Several recent landmark deals have demonstrated to states that they can unlock the value of public infrastructure by attracting private expertise in operating, maintenance and construction and private capital through the use of public-private partnerships (PPP). But the uncertain prospect of user fees may not attract private developers and lenders to a large proportion of the newbuild projects on DOT wish lists.

To get these greenfield deals underway, PPP participants are now grappling with revenue risk and the need in many cases for the public participant in a PPP arrangement to help mitigate this risk with public funding. While public funding will broaden the applicability of the PPP approach in the US, project participants will need to be alert to the issues that arise in combinations of public funding and private capital.

Revenue risk

Investors in greenfield roads projects face the potential for cost overruns and delay at every step in the development of a project. Much of the structuring of a project finance transaction is intended to mitigate the impact of these risks on the project company. However, even if these risks are properly allocated, a project will not be viable if, upon completion of construction, project revenues fail to ramp-up to minimum forecast levels.

The risk that revenues will be insufficient relative to project cost goes to the heart of the viability of a project. For this reason, factors affecting the revenue stream of a project, such as the strength of the concessionaire's rights to toll, the reliability of the collection and enforcement mechanism and the potential for competing roads are so important to the valuation and financeability of a concession.

The biggest factor by far in relation to revenue risk, however, is simply traffic risk. While a handful of developers around the world have demonstrated considerable skill in understanding, valuing and structuring around traffic risk, there are a large number of investors and lenders that have fallen victim to overly optimistic forecasts of potential users and their willingness to pay for new toll roads in the absence of historical data to serve as a reality test. As a result, attracting private capital for greenfield development projects poses a challenge for State DOTs.

Moreover, for a number of greenfield projects on the DOTs' wish lists, it may be that user fees cannot reasonably be expected to support required capital investment. Corridor projects, for example, may experience persistent low traffic volume in segments lying between urban centers. Other projects may reflect public policy objectives at odds with a pure user fee based project structure, such as roads intended to stimulate economic development in rural areas or roads intended to provide excess capacity to meet public safety objectives, such as hurricane evacuation routes. In a number of other cases, there seems to be a fundamental lack of political will for tolling or to allow realistic toll-setting. Without some sort of assurance of sufficient cash flow to repay debt and achieve an adequate return on equity, these projects will not attract private investment.

In contrast, in recent high profile toll roads transactions in the US, the availability of historical traffic data in support of robust cash flow projections has permitted high leverage and high valuations. This was true, even though these brownfield projects needed significant investment in capacity expansion, improvements and, possibly, reconstruction during the life of the concession. In the $1.83 billion purchase of the 99-year Chicago Skyway concession, the winning concession company was able to raise, ultimately, $1.4 billion for leverage of over 80% with a monoline-wrapped 144A bond issue. In the $3.85 billion purchase of the 75 year Indiana Toll road concession, the concessionaire was also able to raise over $4 billion in debt and achieve leverage of over 80% in the bank market.

While both projects rely entirely on user fees and as such, are subject to traffic risk, each has approximately 50 years of tolling history. This history meant that they could be sold in debt markets as straightforward monetizations of existing assets with proven cash flow. Unfortunately, these transactions create no template for project financings of greenfield roads projects with substantial revenue risk.

New PPP structures for newbuild assets

It is no wonder that developers are encouraging State officials across the country to kick off their PPP programs by cherry-picking existing roads segments with greatest revenue potential, as demonstrated by historical road use, to put out to bid to potential concessionaires. Developers correctly point out that brownfield asset sales are easier than greenfield development projects, and provide a means of quickly raising cash.

However, a number of States are not content to cherry-pick. To them, the PPP approach offers an opportunity to obtain increases in roads capacity at less expense, in less time and with less risk to the State than would be the case through more traditional means of funding and building transportation infrastructure in the US. These States, then, are looking at ways to extend the applicability of PPP to their State-wide transportation needs by bridging the gap between projects that are viable on a stand-alone user fee basis and projects that are not. The likely result will be a greater role for public sector funding in US PPPs.

The US DOT has already acknowledged that there is a role for public sector funding in facilitating the adoption of the PPP approach in the US. Under the TIFIA program (a product of the Transportation Infrastructure Finance and Innovation Act), US DOT offers debt financing to eligible transportation projects, in the form of direct loans, loan guarantees and lines of credit, for up to a third of project cost.

