Toll Road Outlook
Chadbourne hosts a meeting each year at its offices in New York with P3Americas to discuss the outlook for privatized road projects in the United States. The meeting this year was in March. The following is a transcript of the discussion. The panelists are Michael Kulper, senior vice president of Transurban North America, Victor Sultao, executive manager for the United States and Canada for BRISA, Bob Dewing, a managing director of Citigroup, Fernando Ferreyra, with the transportation and social infrastructure team at Babcock & Brown, Alec Montgomery, managing director and head of infrastructure for Royal Bank of Scotland, and Tim Vincent, a managing director with Goldman Sachs. Steve Howard from Lehman Brothers and Steve Greenwald from Credit Suisse participated in the discussion from the audience. The moderator is Doug Fried with Chadbourne in New York.
MR. FRIED: Before we launch into the discussion, let me mention some of the things that have recently been happening in our industry.
SH-130 segments 5 and 6 in Texas just closed.
Both the Capital Beltway HOT lanes in Virginia with Transurban and Fluor and the Northwest Parkway in Colorado with Brisa, CCR and RBS closed in 2007.
In Florida, the Miami Tunnel project is moving forward with Babcock and Bouygues, as is the I-595 and the Jacksonville Outer Beltway bid process.
In Virginia, a request for qualifications for the Midtown Tunnel is expected to be released early this year.
In New Jersey, it currently looks like public-private partnerships for existing toll road assets will not go forward, but Governor Corzine is talking about increasing tolls by 50% every four years from 2010 to 2022.
In Pennsylvania, the state is talking about privatizing the Pennsylvania Turnpike.
Other public-private partnership activity is occurring outside of the toll road area, including the potential privatization of Chicago’s Midway Airport and the privatization of parking meters and garages in Chicago.
All of this has been occurring against the backdrop of a very troubled economy, and that’s where I would like to start today. As part of that, there are well publicized problems with the monoline insurers who have used their high credit ratings to guarantee repayment of debt. The monolines are being downgraded. Alec Montgomery, how much of an impact will the downgrades have on the public-private partnership, or PPP, market?
MR. MONTGOMERY: The monolines have done some interesting deals in the public-private partnership sector. Their participation helped people address a lot of the long-term debt capacity issues associated with these deals. But probably the greater impact of the monoline crisis is the effect it will have on the overall financial markets.
We saw monolines in a handful of deals in North America. While those deals were very competitively structured in terms of the type of financing, at the end of the day, they were probably investment grade-type deals that could attract capital from other sources. The biggest challenge I see with the monolines falling away from this sector is how you put these long-term deals into the bond market. Because, to date, the only way we have seen bank debt get refinanced in the bond market on toll roads is with a monoline wrap. It is a challenge that we have to continue to work on.
MR. FRIED: Victor Saltao, when you were involved in closing the Northwest Parkway, how did the monoline problems affect the closing and your decision making?
MR. SALTAO: They caused a delay of several weeks. We expected to close the transaction between August and September, but that proved impossible. Losing the price protection of the monolines was tremendously challenging for our company. We ended up borrowing from banks without a monocline wrap.
MR. FRIED: Bob Dewing, what impact will there be on future deals if monolines wraps are not available? How will the structures change?
MR. DEWING: The issue that monolines dealt with very neatly is that they took the term risk, but they didn’t take the principal risk. The principal risk was deemed to be investment grade. But the monolines took the term risk and the refinancing risk. That loss in the market will make it much more difficult for toll roads and equivalent infrastructure projects to get refinanced. We are going to have to go back to the old days, where we had a series of bonds with various maturities. Highway 407, which predated all of this in Canada, was financed purely on a series of 7-, 8-, 10- and 12-year bonds. This ensured that you only had a certain number of maturities each year, and you had a waterfall of locked up cash to be able to deal with that. I don’t think this is a business that the monolines will be in for some time. They have their own capital issues, and the monolines will probably spend time going back to their old municipal business. We will have to design new structures, with sponsors taking some of the refinancing risk.
MR. FERREYRA: I think the challenge, going forward, will be the lack of monoline appetite vis-à-vis the political landscape. One of the things we’re seeing very clearly is it is much easier politically, in any state, to go after greenfield projects, or new construction, as opposed to brownfield projects, or privatizations of existing highways. Greenfields are exactly the kind of deals that the monolines, even before the meltdown, were shying away from. The monolines were not particularly fond of these kinds of deals before the crisis, and now it’s going to be even tougher than before.
