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