HOW TO EFFECTIVELY FINANCE A P3 PROJECT Gregory Smith President & CEO

HOW TO EFFECTIVELY FINANCE A P3 PROJECT
Gregory Smith
President & CEO
1
Agenda
1. Introduction to the P3 Model
2. Integration as a Driver of Value
3. Key Financing Considerations
4. Conclusion
The objective of this presentation is to assist in the understanding of the
impact of policy and structural decisions on the financing of P3 projects
2
INTRODUCTION TO THE P3 MODEL
3
Introduction to the P3 Model
• A public-private partnership (P3) refers to a contract between the public and
private sector for the provision of essential infrastructure under an integrated
contract
• The private sector assumes key risks relating to delivery and performance of
an infrastructure asset
• The P3 framework is concession based:
• Public ownership of underlying asset
• Public provision of core service (e.g. healthcare, education)
• Private oversight, stewardship and innovation of essential asset delivery and performance
• Focus on schedule and budget
g certainty
y with enhanced service levels
4
Other Private Infrastructure Models
• P3s represent one of four primary frameworks for private investment in public
infrastructure, other models include:
• Contractual (e.g. Power Purchase Agreements)
• Private development, ownership and stewardship
• Revenue is subject to a predefined purchase agreement for a specified period of time, after
which the arrangement can be renegotiated or shifted to a merchant model
• Regulated (e
(e.g.
g most Canadian power utilities)
• Private development, ownership and stewardship of the asset
• Revenue is subject to limitations established by a public authority
• Merchant (e.g. Ports)
• Private development, ownership and stewardship of the asset
• Revenue is dictated by
y market forces
5
Scale of P3s
• P3s are highly flexible model capturing a broad spectrum of risk-transfer
• P3s can involve the transfer and integration of design, build, finance, maintain, and/or operate
responsibilities for a public asset to the private sector for a predefined period
• Revenue and demand risk can be retained by the private sector or shifted to concessionaire, with
retention
i off public
bli ownership
hi
• In addition to greenfield design-build projects, can also include refurbishment, sale-leaseback and
Merchant and
Other Models
Design-BuildFinance-Maintain-Operate
Design-BuildDesign
Build
Finance-Maintain
P3 Models
s
Degre
ee of Private S
Sector Risk
other arrangements
Design-Build-Finance
Design-Build
Design-Bid-Build
Degree of Private Sector Involvement
6
Policy and Procurement
• P3 is primarily a procurement model, not a public policy decision
• Service levels and other output requirements are public policy decisions, not outcomes
of a particular procurement model
• A separation must exist between procurement model and public policy decisions
7
Contractual Structure
• A P3 involves a single point-of-contact for the Government Procuring Entity: ProjectCo, a special
purpose vehicle (SPV)
(SPV), agrees to a Project Agreement with the client and passes down its
obligations through a design-build and/or services contract
• Payments flow into ProjectCo from funders (debt and equity) and the client, and flow out to the
construction contractor and/or facilities manager
• Management of ProjectCo is a responsibility of the equity investor, typically the developer, and the
entity has ultimate control for project delivery
Government
Procuring Entity
Provision of Asset
Lenders
Lending Agreements
Project
Agreement
Payments
Project Co
Design-Build Contract
Construction
Contractor
Shareholder Agreement
Service Contract
I t f
Interface
Agreement
A
t
Facilities
Manager
Developer
8
Contractual Structure (cont’d)
• The ring-fence ProjectCo must pay for all project costs during both constructions and
operations
ti
•
If the ProjectCo is underfunded as a result of cost overruns or other shortcomings of the private sector, additional
project funding must come through either the capital providers (debt and equity) or passed down to the
Construction Contractor or Services Provider under their respective agreements
•
ProjectCo is a standalone company with its own credit rating, which is a function of the credit rating of the
procuring entity, the quantum and nature of security provided by the Construction Contractor and Services
Provider, as well as the underlying credit quality of the Construction Contractor and Services Provider
•
ProjectCo does not have its own balance sheet to back its obligations
• Lenders and the developer add significant rigour to overall project structure, and
provide an additional layer of oversight throughout all elements of project delivery
•
E.g. no advances are made to the Construction Contractor unless the Lenders Technical Advisor and
Ad i i t ti A
Administrative
Agentt are satisfied
ti fi d th
thatt an appropriate