MR. HOWARD (from the audience): I would like to make one comment related to monolines. It is correct that risk has been repriced in the U.S. capital markets, big time, but the markets are open and functioning, including with the monolines. We expect transactions will get done this year without getting into a debate about whether they are publicly delivered or privately delivered. We expect transactions will get done, big transactions, with letters of credit as well as with monolines. In fact, over the last couple of weeks, major deals have been priced and underwritten by Lehman and some of our competitors. In one case, on a major project in Texas, the deal was many times oversubscribed, including with MBIA, and insured as part of the credit package. Then yesterday, there was a private activity bond, tax-exempt deal, underwritten by Lehman with MBIA. Risk has been repriced, but the markets are open. We will see things settle down over the next couple of months.
MR. FRIED: Let’s turn to some other sources of turmoil. The US dollar is continuing to lose value against European currencies. Victor Saltao, how will a devalued dollar affect foreign investment in the US toll road sector?
MR. SALTAO: In my company, these infrastructure deals are looked at with a very long-term perspective. The fundamentals of the economy are key elements for the investment. However, while the exchange rate will be one of those elements, given our long-term perspective, we do not rely on current currency performance. We hedge this risk — not only the risk to our equity, but also to our debt. We are very comfortable managing currency risk.
MR. FRIED: Is the devaluation of the dollar giving an advantage to non-US companies? Are they looking at this and saying, “Let’s grab ourselves a bargain”? Michael Kulper?
MR. KULPER: I think this is a politically expedient discussion in some respects. What I mean is, the emotional argument put forward is that the dollar has been devalued and foreigners are going to come in and pick up our assets, our essential infrastructure, for pennies on the dollar.
The fact is that just as the equity investment in a foreign currency gets cheaper, the cash flows that come back over the life of that investment have also been devalued. So if you look more closely at it, there’s a symmetric relationship between those two things. We’ve never really faced a capital constraint in terms of whether something was worth 1x or 2x or 3x in a local currency. So, I think that’s fairly irrelevant. The issue is not the devaluation of the dollar, but the volatility in the currency markets, much like the debt and equity markets. Most responsible investors in this space hedge and are looking to protect against in volatility. High volatility results in more costs. So if anything, I think the volatility of the marketplace is unhelpful.
MR. FRIED: Fernando Ferreyra, does the analysis change if we are talking about new construction as opposed to pure privatization?
MR. FERREYRA: It depends on a couple of variables. The first one is, what kind of investor are you dealing with? If you are looking at a strictly financial player, looking at a privatization, brownfield player who is hoping to flip that asset around in a year, maybe the person wants to take advantage of a short-term situation like that. I agree with Victor Sultao about the very long-term nature of these assets. Hopefully, investors who are willing to keep the assets on their books will get the returns over a long period of time.
The other point is closer to Michael Kulper’s rationale to avoid the equity being in one currency, and the cash flows being in another. We just closed our US infrastructure fund, receiving the money in dollars. It is much easier if the equity is in the same currency as the cash flow.
MR. FRIED: Will a slowing US economy bring reduced tax revenues? Even in the past five years, when the economy was robust, states had problems meeting their transportation budgets. Will a slowing of the economy cause more states to privatize assets or enter into public-private partnerships for new construction? Tim Vincent?
MR. VINCENT: There is a lot of concern about the potential recession and the effect it will have on the economy. Whether it will be a mild recession or a severe recession is hard to say. The recession alone won’t create deficits, but consider that municipalities are already facing one of the worst municipal bond markets they have ever experienced, so their borrowing costs are increasing for capital projects. Many states have budget deficits on top of that. This suggests the door is open to having conversations with state officials that, perhaps, we were not that fruitful when we had them a year ago. That said, even a concessionaire, who is looking to raise capital to support a PPP transaction, faces higher costs. It is important to manage expectations with municipalities.
MR. FRIED: Where will the money come from for needed public infrastructure projects? It needs to come from somewhere. Michael Kulper, will the effect of a slowing US economy be different for new construction as opposed to pure privatizations?
