Florey Todd, LTD.

Growing Pains:
Public-Private Partnerships In The United States

Over the past several years, public authorities have increasingly relied upon Public-Private Partnerships as a delivery model for large-scale infrastructure projects. This trend will continue, with more and more projects being funded, designed, constructed and operated through a partnership between a public owner and private investors. All industry professionals, including owners, contractors, designers and sureties have a stake in understanding the structure of a P3, through which their role and relative risks become clear.

Accordingly, this paper begins by discussing the rise of Public-Private Partnerships in the United States and then explains the structure and types of Public-Private Partnerships, as well as the ways a P3 project is financed. The paper concludes by addressing the unique concerns of contractors and sureties when engaging in a P3.

I. The Growth of Public-Private Partnerships

The rise of Public-Private Partnerships is the result of necessity. Governments around   the world are struggling to address their infrastructure needs, while at the same time facing growing budget constraints. Many have turned to P3s as a means to reconcile their growing need with shrinking budgets. While the rise of Public-Private Partnerships in the United States has been slow, the federal government and a number of states have recognized the benefit of this delivery model, and begun to utilize P3s in developing their infrastructure. In all, thirty-one states plus Puerto Rico have passed enabling legislation for P3 activity.

The potential advantages of this innovative form of project delivery are well- recognized. In both European and American examples, P3s have reduced the owner’s development risks, provided cost effective and timely delivery, allowed for improved ongoing maintenance, and leveraged limited public resources. While P3s may not be appropriate in all cases, these partnerships can address public needs for new facilities, real estate development, energy, information technologies, education, healthcare, transportation and utilities.

In addition to our nation’s infrastructure crisis and the economic benefits  of infrastructure spending, the rise in use of Public-Private Partnerships is also the result of the model’s benefit to the public and private partner. With or without the government’s expanded efforts, the advantages of P3 to the public are well-documented and include the following:

  1. P3s spread the costs of infrastructure to be spread over the lifetime of the asset and, as such, allows for procurement in a matter of years compared to the more typical pay-as- you-go project financing;
  2. P3s have a track record of on-time and on-budget delivery;
  3. P3s transfer much of the public’s risk to the private sector and provide strong incentives for assets to be properly maintained;
  4. P3s often transfer the responsibility and cost of operations and maintenance to the private sector;
  5. P3s lower the cost of infrastructure to the public entity be reducing construction costs, overall life-cycle costs, and in some cases by funding the project by revenue streams generated by the improvement, such as tolling;
  6. P3s encourage a strong customer service orientation through the inclusion of satisfaction measurements in the contract;
  7. As P3 projects most often involve a design-build component with performance based specifications, P3s enable the private sector to focus on the outcome and typically encourage increased innovation.

Infrastructure investments are seen as long-term, secure, inflation-protected investments that fit well with the payment schedules of pensions and life insurance policies.16 Accordingly, the successful Public-Private Partnership should both increase the quality and quantity  of  the  public service and allow the private business to make a profit.

II. The General Structure of Public-Private Partnerships

The National Council for Public-Private Partnerships defines a P3 as a contractual relationship between a public authority, whether federal, state or local, and a private entity. Through their partnering agreement, the skills and assets of each sector (public and private) are shared in delivering the improvement or infrastructure. In addition to the sharing of resources, each party shares in the risks and rewards potential in the delivery of the service and/or facility.

The Government Accountability Office offers a second useful definition of a public- private partnership, describing it as:

[A] contractual agreement formed between public and private sector partners, which allows more private sector participation than is traditional. These agreements usually involve a government agency contracting with a private company to design, renovate, construct, operate, maintain, and/or manage a facility or system. While the public sector usually retains ownership in the facility or system, the private party will be given additional (often total) decision- making rights in determining how the project or task will be completed.

This method of contracting differs from the sequential design-bid-build approach ordinarily used in the United States, wherein the owner executes one contract for design with an architect, followed by a different contract with a builder for project construction, with the owner taking possession of the improvement upon completion and providing its own maintenance and operation.

In a typical P3, the private sector takes on a larger role in the construction, planning and financing of the project. The amount of private involvement depends on a number of factors, including any limitations imposed by statute, costs, perceived benefits to the private entity, and the public’s goals. The private partner may also operate and maintain the improvement after completion.

