Public-Private Partnerships: A Private Sector Perspective

UNIVERSITY OF BRITISH COLUMBIA SAUDER SCHOOL OF BUSINESS BAPA 508

Nicholas Hann
Macquarie North America March 2008

Agenda
How government pays for and finances a conventional project How did PPPs evolve
DB,DBO(M),DBF,DBFO(M)

Quasi equityperformance bonds, letters of credit, guarantees Debtbanks, bonds, private placements, monolines Role of the Credit Rating Agencies Role of lender advisors: technical, legal, market The financial model Financial StructuringDebt sizing DSCR Profile of debt amortization The essence of a financing agreement How does financing influence the nature of the PPP Who can borrow more cheaplygovernment or private sector Ways to improve efficiency of private financing
Funding competition Refinancing gain sharing Post construction take out Public sector debt funding with private sector guarantee

What are the major payment mechanisms for a PPP

User Pay Shadow Payments Availability Payments Construction Payments Capital Payments Operating Cost benchmarking Hybrids

How does payment mechanism affect the private sector financing The SPV and the importance of "non-recourse" Equity IRRhurdles and profile Mix of debt and equity Nature of debt- fixed rate, floating rate, inflation indexed Hedgingswaps, interest rates, inflation, currency, options Subordinated debt What markets are available and how have they evolved? Equityinfrastructure/pension funds, FM providers, constructors

Case Studies: Sea to Sky Highway and Golden Ears Bridge

Part 1 Conventional delivery and Public-Private Partnerships (PPPs)

Conventional delivery of government goods Introduction to PPPs and its evolution Benefits and other PPP considerations

Private and public sectors may have differing views of each other

Private and public sectors may have differing views of each other

Perspectives on Infrastructure

Private and public sectors may have differing perspectives on infrastructure

Government
600

Private Sector

400

Millions 200 0 Dec-98 Dec-2003 Dec-2008 Dec-2013 Dec-2018 Dec-2023 Dec-2028 Dec-2033 Dec-2038

Economic, social, transport, and urban planning view

Financial View Cash flow risk profile

While governments and private sector have different objectives regarding infrastructure, each partys interests are aligned through PPPs
6

How does the government pay for, finance, and deliver a conventional project? Sequence of events

Identified need for new service or infrastructure

Estimate cost

Consultants

Engage 3rd party to construct the project

Detailed Design of Project

Issue debt to finance project

Operate and maintain the project for the duration of its life

User Fees

Taxation

Imposition of user fees or taxation to repay accrued debt or otherwise cover the cost of the project

How does the government pay for, finance, and deliver a conventional project? Public finance life cycle

Construction contract

Private sector contractor

Construction

Loan

Lender
Repayment

Government

Infrastructure or service

Taxes or tariffs

Users or taxpayers

Service or utility

From the Canadian Council for Public-Private Partnerships 8

How does the government pay for, finance, and deliver a conventional project? Conventional tender process
Limited Liability No Link to Project

Design

Debt

Government

Construction

Operation & Maintenance Low Risk Acceptance No Involvement in DB

Rehabilitation

Limited Warranty Claims for Variations Limited Completion Support Lowest Cost

Tendered only When Needed

Introduction to Public-Private Partnerships (PPPs)

a co-operative venture between the public and private sectors where there is an allocation of the risks inherent in the provision of a Public Service. To be successful, PPPs must build on the expertise of each partner to meet clearly defined public needs through the appropriate allocation of resources, risks and rewards.
Canadian Council of Public Private Partnerships

10

How did PPPs evolve?

Much of PPP development has been attributed to several key factors

Government requirement to deliver service in the face of strained financial resources Desire to introduce market forces into the provision of public goods

Increasing transfer of risk

Desire to acquire private sector expertise and efficiency in the delivery of public goods

Privatisation Privatisation Public-Private Public-Private Partnerships Partnerships Franchising Franchising

Outsourcing Outsourcing Corporatisation Corporatisation Government Government Departments Departments

Increasing Access to Financial Resources

11

How did PPPs evolve?

General categories of PPP involvement

DB
Design-Build Government defines project requirements and undertakes financing activity Private sector assumes risk on its design, construction, and typically any cost overruns
No long-term transfer of risk

DBO(M)
Design-BuildOperate-(Manage) Private sector builds and runs the project, but ownership remains with the Government following construction completion Private sector receives an upfront and ongoing payments for operations

DBF
Design-Build-Finance Private sector arranges financing and construction Government provides payments to the private sector throughout the life of the project to cover upfront costs
Long-term agreement with Private Sector financing

DBFO(M)
Design-Build-FinanceOperate-(Manage) Private Sector finances, builds, owns, and operates the PPP under a long-term agreement Government or service users provide ongoing payments to the private sector to cover costs
Long-term agreement with Private Sector financing and ownership

Long-term agreement

Increasing transfer of risk from the government to the private sector

12

How did PPPs evolve?

The Public-Private Partnerships spectrum

Ministry, Crown Corporations Water Subways (Subsidized) Service Contract (Maintenance Contracted) Road Maintenance Hospitals Management Contract (O&M Contracted) Jails Design Build Most Real Estate Design Build Operate Highway 407 (1993) Design Build Finance (Shared) Operate Highway 104 Confederation Bridge F-M Highway Design Build Finance Operate Airport Authorities Scotia Schools Finance Design Build/Own Operate (Privatization) Highway 407 (1999)

Government

Government Finance

Government Developer/ Sponsor

Government Finance Commercial Finance Government Developer/ Sponsor Commercial Finance

Government

Design/Build Contract

Operations Contract

Operations Contract

Operations Contract

Developer/Sponsor Commercial Finance

Operations Contract

Operations Contract

Increasing private sector involvement

13

How did PPPs evolve?

Transfer of risk
Government Design & Construct Design Build Design Build (Turnkey) DBM Design Build Maintain DBMO Design Build Maintain Operate DBFMO Design Build Finance Maintain Operate Private Sector DBOOT Design Build Operate Own Transfer

Government needs to specify requirements decrease along the risk transfer continuum By the DBOOT end, Government should focus on specifying service levels and outcomes Nature of risk transfer changes significantly when private sector financing is introduced into the PPP (DBFMO/DBOOT)
Move from a contractual basis to an ownership basis Especially true when private sector accepts/shares in usage risk
14

How did PPPs evolve?

Transfer of risk
Design & Construct Design Risk Construction Risk Maintenance Risk Operations Risk Finance Risk Ownership Risk Market Risk DBM DBO(M) DBF(M) DBOOT

Increasing transfer of risk from the government to the private sector

15

When should a PPP be used?

Key decision: what is cheapest method to deliver service, considering whole life costs? Successful PPPs often have many of the following characteristics:
Government lacks resources to deliver service when demanded by the public Free alternatives reduce public opposition to user charges Actual or potential revenue stream, especially if it will cover all or substantially all of service costs Large up front capital investment Private sector has experience in providing service in other jurisdictions Risks are easily identified and packaged

16

Whole Life Costing

Whole life costs include:

Up-front and ongoing design, engineering, soft costs Capital costs (up-front and ongoing major maintenance) Financing costs for the entire life of asset Operating and Maintenance for the entire life of asset Risks (insurance, failure, etc.) for the entire life of asset

Benefits of whole life costs:

Whole life costs may be lower with a PPP because the concessionaire will consider higher initial investment if it results in even greater operational and maintenance savings

Whole life costing is the driving force behind much of the efficiency gains realized from PPPs

17

Example of Whole Life Costing

Whole life costs example (Coquihalla Tollroad) Cost of rehabilitating one km of road after 12 years is $65,000 Cost of rehabilitating one km of road after 20 years is $400,000 (6x greater) Government building Lifecycle costs after construction ( operations and maintenance) typically represent 80% of NPV of total cost Governments almost invariably under maintain assets Sea to Sky Highway concessionaire chose to lay thicker pavement than government standards (higher upfront costs) because they took risk that this would allow only two resurfacings rather than three during the concession (lower O&M Costs)

