Approaches to Financing
This article includes descriptions of some of the most common financing approaches that are used within a P3 or turnkey delivery approach.
Approach 1: Concession/PBI Transaction (Availability Payment)
Concession/ Performance Based Infrastructure(PBI) with an Availability Payment is often used when a new asset cannot generate revenues that are sufficient to cover the cost of delivering the asset (the cost of the debt service payments and return on equity investment), or if the project is viewed as a significant long-term income generator and the public sector wants to capture future revenues. An Availability Payment is used to transfer the risks of project delivery, financing, O&M and lifecycle costs to the private sector while leveraging the credit strength of the public agency to create efficient project financing. As long as the private development partner fulfills its obligations and makes the facility available for its intended use as defined in the performance specifications for the project, the public sector is obligated to make the Availability Payment, which is typically made monthly or quarterly. Failure by the private sector to meet prescribed performance standards for the facility can result in reductions to the Availability Payment. As an example, if an elevator goes down and is not fixed by the private partner within the prescribed rectification period in the contract,which may be two hours, that elevator is considered “unavailable” and there is a reduction to the Availability Payment due that month.
“Debt providers require the private sector to inject more equity for an At-Risk transaction than an Availability Payment transaction for greater cushion in case the projected revenue levels do not materialize.”— Zoe Markwick, Societe Generale
Since Availability Payment transactions usually involve creditworthy parties on both sides (public and private) and does not include real estate market or demand risk, this structure generally allows for high loan-to-cost ratios in the 90% range and flexibility to use bank or bond financing. Concession terms typically last anywhere from 25 to 40 years, with the private partner responsible for lifecycle costs, including maintenance and capital expenditures, such that at the end of the concession term, it hands back to the public sector an asset in good working order.
Bank financing in the current market will typically have a term of five to seven years covering construction and the initial years of operation. Depending on the size of the transaction,bank debt may require the participation of multiple banks, as any single financial institution currently limits its funding to no more than $75-$100 million per transaction.
Bank debt is typically most attractive to those sponsors/investors that, in the short term, plan to transfer their interest in the concession or believe they will be able to return their investment through a recapitalization of the project. Alternatively,if the public sector owner plans to make milestone payments during construction or a large milestone payment upon construction completion, an amount equal to the milestone payment(s) is typically financed with bank debt. This is what was done on the Howard County Circuit Courthouse Availability Payment transaction,which closed in 2018 – a $78 million milestone payment is due to the developer upon occupancy of the new courthouse and that $78 million was financed by a syndicate of three banks. The balance of the private financing, which remains in the deal long-term, includes a combination of equity and privately placed notes.
Bank financing does carry refinancing risk and the possibility of higher or lower interest rates at the time of refinancing. While underlying rates can move, the risk premium(margin) charged by banks typically decreases once construction is complete and the project has completed a few years of operations.
Taxable bonds represent a long-term financing option for both Availability Payment and At-Risk transactions (See Approach 2). Terms on bonds can go as long as 35 years, depending on the term of the concession. Based on market conditions,bonds can represent a higher or lower cost of capital than bank debt, but they serve to reduce refinancing risk. Bonds are most attractive to sponsors/investors that intend to maintain their interest in the concession for the long term and/or remove refinancing risk from the concession term. Bonds typically are non-callable for at least 10 years; so, while interest rates are fixed for the term of the bonds, they provide less refinancing flexibility to take advantage of any market reductions in interest rates during the at least the first 10 years.
The level of equity investment in Availability Payment transactions is typically around 10% of the total project capitalization. Investor equity targets an internal rate of return (IRR) of 10% to 13% over the investment period.
There are some variations in the financing options available for projects, such as toll roads and bridges, which have the private sector partner/sponsor taking real risk on the revenue generation of the project as a means to pay back the project financing, also known as demand risk. Generally, since these projects bring more significant risk to sponsorship, they require a higher level of equity investment and, potentially,return when compared to Availability Payment deals. Equity investment of 30% to 50% of total project capitalization may be required for these At-Risk deals.The debt making up 50% to 70% of the capital structure is typically in the form of Bank Debt, Private Activity Bonds and TIFIA (a form of low cost subordinated federal funds).
Approach 2: Concession/At-Risk Operations (Toll Road/Tunnel/Bridge)
Bank debt for revenue risk projects has similar characteristics to bank debt on Availability Payment transactions except that loan-to-cost ratios will be much lower, in the 50% to 60% range.
Private Activity Bonds (PABs)
PABs are a form oftax-exempt bond available for both At-Risk and Availability Paymenttransactions in which a local government entity or conduit bond issuer helpsraise money for a private company delivering a project with public benefits. Itmust be proven that a public benefit derives from the private activity bond inorder to qualify for tax-exempt status. Private activity bonds generally arenot guaranteed by the revenue of a public agency or the conduit issuer and theyare used for projects such as affordable housing, water and sewer, pollutioncontrol, airports, road and rail. PABs, like other bond debt, have a longtenure but have limitations on repayment. The loan-to-cost ratio for PABs onrevenue risk projects is in the 50% to 60% range, and the ratio can be substantiallyhigher on Availability Payment projects, in the 90% range. PABs have been employed on many notable turnkey transactions,including I-95 Express, Capital Beltway Express Lanes, Midtown Tunnel, LBJFreeway, North Tarrant Expressway, which were all At-Risk transactions, and theDenver FasTracks Eagle and Carlsbad Desalination projects, which were more akinto Availability Payment transactions. The Carlsbad Desalination project is awater supply project in San Diego, in which the San Diego County WaterAuthority has a Take-Or-Pay contract with the private partner, a structure thatlooks like an Availability Payment model.
