The objectives of our analyses were to: (1) identify financial disadvantages to the public sector of PPP transactions compared to traditional financing methods; (2) identify factors that allow the public sector to derive financial value from PPP transactions; and (3) assess the extent to which PPPs can close the infrastructure funding gap. Our quantitative comparison of PPP financing to conventional municipal bond financing involves a purely financial valuation of projects under alternative scenarios.
We worked with a team of contractors led by Charles River Associates International and financial consultants, Scott Balice Strategies. We used published literature to establish a foundation for our work. We constructed representative examples of infrastructure projects to provide a basis for our analyses. We based those representative examples on actual proposed or implemented projects selected to illustrate various features of highway infrastructure projects. We used interviews with investors and other market participants along with data on actual projects and market conditions to help construct the representative examples. In our selection of these examples, we sought coverage of a range of infrastructure finance issues. Some of the key considerations in example selection were:
• Mix of greenfield and brownfield projects-our representative examples include three greenfield and four brownfield projects, a proportion that reflects the U.S. market;
• Variation of evaluation periods-evaluation periods in our examples range from 25 to 90 years;
• Revenue and cost variation-our examples exhibit considerable variation in revenue and cost streams;
• Availability of innovative federal financing mechanisms-we developed one example specifically to illustrate the use of federal innovative financing mechanisms.
The PPP greenfield projects we analyzed are all of the design, build, finance and operate (DBFO) type, meaning that the private partners are responsible for the design, construction, operation, maintenance, and finance of the facilities. The brownfield projects are all long-term lease concessions in which the public sector leases a facility to a private partner who then assumes responsibility for facility operations and maintenance (O&M). Under a DBFO or a lease concession PPP, the private partner pays a lump sum upfront to the public sector to obtain control of a highway for a certain time period, and collects some or all of the revenues associated with the highway during that period.
To value multi-year projects, we used present values. The present value of a cash flow due at some date in the future is the amount which, if it were on hand today, would grow to equal the amount expected at the future date. For example, if one could earn 5 percent interest, $1,000 now would be worth $1,050 a year from now, and $1,000 is the present value of $1,050 next year. The determination of the present value of a future cash flow is known as "discounting," and the interest rate used in the calculation is called the "discount rate." The higher the discount rate or the farther in the future a cash flow occurs, the smaller the present value of a particular cash flow or, in other words, the greater the degree to which the future cash flow is discounted. In our analyses, we used the after tax weighted average cost of capital to discount future cash flows.
We created a discounted present value cash flow valuation model to quantitatively compare the investment value of the representative infrastructure projects using traditional financing with tax-exempt debt and as a PPP using private financing. We treated the choice of project financing mechanism as an investment decision. In other words, we asked the question: "what is the value of the transportation asset in terms of its financial contribution to the public sector?" The model quantified the cost of traditional municipal financing as compared to PPP financing. To obtain revenues, costs, and other financial inputs for the model, we gathered data from relevant financial documents, annual reports, published and unpublished project documents, existing databases, and assumptions in the absence of any other information.
One critical model input derived from our assumptions was the revenue growth rate. For all the U.S. based examples, the base case public sector alternative assumed an annual revenue growth of 5 percent. With gross domestic product growth averaging 4.2 percent between 1999 and 2007, and annual traffic growth in the country usually estimated at about 1 percent, an overall revenue growth rate of 5 percent annually was considered to be a reasonable value for the base case scenarios. The annual growth rate for the French example, Project Example 5, was assumed to be 2.2 percent because the toll setting formula in France is much more conservative than in the U.S., and toll increases usually are pegged to a fixed percentage, usually 70 percent, of the consumer price index. Similarly, in all the examples, the base case also assumed an annual growth in O&M and heavy maintenance of 3.89 percent, which was the producer price index annual escalation rate for maintenance and repair construction between 1999 and 2007.
The valuation model compared the net contributions-derived from the project's gross contributions-provided to a state or local government entity from the project under the two financing alternatives. The gross contribution of a project consists of the monetization of its future cash flows less its financing costs. For a public financing, this consists of the proceeds from the primary debt offering, such as senior lien bonds, that could be financed plus the present value of any residual cash flow available to the government after payment of debt service through the financing term. Subordinate financing, such as junior lien bonds, served as a proxy for this residual. In PPP financing, the monetization of future cash flows consists of the total amount of capital that can be raised by the private sector, from both debt and equity, which would be used to make an upfront payment to the government. In a PPP arrangement, our model assumed that the equity financing component was subordinate financing. In either type of financing, the total gross contribution included the present value of the debt service reserve fund14 that would be available at the end of the valuation period. However, the initial cost of funding the debt service reserve was included as a cost item with the financing costs.
Subtracting the present values of construction, expansion, and heavy maintenance costs from the gross contribution produced the net contribution. Construction costs were broadly defined. They included general contractor and overhead costs, architectural and engineering fees, preliminary engineering, final engineering, environmental mitigation, right-of-way, utility relocation, construction engineering and inspections costs necessitated by the construction of the facility. Expansion costs included the construction costs of any additional lanes and other associated expenses, such as construction or expansion of toll facilities. Heavy maintenance costs consisted of non-routine maintenance costs, such as resurfacing costs.
We also used our model to conduct sensitivity analyses-assessments of how much project values change when some factor is changed-of each example project. For example, we evaluated the effects of changes in the cost of capital and the length of the agreement on project values under the competing implementation methods.
Although debt markets were under stress during the time we conducted our analyses, we did not focus on those market conditions, but emphasized general principles of market function and ways to incorporate market conditions into financial valuations. However, our analyses acknowledged both current and recent, but less constrained, market conditions when we applied the valuation model to representative examples in order to compare the relative efficacy of public and private financing approaches.
While we considered the value of the transportation asset from the perspective of a state or local government, we did not consider the case in which a PPP transaction is used as a vehicle to generate funds for some other purpose outside of transportation infrastructure. Such an analysis might take into account financial benefits that are outside the transaction, such as the use of proceeds or revenue share. These considerations are potentially relevant factors in decision analyses of PPPs, but we did not incorporate them in our analyses.
We compiled the information and results in this report between January 2008 and April 2011. We believe that the data and information we collected, the sources from which we obtained them, and the ways in which we used them, provide reasonable basis for our findings and conclusions based on our stated objectives.
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14 The debt service reserve fund is a set aside of debt proceeds for the benefit of the debt investor in the event that funds from operation are insufficient to pay debt service.