Toll Road Roundtable
Two recent high-profile privatizations of roads in the United States — the 7.7-mile Chicago Skyway and the 157-mile Indiana turnpike — are attracting the attention of both state governments interested in finding new ways to raise money to build roads and institutional investors looking for new places to deploy capital. P3Americas.com and Chadbourne hosted a roundtable discussion in New York in late February about the market outlook. The panelists were Greg Carey, a managing director at Goldman Sachs, Frank Sacr, a managing director at Société Générale in New York, Michael Kulper, a vice president of Transurban North America, Cherian George, a senior director at Fitch Ratings, Jack Bennett, senior program analyst for finance in the policy office at the US Department of Transportation, and Trent Vichie, a senior vice president at Macquarie Securities(USA). Richard Kenton, a managing director of P3Americas, made the introductions, and Doug Fried, a partner in the Chadbourne New York office, acted as moderator.
Potential Market Size
MR. FRIED: How large is this potential market and what sort of deal flow can we expect over the next year or two?
MR. CAREY: The use of project finance and public-private partnerships — called PPPs — in the toll road industry is a process of evolution. There has been an evolution in structures, whether it is design-build contracts, 63-20 corporations or not-for-profit entities. The evolution has been driven by the need for delivery of capital. Texas, for example, is talking about an $85 billion shortfall in funding over the next 20 years. The question is how quickly are people drinking the Kool-Aid and saying PPP will happen? The answer is that because of the Indiana and Chicago deals and a few other transactions, project finance and PPP are alternatives at which everyone now must look.
We are entering a phase where two to four bigger deals will be announced each year for the next couple of years. Indiana proves that Chicago was not a one-shot deal. At a workshop a couple of weeks ago in Texas, 400 people showed up for five greenfield procurements that are much more difficult to pull off than the Chicago and Indiana privatizations. Every deal will be different; all politics are local. I think the activity and the interest in this marketplace are well deserved, and there will be growth in this type of delivery method.
MR. SACR: There is no doubt that we will see many projects each year over the next three to four years. Many US cities and states have budget deficits and are trying to find ways not only to use existing infrastructure, but also to build new infrastructure.
We are at the start of the cycle. It is a cycle we have seen in play in Europe and Australia.We will see whether the US model replicates what we have seen elsewhere.
MR. KULPER: Let me present the cautionary view, which is where I typically go. Chicago and Indiana demonstrated that there is tremendous latent value in the assets that already exist in this market. Given the value of those assets and the budget needs,which are pretty universal across jurisdictions, some more assets will shake loose. One to three transactions a year is about the pace at which the market for privatizations is going to develop.
The greenfield side of the market is a very different story. Over the last 10 years, probably no more than a half dozen greenfield projects have closed in this marketplace. I am not sure that relates specifically to the financing delivery method. It relates more to the inherent difficulty of getting such projects done and the difficulty of working through environmental processes and regulatory approvals. A lot of new laws have been enacted recently in an effort to expedite things, but everybody still has his or her training wheels on. The legislation is a necessary condition, but not a sufficient one for getting these projects done. The pace of greenfield development will continue to be slow.We hope to close the Capital Beltway project later this year, which I think will be the first greenfield to achieve financial closing in about five years.
The market is probably a couple of privatizations a year, and if we are lucky, one,maybe two, greenfields a year. The US is a large marketplace, but it is still an emerging market where no more than four or five deals are going to happen in even the best year. There are more than four or five competitors in each of the relevant spaces, so there will be a lot of tears and frustration. The level of interest is still well ahead of the pace of the development. I think people must take a long-term, five- to 10-year view of this market, because while he market has sufficient opportunity in the long term, it is not there yet.
MR. FRIED: So you think four to five deals in a year in total will not always be the high water mark?
MR. KULPER: Yes. There is a clear need for more roads. There is clearly a funding shortfall, and there are serious congestion problems in many urban areas that will create pressure to do deals. However, in many cases the problems are just being identified and the process of moving from understanding a problem to solving a problem, with all of the approvals — including environmental — that need to happen in between, is a five- to 10-year process.
