The Role of Capital Markets in P3 Financing

Increasing infrastructure demands in Canada and abroad create opportunity

The Infrastructure Deficit

The Public Sector Accounting Board defines an infrastructure deficit as "the added investment in infrastructure assets that would be required to maintain them at appropriate levels and in a good state of repair." By some estimates, the total infrastructure deficit in Canada (federal, provincial and municipal) exceeds $400 billion. As a result, addressing the infrastructure deficit has become a policy imperative. At the same time, governments at all levels face ballooning public debt, unsustainable deficits and a weary taxpayer base with little tolerance for increased tax levels to fund further government programs, regardless of merit. To remain competitive in the global marketplace, Canada must take steps to alleviate the infrastructure deficit – and without further delay. With little in the way of politically palatable alternatives, governments have been forced to consider alternative and cost-effective measures for the procurement and, more importantly, the funding of their infrastructure needs. Public-private partnerships, or P3s, provide a solution to those needs.

What Are P3s?

P3s are contractual arrangements formed between a public agency and a private sector entity for the delivery and financing of public infrastructure projects. P3s can take various forms: design-build, build-finance, design-build-finance, design-build-finance-maintain (DBFM) and design-build-finance-maintain-operate (DBFMO). The hallmark of a successful P3 structure is an appropriate allocation of risk and value for money for the public agency. More important, the structure enhances on-time and on-budget delivery of the asset, and in the longer-term structures (DBFM/DBFMO), maintenance and life-cycle discipline that ensures longer asset life. Apart from these desirable attributes, at the core of many of these structures is the private financing component of P3s. Since P3s typically comprise both debt and equity, for contracts with a fixed pricing structure, lenders' and equity providers’ oversight of their investments acts as a second level of project control to ensure timely and complete contractual performance.

The Transaction Record for P3s

Although P3 procurement has been highlighted in the press more recently, it has a relatively long and successful track record in Canada, with nearly 200 transactions having been completed or in process. Canada is a recognized world leader in the utilization of the procurement model, and the "Made in Canada" approach to P3s, which is both efficient and financeable, has brought many global financial institutions into the Canadian market. Indeed, in the early days of P3 in Canada, the participation of European and Japanese financial institutions, with a more flexible appetite for long-term debt structures and a greater familiarity with P3 infrastructure development, was critical to the success of the longer-term P3 structures. During those early days, many P3 participants expressed mild frustration at the lack of involvement by capital markets players. It seemed only logical that financial institutions such as life insurance companies and pension funds, with their vast pools of capital and appetite for long-term returns (to match long-term liabilities), were well suited to the funding of P3s. At the time, the reason most cited by capital markets participants for not getting involved in P3 deals was a combination of deal size and documentation/transaction complexity, which, with relatively limited "back-room" resources, made the transactions a low investment priority.

The Advent of Capital Markets Participation

As the years passed from the early days of P3 to those of the "credit crunch," and as European and Japanese financial institutions retrenched in their home markets, their participation in P3s waned. This limited the supply of long-term money for P3 projects. Fortunately for P3 market participants at that time, more traditional capital markets participants, facing an uncertain market, turned their minds to investment products with long and, more importantly, predictable and respectable returns. As a result, capital markets participants focused greater attention on the P3 market and developed greater familiarity and expertise with the model. Indeed, their participation played a critical role in sustaining P3 deal flow during those difficult times.

Deal Structures and the Capital Markets Track Record

Capital markets participation has centred, although not exclusively, on longer-term P3 structures (DBFM/DBFMO). These structures typically involve a lump sum payment from the public agency once construction of the infrastructure asset is complete, and periodic service payments as compensation for maintenance/life-cycle/operations services over the balance of the contract term (25–35 years). Accordingly, short-term money, which is to be repaid with the lump sum payment, is required over the construction phase (two to five years). This component of the debt is often fulfilled by the traditional banks and is sized accordingly. In addition to the short-term debt, there is an equity component of funding and, although gearing (debt to equity ratios) for P3 transactions has varied over time, the current ratios range from 85:15 to 90:10, with some occasional outliers.

While long-term bank debt from European and Japanese financial institutions remains available for the role, the long-term piece of the funding puzzle is, together with equity, more currently filled by a capital markets component that normally takes the form of a bond offering, typically as a private placement. The issue amount is funded in full into a segregated account on financial close and deployed to pay construction and development costs – typically drawn in priority to the short-term debt. Pricing for the bonds is usually pegged off the bid-yield on Government of Canada (GOC) Bonds, determined by a linear interpolation of GOC Bonds approximating the average life of the bonds, plus an issue spread. Tenor for the bonds approximates the contract term, less a tail of typically 6 to 12 months. Debt service on the bonds and equity returns are funded from periodic service payments made by the public agency under the P3 contract, which is structured to fund those financial payments and the "pure" cost of service performance. While there is certainly construction risk for both short- and long-term lenders, the bonds are exposed to payment risk in the form of penalties that the public agency may impose if there are performance defaults by the private sector partner. Accordingly, as additional security, bondholders typically require debt service reserves, liquid security in the form of letters of credit and, on occasion, bonding. If a conventional approach is taken to the structuring of the P3 bond investment, the result is an investment-grade product with typical ratings (when rated) in the range of BBB+ to A, with an average of A- (S&P). Although there are certainly some exceptions, it is commonly understood in the market that to attract sufficient investor attention relative to the complexity of the transaction, sizing of the bond issue needs to be in the $75 million plus range.

The track record for capital markets financing of P3 transactions is robust, with approximately 30 bond financings having taken place over the last five years in Canada, ranging from a low of $50 million dollars to in excess of $1.4 billion dollars. By all accounts, the demand will remain robust as long as deal flow remains healthy. In addition, the infrastructure asset sectors in which capital markets financing is deployed vary from hospitals, courthouses and correctional facilities to roads and bridges – and public transit is on the horizon. As one might expect, since the passage of the "credit crunch" and with increased interest in P3s, the available supply of long-term capital markets funding has increased. As a result, pricing margins have come in from a high of roughly 400 bps in 2009 to a current range of 200-250 bps; and while, historically, most bond financings were structured as club deals, underwritten deals are becoming the norm.

The Roundup

Recent history has shown that a robust capital markets opportunity exists in P3 transactions; the structures are disciplined and now time tested. Although not all of Canada’s infrastructure needs will be met with P3s, the sheer demand that will flow from the infrastructure deficit bodes well for future capital markets investment opportunities in these structures. Public transit appears to be the next significant sector in which P3 can play a major role, and the projects that have been planned to date and that are on the horizon will require significant capital investment.