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FMI Quarterly/June 2012/June 1, 2012

What’s Ahead for P3s in the US?

What’s Ahead for P3s in the US?According to FMI’s Research Group, the number of construction projects in the U.S. that are more than $1 billion has gone from zero in 2005 to 104 last year.

PUBLIC-PRIVATE PARTNERSHIPS (P3s) involve a contract between a public-sector authority and a private party, in which the private party provides a public service or project and accepts financial, technical and operational risk in the project. This risk transfer from the public to the private sector is a crucial component of all P3s, with the ultimate goal to combine the best proficiencies of the public and private sectors for mutual benefit. Typically, P3s are highly complicated, involving numerous stakeholders with various business backgrounds and mindsets, and are usually surrounded by a complex political environment.

FMI’s Colin Myer spoke with Geoff Delisio, head of Contract Surety, Zurich North America and Nancy Simonson, senior vice president, Zurich Construction, about what they saw as some of the drivers and challenges for the P3 market in the United States. Colin also spoke with Henry Lombardi, executive vice president and chief global broking officer at Aon’s Construction Services Group. Aon is one of Zurich’s national brokers and has been leading many P3 projects.

Myer: What is your impression of what the next 12–18 months will look like for the P3 market, specifically for the United States?

Delisio: From what we have seen and heard in the marketplace, the next 12-24 months will be somewhat of a transition phase. We are hearing about many more state and regional transit agencies looking and discussing this. We have had several meetings with state agencies to get their thoughts on it and provide ours from a surety perspective. I’d love to say that by the end of the year there will be 50 projects started or out for RFPs, but I think the next 12–24 months will be more of a transition time. We will see folks, for a lack of a better word, sticking their toes in the market from an owner perspective — learning about it, trying it. The Texas DOT has put out several RFPs that actually ask for both, from a construction perspective. “Give us your thoughts on a traditional design-build and give us your thoughts on a P3 model bid.” From our perspective, we see that continuing. But at the end of the day, we see the procurement model becoming a staple over the longer term.

Myer: What do you think the driver for it is? Do they gravitate toward design-build because that is where they think they will get the biggest bang for their buck?

Delisio: From the people we have talked and met with in the states, I think finances (or the perception of finances) have been the biggest driver. I think that when they get into it, multiple owners begin a journey. At first, they may look at it as a tremendous source of cash in a time when most governmental agencies are cash-strapped. The ones that truly understand the procurement model focus more on value for money, while from a pure debt perspective, they potentially can get publicly guaranteed debt for a few points cheaper than they are going to pay under a P3 model. When they holistically consider the entire project, budgetary certainty, speed of construction, the O&M services piece — and some of the efficiencies that a private enterprise can bring — I think owners tend to see some other benefits. However, this tends to happen once they get down the road a little bit. But I do think the first driver is, “Hey, this is a great source of money.” But then it evolves over time.

Myer: That leads to my next question. There are four or five states that are the leaders here. What states do you see next as being adopters of this delivery method?

Simonson: California, Florida, Illinois, Texas and Virginia. Additionally, Arizona was requesting assistance with its infrastructure program needs at last year’s P3 conference. These states have significant infrastructure projects to deliver in the near future, and P3 will be one of the solutions presented. But it will depend upon the learning curve that Geoff talked about earlier. Arizona is looking for a team to explore alternatives for project delivery and advise it on how to put a P3 together — from feasibility to finance to project construction and ultimately operations. A number of states are exploring P3, but it is a tremendous learning curve.

Delisio: Correct. I think the only state I would add is Indiana. It has already had some exposure to P3 through the lease of the existing turnpike to a concessionaire. From what we are hearing now, there is a rather large $3 billion to $5 billion project — the Ohio River bridges in southern Indiana and northern Kentucky. It looks like the project divided into two — the one Kentucky controls will be design-build, and the one that Indiana is going to contract will potentially be a P3. So that would be the only other state that I would add to Nancy’s list.

