America’s basic infrastructure is outdated, worn and, in some cases, failing. Most experts agree that it is inadequate for meeting the demands of the 21st century global economy. In this worrisome state, there is consensus around three factors:
– The public sector does not have the financial capacity or resources to undertake repairs, maintenance and improvements;
– Outside of the US, public-private partnerships (P3s) have been successfully used to repair, maintain and deliver needed infrastructure;
– Anticipating a P3 revolution in the US , vast sums have been raised by private equity and other funds to improve US infrastructure, yet surprisingly few true P3 transactions have been successfully concluded.
Why is the P3 model so often rejected in the US? The answer is complex. The financial crisis, which struck right at the time the P3 model was beginning to gain traction, certainly harmed acceptance of P3s. However, there are deeper, more profound and highly emotional issues at work here.
For one thing, historically, the tax-exempt markets have been used to financing infrastructure in the US. Related to this historic familiarity, P3’s proponents have not taken into account Americans’ deep legacy of trust in, and reliance upon, public agencies as builders and owners of infrastructure.
Furthermore, because P3’s proponents failed to understand this legacy, they then failed to address the backlash around private ownership of public infrastructure, especially when the owner might be a non-US entity. And, playing on all this cultural baggage, participants in the municipal markets proved very skillful in pointing out the shortfalls, political and financial, real and perceived, of P3s.
Meanwhile, traditional public finance techniques are either unavailable or insufficient to satisfy all stakeholders’ financing or investment objectives. The issues relating to privatisation of public infrastructure will continue to limit the number of true privatisations.
Against this backdrop, however, public infrastructure across the US continues to erode. The overall situation is ripe for financial investors who appreciate the economic value of public infrastructure, and are willing to change their traditional investment thesis. The answer may well be a uniquely American one: hybrid structures that will more broadly satisfy all stakeholders’ objectives.
Ongoing discussions about how to pay for infrastructure upgrades are leading to the idea of a P3 hybrid, combining beneficial aspects of public ownership with financing structures using municipal markets and other financing sources, plus the benefits of P3 in infrastructure design, construction and maintenance. A substantial amount of private long-term money has been raised to finance infrastructure by funds and investors which evaluate and underwrite infrastructure in ways that the current municipal capital markets are not able to appreciate or duplicate.
Under a hybrid model, public agencies could:
1. Issue traditional long-term municipal debt to the maximum amount supported by the municipal capital markets for a particular project;
2. Bid out the design, construction and maintenance of the infrastructure project (or long-term maintenance of an existing asset); and
3. Look to the traditional equity investors in P3 to provide long-term (50 to 70 years) subordinate mezzanine loans (mezzanine securities) instead of making equity investments.
The mezzanine securities would have a subordinate lien on project revenues after payment of the public agency’s senior municipal debt secured by the asset. The existing or new public agency would continue to have equal ownership of the asset. For public law and tax purposes, mezzanine securities would be debt.
If desired, the mezzanine securities could be issued as tax-exempt debt, subject to satisfying applicable legal requirements or taxable debt if certain of the legal requirements cannot be satisfied. Subject to satisfying these two overarching requirements, mezzanine securities can incorporate many of the characteristics and investment parameters of a typical P3 investment involving a long-term concession:
Maturity/term: Subject to applicable state law, the term of the mezzanine securities can substantially exceed the term for traditional governmental project debt and can be more in line with the term of many concessions in P3 transactions. For example, the maturity date on mezzanine securities issued for a long-lived asset such as a toll road with a useful life of 100 years or more if property maintained, could be at least 70 years.
Yield: The interest rate on the mezzanine securities would presumably exceed the interest rate on the senior debt, to compensate investors for the substantially longer-term risk and subordination. As a practical matter, interest rates on mezzanine securities should be comparable with yields paid to mezzanine lenders in other project finance deals and not dissimilar from projected yields on a typical concession arrangement. The interest rate could include a contingent component based on gross revenues (but not based on net revenues, to retain its classification as “debt” for tax purposes), in order to provide some upside and inflation protection. Even if the mezzanine securities were structured as tax-exempt debt, properly built they could nevertheless be attractive investments for entities not subject to taxation.
One basic test that would need to be satisfied is whether, based on reasonable projections, sufficient funds are anticipated to be available to repay the mezzanine securities. In addition, the public agency will need to have a reasonable, tangible residual equity interest after the mezzanine securities and all other debts are repaid.
Rate covenants: The mezzanine securities can include rate covenants to assure repayment of all debt, including the mezzanine securities themselves. Rate covenants will have to be carefully crafted to assure mezzanine securities holders that they will be repaid and to assure the public agency that the rates will not unduly burden citizens.
Management input: In traditional mezzanine loans and in concession agreements, the governmental agency retains certain management rights. The mezzanine securities should include similar provisions, granting their holders the right to affect or approve key management decisions.
Maintenance/improvements: As in a typical concession agreement, the mezzanine securities should include covenants relating to improving and maintaining the facility, in order to maximise repayment as well as provide a desirable level of service.
As the markets and economy improve over time, and the need to construct and improve basic infrastructure becomes not only more apparent but more feasible, the evolution to an Americanised P3 structure will accelerate and gain greater acceptance.
There is no single solution which will work to deliver and improve the infrastructure needed for the demands of the 21st century global economy. Rather, we should regard the hybrid P3 as a continuum, ranging from traditional tax-exempt financing options all the way to traditional P3s, giving us the freedom to craft a solution using every tool in between.
Masood Sohaili is a partner in law firm DLA Piper's Corporate and Finance group in Los Angeles. He structures and negotiates infrastructure and development projects involving public and private participation, representing lenders, underwriters, developers and issuers.