MR. FRIED: How about the size of the deals; are they all going to be mega deals like Chicago and Indiana or will some be smaller?
MR. KULPER: I actually think the US deals to date have not been as large as they will ultimately be. On the greenfield side, the next step is to move from the $500 million to $1 billion projects to the $5 billion projects, which this market is not yet ready to do. On the privatization side, I think there are assets that are significantly larger, and you will see those deals happen.
MR. VICHIE: I think greenfield projects will be all over the chart. There will be $5 billion deals that will be hard for the market to accept, but you may see them as soon as one or two years from now, but no later than five years. Greenfield projects will come in a broad range of sizes.
MR. GEORGE: You are not going to be surprised to find that I take the more cautionary view, but I am not going to be too negative. There is a large potential for privatizations to improve infrastructure and significantly accelerate its delivery. In terms of the size of the market, it will depend largely on the perceived success of the deals that are done. Ultimately, the public will decide whether this move makes sense. It is important to make sure that the projects, from a public policy and from a governmental standpoint, are good projects and that people see long-term value. The perception today is that everything is good, but that has the potential to change in the future.
MR. BENNETT: Congress and the administration are betting that there will be an increase in the number of PPPs. The surface transportation reauthorization bill that President Bush signed in August 2005 provided several significant tools to encourage PPPs. The bill authorizes $15 billion in tax-exempt private activity bonds for qualified surface and freight transfer facilities. Additional provisions allow tolling of interstate highways, increased flexibility for design-build arrangements, streamlining of the environmental process, and improvements to the TIFIA and state infrastructure banks programs. The government is proposing in the 2007 budget a pilot program of $100 million to provide funds for up to five states to test alternatives to the gas tax. This would be both for financing and to encourage addressing congestion and efficient use of facilities.
MR. VICHIE: One of the most telling statistics about the market is that, in the last 20 years, you have had a 78% increase in miles traveled while the amount of lane miles added has been 4%. The other obviously telling factor is that governments lack the money to deliver new lane miles.
There is increasing acceptance by government officials that the only way to get new roads built is to allow them to be tolled. Then it comes down to a question of what the delivery method will be. There is a lot of demand among private investors, and that will help drive things.
I also agree with Cherian George that how rapidly the market develops will depend on the perceived success of existing projects. For example, the perceived political success of the Skyway and Indiana is absolutely critical. If those projects proceed well, it will embolden politicians in other states to consider the same delivery method. If those deals are perceived as bad deals, then that will make it a lot harder.
MR. CAREY:We are really in a critical period today where the success of just a few projects is very, very important. Politically, it is a lot easier today to do a greenfield procurement for a new road than to take the much greater step of leasing — we don’t use the word “sell” — an asset for a long period of time. Indiana is the prime example of using a lease to fund a shortfall.
Privatization v. New Build
MR. FRIED:What is your view on the two different types of markets that are emerging — privatization of existing assets and greenfield development of new projects — and where do you think the focus will be in the future?
MR. VICHIE: You will continue to see a mix of both types of projects. States like Texas have very ambitious plans of building a lot of new roads, but you are also hopefully going to see a few more existing assets shake loose in the next few years, and there is potential for some really good deals to happen. There are existing assets that can be leased, allowing state assets to be redeployed in areas where the need is greatest.
MR. CAREY:We will have to see in the next year or so what happens with the greenfield projects that are already underway. Greenfields are more difficult than privatizations. How do you bid with the construction issues? Privatizing an existing asset is a lot easier. The bidding is a lot easier. It is the quantification of traffic growth rate, toll rate and capture rates in the future.We need a couple of successes with greenfields to determine whether more will move forward or whether the market will be largely privatizations that pay for state construction of new facilities.
MR. FRIED: So what’s happening in Texas and Virginia is really instrumental for the industry going forward?