While no two P3s are identical, in most cases, the Owner contracts with a Special Project Vehicle (“SPV”) (sometimes referred to as a Concessionaire) to deliver the improvement. The SPV is typically made up of a group or partnership of private entities, each of which help perform one or more of the essential functions of the SPV. In most modern P3s the SPV helps to secure financing for the project, and provides up-front funds for design, construction, repairs, operations and/or maintenance.

In many ways, the SPV stands in the shoes of the Owner but has more flexibility, resulting in a quality product at  lower cost  to the public.

The SPV is compensated either through availability payments, tolling, or other concessions - such as the right to develop public land to derive additional profits. The benefit to the Owner comes in the form of deferred up-front costs, faster delivery of projects, greater value for money, and a better product.

The structure of each P3 is tailored to the objectives of the project. The following, however, is a summary of delivery models typically considered within the gamut of Public-Private Partnerships:

Operations and Maintenance (O&M)

A public partner (federal, state, or local government agency or authority) contracts with a private partner to operate and maintain some piece of infrastructure. The public partner usually retains ownership and overall management of the public facility or system.

Operations, Maintenance & Management (OMM)

A public partner contracts with a private partner to operate, maintain, and manage a facility or system proving a service. The public partner retains ownership of the public facility or system, with the private party investing its own capital. Private investment is considered in relation to operations costs and potential savings over the term of the contract. Longer contract terms allow for increased private investment because there is more time to recover private investment.

Design-Build-Maintain (DBM)

A DBM is similar to a design/build project except the maintenance of the facility for some period of time becomes the responsibility of the private sector partner. The public sector partner owns and operates the assets.

Design-Build-Operate (DBO)

The private partner designs, builds and operates the facility. Combining all three phases into a DBO approach maintains continuity of private involvement and facilitates private-sector financing of public projects supported by user fees generated during the operations phase.

Design-Build-Operate-Maintain (DBOM)

The design-build-operate-maintain (DBOM) model couples the design and construction responsibilities of design-build procurements with operations and maintenance. These project components are procured from the private section in a single contract with financing secured by the public sector. The public agency maintains ownership and retains a significant level of oversight of the operations through terms defined in the contract.

Design-Build-Finance-Operate-Maintain (DBFOM)

With the Design-Build-Finance-Operate-Maintain (DBFOM) approach, the responsibilities for design, construction, finance, operations and maintenance are all transferred to private sector partners. There is a great deal of variety in DBFOM arrangements, especially with respect to what financial responsibilities are assumed by the private partner. One commonality, however, is that DBFOMs are either partly or wholly financed by revenue streams generated by the project. Direct user fees (tolls) are the most common funding source. Future revenues are leveraged to sell bonds or other secure loans that provide upfront capital for development. DBFOMs are also often supplemented by public sector grants in the form of money or contributions in kind, such as right-of-way. Private partners may be required to make equity investments as well.

Design-Build-Finance-Operate-Maintain-Transfer (DBFOMT)

The Design-Build-Finance-Operate-Maintain-Transfer (DBFOMT) partnership model is the same as a DBFOM except that the private sector owns the asset until the end of the contract when the ownership is transferred to the public sector. DBFOMT is not often used in the United States.

Build-Operate-Transfer (BOT)

The private partner builds a facility to the specifications agreed to by the public agency, operates the facility for a specified period under a contract with the agency, and then transfers the facility to the agency at the end of the specified period. In most cases, the private partner will also provide financing for the facility. Accordingly, the length of the contract or franchise must be sufficient to enable the private partner to realize a reasonable return on its investment through user charges.

Lease-Develop-Operate or Build-Develop-Operate (LDO or BDO)

Under these partnerships arrangements, the private party leases or buys an existing facility from a public agency; invests its own capital to renovate, modernize, and/or expand the facility; and then operates it under a contract with the public agency. A number of different types of municipal transit facilities have been leased and developed under LDO and BDO arrangements.

Turnkey

A public agency contracts with a private investor/vendor to design and build a complete facility in accordance with specified performance standards and criteria agreed to between the agency and the vendor. The private developer commits to build the facility for a fixed price and absorbs the construction risk of meeting that price commitment. Generally, in a turnkey transaction, the private partners use fast-track construction techniques (such as design-build) and are not bound by traditional public sector procurement regulations. This combination often enables the private partner to complete the facility in significantly less time and for less cost than could be accomplished under traditional construction techniques.

In a turnkey transaction, financing and ownership of the facility can rest with either the public or private partner. For example, the public agency might provide the financing, with the attendant costs and risks. Alternatively, the private party might provide the financing capital, generally in exchange for a long-term contract to operate the facility.

