For the purposes of this report, a "buyback" provision is a clause in a PPP contract giving the state a right to terminate the concession early and have the toll project revert back to being the full responsibility of the state (or in the case of Texas, a toll project entity).122
All well-drafted PPP contracts address the potential termination of the agreement before the expiration of its full term. However, unlike termination for cause, buybacks - or "Termination for Convenience" provisions as they are known in the industry - require no breach of duty on the part of the concessionaire.
Several witnesses before the Committee addressed this topic as it related to projects in their own jurisdictions, and the Committee further investigated termination for convenience provisions in other locations. Our investigation reached several broad conclusions.
• Though as with other aspects of PPPs no one size fits all, termination for convenience provisions around the world are broadly similar - granting the government the right to terminate an agreement upon the payment of compensation.
• Generally, termination compensation is based on a determination of fair market value by an independent appraiser(s).
• The termination for convenience provisions of SB792 incorporated a method not in general use elsewhere.
• Buybacks add another element of uncertainty in the parties' calculations. As with any other financial variable, parties bearing that uncertainty will demand compensation for doing so. Buybacks thus will carry a price even in the most benign credit environments,123 and could have the unintended effect of deterring private concessionaires from entering the Texas market.
The only current large scale CDA in Texas - the SH 130, Segments 5&6 project, contains two Termination for Convenience provisions:124
• A limited provision expiring on June 1, 2010; and
• A general Termination for Convenience clause valid for the life of the contract.
Both provisions allow TxDOT to terminate the agreement at its own discretion in return for payment of the "Termination Compensation."125
In the general provision, the Termination Compensation is determined by the project's fair market value adjusted for specified developer out of pocket and demobilization costs. The procedure for determining the fair market value of the developer's interest is based on an independent appraisal. In sum:
• TxDOT and the private developer agreed to appoint an independent third-party appraiser "nationally recognized and experienced in appraising similar assets."
• If agreement on the appraiser proves impossible, both parties are to appoint their own appraisers, who will then pick a third appraiser.
• If no agreement on this third appraiser is possible, each party may petition the Travis County District Court to appoint an independent appraiser.126
Unlike the general provision, the limited provision expiring in 2010 specifies that after recovering out of pocket costs and an amount equal to the project's senior debt (including prepayment penalties), the developer is entitled to a specific return on its committed equity - in this case 18 percent, compounded annually.127
The SH 130, Segments 5&6 contract was signed before the passage of SB792 in 2007, which added Transportation Code, §371.101 - Termination for Convenience. SB792 requires a toll project entity to develop a formula for making termination payments. This formula "must calculate an estimated amount of loss to the private participant as a result of the termination for convenience."128
Section 371.101 states that "the formula shall be based on investments, expenditures, and the internal rate of return on equity under the agreed base case financial model as projected over the original term of the agreement, plus an agreed percentage markup on that amount." However, this formula "may not include any estimate of future revenue from the project, if not included in [the] agreed base case financial model [emphasis added]."
The methodology employed by SB792 represents a fundamental change. Under a Fair Market Value (FMV) based approach, a private developer would receive some of the benefits from upside surprises in traffic and revenue. SB792 specifically excludes a developer upside in the event of termination for convenience. Instead, the determination of value is grounded entirely on the base case financial model.129
This is a crucial distinction, and the approach mandated by SB792 runs counter to the termination for convenience provisions most commonly used in other jurisdictions, both in the United States and abroad.