MR. CAREY:Texas and Virginia and Florida with its Miami port tunnel project. I think it is going to be very, very important that these and other greenfields get done and that they get done right.
MR. SACR:We see a couple of drivers that either enhance the market or constrain it. One of the drivers for greenfield projects is construction risk. How is construction risk allocated, particularly between the banks and the construction contractors? With the size of some of the projects that we expect to see, the ability and the appetite of the construction contractors to absorb construction risks will be a big issue in how rapidly the greenfield market develops. Lenders may be used to seeing different allocations in other areas.
State and Regional Markets
MR. FRIED: Which states or regions will provide the most opportunity in the short term and the long term?
MR. KULPER: You must understand that the United States is not a market. Each state is its own market and, within some states, there are different markets. In Texas, for example, Dallas is its own market and Houston is its own market, and there are other markets in Texas. This makes it very hard to answer the question in a generalized way.
On the greenfield front, there have been more failures than successes in the last 10 years. There have been examples of developers spending two years and a lot of money on processes that go nowhere. The incumbent developers of projects are quite cautious about this marketplace and are looking to the public sector to provide tangible evidence that it is in fact serious about delivering these projects. Having enabling legislation at the state level, where at last count about half the states have legislation, is a necessary, but not a sufficient condition. Having the expedited federal processes is very helpful, but, again, a necessary, not a sufficient condition.What you need is political will to get things done, and you really have to pick your spots very carefully because you are investing between two and five years and millions of dollars. I don’t think you are going to see very many markets develop quickly, and I think people are going to be biased towards sticking with states like Virginia and Texas.
The next series of states and regions that will develop opportunity will be those that have the most need. It will be states and regions where there is a lot of growth, like Florida, and places that have big cities and lots of congestion, like California, New York and New Jersey.
MR. FRIED: Assuming one can get past the political issues in places like California?
MR. KULPER: Politics are interesting. The point at which there is commitment to these kinds of projects is when congestion becomes a political issue. The problems in some parts of California are significant enough, and the budget problems are significant enough, that you are going to see movement within three to seven years.
MR. VICHIE: I absolutely agree with Michael Kulper on that. If you would pick a market, California is one that seems to have the greatest need, but the tough thing about California is that it has really interesting politics. It is hard to get things done there. We are involved in a couple projects in Oregon about which we are pretty hopeful, but they will take a little while. We don’t expect anything this year, but maybe next year we will have a successful project to announce and hopefully that will roll things along there.
I think you might see activity in some of the Midwestern states. I don’t want to point to any one state in particular, but certain states are going to get cash by leveraging their existing facilities that can be used to deliver a whole range of new projects. One of the political drivers of the process will be the creation of new jobs. Politicians think about platforms to run on. If they can create 50,000 to 100,000 jobs with a massive transportation program, kind of like what Mitch Daniels is trying to do in Indiana, then road privatizations to raise financing look attractive. Traditional industries in the rust belt are in transition and political leaders are looking for new ways to create jobs and growth.
MR. GEORGE: To the extent that you have a strong champion of the project and a key position taker, you will see movement. Chicago had a strong champion in the mayor. In Indiana and Texas, you have the governor behind the projects. In Florida, the Florida Department of Transportation is making a big push to get things done in a new way. States where the state department of transportation plays a strong role and can make decisions that go beyond an electoral cycle may see movement because these projects are not going to get done necessarily in four years.
MR. BENNETT: On the question which states will offer the greatest opportunity, the answer is, one, states that have a large portfolio of toll roads, two, high growth states, and, three, states that have lots of congestion. Several candidate states have been mentioned already. There are opportunities in Georgia, Utah, Florida, New York, Oregon and the sleeping giant, California.
MR. FRIED: There seem to be many obstacles to getting this industry going in New York.Would anyone like to comment on that?