i t llevell off progress ((e.g. work
k performed)
f
d) can b
be
demonstrated
• The P3 structure requires significant planning and diligence in advance of action, which
encourages analysis of major issues and innovation opportunities during the planning
(bid) phases of the project, before any hard costs are incurred
9
INTEGRATION AS A DRIVER OF VALUE
10
Integration Under a P3
• The private sector has been providing design, build, operations and
maintenance services to the public sector for a long period
• Construction under design-bid-build contracts by independently procured architects
and contractors
• Long
Long-term
term maintenance or operations contracts for public buildings and vertical
infrastructure
• A key benefit of the P3 model is the integration of multiple elements of a
project under one contract, reducing interface risk and whole-life project costs
• Under a P3, the overall scope of services performed by the private sector often
doesn’t change, but changes are made to how these services are organized and
coordinated
11
Capital Integration
• One of the most basic P3 models is the Design-Build model, integrating
design and construction of an asset under one contract
• The basic benefit is that integration of a project’s capital component enables
th integration
the
i t
ti off construction
t ti considerations
id ti
iin a project’s
j t’ d
design
i
• In addition, an integrated design-build contract transfers the interface risk
between the architect and the contractor from the public to the private sector
12
Capital and Operating Integration
• Integrating operations and maintenance (including lifecycle) services into a
P3 contract further increases risk transfer to the private sector
• The public sector is removed from risks (e.g. latent defects) associated with
h d
handover
ffrom th
the contractor
t t to
t the
th facilities
f iliti manager
• The public sector has certainty over long-term cost of ownership (e.g.
lifecycle costs) and maintenance and lifecycle decisions are integrated into
capital services
• Lifecycle considerations should be a key driver of a project’s
project s overall
concession length
• Vertical infrastructure is often procured under a 30-year concession as this closely
matches with one and two lifecycle renewal cycles for various elements
13
Case Study: LED Road Lighting
• Advances in road lighting technology has led to the development of liquid
emitting diode (“LED”)
( LED ) road lights,
lights which have significant operational
savings to traditional road lights
• LED road lights are ~50% more energy efficient than traditional road
li ht with
lights,
ith greater
t lluminosity,
i
it and
d significantly
i ifi
tl llonger d
design
i lif
life
• Despite the significant benefits, capital/operating budget allocation issues
prevented some municipalities
p
from
or overall fiscal restraint has p
adopting the technology, as the lights have a higher per-unit cost than
traditional road lights
• Rather than view road lights in isolation as a product or material,
material a
whole-system approach would greatly improve overall project economics:
• An efficiently designed LED road light system will illuminate more road with fewer
bulbs than traditional lights
• The
e sys
system
e ca
can be e
externally
e a y financed
a ced by the
ee
energy
e gy a
and
d cos
cost sa
savings
gs assoc
associated
a ed
with the upgrades
• External parties assume technology risk
14
Financing Integration
• In addition to hard cost benefits of whole-life planning and reduced
interface risk, a P3 financed by the private sector greatly reduces
public sector exposure to the credit risk of a project’s contractor and
service providers
• Debt and equity providers mandate that contractors and service
providers provide liquid security in addition to performance bonds and
parent company guarantees to assure performance
Th debt
The
d bt level
l
l for
f a P3 project
j t is
i sized
i d to
t achieve
hi
an iinvestment
t
t grade
d credit
dit
rating
15
Financing Integration (cont’d)
• The credit quality of design-builder has a significant impact on the
cost of project security
• Contractors typically require a letter of credit of 5% - 10% of contract price
under a DBFM P3 Design-Build Agreement with a weighted average cost of
capital of 7% to 10%
• For a representative $100
$100.0M
0M project with a three year construction period
period,
total costs associated with this security range from $1.1M to $3.0M
• Similarly, a service provider is required to post significant security
under a P3 model
• Service providers typically require a letter of credit of 6 – 12 months of their
contract value under a DBFM P3 Design-Build Agreement with a weighted
average cost of capital of 7% to 10%
• For a representative $100
$100.0M
0M project with annual maintenance costs of $2.0M,
$2 0M
total costs associated with this security range from $2.1M to $6.0M