TIFIA loans offer several features that are useful for managing the revenue risk that arises in the early years of operation of a greenfield toll road, such as in the case of a longer than expected ramp-up period for a newly built road. The TIFIA program was intended to augment the ability of a project to raise senior debt by providing financing on a subordinate basis, but its value as a subordinated debt cushion is limited because it represents only payment subordination, while imposing a springing first priority lien (on parity with senior lender claims) on project security in any bankruptcy scenario. The program does, however, provide favourable pricing and flexible repayment terms, including back-ended amortization schedules, relatively aggressive measures of coverage, and principal repayment deferrals to the extent project cash flow is insufficient to enable earlier repayment.

The US DOT has also led the effort to obtain the benefits of tax exempt financing through private activity bonds for certain highway and intermodal transfer facilities that are privately financed. The Secretary of Transportation now has broad authority to approve up to $15 billion in private activity bond issuance over the next ten years. The availability of tax-exempt debt to project developers helps them to obtain comparable pricing to the tax-exempt municipal bond financing available to public sector roads developers.

However, the benefits of this cheaper debt will have to be weighed, on a project by project basis, against the need to comply with the fairly restrictive requirements of the federal tax regulations and the program's authorizing legislation relating to permitted uses, permitted yields, timing of application of proceeds and, in particular, the inability to use an accelerated depreciation schedule in respect of concession lease assets. Another factor to be considered in relation to both private activity bonds and the TIFIA program in projects that do not have federal involvement, is that the use of proceeds of TIFIA or private activity bond financing will trigger the need to comply with federal requirements in areas such as environmental (the National Environmental Policy Act), procurement ("Buy America") and labour ("Davis-Bacon Act").

But federal financing tools cannot, alone, resolve the problem of projects with excessive revenue risk because, as debt instruments, they presuppose the availability of a project revenue stream sufficient to repay debt. In fact, to use either option, a project needs an investment grade rating for its senior secured debt and, to achieve an investment grade rating, it will need an assured revenue stream. Public financing programs may facilitate some marginal increase in private investment in infrastructure, but it pales in comparison to the magnitude of investment capital and debt financing available to fund greenfield infrastructure projects that have long-term payment commitments from creditworthy counterparties.

Creating an availability-based structure

In projects likely to have insufficient revenues to support project cost, the public sector will need to provide some form of public funding that goes beyond financing programs if it wishes to attract private capital. One method for public funding of roads employed in other PPP jurisdictions is the availability payment structure, under which the public sector makes payments to the concessionaire based on the availability of the road, rather than on traffic volume.
Availability payment structures are adapted to the particular cash flow requirements of each project, but typically take the place of all or a portion of toll revenues. In these transactions, investors and lenders are able to overcome revenue risk by relying on the contractual obligation and creditworthiness of the public obligor.

Through the availability payment, public entities may absorb the revenue risk of projects to the extent necessary to attract private capital. At the same time, States are free to require tolling to help fund availability payments or to achieve other policy objectives, such as the development of a tolling culture or the promotion of congestion management by way of a user fee pricing mechanism. The recently closed Golden Ears bridge project in Vancouver is a good example of this sort of a hybrid structure for a greenfield project. The bridge will be tolled, but the public sector will retain the tolls while paying the project company an availability payment that is linked to performance standards other than traffic.

The availability payment approach may provide a means of broadening the applicability of PPP in the US to encompass greenfield projects with high revenue risk or limitations on the ability to toll. The first availability payment structure planned for the US market is the Port of Miami Tunnel Project proposed by the Florida Department of Transportation (FDOT) in partnership with Miami-Dade County, and now at the request for proposal stage. The plan is for FDOT and the county to participate in initial capital funding and, following project completion, to make availability payments linked to the availability of the tunnels that are to be constructed and operated by the winning concessionaire. A major challenge for this project will be the ability of the public participants, particularly at the county level, to identify an assured funding source in order to meet availability payment obligations. While officials have indicated previously that the public participants may collect fees from users of the tunnels at some stage, it is not clear that a consensus position has developed on this. In any case, the importance of a public availability payment obligation that is independent of the decision to toll will be paramount from the perspective of investors and lenders.

It may be that further innovation in relation to funding structures for PPPs is now underway at US DOT as well. In many ways, the US DOT's range of action in promoting the use of PPPs has been limited because most of the activity taking place with respect to roads infrastructure development in the US is at the State level. In its 5 September 2006 notice and solicitation of applications from parties interested to participate in its new "Corridors for the Future" program to accelerate the development of multi-state corridors, however, the US DOT has the opportunity to play a greater role.

The US DOT explains that one of its objectives in launching this interstate corridors program is to demonstrate the advantages of innovative structures using private capital to accomplish these mega-projects. For any interstate corridors approved under this new program, US DOT undertakes to obtain an expedited TIFIA commitment and private activity bond allocation. In addition, US DOT states in the notice, it will work with applicants to "find other discretionary funding sources."