MR. CAREY: Look at the recent failure of the west side stadium recently and the failure of Westway.New York is a unique political environment with many different constituencies, whether they be the unions or the legislature. You have the head of the state assembly and the head of the state senate who are just as strong as the governor, and these three key political leaders don’t agree.New York has very parochial politics.
MR. KULPER: The politics of these projects are difficult wherever you go. I don’t think the politics are any easier in Texas or any other place.
AUDIENCE MEMBER: Does the initiative in this market come more from government officials or from developers and advisers who are looking for bankable projects?
MR. CAREY: I think that the job of the developers and lenders is to go out and stimulate business delivery methods. I think the speaking circuit we are all on these days is an effort to encourage that. That said, you always need the political champion and the ability to reach agreement on the use of proceeds will either make or break a lot of these projects, especially the large asset sales, where there is fighting over the spoils. You need someone willing to take the heat for the difficult decisions.
MR. VICHIE:The market drivers are a combination of factors. A lot of the market stimulation will come from developers asking state officials whether they have considered other options besides state construction of new roads. Here is what a road map could look like. Another driver is a politician who can effectively sell the idea to the public. Yes, this is a good idea. I can run with this. Once there are a few good examples in the market, then other politicians will read about it and decide it makes sense in their states, as well.
MR. FRIED:What is a more important driver: budget deficits or highway congestion?
MR. VICHIE: Both. There is clearly a need for construction of new roads. It is also clear that there is not a lot of money, so there are gaps in transportation plans that need to be filled.
AUDIENCE MEMBER: Many of the existing greenfield projects cost less than $500 million. A number of them are in the $10 million to $20 million range.What rules of thumb are there for the institutional equity market to assess whether deals that size are worth the trouble?
MR. CAREY:The amount of time involved and the level of competition are important. The transaction costs may be the same for a small project as for a large project. The design costs may be the same. These are factors in the return on equity.What are the opportunity costs? When you have to bid a deal, you spend up to 10% of your money before a deal gets bid. The bid costs may range from $1 million to $10 million depending on the deal. Is that too much money to be risking on a greenfield project? In terms of competition, deals will get done if the economics seem to make sense. Competition may ultimately help get the deal done.
MR. VICHIE: If a $10 million or $20 million project still needs 10 years worth of work, developers will not bother with it. On the other hand, if the project has gone through an environmental process and it is just reaching the funding stage and can be closed in six to 12 months, then maybe. It also comes down to the amount of resources the party has. Some people coming into this market may have only a couple guys on the ground. The smaller projects may not be the best use of their time, but someone with a larger deal team may be able to justify it.
MR. KULPER: The level of competition is important. If you ask four people to show up and bid on a $100 million job, you are going to be disappointed. But for the smaller deals, there are probably situations where you can have a negotiated outcome that makes sense for all parties because developers look at risk as well as reward, and while the rewards may not be so big if you can prepare the deal on an exclusive basis and have it environmentally cleared, there may still be an opportunity to do something because there is less risk.
Investment Grade Ratings
MR. FRIED: Cherian George, at what factors do the rating agencies look when determining whether a project deserves an investment grade rating?
MR. GEORGE: Briefly, it is important that the government maintain flexibility. The decisions that are made today may affect the government’s ability to provide for future public needs. It is important to maintain the ability to adjust as times change. The government should also maintain the fair value of the asset. To the extent that the state takes money up front, there is risk that the money might be diverted to other uses. One of the things that has been talked about, in the case of Delaware for example, is the creation of a trust, where the money is kept over a long period of time. That’s extremely important because if there is a termination, at least you can look at the trust. In terms of a concession, an extremely important factor is the long-term track record of the concession holder in doing projects around the world. At the end of the day, these deals are going to have a lot of debt, so there is a balance that must be maintained between financial flexibility — that’s cash flow, rate-making flexibility over the life of the deal and liquidity, on the one side, with leverage, on the other.
