The bumper transport bill that passed congress in 2005 attracted significant public criticism. The Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users (SAFETEA-LU) has provisions that are almost as complex and baffling as its moniker. In particular, it directed high levels of federal funding – $286.4 billion in total – towards an array of projects dear to the hearts of the legislators that approved it.

But private activity bonds (PABs) offer a potential wealth of benefits to project developers. Infrastructure developers have long faced a strict choice between non-profit concessions that can access tax-exempt funding, and for-profits that can only issue debt whose interest payments are taxable. PABs offer a marriage of the two approaches – with conditions.

The rules covering municipal bond issuance are set down in section 103 of the Internal Revenue Code. The rules list the instances in which bonds are exempt from taxation, and interpreting them feeds lawyers in the public finance groups of countless national and local law firms. And adapting them to private, or even public-private concessions had proved impossible.

What took them so long?

That private road projects were not able to access the tax-exempt market was more a factor of their novelty the last time the tax code was overhauled. The 1986 Tax Reform Act introduced a host of uses for private projects, including renewable energy and other projects with industrial uses. Such bonds are a commonplace feature of project finance, whether for biomass, cogeneration, coal or ethanol.

But during the last 15 years, as private projects have gained traction elsewhere globally, contractors agitated for greater access to tax-exempt funding in the US. Since at least 1991, states and developers lobbied for greater access, and came closest in 1999, when states won an allocation of tax-exempt bonds for private transit projects in a tax bill that congress passed, only for then-president Clinton to veto the bill.

Among the projects that would have benefited were the Las Vegas Monorail, which organised as a non-profit and went ahead with a $650 million tax-exempt issue in 2000, although it was too late for the Pocahontas Parkway, which issued $353.9 million in current interest and capital appreciation bonds as a 63-20 corporation in July 1998.

That both projects failed to live up to predictions of their patronage has been one reason for the widespread scepticism in the market that 62-30 corporations are useful vehicles for raising toll road debt. More frequent, however, was profound and widespread distrust of for-profit infrastructure operators, as the tortuous process of the Tacoma Narrows bridge from private to public concern demonstrated.

Moreover, as more than one banker active in the market notes, equity has become much cheaper in the intervening period. The willingness of non-contractors to invest long-term equity in projects was limited before this century, and bondholders frequently were asked to take on risk, particularly traffic risk, at levels that were, in retrospect, too high.
SAFETEA-LU's new styles

The 2005 version of the private activity bond authorisation does not differ markedly from the 1999 version, with the glaring exception that it is limited to highway and intermodal projects, and does not offer tax-exempt treatment to mass transit projects. The reason for the passing of the new version can be summarised as the combination of a Republican Congress and a Republican president.

But behind the passing of the bill lies a shift in sentiment at local and national government towards private infrastructure. In 2005 the head of the Federal Highway Administration (FHWA) was Mary Peters, a strong proponent of new funding method. Peters has since been named US Transportation Secretary, and was in place to approve the first application to use PABs.

The PAB authorisation, with a cap of $15 billion by volume, does not represent a serious hit to the revenues of the Internal Revenue Service. Using a back of the envelope calculation, which assumes that tax-exempt bonds offer interest savings of roughly 2% per year, and thus similar savings on buyers' tax bills, the programme will cost the Federal government maybe $300 million per year.

And this is assuming that the PAB programme is fully utilised. When TIFIA funding, the federal credit programme for transport projects, was authorised in 1998, the Federal Highway Administration spent two years studying the authorisation and rulemaking. The FHWA has approved loans in a much lower volume than its authorisation.

The TxDOT haul

The Texas Department of Transportation (TxDOT) was the first applicant to receive approval to issue PABs. On 18 October, Texas received approval from the US Department of Transportation (USDOT) to issue $1.86 billion in bonds for the SH 121 road project. The allocation will be made available to any private sector developer of the project.

Texas' early start is fitting, since it was the key force in lobbying for PABs to include highways. Its governor, Rick Perry, made a direct appeal to congress for the right to use them, and it was a member of the state's congressional delegation, and a member of the House ways and means committee, Sam Johnson, that inserted the relevant provision into SAFETEA-LU.

Certainly, Texas was much more prepared for the application process for the PABs than any other state. The state's Republican administration was criticised in the run-up to the re-election of Perry in November for spending money on outside lobbyists in Washington DC, at a time when the state had a sizeable effort of its own devoted to this end. But the SH121's potential interest savings alone, up to $37 million, show that in transport at least, Texas was able to exert impressive influence in Washington.

Texas' Transport Commission Chairman, Ric Williamson, demurs when asked how much of the $15 billion total allocation Texas is likely to consume. "We'll go back to Washington and ask for a higher cap, and we're already planning to do so alongside the other states." Certainly other, states, in particular Oregon, are likely to also approach the USDOT for a PAB allocation in the near future.