US DOT's overarching goal of mitigating congestion means that the selected interstate corridors will be built in areas of high traffic density. In addition, it is US DOT's intention that these corridors will provide ample opportunity for revenue sources in addition to user fees, including from rail lines, pipelines, transmission lines, and other commercialization of rights of way. Whether these revenue streams are sufficient to allow greenfield projects of this magnitude to be built without public funding support is still unclear. However, the reference by US DOT to the potential for other funding sources may well be acknowledgement that some level of public sector risk sharing in these projects in conjunction with the PPP approach will be necessary to attract private capital. If so, then US DOT's Corridors of the Future program will serve as a catalyst for not only a greater role for US DOT in the establishment of the PPP paradigm in the US, but also a greater role for the "public partner" in US PPPs.

In the coming years, the involvement of the State DOTs is likely to evolve dramatically as well. As the regulatory and appropriations environment is adapted to better accommodate the PPP approach in the US, the DOTs will become increasingly empowered to innovate and to raise and apply funds with greater effectiveness than is possible under the current framework for transportation funding.

In particular, the DOTs can be expected to have greater latitude to manage a portfolio of assets, with disparate cash flow profiles and revenue sources, in such a way as to optimize resource allocation within the context of a State-wide plan. For example, several DOTs have indicated an intention to use the PPP approach to both sell long-term concessions to operate particular assets and to support greenfield development. In its portfolio management role in relation to these activities, a DOT may dedicate the proceeds of revenue sharing from high-traffic concessions to pay its availability payment obligations under greenfield concessions – achieving a combined cash flow similar to that of a brownfield project.

Combining public funding and private capital

As PPP projects with public funding become more prevalent,  it will be important for project participants to carefully navigate the issues that will arise in combinations of public funding and private capital. At first glance, the use of an availability payment structure appears to represent no more than a natural extension of the basic legal framework between the public entity and the private entity set forth in the concession contract, with attendant issues ranging from enforceability, dispute resolution and sovereign immunity to the need for step-in and substitution rights in favour of the project's lenders. Further consideration, however, reveals a host of new issues requiring a firm grasp of the relevant government entities' transportation funding structure and appropriations process and an appreciation for the interplay between the federal, state and local transportation funding mechanisms in the US.

In US projects relying upon an availability payment, it will be critical to evaluate the appropriations process underlying each project to assess the availability of budget support and to assess the strength of a project's rights to payment. It will also be important to understand the potential compliance obligations and tax implications arising in connection with the receipt of public monies by a project. For example, projects with public funding may face higher compliance thresholds than projects that do not rely on public funding in relation to confidentiality, reporting and audits, the project's procurement choices and the application of certain state and federal tax regulations. In projects that are not intended to trigger federal requirements, it will be imperative to analyze the composition of the public funding proposed to be applied to government payment obligations and to allocate the risk that this composition might change. In any project with a revenue stream from a public entity in the US, it will also be important to anticipate project lenders' expectations in relation to the assignment of the project's receivables.

An availability payment structure will also require changes in the basic risk allocation of concession arrangements. The allocation of revenue risk to the State should be treated in a consistent manner in other aspects of the concession arrangement, such as in force majeure, change in law and tax provisions and in relation to material changes in public entity creditworthiness. However, its impact on the core risk allocations for a financeable project in relation to construction, operation and financing should otherwise be limited, so as not to undermine the advantages of the PPP approach or negatively impact the value of the concession.

As the PPP approach evolves in the US, so too will the regulatory and appropriations framework necessary to facilitate PPP. Throughout this process, developers and lenders will need to be alert to the issues that come with public funding. In many cases, solutions may be found by working closely with the relevant government officials to ensure an optimal legal framework for a proposed project or by negotiating appropriate treatment in a concession or implementation agreement.

The potential for a broader application of PPP in the US is a promising development for the US transportation sector, particularly in light of the urgent need, and limited available resources, for investment in the country's transportation infrastructure. But as public officials recognize the need to mitigate revenue risk in certain greenfield projects by providing public funding support, PPP participants must be prepared to evaluate and resolve the particular issues that will arise in any partnership of public and private funding. n

*Baker Botts' PPP team is comprised of lawyers from its Global Projects, Government Relations, Finance, Tax, Government Procurement, Property and Environmental Practices. Its Government Relations lawyers, including Kirk K. Van Tine, former General Counsel and Deputy Secretary of the US DOT, Kenneth Mead, former US Inspector General for the US DOT, and Robert Strauser, who leads its Texas Government Relations Practice, offer particular expertise in transportation policy, regulatory matters and appropriations.