Myer: What are some of the products that Zurich offers for P3?

What’s Ahead for P3s in the US? - 2

Simonson: We have a timeline, which shows the risks by phase and then correlating products and services that Zurich has to mitigate those project risks (See Exhibit 1.) Additionally, we are talking about adding Geoff’s new liquidity product as well as enhanced professional coverage, which includes design of the contracts and associated IPD development. We have always thought that contract formulation and management is a critical component of a successful P3. It requires a contract development process to assure that the right people are taking the right risks. The end results would benefit the project and all of the participants and stakeholders. As we contemplate adding those two products, we are also taking a look at the process on a horizontal basis.

Myer: You reference rating agencies a couple of times. Geoff, have you discussed P3 with Moody’s or S&P?

Delisio: Yes, we have visited with the rating agencies several times over the past 18 months. In our discussions with them, we think fundamentally that insurance is overlooked and potentially underutilized in these transactions. The basis for all of our products is the transfer of risk to a third party for a fee. In Zurich’s specific case, that risk can be transferred to a AA–rated third party, which can provide the finance folks with a lot of comfort.

Our challenge for the entire Zurich organization is to understand the new risks and rewards as well as the nuances in this procurement method, and then to change our products to match that. I am not saying that the rating agencies are currently embracing this, but it is clearly something that we have tried to make them aware of. From Zurich’s standpoint, we have had discussions with them on the benefits of having many of those coverages with a single carrier. At the end of the day, their driving focus is related to time. If that asset is supposed to generate cash on April 1, then the asset needs to generate cash on April 1. Where that fits into a single carrier approach is that sometimes when there’s an incident and the GL and E&O are handled by separate carriers, they end up pointing fingers at each other (i.e., the reason the retaining wall fell was because of your designer. No, no, it was actually a GL issue). Those are some of the things we’ve talked about with the rating agencies. I think they are a little reticent because historically, all of our products have not been liquid enough to meet some of their needs, real or perceived.

Myer: Do the rating agencies see that there may be more P3 in the future? FMI’s research department has seen that there are significantly more projects greater than $1 billion in 2011 and that the large projects have grown probably by a factor of 30% a year for the last five years. Do you sense that the rating agencies are seeing this too?

Delisio: I don’t want to speak on their behalf, but I will say from the flow of the conversations we’ve had with them, this is something that they are putting a lot of time and effort into. I would think they share the same thought as many people in the market as this is something that will play a major role. But we never talk to them about perceived market size, share or anything like that. I do know they are putting some really smart people on this, which tells me that they think this is a very important area.

Myer: Can you highlight some of the new things you have on the table?

Delisio: Just to give you a little background, 18–24 months ago several of our large accounts came to us from Canada and said, “P3s are in our market, and we think they are here to stay.” At the same time, we had people in the U.S. say, “We see it coming.” Their concern was related to how a traditional North American contractor’s balance sheet is structured; they don’t have the access to a $1 billion or $2 billion bank facility. There are some structural differences between how an exceedingly strong North American contractor looks as compared to some of their global counterparts.

The concern of the North American accounts was that if P3 unfolds and is completely driven by letters of credit, that’s not necessarily a sustainable business model from a project security standpoint. They might be able to have one or two ongoing projects, but once P3 takes hold, they are not going to be able to have a portfolio of 10 to 12 projects because they just don’t have that kind of bank credit.

We spoke to some rating agencies and lenders, and spent a lot of time in Canada looking at their living laboratory of 100+ projects they’ve procured from the P3 framework. From all of those discussions, it really came back to two points. First, the surety product needed to have a liquid element if it was truly going to be useful. Second, there were discussions on how to compress the claims handling time.

For the surety product, we took what would be considered a traditional performance bond, added a liquid feature to it and put some definitive time frames around claims handling. We unveiled this new product at the end of November and have received tremendous positive feedback. We’re now at a point where we are actually going back to the lending community and having them approve the form, because for us, that’s key.

