to the extent they are fed back into funding public works.
A private equity sponsor considering any investment will invariably focus on potential exit opportunities, as the ultimate goal for the sponsor is to generate capital appreciation and realise return. The Lease Concession model presents certain peculiarities that sponsors should consider when analysing a potential investment.
In particular, the fundamental disparity between exit horizon, as necessitated by fund lifespan and Lease Concession duration, is a central issue for most of these transactions. While the typical life of most infrastructure funds is longer than a traditional private equity fund (typically, 10 – 15 years), it is still far short of the considerable Lease Concession periods discussed above: 99 years for the Chicago Skyway transaction and 75 years for the City of Chicago parking deal. This inherent disconnect forces the private equity sponsor to grapple early on with the issue of prospective exit. Those sponsors investing out of a fund that consists of a perpetual pool of capital, such as a publicly listed vehicle, have a distinct advantage in this regard. However, as the medium of the permanent capital vehicle has not established itself with the prominence that was once expected, creative solutions are still needed in order to continue to attract the interest and capital of mainstream private equity sponsors to is market.
In a traditional private equity transaction, a sponsor can engage as a purchaser with the confidence that its exit is grounded in the basic principle of freedom of contract: any willing future purchaser will suffice. By contrast, in the Lease Concession model, the government partner typically imposes certain restrictions on the transfer of the private ownership interest to a subsequent transferee, limiting the exit opportunities otherwise freely available. The governmental authority has an interest in maintaining the public services related to the Lease Concession, and thus the financial viability of the operator or provider of those services becomes a target of focus. The concession agreement in the City of Chicago parking meter transaction contained what are becoming fairly standard restrictions on a potential future transferee of the concessionaire’s interest in Lease Concession transactions. In particular, the Lease Concession agreement gave the City broad discretion to approve or reject a subsequent tran
sferee based the City’s consideration of the following factors:
– the financial strength of the proposed transferee, its direct or beneficial owners, any proposed managers or operating partners and each of their respective affiliates
– the experience of the proposed transferee in operating metered parking systems
– the background and reputation of the proposed transferee, its direct or beneficial owners, any proposed managers or operating partners, each of their respective officers, directors and employees and each of their respective affiliates, and
– the experience and reputation of the operator engaged by the proposed transferee.
Similarly, in the cases of the Lease Concessions for the Indiana Toll Road and the Chicago Skyway, the Indiana Finance Authority (IFA) and the City of Chicago, respectively, each have the right to approve the proposed transferee and are allowed to consider similar factors to those highlighted above, as well as the capitalisation of the proposed transferee.
These restrictions on the transfer of the concessionaire’s interest are a reflection of the operational risk faced by the state or other governmental authority. The number of high profile deals in and around the public sector with operators in financial difficulties have led to increased scrutiny on financial viability for any partnership with private investors. The qualifications of the proposed transferee to operate the infrastructure asset – as well as its capitalisation and stability – provide some assurance to the governmental authority that the infrastructure assets will remain in operation at the expected level, without jeopardising their use as public works. However, such restrictions may limit the field of potential subsequent transferees, and a traditional private equity sponsor may be unaccustomed to the degree of transparency that these restrictions impose, particularly in light of the implications for disclosure regarding fund interests and limited partners.
Indeed, the trend toward greater transparency in Lease Concession arrangements may be increasing: in the wake of the Chicago parking meters deal and the poor public reaction to the rate increase, the Chicago City Council passed the “City Asset Lease Agreements Disclosure Ordinance”. The legislation requires asset lease agreements to be made public as searchable electronic files on Chicago’s finance department website. It also imposes greater transparency requirements for tracking how the proceeds of the transactions are used and what fees are paid for investing the proceeds.
In the face of transfer restrictions such as those outlined above, it may be advisable for a private equity investor to negotiate specific and objective standards for qualified purchasers as part of the initial transaction and even, in certain cases, identify and “pre-clear” obvious potential buyers.
Another solution to the timing disparity is suggested in the recent proposed Lease Concession relating to a 78-mile stretch of Florida highway referred to as “Alligator Alley”. The final proposed bid draft of the Lease Concession agreement contains the expected restrictions on a change of control in the concessionaire, aimed at ensuring continuity of operation, as well as ownership and accountability. However, specifically excepted from the notion of “change of control” are transfers between or among investment funds and the investors therein, provided that ownership interests remain under common ownership, management or control or under a common principal investment advisor. In essence, this would allow the sponsor to trade the Lease Concession asset between funds. While this approach does indicate an increased sensitivity by governmental authorities to the timing issues faced by sponsors in a lengthy Lease Concession, it too has its pitfalls. For example, a sponsor who has difficulty raising its next fund will find no comfort in such a provision. In addition, any transfer among funds will still need the approval of the fund’s limited partners, and limited partners have grown more sensitive to and wary of conflicts of interest that can be raised by such transactions.
Finally, sponsors can also consider shifting some of the exit risk back to the governmental authority through a put structure. If, for example, the sponsor proposes to transfer the infrastructure asset, and the governmental partner exercises its right to reject the identified transferee, the sponsor concessionaire could negotiate for the ability to force a buyback of the Lease Concession interest at a value based on a predetermined formula. This approach would provide for the establishment of a terminal value for the asset at certain defined periods in recognition of the limited duration of the fund structure. At that point, the particular character and the vested interest of the sponsor’s government partner in the Lease Concession may, in some respects, prove to be an advantage for exit: a sponsor may be able to rely on the governmental entities’ ability to tap the municipal bond market and buyout the private investors partnership stake.
Certain issues posed by Lease Concessions are not entirely novel. Private equity sponsors have dealt with issues similar to those highlighted above in other areas of investment in heavily regulated industries, such as telecommunications. In this respect, sponsors have an archive of relevant and meaningful experience on which to draw in considering investments in this particular asset class. At the same time, other issues are unique to the Lease Concession model. A key factor to the continued development of the Lease Concession model is creativity in deal structuring to offer solutions that provide access to much needed capital. Much has been made of the amount of capital sitting on the sidelines in the coffers of private equity sponsors, and it is no secret that many government authorities at both the state and local level are in need of cash. Ultimately, it is in the interests of all participants in the infrastructure market – sponsors and governmental entities alike – to find creative solutions to the special considerations raised by Lease Concessions.
1. www.InfrastructureInvestor.com, 11 June 2009
R. Ronald Hopkinson is a partner in New York at Cadwalader, Wickersham & Taft LLP. E. Eric Rytter and Michael E. Rosado are associates at the firm.