18

Viability analysis

ECONOMIC

COMMERCIAL
(Private Sector Risk-Return Requirements)

BANKABILITY

SHADOW TOLLING FARES

FINANCIAL

Cost Benefit Analysis

Includes positive externalities (environmental, congestion) Economic multiplier effects Economic viability commercial viability: Direct benefits Value of time Development value capture

PPP Analysis
Financial viability depends on maturity, pricing, risk, etc. Govt. mezzanine financing may be used to facilitate private finance Enhancements Leasing Revenue Bonds Securitisation Re-gearing

19

Differences in cost-benefit and requirements between a PPP and a conventionally delivered project
Government Cost benefit analysis determines whether to go ahead with project discount rate usually long term cost of government borrowing (usually higher than current market debt costs) Treasury allocates capital budget for project used to be on annual cash basis now accrual Amortisation of capital has to fit within budgetary forecast (Accounting) Debt is not project specific just part of Governments overall borrowings Project creates a sinking fund to pay back debt raised (cash operating budget ) Project has to meet interest costs on debt (cash operating budget) Project has to ensure that it has the operating budget to meet regular O&M costs (cash) Future rehabilitation generally requires a new allocation of capital budget
20

PPP Cost benefit analysis plus bankability analysis to assess commerciality of project and any government subsidies required Total budget allocated for annual payments inclusive of capital repayments, interest, operating and maintenance costs Debt can be project specific, tailored to risk of project, and is limited or non-recourse to government Future O&M costs and rehabilitation are fixed and are not a public sector risk

Role of the government and private sector in PPPs

Public sectors key role is setting the agenda

Specify desired outcome Controls terms of operation, including right to make future changes Maintains legal title to asset

Private sectors role is setting the price

Calculate financial impact of policy decisions Educate on concession model and how it addresses concerns Responsible for all expansion, maintenance, and operations costs Must comply with concession agreement Collects revenue Some key dials to consider Concession length Tolling schedule Non-compete clauses Revenue sharing Existing employees and labor agreements Condition of facility at end of concession

21

PPP tender process

Preliminary Design and Performance Specifications

Government

Equity

OMR

Build

Debt

Design-Build

Debt

Design-Build

Debt+Equity

Design

OM R

Equity

OMR

VIRTUOUS CIRCLE: KNOWLEDGEABLE INTEGRATED TEAMS IN COMPETITION

22

Typical transaction participants

Engineering Engineering Support Support

Project Project Sponsors Sponsors

Equity 5% - 40% Debt 60% - 95%

Government Government

State Support Offtake Agreement

Project Project Financier Financier

Project Project Vehicle Vehicle

Purchaser Purchaser

Design & Engineering

Turnkey Construction Contract

O&M Agreement

Engineer Engineer

Construction Construction Consortium Consortium

Operator Operator

The concession model of PPP

TRADITIONAL PROCUREMENT

CONCESSION MODEL

+ +
VS.

Revenue Efficiencies CAPEX Efficiencies OPEX Efficiencies Equity Additional Debt

ADDITIONAL: Infrastructure Economic Development Jobs

+ +

+
Standalone Bonding Capacity

Standalone Bonding Capacity

Examples
States estimate of value Indiana Toll Road Chicago Skyway $2.0bn $1.0bn Private Sector Valuation $3.8bn $1.8bn Additional Value Approx 90% more Approx 80% more
24

Comparison of approaches in toll roads

CONCESSION MODEL

More Money

Revenue

TRADITIONAL MODEL OF TAXEXEMPT BOND FINANCING

Toll = $2.00 Raises $100 M

Growth Stronger

Equity

Bank Debt

0 Revenue
Debt Coverage

40 Years

75

OR

Tax Exempt Bond Debt Years 40

CONCESSION MODEL WITH LOWER TOLLS

Revenue

Growth Stronger

Equity

Bank Debt 0 40 75

Lower Tolls
25

What are the major payment mechanisms for a PPP?

Demand-driven Payments

Non Demand-driven Payments

User Payments Tolls

Shadow Payments

Construction Payments
Operating cost benchmarking

Availability Payments

O&M

Capital

Hybrids

26

How does payment mechanism affect private sector financing?

Demand-driven

Non Demand-driven

User Pay

Shadow Payments

Construction Payments

Availability Payments

O&M

Capital

27

How does payment mechanism affect private sector financing?

Profitability-focused Project

Cashflow-focused Project

Asset-focused Project

Publicly Traded Equity

Corporate Debt Finance

Securitisation

Project Financing

Traditional Bank Debt

Asset Backed Securitisation

Private Equity

Public Equity Held Through Trust Structures

28

Examples of payment mechanisms Sea to Skyno user pay

Type of Payment
Availability Payments

% of Total Net Present Value

83%

Key Terms
Commencing on completion of each segment of highway. Subject to deductions for lane closures and for weaknesses in O&M. 33% [CHECK] of payment is indexed to cover inflation designed to cover O&M portion of costs Volume payment commencing only upon completion of entire highway and linked directly to number of vehicles using the road. Directly linked to the number of accidents on the highway compared to safety benchmarks Paid during construction period to incentivise superior traffic management

Shadow Traffic Volume Payments

13%

Safety Performance Payments

1.7%

Traffic Management Payments

0.3%

29

Examples of payment mechanisms Golden Earsuser pay

Golden Ears Bridge will be tolled ie: user pay Translink decided that it understood the traffic risk and that it would collect the tolls Translink makes an availability payment to the PPP Concessionaire This is somewhat backended to reflect the profile of the expected traffic revenues but there is a period where Translink is having to bridge a funding gap between expected revenues and its availability payments Availability payments are split into those to repay the capital portion of the transaction (debt and equity to fund initial capital costs) and those to meet operating and maintenance costs over time Bidders determined what the mix of payments is within parameters set by Translink All availability payments escalate at inflation All payments are at risk if construction is not completed Abatements to O&M Availability Payments cannot affect capital payments

30

Key financing features of Sea to Sky and Golden Ears

Finance Issue Sea to Sky
Equity 17.4%

Golden Ears
4% equity plus 4% subordinated mezzanine bank debt

Senior Debt

$498m 25 year international bank syndicated loan None

$900m 34.5 year international bank syndicated loan

Credit Support

Monoline Insurance Wrap (AMBAC and XL) Rated BAA2 Moodys

Hedging

Floating rate debt swapped to fixed

Floating rate debt swapped to fixed CPI Swap (RBC)

DSCR

1.17x

1.24x average 1.10x (even with 100% abatement of O&M payments)

31

PPPs deliver

A recent UK Treasury study into PFI projects showed: 89% coming in on time or early No cost overruns on construction borne by public sector Noting: 70% of Non-PFIs were delivered late, and 73% ran over budget UK National Audit Office Study of Highway PPPs found savings of: 19% on capital costs 34% on operating costs 17% overall lifecycle savings

Reasons for cost savings in UK PPPs Transfer of whole life responsibility to private sector Transfer of risk to private sector Broader competition (not just contractors, but also operators, suppliers) Reduction in scope for claims against governments Economies of scale in project management, design, construction, operation

Source: HM Treasury July 2003 32

Successful examples show that PPPs work in the US

ILLINOIS
Chicago Skyway
VIRGINIAN PILOT JUNE 5, 2006

INDIANA
Indiana Toll Road

TEXAS
Trans-Texas Corridor SH 121

VIRGINIA
Pocahontas Pkwy Capital Beltway I-95

THE INDIANAPOLIS STAR MAY 24, 2006

CHICAGO SUN TIMES OCTOBER 28, 2004

33

Why do PPPs bring these benefits?