“When short term bank financing is used, the private sector assumes the risk of whether the debt will be able to be refinanced.”— Zoe Markwick, Societe Generale
At-Risk Concessions,unlike Availability Payment transactions which have credit worthy governmental counterparties obligated to pay, rely solely on outside, third-party sources of revenues such as tolls or user fees to repay the cost of and return on investment. Due to the greater risk of revenue generation from these sources, At-Risk Concessions require equity to fund a higher proportion of the capital structure. Equity is typically provided by the sponsor entity with some participation from contractors and other investors. Equity IRR requirements for full revenue risk projects are in the range of 15% to 20%.
Approach 3: Built-to-Suite Operating Lease
The build-to-suit operating lease structure is common to standard commercial real estate with a major distinction from a concession being that at the end of the lease term, ownership of the asset remains with the private sector. The public sector either needs to renew its lease or vacate the facility. Financing options on build-to-suit operating lease transactions are quite flexible with the main drivers impacting the loan-to-cost ratio and interest rates being the credit quality of the public agency tenant and the financial strength and experience of the private sponsor,not unlike an Availability Payment transaction.
The U.S. Department of Transportation used a build-to-suit lease structure for their 1.5 million square foot Washington, DC Headquarters, built in 2008.
Bank/Institutional debt is available to finance the construction and early operations of new development under build-to-suit operating lease scenarios. This is the traditional method of finance for commercial real estate development. Whether construction financing or construction/mini-perm financing, banks, insurance companies and other lenders will provide financing for the construction period and up to five years of operations. The amount of debt that will be provided is dependent upon the credit quality of the public tenant and the financing strength of the borrower. If the borrower is willing to guarantee (recourse) a portion of the loan amount, they can typically borrow more than is available on a non-recourse basis. Generally, loan-to-cost ratios for build-to-suit operating leases are in the 50% to 70% range with equity IRR requirements in the range of 7% to 15%,depending on the credit quality of the public tenant.
Credit Tenant Lease (CTL) Bond Financing
CTL financing is taxable bond financing which is typically structured in a private placement transaction to institutional lenders such as insurance companies or pension funds who like the long term nature of the debt instrument. CTL is attractive to developers. It offers construction and permanent financing with a term equal to the length of the lease term, and can cover as much as 100% of project cost on a non-recourse basis to the borrower. Also, because the CTL structure provides a fixed interest rate for the term of the loan, it offers the added protection of guarding against refinancing risks present with shorter-term obligations. Depending on the market location and the product type, CTL financing may have an amortization period that exceeds the term of the lease. A longer amortization period is acceptable to lenders when they believe the tenant will renew its lease due to limited alternative options or when a market study shows that there is a strong possibility for a replacement tenant at lease expiration. Historically, lenders would not accept construction/delivery risk without some form of mitigation. Lenders would fund 100% of the loan amount to a bank which would issue a Letter of Credit, effectively guaranteeing construction completion. Today, CTL loans will treat draws during construction like a traditional bank construction loan while other lenders fund all cost up front like a traditional bond financing, creating differences in the amount of capitalized interest required for interest payments prior to the commencement of rent. The CTL structure works best when the underlying tenant is an investment grade credit. Typically transactions have included single tenant retail outlets; corporate sale-leaseback arrangements; institutional facilities; and federal, state, or local governmental design-build-leaseback projects.
Equity investment can vary significantly in the build-to-suit operating lease market depending on the specific terms of the lease, the debt financing options available and the philosophy of the developer/sponsor. Equity investment can be as high as 100% cash (for certain pension fund investors) to no equity under CTL financing structures. Equity IRR requirements are dependent on the capital structure and credit quality of the public tenant, with a minimum IRR requirement.
Approach 4: Capital Lease for Vertical Social Infrastructure
Capital lease financing is a method which is used to finance a number of Non-Federal public facility-types including schools, healthcare facilities, jails, municipal centers and stadiums. Capital lease financing can be utilized with a turnkey delivery approach to provide risk transference to the private sector for the delivery and operation of the project. Capital lease financing is typically in the form of either tax-exempt Lease Revenue Bonds or Certificates of Participation that are subject to annual appropriation. The term of these tax-exempt bonds is generally anywhere from 15 to 30 years depending on the asset type and the appetite of the government entity. Capital leases generally do not require a referendum for approval and can be entered into by State and local governments without voter approval.
There are numerous ways to finance infrastructure projects that employ a turnkey delivery approach, and the ultimate plan of finance should be tailored to meet the specific goals of the project and public sector owner. This financial flexibility makes turnkey delivery available to any project where there is value in risk transference.