Knowing the basic structures of a public-private partnership is an important first step in understanding a surety’s considerations in underwriting a P3 project, and foreseeing the types of novel claims that may arise. While the delivery model may seem exotic, the surety is simply guaranteeing the performance of the design/build contractor, generally limited to its construction activities. Nevertheless, one of the main benefits of a P3 to the Owner, is shifting risk down the chain to the SPV. In turn, the SPV shifts as much risk as possible to its design/build team and O&M team. It is therefore crucial for the surety to understand the risks assumed by the contractor on the P3 in question, and play as active a role as possible in contract negotiations. These issues are discussed in greater detail in the sections below.

III. Financing Options Through A Public-Private Partnership

Addressing the country’s infrastructure needs requires raising additional revenue, reducing costs or finding new financing sources. Given government restrictions on tax-exempt bonds and the difficulty of raising funds through taxes, one of the more viable options is to draw upon private financing for new projects, and then benefit from revenue generated through long term leases of existing assets.  Accordingly, in many P3 structures, financing is  secured by the SPV as part of its Concession Agreement with the public authority.

Funding for a P3 is secured in a number of ways, including private investment in the form of bonds and bank loans, equity participation by the SPV partners, “TIFIA” loans, Private Activity Bonds, Grant Anticipation Revenue Vehicles, and revenue from the improvement itself. The public authority may also contribute.  Further, the Owner and SPV often work together to tap into state and federal financing options that have a  lower  cost  of  money,  thereby  reducing the  cost  of the project to the public authority, and increasing potential profits for the SPV.

1. Private Investment

Private investment through the purchase of bonds or issuance of loans is key to the financing of a P3. The SPV sells bonds or buys loans from a private investor, which it agrees repay over the life of the project. The SPV repays its debt through funds it receives through either availability payments made by the owner, or tolls collected during the operations and maintenance phase.

Over the last several years a substantial amount of money has been invested in infrastructure projects by private equity firms, institutional money managers, pension funds, insurance companies and wealthy individual investors. In fact, the emergence of private capital willing and eager to invest in infrastructure projects is driving government’s interest in P3s. Infrastructure investments are seen as long-term, secure, inflation- protected investments that fit well with the payment schedules of pensions and life insurance policies.

Equity investment is another important category of private investment. Each SPV member is typically an equity investor, and as more investors contribute, they become owners or shareholders of the Concessionaire in proportion to their share of capital. Equity investors are remunerated from the payment of dividends, usually paid on a yearly basis from the profit generated by the concessionaire (after lenders are paid). Project revenues, however, are first used to pay operations costs, and then to repay lenders, before the equity investor is paid.

2. TIFIA Loans

The Transportation Infrastructure Finance and Innovation Act (“TIFIA”) provides federal financing assistance to state and local governments as well as private entities, for surface transportation projects.  TIFIA is designed to fill funding gaps, and was passed in response to the difficulty state and local governments encountered in financing large-scale infrastructure projects at reasonable rates with tolls and other user-backed revenue. Private investors consider those revenue sources uncertain. TIFIA encourages private investment by providing supplemental capital that is subordinate to the private debt. The amount of federal credit assistance may not exceed 33 percent of total reasonably anticipated eligible project costs. All major P3 projects since 2008 include TIFIA as a key component of the finance plan.

The TIFIA credit program offers three forms of financial assistance designed to address the varying requirements of projects through their life cycles:

  • Secured (direct) Loan: Offers flexible repayment terms and provides combined construction and permanent financing of capital costs. Loans have a maximum term of 35 years from substantial completion. Repayments can start up to five years after substantial completion to allow for facility construction and ramp-up.
  • Loan Guarantee: Provides full-faith-and-credit guarantees by the Federal Government and guarantees a borrower’s repayments to non-Federal lenders. Loan repayments to lender must commence no later than five years after substantial completion of the project.
  • Standby Line of Credit: Represents a second source of funding in the form of a contingent Federal loan to supplement project revenues, if needed, during the first 10 years of project operations, available up to 10 years after substantial completion of the project.

3. Public Activity Bonds

A Private Activity Bond (PAB) is issued by or on behalf of a state or local government for the purpose of financing the project of a private user. Sections 142(a)(15) and 142(m)  of  the Internal Revenue Code (added through Section 11143 of the Safe, Accountable, Flexible, Efficient Transportation Equity Act) authorizes up to $15 billion of tax exempt PABs for a qualified highway or surface freight facility. The Department of Transportation is solely authorized to review requests made by the state or local authority, approve the proposed project, and allocate bonds from the $15 billion national limitation. State and local governments then issue the PABs as the conduit for the concessionaire. PABs are typically backed by project revenue only, and are therefore financially riskier than municipal bonds backed by broad-based taxes; the government generally does not pledge its credit.