Transfer whole life responsibility to private sector (not just construction) Transfer of risk to private sector
Each party manages risks they are best able to handle Creates incentives for private sector to perform

Government has ability to penalize for poor performance; replace poor service
Right to terminate contract

Broader competition Reduction in scope for claims against governments

Clear accountability

Economies of scale in project management, design, construction, operation Note key differences:
Traditional: Government specifies design PPP: Government specifies outcome or service

34

Major criticism of PPPs

Most of the risks are in construction, so if you do a design-build you get all advantages of a PPP with none of the unnecessary expenses Discount rate makes PPP look better than it is Value for Money analysis structured to put government provision at a disadvantage Private sector seem adept at shifting as much risk as possible to the government PPP contracts are highly complex and cumbersome

35

Questions for consideration

What are the key differences between PPP and conventional government delivery? How important is private sector financing to a PPP? Should a DBOM project be regarded as a PPP? What are the advantages/disadvantages of DBOM compared to a DBFO? How do the payment mechanisms used by the public sector determine the financing structure? How should the public sector account for
An availability payment transaction? Auser pay transaction?

36

Part 2 PPP structure and financing

Debt, equity, and the financial framework The Special Purpose Vehicle (SPV) Risks, challenges, and failures

Mix of debt and equity

Range of financing options

Financing Options
Debt

Equity

Banks Public listing Infrastructure Funds Financial Institutions Operators and Constructors Capital Markets CIB FRN Private Placement Sub-ordinated debt Lease-based Finance
38

How do financial markets deal with risk?

Private Sector
LOW RETURN LOW RISK

Public Sector What Risk?

Senior Debt Debt Guarantee By Taxpayers

MEDIUM RETURN

MEDIUM RISK

Subordinated Debt
HIGH RETURN HIGH RISK

Equity

39

Role of private sector debt in PPPs

Require vigorous risk assessment upfront Generally bring wide international experience Adjusts quickly to mistakes Forces clear allocation of risks among parties to PPP Forces much stronger contractor support packages than typical under unconventional delivery Requires equity necessary to cover residual risks in project Monitors project closely and steps in to solve problems Without arms length private sector debt, it is highly unlikely that risk allocation will be as effective

40

Financial structure

Debt is low cost starting point in a PPP is to see how much debt can be supported by the project The lower the risk (i.e.: the more guaranteed the payments by government are) the more debt will be able to be used The amount of debt can be supported by various forms of synthetic equity
For example if the main risk is O&M and this is supported by a guarantee from a credit worthy FM provider then this will allow more debtthe sub-contractor support packages in PPPs are often very important

If there is sufficient gap between the cost of senior debt and the cost of equity, then subordinated or mezzanine debt may be used
Note this is unusual in PPPs and is more driven by limitations in the availability of equity

Any capital which is required after all these sources are exhausted is equity The Weighted Average Cost of Capital from the combination of these is the most importantif there is only a small amount of equity it may not matter if it is a bit more expensive

41

Effect of WACC (Cost of Capital)

Type of Finance
Equity Subordinated Debt Senior Debt WACC

Project A
15% at an IRR of 12% None 85% at an interest rate of 6% 6.9%

Project B
5% at an IRR of 15% 5% at an interest rate of 10% 90% at an interest rate of 6% 6.65%

Cost of equity is often not very significant although it gets a lot of political attention Leverage is a key competitive advantage Subordinated debt can reduce cost of capital This is a simple WACC calculation as the profile of each source of finance varies over the life of the concession a more accurate WACC needs to be modelled WACC is very close to Project IRR (the return on the free cashflows of the Project before any financing structure)

42

Choice of Discount Rate

Criticism of PPPs often focuses on choice of discount rate (e.g.: CUPE Critique of VfM) Argue that Value for Money is created by choice of higher discount rate than government borrowing rate People who create PSC tend to front-end load the public sector costs and back end load P3 Costs. This is what PBC did with the Sea to Sky Highway CUPE 2007 Discount rate only changes the impact of a different timing of payments: a future dollar is worth less with a higher discount rate Conventional delivery and PPP delivery with the same payment profile will deliver the same result whether a high (private sector) discount rate or a low (government cost of borrowing) discount rate is used Choice of discount rate for evaluation affects bidders choice of payment profile if flexibility allowed:
Low discount rate encourages bidders to front end payments High discount rate encourages back ended paymentswhich typically means private sector more exposed to risk

Recommend consistent use and private sector WACC as the best reflection of project risks and the most neutral evaluation Note in absolute terms a higher discount rate can make a project look cheap
43

The Special Purpose Vehicle (SPV) and the importance of non-recourse financing

Recourse
Government
Loan, Recourse

Non-recourse
Government

No recourse if SPV fails

Lenders Private Sector Proponent
Loan

Private Sector Proponent

Repayment

Lenders Project
Repayment

Arms Length Special Purpose Vehicle

If the project fails to deliver cashflow and the loan cannot be serviced or repaid, the lenders will seek recourse in the private sector proponent

Project

No recourse is possible in this case

44

The Special Purpose Vehicle (SPV) and the importance of non-recourse financing
Banks and even PPP proponents dont like lending money or taking risks, particularly to stand-alone projects
Resultproject finance strategy (analogous to the public sector developing a PPP strategy) Will allow projects to occur without the Public Sector taking on an unacceptable level of risk or those risks the Private Sector is better able to manage

Project financing, often known as limited recourse financing, is a form of financing which relies entirely on the cashflows generated by an individual project and on the asset value of that project, and has no rights to any other corporate assets or guarantees
The borrower is usually an SPV, set up with the sole purpose of developing an individual project The SPV is bankruptcy remote, i.e.: it stands on its own independently of its corporate shareholders

Can government finance non-recourse? Revenue bonds in the US Non-share capital corporations in Canada (eg: Airports) Government-owned self supporting corporations (BC Hydro, BC Ferries)

45

Increasing sophistication of project finance

Structured project finance is becoming increasingly sophisticated:

Computer modeling, capital markets, structured equity products, infrastructure bonds, domestic leasing, crossborder leasing, etc. Project cashflows are being analyzed by risk and different risk categories financed separately Why? The lowest cost of funds creates the highest bid!

Project Finance as it was 12/15 year term very long Bank market only source Very restrictive bank terms and conditions In short: not very sophisticated

Project Finance as it is Capital markets accessiblemore flexibility

Indexed, nominal, convertible, subordinated bonds Terms up to 35 years Accept full project risk (construction?) Competitive debt service coverage ratios and terms

The banks fight back

Now lengthening terms (20 years plus being bid) Reducing debt service coverage ratios (DSCRs) Margins reducing

46

Major PPP risks

Construction completion on time

Government payments begin after completion Concession period starts from financial close not construction completion time Long Stop Date termination Incentives for early competition

On budget
Fit for purpose design: limit variations

Asset performance
Asset condition requirements End of term hand back payment/retention

Operational performance
Financial penaltiesabatement Default and termination

Service standards
Payment incentives Shadow Tolls
47

What creates a bad PPP

Government doesnt understand what it wants Government creates wrong incentives Political influence, e.g.: Asian development banks Government tries to transfer unrealistic risks and cost is too high Tender process is not competitive Risk is not satisfactory transferred Political interference changes risks Political bail out of troubled projects

48

Do PPPs fail?

