It's All About Timing: PPP Payments

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Originally Published in Project Finance International - June 2013.

During the afterglow of the closings for the Chicago Skyway and Indiana Toll Road projects, transportation officials across the country viewed public-private partnerships (PPPs) as a panacea for the challenges caused by dwindling highway funds coupled with increasing transportation infrastructure needs.  Many were hopeful that PPPs could produce new assets in addition to new funds for the maintenance of existing assets. However, we all know the saying: "There are no free rides". There are a finite number of existing revenue producing facilities that could be leased to the private sector for a large upfront payment. Yet, there is a great need for new capacity, while transportation funds are being swallowed up by the costs of rehabilitation and maintenance of an ageing highway system. Most, if not all, of the PPPs for greenfield transportation projects in recent years have required public funds, regardless of whether user fees are imposed.

The introduction of public funds in the plan of finance for a PPP project requires the public agency to carefully consider the appropriate timing of and methodology for payment of the public funds to meet the agency's goals for the project. The agency's determination may be influenced by a number of factors, including the value for money analysis, the agency's interest in receiving something of value for public funds expended on the project, incentivising efficiency, and the availability of public funds.

Value for Money

Prior to undertaking a PPP procurement, best practices dictate that the agency conduct a value for money analysis. During this process, a public sector comparator is created, which estimates the life-cycle costs of the project if it is carried out through a traditional approach. In addition, a shadow bid is created, estimating the life-cycle costs of the project if delivered through a PPP. Factors that are considered in both models include capital and operating costs, the value of retained and transferable risks, ancillary costs, and financing costs. The analysis results in a comparison of the costs to the agency of delivering, operating and maintaining the project through a traditional approach versus a PPP.

The models produced in the value for money analysis are highly sensitive to the inputs. For example, financing costs are reduced if public funds are injected early in the project development phase. Transportation funds available to the agency are typically the cheapest funds in the plan of finance and, unless obtained through a bond issuance, do not carry a financing cost. On the other hand, private equity is generally the most expensive capital, as investors are looking for a higher rate of return than can be earned on other forms of debt, such as private activity bonds, TIFIA loans or even bank debt. Therefore, without considering other factors, the PPP project will be most cost-effective and produce the most value for money if the public funds are used first during design and construction of the project before debt is drawn creating debt service requirements.

So why don't public agencies always pay all of the public funds early in the design and construction phase and reduce the overall cost of the project (or get a bigger project for the same amount of public funds)?

Security for Performance

Public agencies have an interest in ensuring that they receive definable and useful work in exchange for public funds expended. The concern is that if the public funds, which could comprise a large portion of design and construction costs, are the first funds used for the concessionaire's design and construction costs on a progress payment basis, the public agency could be left with little of value if the concessionaire did not efficiently expend monies in the beginning and the project is then terminated due to performance issues by the concessionaire or for other reasons beyond the agency's control.

Although payment and performance bonds or letters of credit and project insurance are
typically required under concession agreements, until recently, maximum available bonding amounts have been limited, except in extraordinary circumstances, and letters of credit in the full amount of large projects add cost to the project. Furthermore, security may be burdensome to access. Accordingly, available security may not provide sufficient funds for completion of the project, where the public funds were not efficiently utilised.

In addition to security instruments, public agencies rely on lenders and their inherent incentives to ensure project completion. Thus, it is important for public agencies to ensure that concessionaires and their lenders always have some investment in the project as "skin in the game". This investment or skin in the game provides additional incentives to the concessionaire to find innovative ways to work through problems encountered on the project rather than walking away from a project plagued with problems early on. Since concessionaires are single purpose entities, there may be no recourse against equity members if the concessionaire abandons the project. As discussed above, the security provided for the project may not be sufficient. From the agency's perspective, the timing of the payments of the public funds serves as part of the overall security package for the project.

However, there is a tension between the objectives of (i) minimising project costs and (ii) ensuring both that value is received for the public funds expended and that the concessionaire has an appropriate level of investment in the project at all times. The amount of public funds available for the North Tarrant Express Segments 1 and 2W project located in the Dallas-Fort Worth region of Texas is US$573m. A large factor in the evaluation of proposals by the Texas Department of Transportation (TxDOT) was how much of the project could be developed as a toll concession using the entire amount of the public subsidy. The public subsidy is paid on a quarterly basis as a percentage of the overall design and construction costs of US$1,807m based on completed payment activities.

Payments are also subject to a maximum payment curve. In other words, each quarter, the concessionaire is paid 32% of the price for the work completed in the previous quarter, up to a maximum amount. This ensures the concessionaire and the concessionaire's lenders always have a proportionate amount of skin in the game. In addition, by only paying for completed payment activities, or identifiable portions of work, TxDOT ensures that something of value is received for each payment of public funds. Providing a portion of the public funding proportionately with other funding sources is an innovative way to ensure that something tangible and of value is received for the public funds expended by TxDOT.

For the latest phase of the North Tarrant Express (Segments 3A and 3B) project, which reached commercial close in March 2013, TxDOT is building a portion of the project through a traditional approach as part of the public funds dedicated to the project. The rest of the public funds are being paid to the concessionaire in accordance with the same process as the North Tarrant Express Segments 1 and 2W project.