Myer: Absolutely.

Delisio: Our clients want to use these products, but it ends up getting kicked up to the concessionaire and then the lender who says “No, that’s not acceptable.” So we are doing a lot of legwork and are having meetings with lenders and influencers within that community to get some sort of pre-approval on the format.

Myer: You have a product that really is evolving, and you are doing the right things by getting out in front of the lending community to make sure that they are OK with the liquidity portions of it. That is really their ultimate goal — that they get their compensation or coverage as quickly as possible. You are right in the middle of getting that perfected.

Delisio: The positive that has come out of these efforts is that many of our contractors have been an effective sales force. They are interested in using the product yet the decision makers will be the lenders or underwriting group if it’s bonds. We have had several contractors out in the marketplace actively talking about the new form to that community. So it’s been very positive to date.

Myer: Is there anything else you would like to cover?

Delisio: If we are just talking about a contractor coming in to do a design-build project (i.e., with no percentage to a concessionaire, etc.) what are the risks? You’re doing a normal publicly funded project where there are change conditions; regardless of who may be at fault, there is an ability to secure additional money because it’s a taxing entity. There is the ability to get a change order approved because there is a pot of money somewhere.

In the P3 world, while there are contingencies built-in for things like change orders, there is not a bottomless pot of money. While that is somewhat of a nuance risk from the financial perspective, it is always one we talk about with our clients. Through the pre-con and preparation processes, there are ways to mitigate this risk, but there is a fundamental difference because of the funding source.

Myer: I guess that risk is probably the same in design-build, isn’t it?

Delisio: Yes, but if it truly was a change condition, there is the ability to get relief in a traditional procurement method. With several of the P3 projects we have seen, that same type of relief that would traditionally be accepted with a change order are now risks the design-builder or the concessionaire has to take.

Myer: It’s a risk they have to absorb.

Delisio: Right, particularly through pre-con and more exhaustive engineering and especially on the geotech side. We’ve heard some of the geotech studies prepping P3 projects are more exhaustive as compared to the prep work normally done with design-build. There are a lot of ways to mitigate that risk, but it can fundamentally be a very different risk.

Myer: When a contractor wants to get into the concessionaire box, how do you deal with that? Is that a serious red flag? My sense is that you are going to see more and more of that as we move forward.

Delisio: Making the transition from being solely at a design-build level to also being a 2%–3% player at the concession level really comes down to the financial strength of the underlying credit. It does change the underlying risk profile of that construction account. To date, many of the folks who have been interested in this area have the financial wherewithal where the transition makes sense. But it is very much a credit decision.

From a surety perspective, we are the historical “the glass is half-empty” industry. We tend to take a relatively conservative view of the world. Not only do you have more activities to manage, but you have to have the balance sheet and the financial wherewithal to weather those risks. Construction in and of itself is a risky and challenging business. Making that switch to, in essence, a developer at the concessionaire level introduces some additional risks. At the end of the day, most of the debt is non-recourse. What is more problematic for us tends to be the GAP-financed projects. The majority of the competitive debt in that market tends to be recourse; it puts the risk in a completely different basket.

Myer: That does tend to be a challenge for people.

Simonson: We’ve been asked by several of the larger contractors to go through the whole P3 risk scenario from project feasibility through operations. There appears to be increasing interest from contractors in the P3 delivery method. Zurich is the only insurance carrier that has the capability of putting all of the services and coverages together, from beginning to end, and increasing that liquidity for all stakeholders through the combined claim process.


Colin also spoke with Henry Lombardi, executive vice president and chief global broking officer at Aon’s Construction Services Group. Aon is a market leader in contractor and homebuilding insurance products, surety bonding, owner and contractor wrap-up programs, and risk assessment services.

Myer: Henry, what is your impression of what is ahead for the U.S. P3 market?