MR. KULPER: Even when times were good and tax revenues were flowing in, there was never enough money for new construction. So in a sense, the recession is kind of irrelevant. The realities are that public sector funding for infrastructure has systematically declined in real terms over the last 30 years. The gas tax, in real terms, is about a third of what it used to be. Vehicle miles traveled continue to grow at up to 3% a year. Lane miles are not keeping pace with this growth. The interstate highway system is 50 years old, and the design life of most structural elements is 50 years. We have tens of thousands of bridges in this country that are structurally deficient or functionally obsolete. As the money trickles down from the federal level, to the states and to the localities where projects must be done, there is never a critical mass of money available to do projects.
The issue of a slowing economy also presents problems for private sector funding of new construction, due to the fact that revenues for these projects in the near-term will not be as high as they once would have been in a projected sense, because traffic and revenue are correlated with GDP.
Another issue is that in the environment created by a slowing economy, risk assets -— be they debt or equity —- are repricing. So capital is more expensive, whether it is municipal or private. For new construction projects, the issue has always been, are they feasible, and in this environment, it is tougher to get the numbers to work.
MR. SALTAO: I think we should focus on the fact that the problems are still there. The congestion remains, as does the existing deficit in capacity to maintain existing facilities. The problems are there, but the needs are also there. The economy is slowing, everyone has to make better calculations, better estimations, about everything. But we should not make excuses. We should move forward because in five years, 10 years, the problems will have gotten worse. We should focus on the solutions, on how efficient the private sector can be in delivering infrastructure. How innovative it can be, how creative it can be and how it delivers value.
MR. FRIED: Michael Kulper, is the federal government doing enough?
MR. KULPER: The federal dynamics around this industry are quite interesting. You have reauthorization, which is coming next year. You have the debate at the Congressional committee level about how significant a role the private sector should play versus having federal oversight and control. My view is that the funding of infrastructure isn’t given the priority at the federal level that it should be given. There has been systemic underinvestment in this industry. The funding mechanism for this industry is effectively broken. There is a reliance on the gas tax, yet politically, no one can increase the rate. So politically, there seems to be almost no alternative other than turning to private solutions.
It is troubling that there continues to be significant debate about that basic fact. The more difficulties there are in the political arena and the lack of clarity and direction to solve the problem, the longer it will take to start to roll out solutions.
As an initial step, we need to get clear policy mandates. Hopefully, after the 2008 elections, there will be a certain degree of clarity brought about through reauthorization, which will happen sometime between 2009 and 2011, depending on whether the bill comes in on time or two years later, as it did last time. This will bring about a clarity of framework. Then you have the issue of how much regulation there is in terms of what the private sector can and can’t do. Hopefully the balance is struck at a level where there is clear public interest protection and oversight, and definite rules are established. Once this occurs, then the private sector will be able to do what it can to solve problems, which is to be creative and innovate and bring funding solutions to solve very real needs.
MR. GREENWALD (from audience): Can someone tell me why, when you’re looking at a massive toll road where, by far and away, the largest component of its costs over time is capital, a municipal bond issued by the Jersey Turnpike Authority or the Pennsylvania Turnpike Authority isn’t always going to be a cheaper solution for the US citizen than the higher cost of capital that commercial banks and private investors are going to require?
MR. VINCENT: That’s the ultimate question. Why would you ever even pursue this? The problem is, it can’t always be about cost of capital. If you are just going to zero in on cost of capital, then it will always be difficult to answer that question. It is also about risk transfer. Risk transfer is a very important component to all these transactions.
MR. GREENWALD: The way I see it, what Governor Corzine is talking about in New Jersey is basically, keep it in the hands of the state, issue municipal bonds, and do the same kind of financing that you guys would do, but do it on a tax-exempt basis.
MR. MONTGOMERY: Steve, tax-exempt financing is just a mechanism to give a federal subsidy to a project. The government can do that by giving a grant, or by allowing a state to use tax-exempt financing.
MR. GREENWALD: But as a citizen of New Jersey —- I’m not a citizen of New Jersey, but if I were a taxpayer in New Jersey — isn’t it a better solution for me to have the government issue tax-exempt bonds that are going to transfer the risk to the bondholders, just as the risk is transferred in Indiana to the banks? In that situation, you have the risk transfer. The state keeps the asset. It is not selling it to guys who might require a 12 or 15% rate of return for the equity. I understand the argument that you guys operate it more efficiently. I don’t fully understand or appreciate how much that really means. Maybe it means a lot more than I’m aware of. But I do know that the overriding cost associated with toll roads is still the cost of capital. So help me understand why a revenue bond that transfers risk to those bondholders isn’t a better solution to the citizens of a particular state.