The clarity of performance requirements is also important. It should be clear what the basis of performance can be and how any defaults might occur in terms of performance. Another important factor is complete independence in ratemaking. There should be no ambiguity within the approved toll rate regime. The project should have latitude to do what it needs to do.
Very aggressive traffic and revenue assumptions would clearly be a negative.We do see, particularly with deals like Indiana and Chicago, where nominal GDP per capita has been factored into the equation for setting tolls, so that there is the ability to raise revenues at much higher rates. This is particularly true here in the United States, which economically has much stronger characteristics than almost any other country in the world to generate greater levels of revenues than we have ever seen. But maintaining some conservatism in that respect will be important.
Political risk is something that we know exists.We are sensitive to it in deals and take it into account in the rating.
Another point is unamortized balances. You are looking for the ability in short-term deals to take out the deal as soon as possible. You might have an element of refinancing risk. The debt might be short- or medium-term debt with a bullet payment. Clearly, with 99-year deals and 75-year deals, there is a lot more flexibility about when to refinance. Macquarie demonstrated that with its recent financing of Skyway. Refinancings can be expected to occur a number of times. It’s not an issue any of us will have to deal with in our lifetimes, but somebody at some point is going to have to make sure that the amount of leverage on the deal is enough over the life of the concession.
Finally, traffic forecasts are a concern.There is no surefire way to forecast future value and limit the leverage over time, and that is something about which all of us need to be vigilant.
MR. FRIED: How do you analyze traffic forecasts?
MR. GEORGE: The traffic forecasts give us a good sense of the background on the project, the nature of the demand and the economics over time. In terms of the actual numbers, we at Fitch think that the magnitude of volume that these forecasts predict is more important than the actual number. The reason is these models are not designed for financial planning purposes. They are engineering and planning models. To be safe, they err in the opposite direction of how a conservative financial model would err.
What we have seen in our experience is that while the forecasts have been higher than the actual traffic in the near to medium term, particularly on the long end, they tend to severely underestimate. So there is a lot of value on the back end. That’s where I think the debt structure is. Macquarie and Transurban, which do some of these deals, have brought structures to market that reduce the default risk.
I think even the Dulles deal that was done by Bear Stearns last year did that very well where Bear Stearns was able to reduce the default risk by recognizing the growth in long-term value of these deals. The combination is what we look at.
MR. FRIED: So the lenders have to be a little bit more patient at the beginning and allow for longer ramp-up periods and then make it up later?
MR. GEORGE: Absolutely.
MR. SACR:That’s actually very helpful, Cherian. The rating agencies have a crucial role to play, particularly in the US market.We talked earlier about toll rates in Australia and Europe. The potential toll rates in the US just swamp everywhere else and the demand, if you count up all the roads, the huge amount of capital and the ability to recycle capital and to have projects rated and distributed into the biggest capital market in the world, these are all reasons for optimism.
I think one of the things we as lenders are looking for from the rating agencies is transparency. It is important to understand the ratings criteria.
MR. CAREY: Let me ask Cherian George a question.We used to have discussions years ago about pricing capacity and the ability to raise tolls even though municipalities obviously prefer not to raise tolls. Please talk about the evolution of raising tolls, the trend of linking toll increases to GDP per capita and where you think the market is going with this.
MR. GEORGE:We tend to think if you raise rates consistently, you should be able to raise them at least at CPI, meaning the real cost to the user remains constant. People’s expectations that toll will increase regularly over time should not lead to a reduction in traffic volume.What that would argue for, particularly in a free network that is congested where the toll road has the capacity, is the ability for the toll road to accept growth even at rates higher than inflation. That’s where the concept of GDP per capita comes in because it is a sense of economic activity.We don’t see any reason why you should not be able to raise rates at or close to GDP per capita, particularly in good times, and also have traffic growth at some level. At least, there should not be any traffic reductions.
MR. FRIED: Now that people in the industry have had a chance to think about the economics of the Chicago Skyway, including the various assumptions that were made, how much competition would you expect for similar deals in the future?