If PPPs never ran into trouble, then not enough risk transfer Construction delays or cost over runs: often not public, absorbed by contractor
Examples: Transurban City Link, Channel Tunnel, Lane Cove Tunnel, SR125

Inability to raise finance

Examples: Channel Tunnel Rail Link

Inability to meet performance standards

Examples: Natural Physical Laboratory, Metronet, some prisons

Concessionaire weakens
Examples: Jarvis, Amey, TOLs

Errors in usage forecasts

Examples: Cross City Tunnel, Rostock Tunnel, Herren Tunnel, Dulles Greenway, Natural Express Group Melbourne

Accounting Treatments
Examples: Nova Scotia Schools

Political risk
Example: Frederickton Moncton
49

Default and termination

Major failures in a PPP (total loss, abandonment, insolvency) and persistent uncured minor failures (performance penalties) can lead to default under concession agreement Lenders will typically have a cure period to experience step in rights to:
Take over the SPV Replace non-performing contractors Provide more financing

If no cure, then government can terminate concession and take break asset or re-tender concession Termination rare usually step-in works

50

Compensation for termination

Early PPPs provided a government guarantee of debt repayment Now very unusual - many (eg. UK DBFO roads) have no debt compensation Unlike most companies, lenders have no rights to PPP assets Usual for government to:
Termination for default: pay lenders market value of concession determined by re-tender or consultant reports Termination for force majeure: pay lenders full value plus equity principal but no return Termination for convenience: make whole payment to debt and equity

51

Lenders and termination

Lenders keen to ensure that project has

Liquidity to ensure debt obligation always met Recovery to ensure principal can be repaid under a default or termination Note that several rating agencies do not consider recovery

Liquidity
Debt Service coverage ratio Liquidated damages for construction delay to long stop date Letter of credit to support LDs Letter of credit to cover default by OMR contractor

Recovery
Equity cushion Liability cap under construction contract OMR performance Security Terms and conditions of compensation

52

Why do PPP toll roads experience political challenges in the US?

Many stakeholders think road access should be free Equate PPP delivery with tolling although many public sector owned tollroads in US Loss of control of strategic assets specially to foreigners Lack of understanding of delivery efficiencies of PPP Threaten established interests Example Investment banks profiting from municipal bond issues
Davis Bacon and Buy America

53

The role of equity in PPPs

The equity IRR and investor profiles Equity valuation and stages of development Other factors impacting equity value

Equity IRRhurdles and profile

A TYPICAL IRR PROFILE

75%

50%

25%

0% 30 years -25% Breakeven

-75%

-100%

55

Why invest in infrastructure?

Reasons vary between investors: Long term assets Steady cash flows Lower volatility than other investments Backbone to economy and industrial development Defensive investment to hedge against recessions Most have sustainable competitive advantage Risk profile and re-rating opportunities, resulting in capital gains

56

Equity investment criteria

Investment criteriaperformance targets Different investors have different criteria NPV, IRR (direct investments, infrastructure funds) Cash/distribution yield (listed equities, listed infrastructure funds) Accounting profit, P/E ratios (corporates) WACC (corporates) Times capital returned, exit multiple (private equity) Returns over 3-5 years with assumed exit strategy (private equity) Years to cash flow positive (various)

57

Equity investment constraints

Investment constraints
Cash yield Debt coverage Earnings IRR hurdle rate Leverage

58

Investor profiles Overview

Groups of investors commonly found in PPP financing
Infrastructure funds Pension funds FM providers Constructors

Types of investors
Strategic investors Financial investors

Industry players

Construction, engineering firms

Institutional investors

Infrastructure funds

Retail investors

Fund managers

Pension funds
59

Investor profiles Strategic investors

Strategic investors
Examples of strategic investors
Toll Roads Cintra (407 ETR) SNC-Lavalin (407 ETR) MIG (407 ETR) Dragados (Fedricton-Moncton) Utilities SNC Lavalin (AltaLink) Trans-Elect (AltaLink) General Electric Alsthom Social Infrastructure Armoyan Group (Nova Scotia schools)

Key investment drivers

Earnings Cost of capital Ancillary revenues (i.e. operating agreement, engineering contracts) Control (including pre-emptive rights)

60

Investor profiles Financial investors

Financial investors
Institutional (direct) and semi-direct investors
Direct Investor

Direct investors
Mostly pension plans including Ontario Teachers, OMERS / Borealis, Caisse Performance benchmark depends on nature of liabilities Key investment drivers Returns Cash yield (for some investors) Match assets against liabilities (inflation hedge, term)

Infrastructure Asset

Semi-direct investors
Direct Investor

Some investors want to invest directly, but lack expertise or resources to manage investments Intermediary performs ongoing management (and in some cases, initial assessment) of assets: Representation on Board Valuations and reporting Exit strategies

Manager

Infrastructure Asset

61

Investor profiles Financial investors

Financial investors
Listed equity fund managers Private equity fund managers

Note: for public equity only (mutual funds) Fund managers invest funds on behalf of investors in their managed funds Fund managers generally have in-house analysts who manage one or more industry groups Performance assessed against benchmark of the underlying managed fund Key investment drivers:
Views of equity analysts Returns, earnings Cash yields (depending on underlying fund) Whether stock is part of the stock market index Number of investors, depth and turnover of stock
Stocks Investors

Private equity fund managers usually manage funds that invest in unlisted equity, such as venture capital, development capital, management buy-outs, etc. Most private equity fund managers do not invest directly into infrastructure
Infrastructure investments usually made through managed infrastructure funds (diversified and single-purpose)

Fund Manager

Managed Fund

Key investment drivers

Total returns Liquidity and exit strategy

Often more appropriate for smaller, specialised investments which meet a funds investment philosophy

62

Investor profiles Financial investors

Financial investors
Infrastructure funds Retail investors

Listed and unlisted equity funds which invest only in infrastructure projects Fund philosophy and performance benchmarks may vary Key investment drivers:
Total Returns Fit with investment philosophy Control/Influence (for some funds) Exit strategy (for some funds)

Retail investors are significant investors in a number of projects listed on Australian and other stock exchanges
e.g. Hills Motorway Group, Transurban, Envestra

Key investment drivers:

Cash yields, capital gains Views of equity analysts Profile and coverage

Fund Manager Investors Infrastructure Fund Infrastructure Asset

63

Equity valuation

Cash versus accounting As infrastructure assets are mainly cash generating businesses, the focus is on cash
Cash is king

Accounting income does not fully reflect the underlying cash flow
By convention or at times by design e.g. capitalization and amortization of R&D, interest expense, exploration, depreciation, etc. Does not take into account working capital movements / adjustments

Equity Discount Rate Equity discount rate used will reflect the level of risk in the project at any point in time
e.g. construction vs. operations phase

In addition, the appropriate discount rate applicable will depend on the type of project / assets being acquired
e.g. Electricity generation vs. electricity transmission or distribution

64

Toll road risk profile

The risk profile of a toll road changes throughout the life of the project and thus the applicable risk premium employed by equity investors will change
10% Risk Premium to Risk Free

8%

6%

4%

2%

0% Development Construction Ramp-up Maturity

Assets are likely to be re-rated as they mature and traffic pattern is established
65

Risk profile of the utility sector

The following graph illustrates the risk premiums that would be attached to various segments of the utility sector

25%
Risk Premium to Risk Free

20%

15%

10%

5%

0%
Generation Transmission Distribution Retail

66

Stages of development infrastructure assets

In general, the following diagram shows the change in asset value as the project develops and matures over time

Asset Value

Development Risks Development Design Construction Ramp-up Throughput Operating Construction

Ramp-Up Consolidation

Maturity

67

Evolving risk profile, e.g. roads

Project

Year

Construction Risk

Traffic Volume

Tax Risk

Financial Risk

Network Risk

Force Majeure

Gateway Bridge Harbour Tunnel M4 Motorway Upgrade M5 Motorway M2 Motorway Melbourne City Link Eastern Distributor

1983 1986 1988 1990 1992 1995 1997

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Examples of toll road risks

While the value of an asset may increase from the development phase through to the maturity phase, there are a number of risks associated with each phase Listed below are a number of examples where risks have materialized on toll road projects at various points of their development
SR125 - Development phase was delayed for over 10 years due to environmental issues, with significant amount of funds spent during this phase and a corresponding delay in any profits Melbourne City Link Construction phase was interrupted when an underwater tunnel began to leak. Further issues arose when the tolling and billing systems were unable to handle the traffic volumes experienced Dulles Greenway Traffic was 50% below forecast at opening and the operator halved the toll in order to encourage greater use