Lombardi: A large number of ownership of contractors is changing. Colin, I think the issue that we see is that in the last few years is that many European contractors are coming in and buying contractors or establishing a beach head here in the United States as contractors. So if you look at the Spanish contractors — Dragados, OHL, FCC — if you look at other contractors who are coming here from China, from Hochteif — they are all looking at the privatization model and they’re putting contractors here. So what you have is a more global platform where contractors who come from Europe bring their expertise on privatization projects they have done in Canada. They are coming into the United States.

Myer: You are absolutely right. There is no question that the leaders on the concessionaire side, the design-builder side, are really the Europeans. The Americans are playing catch-up right now.

Lombardi: When you look at it, the U.S. has a definite need for updated infrastructure. The U.S. has, in the past, bid out projects to contractors, who have received their funding, built the job and moved on. The privatization model presents challenges for the contractor or the concession team from a standpoint of running the operations in conjunction with running the construction operations. I think those are the unique challenges that the U.S. market is starting to deal with.

I think the other issue is the legal side within the U.S., where contractors and even concession teams are having great difficulty because there is no uniform contract. Each state has its own contractual requirements; each authority has its own contractual requirements. The cost to bid these becomes very high and time consuming from a standpoint of constantly having to reinvent the contract and look at the risks associated with it. In Europe, much of the risks center on builder’s risks and property. In the U.S., many of the risks center on workers’ compensation and general liability.

Myer: What does the impact of that change or that difference lead to in terms of the discussion between the owners and the design-build team?

Lombardi: I think what happens is that you have a board of requirements or a board of risks. Traditionally, you do not have worker’s comp in Europe, and you don’t have the general liability exposures in Europe that you have in the United States I think what is happening is the owner, the municipality or authority is trying to push as much risk to the concession team. The concession team is looking to move as much risk off its balance sheet to the contractor, and the contractor, traditionally, is always looking to limit its risks. I think that it is unique in the U.S. that we are still learning how to deal with this.

Myer: Talking about risks, the model of the letter of credit versus the surety is a significant difference that the American contractors and maybe even the American surety industry are getting their hands around. It’s a different ballgame.

Lombardi: This is not my area of expertise, but traditionally, in the U.S., you would bond a project for 100% of the costs. Recently, as jobs have gotten bigger, sureties or authorities have agreed to put out a bond for a percentage of the project. However, they still charge based on the total project. The European model is to use letters of credit. That is very different philosophically — two very different approaches.

Myer: According to FMI’s Research Group, the number of construction projects in the U.S. that are more than $1 billion has gone from zero in 2005 to 104 last year. Not all of those are P3s, clearly, but there is a significant trend toward owners grouping projects together under a bigger dollar amount. Is that something that you have noticed as well?

Lombardi: Yes, we see project size getting bigger. There are many corporate plants, such as Apple that is in the process of working on a $3 billion campus. What you do see, and again I think it’s a combination of an aging infrastructure — is when you’re looking at the Tappan Zee Bridge, which is a huge project, and you’re looking at some of these other projects, the owner is trying to say, “OK, if I’m going to privatize it, I might as well put together as big a project as I can.”

What you also have to look at in privatization is that some of these contracts include a large portion of O&M — the operations and maintenance of the existing assets. When you’re looking at a project where you’re taking over an existing facility and you have to collect a toll or improve the toll collecting system, that’s over a period of time, so the project size tends to be larger. I do think that people are trying to aggregate the job size.

Myer: It seems to be a noticeable trend, and along with that comes the desire to think about the P3. One of the things that is part of the P3 is you have to bring the financing. What are your thoughts on delivering that as part of an overall package, and what are the implications for contractors?

Lombardi: There is really a line that is drawn between the concession team, which is looking at the money, versus the contractor, who is going to bid out the project. Traditionally, I have been involved in more of the contractor side, where the contractor is building the project. On the financing side, that really goes back to your question about the surety and letter of credit and the financing of the project. What we have found is, in a large number of these projects, even though there could be the same ownership at the top, the concession team and the contracting team are two separate entities that are both looking to make the most of the project from an economic standpoint and move as much risk off of their balance sheets to someone else.