MR. CAREY: The number of new entrants into the US market, whether foreign or domestic, continues to grow at an outstanding pace. Competition has probably tripled since the Chicago bid. There are many investors interested in this asset class. The ability to invest long-term equity, patient equity as we call it, is phenomenal.
MR. KULPER: There will be vigorous competition for privatization projects. The international toll road concessionaires will continue to show up, and my expectation is that there will be a domestic US industry that grows up over time. A lot of institutions have raised infrastructure funds looking to put money to work, and those guys will show up. Competition for privatizations will be intense.
On the greenfield side, the ideal situation for state departments of transportation is to put projects out for bid.
The problem with that is private sector resources are needed in most cases to expedite projects and get them to a position where they are in a position to close. You are going to continue to see a bifurcation between those markets where greenfield projects will be awarded based on qualitative criteria and others where the developer will be a partner with the state department of transportation to move the projects to closing. A perfect example is the hot lane projects that we are doing in Virginia.
MR. FRIED: Do you expect more non-US entities to compete in the US market?
MR. KULPER: Most of the experienced overseas players are already here. The next big stage is going to be the financial guys in the US wanting to play. The difficulty they have is lack of knowledge and experience in dealing with roads.
MR. VICHIE: It seems like every week you read another article and you hear about another Wall Street firm raising a fund to invest in this area. The problem is that successful investing in roads requires a lot of expertise. It requires a lot of bodies on the ground and a lot of people who understand the asset class. The real competition from US financial houses is still a few years away.
MR. FRIED: How important is knowledge of the local market?
MR. VICHIE: It is important, but it is more important to understand the asset class. You can hire locals who can help you navigate the market. That’s important, but that is really not what differentiates market participants.What gives someone an edge is understanding the asset class, including how to price the risks involved and how to structure a deal.
MR. FRIED: How will developers and lenders in the US get comfortable with traffic risk?
MR. SACR:We are trying to apply to US roads the same rules and lessons that we apply globally. The main differences among bidders in the US are not so much their financing structures, which are more or less of a similar style, but rather their traffic growth assumptions. Everybody has his or her own traffic consultant, and the bank also takes its own view. I am sure that rating agencies take their own views as well.
MR. KULPER:Traffic is an issue with which we all grapple. It is interesting that for both the Chicago and Indiana projects,Macquarie decided to use a foreign firm. Transurban’s approach to its projects today has been to rely on very substantial in-house expertise.We view traffic risk as such a critical area that we have a team of eight individuals, and we have a competency in-house that we supplement with locals.We are very active participants in the process.
I think the US industry has relied on traffic studies that are not suited for all the purposes to which they are being put. The studies may have been done for a department of transportation whose motivation is to deliver infrastructure and not necessarily to ensure the sufficiency of the investment. The other primary consumer of traffic studies has been the construction contractors who want to build the roads. There has not been enough investment yet in traffic studies, and the result is the existing studies may lack the rigor and comprehensiveness that the financial community needs. My guess is there is a high degree of correlation between the amount of time and effort put into traffic forecasts and how much actual traffic usage has varied from the forecasts in the projects that have been done to date, and that this is a key factor in whether projects succeeded or failed.
MR. CAREY:Traffic risk is the $64,000 question. How is the investment going to pay off and how much room do we have at the end to fix it if it doesn’t?
MR. FRIED: I think, as Cherian George said, traffic volume often starts out low and then improves on the back end.
MR. VICHIE: The macroeconomics are driven off what is going on in the surrounding area. Having a good understanding of the macroeconomics, certainly when you are looking at a 75-year concession, is absolutely critical because you are ultimately investing based on a cash flow projection. The question is how much risk is there in a particular project. It may be tougher to get lenders to take traffic risk for projects that have lots of tunneling or development of mountain faces or other construction risks.
MR. CAREY: I think private activity bonds will have an effect on the market. The availability of tax-exempt financing will not determine whether projects get