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Equity value enhancements

There are a number of equity value enhancements which may be included in a private sector bid for a toll road:
Terminal value Refinancing and re-leveraging Tax efficiency Discount rate differential between government and private sector Subordinated debt Timing of draw downs Non-recourse / no guarantees Letter of credit vs. cash reserves Triggers to release reserves Capital distributions

These are explained in further detail on the following pages

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Terminal value

Terminal value measures the total value of a corporation or asset beyond a particular analysis period For example, depending on the term of the toll road concession proposed by the government and the term of the financial model developed by the bidders, it may be appropriate to include a terminal value as part of the equity valuation
For a 100 year concession and a 20 to 30 year financial model, it would be appropriate to include a terminal value at the end of the valuation period For a 50 year concession and a 50 year model, it would not be appropriate to include a terminal value

There are a number of approaches when determining the terminal value for a company or an asset
Annuity (or perpetuity) calculation

1 (1+ i a ) TV = C ia

where : TV = terminal value C = terminal year cashflow n = number of years

i g ia = 1 + g g = growth in cashflows i = discount rate

Multiples e.g. EV / EBITDA or rate base multiples

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Tax efficiency

Optimal acquisition structure should take into account:

Structuring of the equity investment Composition of the consortium (financial vs. strategic partners)

Structuring of equity investment

Potential value may be obtained by introducing additional leverage from internal sources (i.e. shareholder debt) Additional leverage may result in a reduction in taxes paid

Composition of the consortium

Tax status of pension plans vs. other investors Tax implications for strategic investors and the ability to utilize a tax efficient in-bound investment structure

Generally, pension funds do not factor tax exempt status into bids
Desire to be on the same terms as other investors

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Discount rate differential

There is usually a difference between the discount rate applied by the public sector (lower) in evaluating the cost of the project and the discount rate applied by the private sector (higher) in evaluating the benefits of a project Private sector values cash upfront more than it costs the public sector due to the higher discount rate applied by the private sector Ability to increase returns to private sector by sculpting revenue profile to the benefit of both parties For example, structuring of a Power Purchase Agreement tariff between a government-owned electricity distribution company and electricity generation company to allow higher tariffs upfront

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Other equity enhancements

The remaining equity enhancements include: Subordinated debt
Cheaper than equity and provides additional leverage to reduce tax payments

Timing of draw downs

Delaying equity investment until the end of construction vs. pro-rate funding with debt during construction may improve equity IRR

Non-recourse (or no guarantees)

Does not restrict or inhibit the Balance Sheet of the parent or the equity investor

Letter of credit versus cash reserves

Letter of credit provides a much more efficient mechanism to provide for reserves than maintaining cash balances

Triggers to release reserves

Allows equity to value an earlier release of cash reserves

Capital distributions
Returning distributions as capital rather than dividends can push tax liabilities further into the future

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Quasi equity

Equity risk can be covered in a variety of ways

Someone needs to own the SPV Shareholder subordinated debt can substantially replace equity 99% - 1% subject to thin capitalisation rules Banks may require limited equity if risks are fully covered by contractor performance security in form of: Parent company guarantees Performance bonding Letters of credit Retentions and cash reserves

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Dramatic changes in infrastructure equity

As it was Small funds Private Placement Contractor or operator-supplied Cost at 20-25% (plus) after-tax As it is now Financial institutions (pension funds, insurance companies, fund managers) now interested
Many have infrastructure teams

Public listing now a serious option Listed infrastructure funds emerging Characteristics of public equity
Cost can be as low as 8 to 15% pre-tax IRR Liquidity Understand risks Prefer pre-tax cash distributions

Equity summary

As a result of the infrastructure funding gap, there has been increased opportunity for private sector equity investment in infrastructure projects Infrastructure assets provide private sector equity investors with:
Long term assets that have steady, predictable cash flows Assets that generally have a sustainable competitive advantage A defensive investment to hedge against recessions

There are two type of investors:

Strategic Includes construction and engineering companies. Key investment drivers include earnings, ancillary revenues and control Financial Includes pension plans and life insurance companies. Key drivers include equity yield and IRR

The equity discount rate applied by investors will depend on the risk profile of the project or asset Improvements in equity returns can be achieved through various mechanisms
Terminal value, refinancing / re-leveraging, tax efficient structures etc.

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Part 3 The role of debt in PPPs

The nature of debt and debt profile Swaps and other debt instruments Refinancing and releveraging Sources of debt and credit rating agencies

What do lenders look for?

track record

assets

cashflow

Nature of debt

Fixed rate
Interest rates can be fixed either On medium term rolling basis More usually long term Bank marketfixed for floating swaps Bond markettypically fixed rate issues Essential when payment stream is fixed and does not escalate, e.g.: STS Highway Note swaps can extend beyond term of debt

Floating rate
PPPs generally do not use floating rate debt Too much uncertainty Too difficult to assess forward looking DSCR test May use floating rates for deposit interest

Inflation indexed
Some PPPs have revenue stream linked directly to CPI Examples GEB and most toll roads Fixed rate debt leaves concessionaire exposed if inflation is lower than their forecast Or less competitive if inflation is higher Issue a Real Return Bond Strong interest from pension funds Add a CPI swap Cross currency swap also possible

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Real Return Bonds

An RRB is a real-return bond It differs from a nominal bond in that investors receive a real interest rate, plus indexation for inflation
Investors in a nominal bond accept inflation risk because of their fixed payment stream RRB investors are hedged completely against inflation

Because of the inflation hedge provided to investors, the payment increases over time With the payment increasing by inflation, this allows PPPs with inflating payment to match their payment stream to their debt costs
RRBs are therefore useful in PPPs where a user fee is charged that escalates with inflation, or where a high proportion of the availability payment escalates with inflation

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Swaps

CPI income swap Foreign exchange swap Interest rate swap Total return swap Accreting swap Step-up swap

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Subordinated debt

Shareholder subordinated debt common Tax structuring advantages Mezzanine debt taking a risk profile between senior debt and equity is advantageous Usual where there is an equity shortage PPPs rarely have room for third party subordinated debt US subordinated debt market (second lien debt) is typically looking for higher returns than PPP equity Critical subordinated debt issue is whether it has the right to accelerate senior debt in event of default

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Refinancing and re-leveraging

As risk profile changes, credit rating typically improves Improvements in credit rating can be converted to value through:
Refinancing at better terms and conditions Re-leveraging at increased debt levels and making distribution to equity

Financing is key to value creation Refinancing can add substantial value to equity investors Interlink Roads (M5, Sydney) refinancing

Examples
Interlink Roads: Refinancing brought forward distributions to equity by 9 years
Before
250 200 150 100 50 0

After
180 160 140 120 100 80 60 40 20

Operating Expenses Bank Debt Tax Equity Distributions

Operating Expenses Bank Debt Tax Equity Distributions

Time

Time
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Sources of debt
Debt Enhancement Monolines
Underwriters and MLAs International Syndicate Typically European Bank Lead Long Commitment Periods Drawdown as Needed Flexible prepayment Priced off GOCs Relatively Easy Renegotiation Long Term Maturities Priced Off LIBOR/CDOR Inflexible Renegotiation Maturities to 30 years but expect Refinancing Make Whole on Early Repayment More limited number of Parties under Renegotiation Bought deals Difficult to Lock in Margin Tend to be Price Setters Require at least One Rating Can be Unrated A rating easiest to Market Negative Carry from Lump Sum Drawdown More Flexible Structures: Drawdown and Amortisation Firm Underwrites more Likely Limited Pension Fund and Lifeco Market Provide Guarantee to Increase Underlying BBB Rating to AAA Charge Annual Premium less than the reduction in Bond Margin Regulatory and Market Limitations to Competitiveness in Canadian Bond Issue Very common in US (municipal bonds) and UK Under BASEL 2 attractive to Banks Require Moodys and S&P Ratings Monoline downgrade risk now big issue
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Banks

Bonds

Private placements

Role of the credit rating agencies

To objectively assess the credit risk of the projects, companies, and financial instruments seeking debt finance

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Questions for consideration

What is the most appropriate method to determine equity returns? What should be the public sectors level of knowledge of and involvement in the private sector financing? What are the major differences between a bond and bank financing? How do monoline insurers work? What value do they add to a transaction and why? What is the relationship between the Debt Service Coverage Ratio, the Debt Equity Ratio and the equity return? What is the purpose of the different types of Debt Service Coverage Ratio? What would influence government's to use public sector debt within a PPP structure?