• Security pricing, and thus contractor and service provider quality, is a
key factor in overall bid competitiveness
16
Risk Allocation
• The public owns all risk under traditional procurement models; a P3 model
should transfer risks to the private sector where the private sector can add
value
• Inappropriate risk transfer limits Value-for-Money and financeability
• P3 risk
i k allocation
ll
ti should
h ld ffollow
ll
th
thatt th
the party
t b
bestt able
bl tto price
i and
d mitigate
iti t
the risk, assumes the risk
• Events and risks under the responsibility of the private sector causing non-
performance
f
result
lt in
i deductions
d d ti
b
being
i llevied
i d against
i t ProjectCo
P j tC
• Under a drop-down Construction Contract or Services Contract, these
deductions are passed through to the Construction Contractor or Services
Provider
17
Risk Allocation
• While P3 risk allocation is flexible and adaptable, the following represents a typical risk
allocation for a DBFM P3
Construction
Risk
Facilities Management / Services
Private
Risk
Price
X
Price
X
Schedule
X
Schedule
X
Scope Change
Public
X
Weather
Scope Change
Public
Private
X
X
Weather
X
Contamination
X
X
Insurance
X
Geotechnical
X
X
Permitting
X
X
Quality and Safety
X
St ik
Strikes
X
Insurance
E i
Environmental
t l Approval
A
l
X
Permitting
X
Permitting
X
Quality and Safety
X
Lifecycle
X
Strikes
X
Right of Way Acquisition
X
18
Risk Allocation (cont’d)
• Some obligations, such as contamination and hazardous materials
are shared by both the public and private sector
• Often the P3 agreement is structured in that the private sector retains responsibility
for all disclosed or reasonably inferable issues
• Geotechnical responsibilities are often shared as geotechnical
concerns are often seen as both a potential barrier to financing and a
driver of significant contingencies
• Typically, a developer will structure drop-down contracts (e.g. to the
contractor and facilities manager) that pass through performance
responsibilities and associated risks
• Both debt and equity investors will seek to have as few responsibilities and risks
retained at the ProjectCo level as possible
19
FINANCING CONSIDERATIONS
20
Typical P3 Financial Structure
• DBFM P3s are typically financed by a combination of public sector
contributions
ib i
((either
i h progress payments, milestones
il
or completion
l i
payments) and private sector capital (debt and equity)
• Private sector capital is repaid over time through either public sector or
user payments
Provincially Procured Greenfield
Availability DBFM ($ M)
Provincially Procured Greenfield
Revenue (Throughput) Risk DBFM ($ M)
54.0
36.0
6.0
24.0
Total Long-Term Private Capital
60.0
60.0
Progress Payments or
Short-Term Debt/Completion Payment
40.0
40.0
100.0
100.0
Long-Term Debt
Equity
Total Project Capital Cost
21
P3 Sources of Capital
• There is significant demand by both debt and equity providers to deploy P3
capital
• Long-term debt is offered in the public bond, private bond, and bank markets
• Many larger (>$150.0M) projects are financed through long-term public bonds,
underwritten by Canada’s top six banks
• Insurance companies (Canada Life, Sun Life, Manulife) are also active in the
Canadian P3 market, given the timing match between the long-term nature of the
concession and these institutions’ liabilities
• Bank solutions not requiring a refinancing during the concession term are limited to
foreign institutions
institutions, as Canadian institutions have limited appetite for long-term
long term
(>15 year) lending terms
22
P3 Sources of Capital (cont’d)
Public Bond
Private Bond
Long-Term Bank
Advantages
• Most competitive spreads
• Fixed interest rate
throughout term
• Generally
G
ll no capacity
it
constraints
• No refinancing
requirements
• Fixed interest rate
throughout term
• Opportunity for delayed draw
• No
N credit-rating
dit ti from
f
rating
ti
agencies
• No refinancing requirements
• Opportunity for delayed draw
• No credit-rating from rating
agencies
• Opportunity
O
t it for
f early
l
repayment
Disadvantages
• Negative carry throughout
construction period (due to
nature of upfront draws)
• Require credit-rating from
rating agencies
• No opportunity for early
repayment
• Higher spreads than public
bonds
• Potential capacity issues
• No opportunity for early
repayment
• Escalating spreads (ratchetup interest) throughout term
• Potential capacity issues
• Typically limited to 20-year
tenor; require refinancing for
longer concession lengths
• Require hedge to fix interest
rate
23
P3 Sources of Capital (cont’d)
• Where a completion payment structure is used, a short-term debt facility is
required;
i d short-term
h tt
d bt iis ttypically
debt
i ll fifinanced
d through
th
h a bank
b k ffacility
ilit
• Canadian institutions remain active in short-term lending to P3 projects
