DC-#1010156 v1
Meeting the Challenge of Public Private Partnerships and Project Infrastructure Construction
Roger D. StarkPartner, K&L Gates1601 K Street N.W.
Washington DC [email protected]
202/778-9435
Cynthia M. WeedPartner, K&L Gates
925 Fourth Avenue, Suite 2900Seattle, WA 98104-1158
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OVERVIEW
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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
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Background on P3s, Public Financeand Key Paradigms
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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
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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
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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
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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
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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
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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
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“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
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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
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Structural Paradigms
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Municipal Finance
General Obligation Municipal Bonds (tax exempt, indenture trustee)
“Private Activity” Revenue Bonds Lease Purchase Certificates of Participation (“non-
appropriation risk,” “essential services”)
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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
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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
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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
Bond Repayments
Project Trustee
InvestorsGovernment Issuer
Trust agreementBond proceeds
Proceeds to pay cost
Revenues from project
Bonds
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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
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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)
Project Trustee
InvestorsGovernment Issuer
Trust agreement
Bond proceeds
Proceeds to pay cost
Revenues from project (may be secondary or absent)
Bond Repayments
Bonds
Govt. revenues
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Partnership Financing
Risks Security of Govt. Revenue Source (how critical)
Mitigating Factors Back up Guaranty from govt. entity
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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
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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
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Privatization Models
Concession of public services Build/Own/Transfer Sale/Leaseback “Contracting Out”
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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
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Legal Counsel
Design Engineer
Investment Banker
Revenue Modeler
Accountants
Rating Agency(ies)
Parent Guarantor
O&M Provider
Sponsors Senior LendersTerm Notes -Banks -Public -Institutional InvestorsBank Revolver/LC Facility
Subordinated Lenders
Subcontractors
Equipment and Material Suppliers
EPC Contractor
Parent Guarantor
WarrantiesPerformance Guarantees
Equity InvestmentShareholders Agreement
Project Input ContractFixed PriceEPC Contract
Offtake Agreements/Concessions/Project Agreements
O&M Agreement
Guarantees orSupport
PayingAgent
CollateralAgent
Funding Company
Passive EquityInvestors
Insurers
Supplier
Legal Counsel
Independent Engineer
Market Consultants
Insurance Consultant
Project Company
Offtake Purchaser(s)
ParentGuarantor
Subsidiary Infrastructure(e.g., rights-of-way)
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Typical PFI Structure
Procuring Authority
Project Company’sShareholders
Project CompanyProject Company’s
Lenders
D&BContractor
OperatingContractor
Lender’s DirectAgreement
Loan andSecurityDocuments
Key: = contract = flow of money
Project Agreement
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Risk Mitigation Paradigms
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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
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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”)
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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
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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
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Transaction Risk MatrixAllocation of Project Risks/Burdens
Financial Structure Development Construction Financing Permitting Project Operation
Municipal Finance GC Entity GC Entity GC Entity GC Entity GC Entity
Project Finance Sponsors EPC contractor, project entity, sponsors
Project entity and sponsors
Sponsors, EPC Contractor
O&M contractor, project entity, sponsors
Privatization Transaction Specific
Transaction Specific
Transaction Specific
Transaction Specific
Transaction Specific
PFI Project Company
Design/Build Contractor
Project Company
Project Company, Design/Build Contractor
Project Company
GC Entity= Government controlled entity
Project Company= Privately controlled entity
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Design Bid Build
Private Contract
Fee Services
Design Build
BuildOperateTransfer(BOT)
LongTermLease Agreement
DesignBuildFinanceOperate(DBFO)
Build OwnOperate(BOO)
Other InnovativePPPs
PUBLIC Responsibility PRIVATE Responsibility
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Legal Constraints on P3s
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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.
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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
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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
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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”
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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.
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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.
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The Role of Government
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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)
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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
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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
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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
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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
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Roger Stark (Washington, D.C.) concentrates his practice on a wide variety of domestic and international energy and infrastructure transactions. His experience includes complex project and structured financings, mergers and acquisitions, privatizations and all manner of commercial agreements relating to energy and infrastructure. Building on over 10 years of domestic practice involving projects in 12 U.S. states, he has worked in over 25 foreign countries and is fluent in Spanish and proficient in Portuguese.J.D., Vanderbilt Law School (1984), B.A., Queens College of the City University of New York (1981)[email protected]
Cynthia Weed (Seattle) has nearly 30 years of public finance experience and has worked on a majority of the private activity bonds issued in Washington since they were authorized by statute in 1981. She has collaborated on notable public/private projects including the following in Washington state: Tacoma Narrows Bridge (a historical engineering fete financed by approximately $800 million in tax-exempt bonds); Safeco Field ($500 million Seattle Mariners baseball stadium financed through general obligation bonds issued by King County backed by several non-voted public tax sources); Pacific Place and Related Development ($500 million plus privately financed multi-block redevelopment of the downtown Seattle retail core); and Seahawks Stadium (new $500+ million NFL football stadium financed through $300 million in bonds issued by the State and at least $130 million in private funds (from billionaire Microsoft co-founder, Paul Allen). In addition, she has worked on numerous urban center and port renewals (multi block development with various civic, retail and residential development projects). J.D., University of Missouri (1978), B.B.A. University of Wisconsin (1969)+1. 206.370.7801 [email protected]
Speaker Bios
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Questions?