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Part 4 Financing a PPP project

Financial modeling and structuring The financing agreement Government versus the private sector: who can borrow more cheaply? and risk pricing Ways to improve financing efficiency

Financial modeling

Highly complex spreadsheet Contents separated into different pages

Summary page Assumptions Cashflow Depreciation Equity Income Charts and graphs

Financial information can be modeled monthly, quarterly, and annually Use of macros to automate optimization of solution and other tasks

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Financial structuring
Case 1 Project cost Debt-to-equity ratio (leverage) Minimum ADSCR required Debt interest rate Investors required Equity IRR Debt term (years) 1,000 95:5 1.20x 6.0% 15.0% 26 Case 2 1,000 91:9 1.20x 6.0% 15.0% 26 Case 3 1,000 93:7 1.15x 6.0% 15.0% 26 Case 4 1,000 91:9 1.20x 6.0% 9.0% 26 Case 5 1,000 70:30 1.20x 5.8% 9.0% 26

Annual payments Annual debt service (annuity repayment) Investors required annual return Service Fees to cover debt service + return* Actual ADSCR Service Fees required for Cover Ratio*
* net of amounts to cover opex.

73 8 81 1.11x 88

70 14 84 1.20x 84

72 11 82 1.15x 82

70 9 79 1.13x 84

53 30 83 1.57x 63

Source: Yescombe
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Profile of debt amortization

Payments

Debt Equity Equity Debt Debt Equity

Time

Payments

Time

Payments

Time

Equal Debt and Equity Payments

Front-end Equity Payments

Back-end Equity Payments

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The essence of a financing agreement

Authority
Concession Agreement

Lenders Direct Agreement

Concessionaire
Collateral Agreement

Credit Agreement

Lenders
Banks

Design Build Contract Bondholders

Subcontractor
Design Build Guarantee

DB Direct Agreement

Sub. Guarantor

DB Guarantors Direct Agreement

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Who can borrow more cheaply government or private sector?

Since Government can borrow for less than the Private Sector, the Government should finance all public works projects. Is this true?

Debt Service

Equity

Government

Project Debt Margin Debt Service

Private
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Who can borrow more cheaply government or private sector?

Government Financing
Government Debt, such as municipal and government bonds

Government Sources of Payment

Taxation, such as gas, property, and income taxes
Advantages

Tolling, User Fees

Implicit Government guarantee traditionally lowers the Governments cost of borrowing

Reliable source of funding due to perpetual mandate to impose taxes

Pay-for-use framework, a better approach to internalize costs and account for externalities

Disadvantages

High existing leverage Additional borrowing consumes borrowing capacity and strains the Governments credit rating, thus increasing its borrowing costs Lower rates argument ignores the pricing of risks

High existing taxation rates Can result in unintended augmentation of incentives Albertas and BCs budget is dependent on volatile resource industries, thus, the results of piecemeal development can lead to higher costs and delays

In practice, tolling of roads is not used in Canada outside the realm of PPPs Not a feasible method of funding for certain types of projects (i.e. the health care sector) Potentially high overhead costs (i.e. London Congestion Charge)
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Who can borrow more cheaply government or private sector? Lower rates argument ignores the pricing of risks
Pickering A
Refurbishment originally estimate at $800 million Now estimated at $2.5 billion

Highway 407
When Highway 407 was opened, the toll system was not ready for operation Ontario lost approximately 6 months of revenue while servicing the debt

Pacificat Fast Ferries

Unfortunate and massive cost overruns

Vancouver Convention & Exhibition Centre

New cost estimated to be in the range of $800 million Cost overruns projected to be $300 million
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Who can borrow more cheaply government or private sector? Lower rates argument ignores the pricing of risks
Private Sector Cost of Capital (Debt and Equity) reflects implicit and explicit risk of Project
Government typically cannot finance nonrecourse (more on this later) Therefore it finances with 100% equity at risk, i.e. it is responsible for any cost overruns

Implied Government Guarantee: taxpayers assume the Project Risks

Government has access to tax base to guarantee debt payments Government can impact fiscal policy in their favour to ensure debt is paid (print money)

If the Government Cost of Capital is its Cost of Debt, then all Government investments are risk-free!

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Who can borrow more cheaply government or private sector? Lower rates argument ignores the pricing of risks
An example
Take a typical $100 million project over a 30-year concession financed at 7%... If the project experiences a 5% construction cost overrun and a 6 month delay, the cost of capital needs to be 0.79% lower (0.466% and 0.326% respectively) to compensate for the higher borrowing requirement

In fact, typical cost overruns for Government projects are far higher than the 5% used here
Study conducted by Flyvberg, Holm and Buhl in 2002 (Underestimating Costs in Public Works Projects) reveals the following: Average Cost Escalation Project Type Rail Fixed Link (Bridges and Tunnels) Road All Projects Number of Cases 58 33 167 258
(Actual construction cost over estimated costs at project approval)

44.7% 33.8% 10.4% 27.6%

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Who can borrow more cheaply government or private sector? Lower rates argument ignores the pricing of risks
An example (continued)
Lets look at the same $100 million project and assume that it has now been successfully completed on time and on budget Assume its a facility (building) that requires $10 million of operating and maintenance costs If the facility experiences a 5% operating cost overrun, the cost of capital needs to be 0.63% lower to compensate for lower funds available for debt service

Typical operating cost savings in a PPP are again much greater than this example:
19% on capital costs 34% on operating costs 17% overall over entire life of project

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Who can borrow more cheaply government or private sector?

Risk balances the equation

Risk Transfer Debt Service

Equity

Debt Service

Government

Private

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Who can borrow more cheaply government or private sector?

Governments ability to borrow at a low rate is not unlimited
The Governments borrowing capacity is limited and faces an increasing marginal cost due to a worsening credit rating
26 year Government of Canada 26 Year Province of BC 24 Year Province of Ontario 28 Year Province of Newfoundland 5.37% 5.75% 5.79% 5.85% Spread 0.38% 0.42% 0.48%

Government and private sector have access to the same pool of investors and lenders
All else equal, increases in Government borrowing increases the markets overall borrowing costs and crowds out private sector borrowers
Net New Issuance Governments Corporates Infrastructure 1990 to 1995 84% 15% 1% 1996 to 2000 47% 47% 6%

Decreases in Government issuance allow for an increase in private sector issuance Thus, our Province should save its credit capacity for those projects which cannot be effectively completed without provincial borrowings
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Who can borrow more cheaply government or private sector? Rising debt restrict infrastructure spending
Note: curved path indicates how the ratios of debt changed through the years

Government debt has risen substantially since the 1960s

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Who can borrow more cheaply government or private sector?

Limited borrowing capacity

Use of Debt Capacity

Equity

Risk Transfer Debt Service

Debt Service

Private

Government

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Who can borrow more cheaply government or private sector? Benefits from PPPs
Achieve public policy sooner, at lower cost while continuing to reduce provincial debt
Improved speed and efficiency of procurement Service delivery at lower overall cost Additional financing without impacting Government credit capacity Proceeds from PPPs may be used to reduce Government debt Value captureprivate sector may be given a wider mandate than public provider Transfer of risk from the public sector to private sector Clear accountability

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Who can borrow more cheaply government or private sector?