Virginia currently has two CDA projects: the Pocahontas Parkway in Richmond and the Capital Beltway HOT lanes in suburban Washington. The current Pocahontas Parkway concession has a termination for convenience provision, based on an appraisal of fair market value, but it is exercisable only after forty years.130 The parties agreed to the forty year term because at that point, all of the project's debt will have been repaid.131
Virginia's second CDA, the Capital Beltway HOT lanes, does not contain a termination for convenience clause - a decision based primarily on the need to mitigate the private party's risk in the current credit environment (as well as the concessionaire's agreement to fund $400 million in additional highway improvements designated by VDOT).132 The Capital Beltway HOT agreement, however, does contain strong provisions protecting the state regarding termination for cause.133
Two Florida projects currently under negotiation are expected to contain similar termination for convenience clauses. The draft agreement for the Port of Miami Tunnel concession specifies that in the event of a termination for convenience, the Florida Department of Transportation must pay compensation equal to the senior debt, the concessionaire's out of pocket and redundancy costs, plus an equity IRR (as yet to be determined at the time of this report).134 The I-595 project outside Fort Lauderdale will, in all likelihood, contain similar language.135
Projects in Canada and Australia employ similar terms. Toronto's Highway 407 concession agreement requires the government to pay fair market value for terminations not for cause or force majeure.136 Project fair market value is defined as the aggregate of breakage costs plus, essentially, the amount that would make the concessionaire whole as if the early termination had not occurred.137
As to the determination of FMV, the parties are instructed first to negotiate; then, if agreement proves impossible, they are to select "a skilled and experienced commercial mediator." If this fails, the parties then are to appoint a "duly qualified business valuator having not less than fifteen years' experience in the field of business valuation," and in the absence of agreement as to the valuator, each party may request that a judge of the Ontario Court (General Division) appoint the valuator. The valuator then has 60 days to complete the valuation under Ontario's Arbitration Act of 1991, and the decision of the valuator "shall be final and conclusive and not subject to any appeal."138
The Australian state of Victoria has gone even farther with the publication of Standard Commercial Principles governing PPPs. These affirm the government's right to terminate a project at any time, at its sole discretion, subject to a termination payment to the private contractor, with the payment amount determined by an "independent valuer's reasonable assessment of forecast cash flows to equity from the date of termination to the expiry of the project agreement."139
Given the distinctions between termination for convenience provisions in Texas and other jurisdictions, the Committee believes that it is important to address the fundamental reasons for such provisions in the first place. Boiled down to the essence, governments insist on termination for convenience provisions (as opposed to termination for cause) for two fundamental reasons:
• To prevent a private developer from making excessive profits off the state's motorists; and
• To create a mechanism by which the state may avoid a lengthy and expensive court battle with the private developer.
The Committee heard testimony that excessively stringent buyback provisions are a crude instrument that can become counterproductive, and that other mechanisms may resolve the above concerns in a manner less discouraging to potential PPP developers.
Two mechanisms exist to solve the issue of excessive developer profits: revenue sharing and Equity IRR caps.140 Texas already employs revenue sharing. SH 130 Segments 5&6 requires the concessionaire to remit a specified percentage of toll revenues above a threshold level to the state. The amount of revenue shared is based on a sliding scale where the state's share rises as toll revenues increase - reaching 50/50 after certain defined points.141
Revenue sharing can take on a number of varieties, as well. Australian states emphasize that the state must share in any gains earned by the private concessionaire through refinancing,142 as well as any upside from a project's modification.143 Ontario required the Highway 407 developer to make congestion payments to the government if toll revenues and congestion exceed defined thresholds - reasoning that congestion on the toll road pushes traffic onto nearby streets thereby increasing the government's costs.144
Equity IRR caps have a similar effect of reducing developer profits, but can prove more complicated in practice. Unlike revenue sharing, which is ultimately based on a single, easily verifiable, variable - revenue - the determination of Equity IRRs requires the assessment of a number of disparate factors, including the condition of the credit markets at the time of the calculation and the specific level of risk assumed by the project's developer.
For instance, projects involving shadow tolling - whereby the state bears the cost of traffic and revenue shortfalls - merit much lower IRRs than do concession agreements whereby the private developer bears the full spectrum of project risks, from environmental issues to construction overruns to lighter than expected traffic flows.
Ultimately, the determination of an equity IRR cap raises the issue of what is the "proper" number for a given level of risk. Unfortunately, the Committee is not in a position to issue a definitive statement on this matter. Too few data points exist, many of the transactions addressing the matter remain under negotiation, and the specific number will - almost by definition - vary with the details of each individual PPP.145
We note that buyback provisions depend on the decision to cross-subsidize. If the decision is made to use tolls to pay back only the cost of a particular road's construction, operation and maintenance, an equity IRR cap would have the practical effect of limiting toll increases to the level required to reach that cap.
On the other hand, if the state has determined to extract the maximum revenue from a particular road, a revenue sharing arrangement may be the most appropriate mechanism to limit a concessionaire's profits.
Regarding the danger of drawn-out, expensive court battles, many PPP contracts provide for some type of binding arbitration (including that for SH130 Segments 5&6), and the Committee notes that Texas already has a well established network of arbitrators experienced in large scale commercial dispute resolution.
Finally, we must note that excessively stringent buyback provisions may have the unintended effect of raising the price of PPP projects as well as causing the most experienced and reputable private developers to avoid the Texas market.
It is almost axiomatic that any provision increasing the level of a developer's uncertainly will require that party to earn an additional level of return - whether through higher toll rates, more aggressive discounting of cash flows or a higher buyback price. It is for this reason that transportation authorities in Florida urged the Florida legislature not to mandate buyback provisions.