Myer: And even though the groups may be the same, those are sometimes conflicting priorities.

Lombardi: Right, and that is something that I think is unique here.

Myer: One of the trends I think we see is more and more contractors saying, “I want to be in the concession box.”

Lombardi: I think that the larger contractors have divisions that are not concession operators. I don’t know that contractors are going to say, “I want to get into the operations of the hospital or the operations of the toll road.” They might have a subsidiary that wants to do that, but the contractors who are building are really builders.

Myer: I think that’s right. Obviously, these models leave room to bring in, in effect, an outsourcing solution for operations and maintenance. I sense that the contractor is interested to be in the concession box and talking directly to the owner.

Lombardi: You can have Balfour Beatty and Fluor as both the design-build contractor and the maintenance for the partnership of the Denver Eagle Fast Track P3. However, for that instance, I think what you have is two separate structures. It’s the same company, but they break the structure down.

Myer: So what you are saying is in the separate structures, they have groups that do the operations and the maintenance.

Lombardi: Right. The contractors go in and bid a job, allocate their assets, finish it and close out the project. From their balance sheet, they are going to shut that down. There is a separate balance sheet that’s going to run the project as an ongoing operation. So, though the names may be the same, like a Skanska or a Dragados, an ACS, — all the same ownership, but there is a distinct understanding of what each party does and what their responsibilities are.

Myer: In the negotiation of the design-build contract, what I have gathered from different contractors is that they feel like they are told what the number has to be, as opposed to having some flexibility as to negotiating, and therefore, that seems to be a driver to get into the concessionaire box. Not necessarily the profitability of the operations and maintenance, but more of a “seat at the table”. Is that something that you have noticed?

Lombardi: I’ve noticed that some of the ones that we’ve been involved with lately, they’re trying to be more collaborative and there’s more connectivity. But there’s definitely still an aspect of, “I’m the concessionaire, I’m bringing the money — you’re the design team, you design it — and I need your best price.” In the traditional model where the government or municipality would bid out a road, it’s low bid. In this instance, much of this hinges on value engineering, on the ability to come in with a different methodology for the construction.

Myer: It’s the best-value approach.

Lombardi: Right.

Myer: What is your view about P3s in the future?

Lombardi: I think P3s are the future in the United States, and I think the U.S. still struggles with that. There is a lot of work that has to be done to rebuild the infrastructure. The concept is sound, but we as a country have not endorsed it or embraced it to the degree that Europe or Canada has.

Myer: It seems a little bit like where design-build was 15 years ago. Is that your impression as well?

Lombardi: I think in design-build there was more of an understanding that there would be a design team and a contractor that would work together. I think the issue here is still one of politics. The Elizabeth River Crossing Midtown Tunnel, which is a project that is supposed to go forward — it just came out that there’s a political movement that wants to stop the project. Now whether they do or they don’t, the issue is that somebody is trying to stop a project. If you look at many of these projects, some of them seem to get tangled up in some type of government or political agenda where somebody is trying to control what’s happening, instead of saying, “This is in the best interest of society. We can add real value; we can bring an asset to the table that will not impede or hurt the taxpayers.” But yet, there seems to be a pushback on that.

Myer: So, you feel that the political aspects are greater when it goes P3 than when it goes traditional design-build or design-bid-build.

Lombardi: That’s my opinion. Others might disagree with me.

Myer: Maybe that’s part of the Elizabeth River issue — that people are realizing that in order for these P3s to be successful, there has to be a separate revenue source.

Lombardi: If you ask the general population about P3s or privatization, I think that they believe that some foreign countries are going to come and take over an asset. We had that example on the ports when they were going to bid out one of the ports years ago. They really don’t understand the concept that it’s a net-net lease, and those people who are going to use that asset are going to pay for it versus the old system where everybody got taxed and whoever had the better political lobby got money for their projects.