Significant cost savings in PPPs

Improved project delivery under PPP in UK Report by Comptroller and Auditor General Feb 2003
Government Delivery Over Budget Delivered Late 73% 70% PPP Delivery 22% (1) 24% (2)

(1) (2)

No impact to government except where scope changes Only 8% delayed more than 2 months.

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Who can borrow more cheaply government or private sector?

Public sector comparator reveals improved performance

Equity Value of Better Performance

Use of Debt Capacity

Debt Service

Risk Transfer Debt Service

Private

Government
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Who can borrow more cheaply government or private sector? Private sector capital is not that expensive
Governments generally issue plain vanilla debt Private Sector debt costs if structured can be close to government cost Equity delivers improvement in risk management and performance Taxation effects Structured Finance UK estimate that the risk premium for private sector finance is between 30 100 bps Government holds assets at costdoesnt revalue.

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Ways to improve efficiency of private financing

Funding competition
Common in mature UK PPP sectors Selecting a preferred bidder without committed finance Competition for debt finance monitored by Government after award Can result in more competitive funding Only works when risk allocation between different bidders is the same

Refinancing gain sharing

Now typical for Government to share in 50% of any refinancing gain Except where refinancing benefits bid, e.g.: STS Highway Gain sharing based on excess above a threshold IRR Open to gaming by bidders

Post construction take out

Similar to DBF concept Government takes out construction period financing a few years post completiondependent upon performancenot a guaranteed take out Benefits debateable

Public sector debt funding with private sector guarantee Pilot schemes in UK Idea is to reduce base rate costs UK gilts lower cost of funds than interbank Currently topicalCDOR swap currently 60 bps over GOCs35 bps when we did STS Banks issue a letter of credit to support project Margin should reflect credit risk Often difficult to issue long term LCs No funding required by private banks
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Questions for consideration

What were the unique features of the Sea to Sky Project and how did these benefit or disadvantage the transaction? What were the accounting issues with Sea to Sky? Would Golden Ears Bridge have been a better PPP if Translink had passed demand risk to the private sector partner?

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Part 5 PPP transactions and public sector accounting

Government budgetary considerations The ideal PPP transaction and impediments Accounting treatment of PPPs

Introduction

Similar to the private sector, the accounting treatment of certain transactions are crucial. They can make or break a deal. Macquarie has experienced many transactions that provide value for money which do not go forward due to negative accounting implications This section will explore the potential accounting issues that must be dealt with when structuring a PPP and the possible outcomes

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Budgetary and accounting objectives

Governments do not budget and account in the same way BC has moved further (and faster) to full accrual accounting Unique set of issues, requiring a unique BC framework Balance the accruals budget
Avoid unnecessary asset write-downs Avoid crystallization of potential future liabilities

Substance over form Ownership important from presentational perspective Sufficient control to capitalize contributions (assets and monetary) No great focus on off balance sheet

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The ideal PPP transaction

Private sector provides a service to contracted performance standards Province pays for service as and when delivered No payment if service is not delivered or not to agreed standards Province expenses payments as and when incurred No balance sheet impact: No budgetary impact other than year in which service is provided and paid for Private sector has full flexibility to deliver the service in the most efficient way (i.e. mix of capital versus operating inputs)

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Factors which get in the way

Use of existing public sector assets to deliver service Creation of assets underlying the service Reversion of existing and new assets to Province at end of contract term Requirement of Province to step in and acquire assets in event of default Need (sometimes) for minimum service payments (e.g. availability) Preference (sometimes) for public sector money to be contributed up front Presentational need for Province to own assets or to exercise use and control No recognised accounting standard for PPPs: treatment often politicized

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Accountingassets

Existing
Risk of write down Lease classification: operating lease JV or partnership? Periodic review

New
Should they appear on balance sheet
Corresponding liability?

Lease classification: finance lease Use and control Right to tax depreciation Asymmetry of private sector and public sector treatment (SPE guidelines) Default

Termination and Step-in

Residual risk Contingent liabilities

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Accountingservice payments
Separability of payments
Payments for an asset (availability) Payments for a service (usage)

Separability of contracts Unitary payments: total payment applied to lease classification Demand linked payments: shadow tolls

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Worst outcomes
Desirable PPP attributes are weakened by accounting and budgeting requirements Examples Accounting treatment affects flexibility to determine appropriate mix of capital investment and operating costs to deliver service over long term Accounting treatment results in abandonment of PPP, even where value for money is demonstrated Accounting treatment distorts the transaction structure Accounting treatment forces inappropriate risk transfer Accounting treatment reduces private sector appetite and/or competitiveness

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United Kingdom and Australian examples

UK Formalised Guidelines FRS5 SSAP21 SORP Treasury Taskforce TNI Major emphasis on off-balance sheet treatment Highly centralised: Partnerships UK, Treasury, Auditor General and Inland Revenue cooperate Emphasis on: Separation of contract Qualitative indicators (similar to use and control) Quantitative indicators (similar to SPE guidelines)

Australia Transaction Based Mix of on and off-balance sheet depending on sector and level of public sector involvement Australia Tax Office attacks PPPs as potential tax leakage from Federal to State; aggressive Auditor Generals Closer to full accrual accounting Greater variety of financing techniques Well regarded public agencies in terms of accounting (e.g. RTA)

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PPP issues and accounting treatment

PPP ISSUE Contribution of existing asset

ACCOUNTING TREATMENT Transfer of ownership to private sector Operating lease to private sector Expensed Finance lease to private sector Contribution of asset into JV

BUDGET IMPLICATION Expense of difference between transfer value, if any, and book value Remains on balance sheet Expensed Expense a portion Capitalization and amortization Expensed Recognized as asset; book income Recognized as asset; reduce as services provided Capitalization and amortization (and revaluation) No immediate effect Note to accounts Expensed as incurred Capitalized with payments crystallized as liability Operating lease payments expensed as incurred

Up-front contribution from public sector

Acquisition of portion of asset Grant Classified as subordinated debt Prepayment for services

Public sector acquisition of asset at end of Emerging asset through the concession period concession Recognize as asset on transfer Termination buy out Ongoing payment: payment for services Contingent liability Variable payment for services Payment for asset: Finance lease Payment for asset; Operating lease

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Sea to Sky Highwayaccounting issues

The BC Government faced accounting difficulties regarding the size of the liability to be recorded on their balance sheet for the Sea to Sky Highway Improvement Project The Auditor General's office believed that the payment stream should be discounted at the government's cost of borrowing
This results in a liability significantly greater than the build cost In contrast, utilizing the Project IRR would result in a liability equivalent in value to the upfront private financing

While accounting should actually be irrelevant in determining the source of financing for a project, this difficulty forced accounting considerations to the fore in PPPs This clearly demonstrates the importance of the discount rate in PPPs

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Summary

Accounting treatment of PPP transactions can play a large role in the successful implementation and adoption of PPP projects by the government Macquarie have experienced projects that were purely driven the accounting treatment to projects driven by value for money Some governments promote PPP transactions through regulations while others attack PPPs and view them as a form of tax leakage. These issues must be clearly understood before any PPP transactions can proceed

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Part 6 Case studies

Sea to Sky, Golden Ears Bridge, Chicago Skyway, SR-125, South East Anthony Henday Drive Airports, FBOs Tarcoola to Darwin Railway

Sea to Sky:
Case Study

Overview of Asset Upgrade of existing road between Vancouver and Whistler 105km in length 2 and 3 lanes in most sections 25 year concession from financial close Construction must be completed by 2009, prior to Winter Olympics Operation and Maintenance for 25 years Availability, safety and traffic payments Overview of Transaction Located in Vancouver B.C. Upgrade of an existing road Total cost of CAD $600m Shadow toll Project is being procured as a Public Private Partnership by Partnerships BC Macquarie selected as preferred proponent and reached financial close in June 2005
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Organizational structure