Incentivising Efficiency in Availability Projects

In availability payment PPPs, the concessionaire provides the design, construction, financing, and long-term operations and maintenance for the project, while the public agency retains any demand risk and makes periodic payments to the concessionaire during the operating period based on achievement of quality and performance standards. Delivering a project through an availability payment model can reduce life-cycle costs, improve project quality, and provide additional financing options. In fact, one of the key objectives of the use of an availability payment structure is to incentivise the concessionaire to provide efficiency gains in the construction, operations and maintenance of the project.

While the early payment of public funds to the concessionaire will lower financing costs and therefore the costs of the project, these strong efficiency incentives may be diluted if too much money is paid by the agency upfront. If the concessionaire must wait for its payments, the incentives to maximise life-cycle efficiencies, provide a quality project and meet performance standards will be preserved. On the other hand, to enhance project financial feasibility, the agency may need to make payments to the concessionaire during the design and construction phase.

A public agency evaluating an availability payment model must consider both financing costs and efficiency incentives and try to balance the competing objectives of delivering an affordable project and retaining strong performance incentives in determining the amount and timing of milestone payments during the construction period and final acceptance payments during the early years of the concession after substantial completion. Different approaches on how best to strike this balance and achieve the public agency's goals can be seen with the four US availability payment highway, bridge and tunnel projects that have achieved financial close to-date. Note that in each instance the agency opted for one or more milestone payments in lieu of a structure that includes regular payments during design and construction. 

Public Funds Payment

 Project 

 Total Project Cost

 Design & Construction Cost

Milestone Payment Amount

Milestone Payment Timing 

Miami Tunnel US$863m US$652m US$450m

US$100m during design and construction phase; US$350m at final acceptance

 I-595 US$1,833.8m US$1.2bn US$685m

Seven annual payments commencing at final acceptance

Presidio Parkway US$362.2m US$271.2m US$173m

Single milestone payment made at substantial completion

East End Crossing US$1,18bn US$763m US$392m

US$297m during design and construction phase; US$95m at substantial completion

The Florida Department of Transportation (FDOT) determined for the US$863m Port of Miami Tunnel that the optimal balance given its available resources and goals was to be achieved by providing US$450m of public funds to the concessionaire through five milestone payments during the design and construction phase.

The milestones payments comprise approximately 52% of the total project costs (and approximately 69% of the US$652m design and construction costs). The milestone payments include US$350m at final acceptance of the work and US$100m in interim milestone payments during the construction of the project.

Conversely, for FDOT's US$1,833.8m I-595 managed lanes project, no milestone payments are provided for prior to final acceptance of the project. However, seven annual payments are scheduled to be made after final acceptance.

The total amount of these payments is US$685m. The first milestone payment of a maximum of approximately US$70m at final acceptance includes US$50m in potential bonuses to incentivise the concessionaire to meet interim milestone deadlines during the construction of the project.

The seven final acceptance payments, including the bonuses, comprise approximately 37% of the total project costs (and approximately 57% of the US$1.2bn design and construction costs), but are spread out over the first seven years of the operations and maintenance period.

The concession agreement for the US$362.2m Presidio Parkway financed in June 2012 provides that a single milestone payment will be made at substantial completion of the project in lieu of larger availability payments in order to maximise value to the California Department of Transportation. Comprising approximately 48% of total project costs (and approximately 64% of the US$271.2m design and construction costs), the amount of the milestone payment is US$173m. To incentivise performance during the design and construction of the project, the milestone payment is subject to adjustment up to a cap for construction, operations and maintenance noncompliance prior to substantial completion, as well as changes in the Consumer Price Index.

For the recently closed US$1,180m East End Crossing project, the Indiana Finance Authority will make eight milestone payments through to substantial completion of the project, totalling US$392m. The final milestone payment at substantial completion of the project is US$95m, leaving close to US$300m in interim milestone payments scheduled throughout the design and construction phase. These milestone payments comprise approximately 33% of the project costs (and 51% of the US$763m design and construction costs).

Other Considerations

TxDOT's I-635 LBJ project in Dallas includes a US$490m subsidy toward the US$2.6bn design and construction costs. Unlike for the North Tarrant Express Segments 1 and 2W project, payment of the public subsidy does not commence until three years after the commencement of construction. The reason for this is twofold. First, the public funds for the project were not available at the commencement of design and construction. Another factor determining the timing and amount of payments was the evaluation for the proposals for the project. A significant evaluation factor was the net present value of the public subsidy in the proposer's plan of finance. Although the procurement documents released to the shortlisted proposers offered a maximum public subsidy of US$700m for the project, the winning proposal included only US$445m of public funds1, and the payments are back-loaded.

There may also be legal considerations in the timing of payments of public funds. Some states have constitutional restrictions or laws that prohibit or restrict the payment of certain costs, such as financing costs, to private entities. In addition, in some states, there may be legal constraints on the public agency's ability to make payments in advance of progress, which may be construed as a prohibited gift of public funds. Before determining the appropriate methodology for the payment of public funds, these types of restrictions must be researched and analysed.

Conclusion

As many PPP projects may require a substantial amount of financial support from public agencies, the timing of and methodology for the payment of public funds deserve special attention. Considerations such as value for money, security for performance, incentivising efficiencies in availability payment projects, availability of funds and legal considerations will all factor into the determination of the appropriate structure for the payment of the public funds.

1 This figure was updated at financial close to address changes in the benchmark interest rates pursuant to the terms of the agreement.