In addition, Florida transportation officials expressed concern that the more reputable concessionaires with extensive track records of successful PPP development simply would not participate in the Florida market if onerous buyback provisions were in place.146 Likewise, Virginia declined to include termination for convenience provisions in the Capital Beltway HOT lanes project for the same reason.147
We note that projects currently under negotiation in Florida will probably contain termination for convenience provisions. However, an important distinction exists between taking such provisions into account during individual negotiations and imposing them via statutory mandate. Like other aspects of PPPs, termination for convenience provisions should be tailored to the requirements of each particular transaction.
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122 Technically, the term "buyback" is inaccurate since under any structure contemplated in Texas, the asset will never be sold - and thus cannot be bought back.
123 Much of the current credit crunch is driven by the downfall of irresponsible lenders who ignored this fundamental truth and wildly underpriced risk - often in a grab for market share. We expect the pendulum to swing the other way - perhaps too far - as it often does when markets correct after a period of excess.
124 See Facility Concession Agreement, SH 130 Segments 5 And 6 Facility Between Texas Department of Transportation and SH 130 Concession Company, LLC, March 22, 2007. Article 19.1 (Termination for Convenience provisions) and Exhibit 22 (Terms for Termination Compensation).
125 Note: the provision expiring in 2010 also contains additional restrictions limiting TxDOT's ability to contract the facility to a different private concessionaire.
126 The independent appraiser's determinations of the project's Fair Market Valuation and the developer's WACC are themselves subject to challenge by either party under the contract's Dispute Resolution Procedures, which, in essence, allow each party to appoint members to a Dispute Resolution Board that functions like an arbitration panel. The subject of the extraordinary complexity of CDA contracts and the ability of TPEs to negotiate such contracts effectively will be addressed elsewhere in this report.
127 See Facility Concession Agreement, SH 130 Segments 5 And 6 Facility Between Texas Department of Transportation and SH130 Concession Company, LLC, Exhibit 22, §A.4.(c).
128 Transportation Code, §371.101(a).
129 Transportation Code §371.101(b) does provide for "an agreed percentage markup" over the base case, but provides no details as to its calculation. We note also that downside surprises from the base case are also excluded, but in such a situation, the TPE is unlikely to exercise the right of termination for convenience, and termination for default by the developer is governed by a different set of contractual provisions.
130 Note that the current Pocahontas Parkway concession is a re-bid after the first concessionaire defaulted.
131 Source: Barbara Reese, Virginia Department of Transportation.
132 The risk of Capital Beltway project is enhanced by the fact that it will be the first in Virginia to add High Occupancy Toll (HOT) lanes to a road that did not already have existing HOV lanes.
133 Source: Barbara Reese, Virginia Department of Transportation.
134 Source: Florida Department of Transportation, Port of Miami Tunnel & Access Improvement Project Concession Agreement, RFP-DOT 06/07-6084DS, Addendum #3, February 5, 2007.
135 Source: Lowell Clary - former Assistant Secretary for Finance and Administration, Chief Financial Planner, Inspector General and Deputy Comptroller for the Florida Department of Transportation.
136 Highway 407 Concession and Ground Lease Agreement, Article 23, pp. 91-94.
137 Ibid, Article 23.2(b), p. 92.
138 Ibid, p. 93.
139 Partnerships Victoria, Updated Standard Commercial Principles, §29.3.1, April 2008.
140 The subject of excessive profits is inextricably tied to the issue of cross-subsidization whereby a profitable road's motorists are charged tolls the traffic will bear rather than the tolls required to construct and operate the road itself.
141 In the SH130 5/6 agreement, the state's share also rises as the SH130 speed limits increase. See Facility Concession Agreement, SH 130 Segments 5 And 6 Facility Between Texas Department of Transportation and SH130 Concession Company, LLC, Attachment 1 to Exhibit 7 (Compensation Terms).
142 NSW Guidelines, §6.2.4;
143 Partnerships Victoria, Standard Commercial Principles, §22.2.5.
144 See Schedule 22: Tolling, Congestion Relief and Expansion Agreement between The Crown in Right of Ontario and 407 ETR Concession Company, Ltd.; Article 3.3, Purpose of Congestion Payments
145 We note that the early termination provisions of Segments 5&6 expiring in 2010 specify an equity IRR of 18 percent. The Committee heard from a variety of sources off the record that projects whereby the developer does not assume full traffic and revenue risk (unlike Segments 5&6) would merit an equity IRR of roughly 12 percent ± 2 percent or so.
146 Source: Lowell Clary - former Assistant Secretary for Finance and Administration, Chief Financial Planner, Inspector General and Deputy Comptroller for the Florida Department of Transportation.
147 Source: Barbara Reese, VDOT.