Ministry of Transportation DBFO Agreement S2S Transportation Group Equity Debt

DB Contractor

O & M Contractor Miller Group

Kiewit

and Capilano Highway Services Joint Venture

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Partnership objectives

Province wanted:
Transfer full Design Build Operate Finance (DBFO) risks to private partner Maximum Highway improvements for a defined budget over 25 years (Provincial Corridor Objective exceeded money available) Safety, mobility, asset management, traffic management, environmental and First Nations improvements Strong Concession documentation and payment mechanism to incent high level of performance Fair and competitive procurement process High level of bid commitment and certainty of timely close and delivery

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Partnership results

Province received all of the above, and:

Three strong competing consortia: ultimate winner a consortium of Macquarie, Kiewit, Hatch Mott, Miller and Capilano Substantial added value beyond expectations (including 20km of additional passing lanes, 16km of additional median barrier, 30km of additional shoulder improvements) Commercial Close within 2 months of selection and Financial Close within 3 months (with election in the middle!) Weighted average cost of capital in mid 6% range

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Financing

$105m equity and $496m of debt (17:83) Competitive tax exempt equity from Macquarie Essential Assets Partnership Fully committed underwritten long term European bank debt at bid
Swapped into fixed rate

Refinancing expectations bid Very tight coverage ratios considering the payment mechanism

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Significant issues

Very strong construction completion support package required Liquidated damages for delay Letter of Credit Retention Milestone Payments and schedule defaults Longstop Date

Strong OMR support package required Performance Bonding and Letter of Credit Reserving

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Major innovations

Complexity of optimising Highway improvements to the available budget Construction period staged completion to earn revenues Exceptionally high level of financial commitment at bid facilitating quick close and minimal changes Highly efficient combination of debt and equity drawdowns, ensuring no negative carry and lowest cost funding used first Tax efficient investment structure

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Golden Ears Bridge

Case Study
Overview of Asset A 1 km, six-lane bridge that spans the Fraser River The most significant improvement to the Greater Vancouver road system since the completion of the Alex Fraser Bridge in 1986 Construction began in summer 2006, with a scheduled opening date of summer 2009 Project developed by TransLink, and the South Coast British Columbia Transportation Authority Studies conducted for TransLink show that the new bridge will have major long-term impacts on the region, improving travel times and promoting economic activity The Golden Crossing Constructors Joint Venture is managing design and construction. The joint venture is made up of Bilfinger Berger (Canada) Inc., the Canadian arm of a global engineering and construction firm, and CH2M HILL, an international engineering and project management firm Overview of Transaction Financing is provided by the Golden Crossing General Partnership under a 35.5 year agreement with TransLink The transportation authority is to repay the General Partnership over time after the bridge is open

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Golden Ears Bridge

Case Study Financing structure
Bilfinger Berger AG (Unrated) GERMANY CANADA Golden Crossing Holdings Inc. 100%
Equity Infusion

United Kingdom

CANADA

100%

100%

Golden Crossing Finance Inc. On Loan

Senior Secured Credit Mezzanine credit Equity Bridge

Depfa Bank (Mezzanie Agent)

Golden Crossing investments Inc.

9% .9 99

Depfa Bank PLC & Dexia Credit Local (Lead Arrangers) Financial Guarantee 50% Ambac Assurance UK Limited (Aaa insurance financial strength) Financial Guarantee 50% XL Capital Assurance (UK) LTD (Aaa insurance financial strength)

100%

Golden Crossing Inc.

0.01%

Golden Crossing General Partnership

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Golden Ears Bridge

Case Study Sea to Sky and Golden Ears Bridge contractor support packages
STS DB Contract Liquidated Damages + Letter of Credit Limit of Liability Parent Guarantee OM Rehabilitation Kiewit 10% 50% KCC Miller Capilano GEB Bilfinger Berger/CH2M Hill 15% 50% Bilfinger Berger AG/CH2M Hill Companies Ltd. Capilano Labour and Materials bonds 1 year cost cap SPV = MRF 3 year look forward

Letter of Credit

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Chicago Skyway:
Case Study
Overview of Asset Built in the 1950s 7.8 miles in length 3 lanes in both directions Mostly elevated structure Completion of a $300m rehabilitation project expected in 04 Manual tolling (no electronic tolls) EBITDA (2002): US$33 m Understated due to construction rehabilitation program Average Passenger Vehicles per day: 50,000 Overview of Transaction City of Chicago sold a 99 year concession for the Chicago Skyway Competitive process involving 5 qualified parties Cintra-Macquarie consortium was the successful bidder Final Sales proceeds of $1.83 billion (49 x 2005 EBITDA) Process run by Goldman Sachs First privatization of an existing toll road in the U.S. Financing structure used taxable debt (no tax-exempt debt)
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SR-125
Case Study
Overview of Asset SR125 South Toll Road 18km in length 4 lanes wide in most sections 35 year concession from date of road opening Flexible toll setting based on demand Estimated opening is in 2006 Designed to reduce congestion on Interstates 5 and 805 Reduce congestion on local arterial roads in Chula Vista and Bonita Serve existing and future development in the South Bay and Otay Mesa Area Overview of Transaction Located in San Diego California Total cost $900 million Green field toll road, under construction, due to complete in 2006 Significant congestion reliever Strong demographic growth First ever TIFIA concessional loan for a private toll road development in the USA

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South East Anthony Henday Drive

Case Study
Project Scope Construction of New Infrastructure: Construction of 11 kilometres of new 4- and 6- lane highway 5 interchanges, 3 fly-over structures, 2 water crossings, 3 rail crossings Straight forward construction The Province has specified the technical requirements of the Project. Limited opportunity for innovation Operations and Maintenance: Operation and Maintenance and Rehabilitation of New Infrastructure for 30 year period Operation and maintenance (but not rehabilitation) of Existing Infrastructure for 30 year period

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Airports
Case Study
Macquarie Managed Airports Bristol Birmingham Sydney Brussels Copenhagen

100% owned 5m passengers Fast growing UK regional airport Airline Marketing Excellence (2004)

24% owned 9m passengers 2nd busiest UK airport ex-London Airline Marketing Excellence (2004)

64% owned 29m passengers Busiest Australian aviation hub Asian Airport of the Year (2004)

70% owned 16m passengers Serving political capital of Europe #1 Airport in Europe (2005)

53% owned 20m passengers Scandinavias largest airport #1 Airport in Europe (2005)

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FBOs
Case Study
MICs airport services business operates 69 FBOs across the United States serving the general aviation industry. Macquarie Infrastructure Company (MIC) acquired the Las Vegas Executive Air Terminal FBO in August 2005. MIC was attracted to the Las Vegas FBO because of its following characteristics: Located in a strong general aviation market No maintenance operations Long term lease: 20 years + Only one other FBO on field Strong GA location Process MIC and the vendor executed a CA and vendor provided desktop due diligence information Vendor requested $58 million purchase price MIC and the vendor executed a Letter of Intent (LOI) with a one month exclusivity for due diligence Purchase Agreement executed precisely one month later MIC closed the transaction 2 months thereafter

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Tarcoola to Darwin Railway

Case Study
Rationale: Develop the domestic freight market between the Northern Territory and the rest of Australia Facilitation of land bridge traffic through the Port of Darwin Government determined that the project should be a Public Private Partnership Government created a Special Purpose Vehicle to co-ordinated the project Project entailed: Completion of the Alice Springs to Darwin Rail link 1420 km Development of the integrated rail and port operation linking southern State capitals and Darwin Government contributed the rail between Tarcoola to Alice Springs - 831 km Project was 50 year concession to build and operate Initial 30 years open access Construction began in April 2001 Scheduled completion was in March 2004

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