Still, Williamson would not be a Texan transport commissioner if he did not play up the state's exceptional circumstances. "Other states have presumed a certain level of funding for their road projects, but we have assumed none. We don't view the other states as enemies, but those in the north-east, in particular, have much different needs. They're focused on managing and rehabilitating older infrastructure, and their phase of industrialisation is over. Our plan recognises the huge migration that we're having to this state, and there will be others in similar circumstances as well."

The allocations are done on a first come, first served basis, and unlike many other types of PAB, highway PABs are not subject to caps at a state level, a provision that Texas is likely to ensure made it into the final version of the bill.

Reading the 121

The SH 121 project involves the completion and operation of a 37km toll road running through Denton and Collins Counties. The potential concession originated as an unsolicited proposal from Skanska in January 2005. In February, the Commission authorised TxDOT to seek alternative proposals, and on June 2005 the following groupings submitted proposals and qualifications. Skanska, Macquarie, Texas Toll & Power, Cintra and Pioneer Heritage Partners.

In June 2006, TxDOT gained approval to issue a detailed RFP, and in July shortlisted the following groupings. Skanska has brought in Morgan Stanley, URS and Granite, while Transurban has lined up Fluor and Parsons, Macquarie has taken on DMJM, Gilbert, Kiewit, and Maunsell, and Cintra is preparing its own bid. The RFP went out in August, and responses are due in January 2007.

The project runs between the west end of Business SH 121 to the Dallas North Toll road, and consists of six toll lanes, which run uninterrupted, and frontage lanes that run in parallel but are used for local traffic and run more slowly. The North Texas Tollway Authority, which had initially proposed a competing bid for the stretch, will supply the tolling technology and collection and back office systems to the project for the first five years of its operation.

The bidders are not obliged to use the PABs, or even a corresponding $700 million in subordinated TIFIA funding, when submitting their proposals. Given the clear interest benefits to the PAB bonds, the main concern to bidders will be working inside the Federal guidelines that attach to TIFIA and PAB funding, mostly with respect to US content, wage levels, and other procurement rules.

The greatest challenge to structuring a PAB is the requirement that the issuer of the debt still be a public entity, whether this be TxDOT, a municipal government or even an existing independent toll authority such as the NTTA.

This provision will likely be met using a leaseback structure, much as would e the base for a power project. But the most difficult thing for sponsors to work around, therefore, is the loss of depreciation benefits that come with the transfer of titular ownership to the public sector issuer.

Incorporate and refinance

The January arrival of the competing SH121 proposals will give the market a better opportunity to assess the hurdles attached to the instruments, and working round these requirements will provide some of the edge that the successful bidder brings to TxDOT. The standard questions attached to the use of capital markets debt, such as the negative carry effect, the possible presence of call penalties, and the lower flexibility with respect to default provisions, will also apply.

The second tool at TxDOT's disposal is much less its exclusive preserve, although here, too, TxDOT has led the pack. On 10 February it signed an early development agreement with the FHWA under the SEP-15 experimental authorization programme. This relaxes some of the rules that cover the NEPA and environmental review process, as well as the contracting and right-of-way acquisition process. It also allows TxDOT to apply for TIFIA funding at an earlier stage than would normally be the case.

TxDOT is not alone in gaining SEP-15 status, although of seven approvals that the FHWA has listed to date, five are from Texas, with Oregon and Virginia supplying the others. Texas' toll collection programme, the I-635 project, and the US 290 have SEP-15 status. Its two master development agreements – TTC-35 and TTC-69, also have approvals.

The TTC-35 agreement, which Cintra won in December 2004, put Texas on the PPP map, and has been the source of most of the comment on the state's toll road potential (for more on the project, as well as information on the state's other projects, search for "TTC-35" at projectfinancemagazine.com). State officials and their advisers, however, are anxious to point out that Texas has much more than simply TTC-35 to offer.

In the TTC-35 plan, released in early October, Cintra puts forward a mixture of concession fees ($2.25 billion) and the occasional subsidy ($563 million in total) to spur $7.47 million in construction. The 534km in construction, divided between seven concessions, would require Cintra to spend, and thus raise, roughly $2.7 billion in equity alone. Cintra also holds the SH130 concession, and is presently applying for a TIFIA loan in connection with the project.

TIFIA presents the same challenges to developers that it has always featured. Sponsors need to obtain an investment grade rating, and the TIFIA loan, while subordinated in cashflow terms, ranks equally with commercial lenders in the event of a default.

The investment grade rating, in particular, looks like causing problems for sponsors, which have repeatedly complained about the time it takes to persuade agencies that their structures are not too aggressive.