MR. KULPER: Let me jump in here. I think there is a better argument here, which is, tax-exempt debt is available to PPPs. The cost of debt capital doesn’t have to be any different in a public model than in a private model, particularly for new construction projects. I think you are taking a very narrow funding view, whereas you need to look at what a PPP is in a broader sense.
The cost of capital is, obviously, a very important element. For example, in our Capital Beltway project, our funding mechanism is tax-exempt senior debt. You can’t ignore the efficiency arguments and the innovation arguments. When discussing the provision of transportation services, you need to take into account what the private sector can deliver in a PPP model where there are risk transfer and incentives to operate efficiently and provide better service, versus a typical municipal structure where, to be honest, you create public funding corporations where it is all about perpetuation of a set of political dynamics, not necessarily the best service or economic outcome.
MR. GREENWALD: So why not have the state outsource it to you guys?
MR. KULPER: Because if you sign people up on contracts or subcontracts, what you find is that people execute in accordance with the letter of those contracts, and soon they are looking for change orders or they are doing the minimum necessary, as opposed to actually optimizing the service and the value of the asset.
MR. MONTGOMERY: I would also throw in that you don’t pay that 12 to 15% return to the private capital for nothing. There is a value proposition there. When tax-exempt bonds are used, the federal government provides a subsidy. It is there, and people are going to take advantage of it as they did in Capital Beltway.
MR. GREENWALD: If you could do it all the time the way you did Capital Beltway, maybe that’s a solution.
MR. SALTAO: When we are talking about risk transfer, the US does not have the maturity of the European markets, where these issues have existed for 30 or 40 years. For example, traffic risk is a dramatic risk. There is a premium for that risk, and when the economy slows, as Tim Vincent just mentioned, everything slows. The traffic decreases, and you cannot raise the tolls as expected. These are deficiencies that you have to work on and are costs to be accounted for in your business model.
Depth of Financial Market
MR. FRIED: Let’s turn to another subject. How much depth do you see currently in the financial markets for financing PPPs? If the lenders are pulling back, will it be harder to finance these projects? Bob Dewing?
MR. DEWING: It is a calamitous market right now for all types of debt. However, I think PPP debt, as with the best projects, still is being received favorably by the market. Many projects in Europe have been financed in the last six months. Even in the US, I think the sponsors will still find many financiers keen to participate in PPP projects. What is completely missing right now is the bond market as a take-out. The banks are going to have to take that risk for an interim period of time. There is no retail market or secondary syndication market for PPP-type assets. There are just no long-term holders coming on the secondary level. The senior lenders who are in the market all the time are still willing to participate, but they are finding that they are having to hold bigger pieces for longer than they would have liked in the past. That is less than appetizing for institutions with capital constraints. The better projects will still get the capital. The marginal projects, I’m afraid, are going to struggle.
MR. FRIED: if lenders are providing mini-perm loans, will they be refinancing or restructuring at the end of those mini-perms?
MR. DEWING: The mini-perms now are five to seven years. I don’t think anybody anticipates this to be a five- to seven-year problem.
MR. FRIED: Let’s hope not. Michael Kulper, how much of an impact did this have on the Capital Beltway closing in December?
MR. KULPER: It created execution issues. I think the point has been made correctly that good projects with good sponsors are getting done. It is as much an issue around execution, that is, how you do your execution and what the execution costs will be, but fundamentally good projects done by credible sponsors will get done in this market. I think the difference is that a year ago, the quality control probably was not as rigorous as it is today. It was relatively easy to go into the market and get both debt and equity capital. There was not as much of a focus on the underlying project or the underlying business model or the underlying sponsors.
There will be a flight to quality in this environment, and I think that will result in the cleaning out of some marginal players on the debt side and on the equity side. But those sponsors who have a good track record and are established will benefit from an environment where the risk-reward equation has shifted towards getting better returns for capital.
MR. FRIED: Alec Montgomery, do the problems in the financial market have a different impact on the bank market than on the bond market?