Of course, since the SPV has agreed to take on the all or most of the upfront funding of the Project, it must recover those costs (and make a profit) over the term of the public-private partnership. In the context of transportation projects, revenue is generated either by tolls collected by the SPV or through availability payments from the owner to the SPV.  Availability payments are made using the funds collected by the SPV pursuant to its Concession Agreement, including bond revenues, loans, equity investment and revenues from the infrastructure. The public partner may have also contributed funds for a portion of the construction costs. Those funds are placed in the hands of a trustee who releases payments based on completion milestones certified by a third-party consultant.

IV. Considerations For Contractors and Sureties

1. Expanded Scope and Time for Performance

Understanding P3 types, structures, financing and players is key to assessing the risks of the contractors, design team, other members of the SPV. As the Owner hands off more responsibility to the SPV, the SPV takes on a corresponding amount of risk. In some (but not all) P3s, the design-build joint venture not only designs, constructs and manages the improvement, it may also then perform operations and maintenance services over the life of a contract that can exceed thirty years.

In other cases a second team assumes the operations and maintenance piece of the project. In either case, the increased scope and length of the contract opens the door to risk that may not be fully covered by typical defenses, insurance, and bonds. The contractor and surety may find themselves responsible for defects in material and workmanship much longer than anticipated.

2. Risks Related to Financing Structure

The manner in which P3s are financed raises two areas of concern for the surety.  First, in its underwriting efforts the surety should confirm adequate funding, as well as the right to control that funding. If the surety is forced to undertake the contractors’ obligations, access and the right to necessary funding for completion of the work is crucial. Many of the bonds used on P3s do not offer a process for release of the contract balance that is typical in bond forms, such as the AIA-A312. The Concessionaire may not even have access to the full contract amount, which is in the hands of a trustee. Further, some or all the contract balance may be generated by revenues during the operations and maintenance portion of the project.

Second, the financing structure potentially increases the number of parties with a stake in the bond and guarantees of the surety.  Lenders and equity investors are repaid using the availability payments made to the SPV and revenues generated by the infrastructure. In fact, many Concession Agreements require a Multiple Obligee Rider, which names the Lender and Owner as Additional Obligees, allowing them to make direct claims against the bond. Further, broad indemnification terms included in some bonds mandate the surety’s responsibility for all damages suffered by the SPV as a result of the contractor’s default.

3. Broad Surety Guarantees and Liability

Bond forms often required by the Owner on P3 projects impose broad guarantees, without any of the protections or defenses allowed in other bond forms, which require, among other conditions precedent, that there be no owner default. Examples of typical performance and payment bond forms used on a P3 are attached to this paper in Appendix A. As evidenced in those examples, bonds generally list all of the Principal’s duties under the Design/Build Contract, without identifying any duties of the Owner or Concessionaire.

4. Broad Contractor Guarantees and Liability

Because each P3 is uniquely structured, it is important to know exactly who the contractor is working for, its partnering arrangements, and to recognize any long term liabilities that may be transferred by contract. Further, the contractor and surety should look to what specific areas of liability may be assumed in the Concession Agreement, Design/Build  Agreement and Operations & Maintenance Agreement.

V. Conclusion

Public-Private Partnerships are creating new opportunities for all industry players, including sureties. With new opportunity, however, comes new risk and uncertainty. It is essential that contractors involve experienced insurers, bonding agents and counsel to assist in understanding the risk potential in some P3s. After examining these and other related factors, contractors and sureties can then determine if P3s are a good opportunity. Each of the issues discussed above should be considered from a claims and underwriting perspective, and to the extent possible, the surety should be engaged as early in the contracting process as possible to avoid some of these risks.

 

 

VI. CONCLUSION

Public-Private Partnerships are creating new opportunities for all industry players, including sureties. With new opportunity, however, comes new risk and uncertainty. It is essential that contractors involve experienced insurers, bonding agents and counsel to assist in understanding the risk potential in some P3s. After examining these and other related factors, contractors and sureties can then determine if P3s are a good opportunity. Each of the issues discussed above should be considered from a claims and underwriting perspective, and to the extent possible, the surety should be engaged as early in the contracting process as possible to avoid some of these risks.

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