I guess the question I would ask is, “Would you have gotten a concession team to build the Central Artery Tunnel in Boston? Would that have made financial sense for any concession team?

Myer: No. I can answer your question because I lived in Boston when they broke ground and approved it. The Ted Williams tunnel tolls are not sufficient to pay for $15 billion.

Lombardi: That, for me, becomes a political agenda. Tip O’Neill pushed and pushed and lobbied to get something that really the whole of society has paid for, and yet, very few benefits were gotten from it. That versus the privatization model, where business comes in and makes a business case for what value- add this will bring. Will there be enough economic cash flow to make it a viable project?

Myer: You’re absolutely right — whether it’s the HOT lanes or the Elizabeth River crossing. So in some ways what you are saying is there is a bit of a limitation. The HOT lanes in Virginia were clearly something that people absolutely knew needed to be done, where it seems that with the Elizabeth River crossing there is a political groundswell against paying the tolls they will have to pay.

Lombardi: Right. So they are going to build it with taxpayer’s money and keep the toll artificially low, so they can charge the taxpayers to pay for the construction of the project versus “What is the economic benefit?” and “Is this a prudent investment for business?”

I’m a firm believer that privatization makes sense, but I think that we need to educate society that this is a viable way of rebuilding our infrastructure. You can’t keep putting gas taxes, etc. on whatever you want and think that’s going to be enough to pay for these projects. Let’s be honest, some of these projects become pet projects of whomever is in office at the time and who has the political clout to move dollars to their areas.

Myer: It’s a very political process, isn’t it?

Lombardi: We have an infrastructure that needs to be redone. I’ve been involved in construction for the better part of 25 years, and honestly, when you realize what has to be done, such as our bridges, and if you look at Europe — Europe basically rebuilt itself 50 years ago. We have structures that are more than 100 years old that have not been rebuilt, like the bridges in Manhattan. How are we going to get those done? I think what has to happen is we have to get people to understand that this is in their best interest.

Myer: It may take another bridge collapse for people to realize this.

Lombardi: I hope that doesn’t happen — that’s something we don’t want to see. The issue becomes a political agenda where politicians have to get behind it and say, “Hey, this is a great thing — we have to do this.”

Myer: One of the things that Andrew Cuomo did was focus the different labor union pension funds into investing, at least partly, in something like this, so that it was easier to get buy-in from the unions and to get buy-in from a source of funds that need long-term investment. What are your thoughts on that?

Lombardi: If you look at all of the money we have in pension plans throughout the United States, I think that if the modeling works, it’s a great way for our aging society to look at a stream of revenue that would be consistent for investments. It would almost be similar to a tax-free bond — if you know that this asset could return 4% or 6% and you can pay the pension plan 4% or 3.5%, I think that’s a very interesting approach. I think people would look at that very positively. Again, we’re not there yet — we haven’t gotten to that turn in the road where people understand that.

Myer: When Andrew Cuomo came out with that, that was one of the first times I had seen a politician link the labor union pension funds with work to be done.

Lombardi: I’m impressed with Cuomo because he seems to be making the right decisions. I’m not so sure that he’s as lined with his party as he is with trying to make a difference and trying to position himself maybe wherever his next move is. But he is realizing that it’s bigger than, “I need to make the unions comfortable so they’ll vote for me — I need to do what’s right for New York.”

Myer: That’s a really good point. Do you have any parting thoughts or comments?

Lombardi: America has come through a very difficult economic time and is still not out of it. But you do not want to repeat the errors of the past, and you have to look at changes on how we are going to move our society forward. I think that privatization is one of those game changers that really can move us in a better direction than where we are going.

FMI thanks Henry Lombardi, Geoff Delisio and Nancy Simonson for their insights on the P3 market in the United States in the upcoming few years. ■

Colin Myer is a managing director with FMI Capital Advisors, Inc. He may be reached at 919.785.9290 or via email at cmyer@fminet.com

 

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