MR. MONTGOMERY: Initially, most of the focus has been on the bank market. That is where all the headline losses have been taken. But at the end of the day, it is a question of liquidity and de-leveraging. We started to see it rip through all different pockets of liquidity. If you step back, it’s really a question of the difference between high-grade credits and non-investment-grade or lower rated non-investment-grade credits where the impact is probably equal both across the bank and bond markets. The single B market is pretty well shut. The higher-quality projects, certainly, and the higher-quality credits and sponsors in the market, who have strong relationships with financial institutions, are not going to suffer like the rest of the market.
MR. FRIED: So it is back to basics. A strong project with strong sponsors should succeed.
MR. MONTGOMERY: It is going back not only to risk and return, but also longer-term perspectives on relationships and where investors want to drive the business.
MR. FERREYRA: I have some comments that tie in with the questions that Steve Greenwald asked earlier. I think that the types of assets, toll roads in this case, that may prove more resilient are the ones that have greater profits. These are projects where traffic risk is kept on the public side. This is one of the reasons that such projects are put to the private sector, of course. These are deals where, essentially, you are still likely to see substantial appetites. In Florida, for example, we are working on the Miami Port Tunnel and, hopefully, I-595. Those are projects where you will see, probably, more appetite and higher quality kinds of structures. Hopefully there are going to be more states that use the successful formula that Florida has been using for the last year and a half.
MR. FRIED: I want to talk about public perception for a moment. Michael Kulper, America Moving Forward is a coalition that has been formed recently by some members of our panel. What does this coalition plan to do to convince the public of the value of public-private partnerships?
MR. KULPER: The coalition is primarily about education. There are many misconceptions: such as that the public sector always owns the assets and the assets aren’t foreign owned. The public sector is always in control of the project because it gets to set the rules of engagement. It writes the concession agreements. It specifies contract terms that ensure that the asset is operated in the public’s interest. Performance standards are often well in excess of standards for public-run assets. You actually end up with a premium facility. There are always consequences for failing to live up to those standards.
Then there are the issues related to risk transfer. There is real value, for example, in doing turnkey contracts where price and schedule are agreed and there are real financial consequences for failure to deliver. We only have to look at the debacle that was the Big Dig to see what happens when the public sector doesn’t shift risk to the private sector: you get schedule delays, and you get cost overruns.
Every PPP is different. What the public sector should be doing is making sure that the deals are structured so that the public interest is protected. In most cases, that is successfully achieved and real value is created out of these processes. This coalition is aimed at educating politicians and the communities at large about the value that PPPs can bring.
MR. VINCENT: The coalition exists to address some of Steve Greenwald’s questions. Steve should log on to the website, and he can read all about the value of PPPs. It is truly a communications effort. It has a lot to do with the message itself. What are you asking the public to accept? By doing this potential structure, it frees up so much more capital for hospitals and education.
MR. DEWING: It is also a movement from the public sector providing a service to the user paying for the service.
MR. FRIED: Bob Dewing, has the public perception gotten worse, better or stayed the same since a year ago?
MR. DEWING: It has gotten worse. PPPs are being dragged through the mire by the press. There is some time to go before there are enough successfully operated projects for people to see that there is, truly, a better service with the private sector. You can look at Corzine’s proposal, which was well thought out and put together, and was virtually dead on arrival in the press. Before he got to present his case in the public meetings, the press and the public had already decided.
MR. FRIED: Governor Corzine has proposed raising tolls by 50% in 4-year increments, in a non-PPP environment with a public benefit corporation. Does that actually help the PPP cause?
MR. KULPER: Toll-rate setting is entirely a public sector decision. It has no bearing on whether to use a public benefit corporation or a concessionaire for a road project. I think that our industry has suffered somewhat from the fact that there were clear public policy decisions around toll-rate setting for some of the earlier PPPs, and I’m referring specifically to Chicago and Indiana, where they built in these 75- and 99-year deals, and they allowed tolls to increase per schedule, which they set to increase in real terms substantially over time. That was for the explicit purpose of maximizing the value of the asset. That was a decision that was in the public sector’s control. This isn’t a private decision, it’s a public decision.
MR. FERREYRA: Just thinking about public perception after the bridge collapse in Minnesota last year, I think that was like Andy Warhol’s comment: suddenly we got our 15 minutes of fame and the public’s attention. I think that it increased public awareness to a small extent, but the public has a short attention span. Nowadays people are talking about elections, and public infrastructure is way down the waterfall.
MR. FRIED: Talking about public perception, in an interview with P3Americas, former Repre