• Public bonds are also an option for projects with a significant short-term
component
• Equity capital providers are typically dedicated infrastructure investors with
development expertise, and are increasingly requiring subsector expertise
• Capital mix (or gearing) is a key driver in a P3’s cost of financing
• Debt capital is significantly less costly than equity capital
• Balancing risk transfer with financeability (and ability of the private sector to
achieve
hi
a hi
high
h llevell off gearing)
i ) should
h ld b
be a kkey consideration
id ti iin project
j t planning
l
i
• Lender Debt Service Coverage Ratio (DSCR) requirements drive gearing
– Typical DSCR requirements of 1.20x to 1.25x on availability-based transactions result in
gearing ratios approaching 90.0%
24
Cost of Capital
• Strong appetite for investment in P3 projects has kept spreads
compressed
d
Category
Source
Spread
All-in Rate
Long Term Debt
Long-Term
Bank (Assumed
(Ass med Refinance)
1 75% – 2.25%
1.75%
2 25% (Over
(O er CDOR)
4 75% – 5.25%
4.75%
5 25%
Long-Term Debt
Bank (No Refinance)
2.25% – 2.75% (Over CDOR)
5.25% – 5.75%
Long-Term Debt
Private Bond
2.25% – 2.75% (Over GOC)
4.75% – 5.25%
Long-Term Debt
Public Bond
2.00% – 2.50% (Over GOC)
4.50% – 5.00%
Mezzanine Debt
Pension Funds, Other Funds
N/A
8.00% – 10.00%
Equity
Pension Funds, Other Funds
N/A
10.00% – 13.00%
Short-Term Debt
Bank
1.50% – 2.00% (Over CDOR)
3.00% – 3.50%
Category
Source
Spread
All-in Rate
Long-Term Debt
Province of Saskatchewan Bond
0.85% (Over GOC)
3.35%
Assumed 3 year CDOR rate of approximately 1.50% as base rate for Short-Term Debt – Bank
Assumed 20 year CDOR rate of approximately 3.00% as base rate for Long-Term Debt – Bank
Assumed 20 y
year Government of Canada Bond rate of approximately
pp
y 2.50% as base rate for Long-Term
g
Debt – Private Bond,, Public Bond,, and Province of Saskatchewan Bond
25
Timing of Public Capital Contributions
• Partnerships BC typically funds through monthly progress payments, paid
throughout the construction period as a percentage of hard costs
• Infrastructure Ontario and P3 Canada typically fund through substantial or
i t i completion
interim
l ti ((milestone)
il t
) payments
t
• Progress payments are timed with a project’s cash obligations, whereas
completion payments typically require short-term financing to bridge the
period between when costs are incurred and payment is received
• Completion payments can lead to significantly increased financing costs
during construction, with limited risk transfer benefits
• For a representative $100.0M project with 50% capital contributions and a three
year construction period, a completion payment structure would yield $2.6M (or
200%) higher financing costs during the construction period
26
Payment
y
Mechanism Options:
p
Availability and Revenue Payments
• Long-term private capital is repaid through availability or revenue payments, or a
combination
bi ti th
thereoff
Availability payments indicate that the private sector will be compensated a fixed amount for the asset being
made available for use, independent of number of users, less deductions for non-performance (e.g. courthouse
or hospital)
• Revenue payments indicate that the private sector will be compensated based on actual revenue generated by
the asset (price and volume), and typically will be responsible for collection from the end-user (e.g. some tollroads such as Highway 407)
• Hybrid payments indicate that the private sector will be compensated by some combination of the availability and
revenue payment structure (e.g. shadow toll-roads, where the private sector collects a fixed fee per car,
irrespective of actual cost to the user)
•
• While a revenue payment structure passes additional risk to the private sector, it
increases financing costs by decreasing project gearing
•
Debt providers size their maximum contribution as a function of both the certainty of revenue and credit quality of
the counterparty (a strong government counterparty with a fixed payment mechanism warrants the highest
gearing)
• Revenue based transactions are typically limited to 40 – 60% gearing, whereas
availability based projects can achieve up to 90% gearing
27
Equity Economics
• A significant pool of capital in pursuit of limited opportunities has compressed
P3 equity returns
• Returns become further compressed in secondary market opportunities given the
decreased risk profile of construction completed projects
• Due to the significant transaction costs of a P3 proposal, developers and
investors will seek an honorarium (e.g. design and bid fee) to cover a portion
of failed transaction costs
• Transaction costs include legal, technical and financial due diligence costs
• Development fees on any given project are sized, in-part, to cover failed transaction
costs from failed projects based on an assumed success rate
28
CONCLUSIONS