February 16, 2006 - From the February, 2006 issue

Public-Private Financings Are Providing Billions for Infrastructure

Public-private financing is emerging as one of the most innovative and efficient ways to pay for and maintain major public infrastructure projects. Few people understand these partnerships better than David Narefsky and John Schmidt, both of Meyer, Brown, Rowe, and Maw LLP. They helped broker what are, to date, the two largest public-private deals in the country – the Chicago Skyway and the Indiana Toll Road – which have garnered billions for their public clients. MIR was pleased to speak with Mr. Narefsky and Mr. Schmidt about both the finer points of public-private financing and its potential to support California's ambitious investment plans.

John Schmidt

California is considering a strategic infrastructure investment plan that involves the passage of more than $68 billion in bond financing and the utilization and leveraging of private equity. Your experience in Chicago, representing the mayor in privatizating their Skyway, would be instructive. Generally, what public benefits does privatization offer?

John Schmidt: I think the big benefit for a city or for a state that does this is you can potentially get a lot of money out of an existing piece of infrastructure, such as a toll road, and use that money for other purposes and to meet other needs. If you have an asset such as what the mayor of Chicago decided was true of the Chicago Skyway, which is a toll road and bridge that was built in the 1950s and no longer needed to have public investment in it. As it turned out, Chicago got $1.83 billion for that asset from a private operator that the city could put to work for other purposes. It can be a very good way to raise capital that the city or state can then put to better use.

If private lenders can turn a profit by operating toll roads, why can't governments? Why does a city or state need one leg of the financing stool to be a public-private partnership?

David Narefsky: There are a couple of reasons. One is if the government is going to do it, it's going to do it with traditional tax-exempt bond financing. The Skyway experience taught us that there are limits to how much leverage you can achieve with tax-exempt bond financing, because it's all debt, and it's all very conservatively priced and structured debt. So there's a limit to how much the municipal finance capital markets are willing to leverage an infrastructure project.

Privatization poses the potential benefit of bringing equity into a transaction, which you would not see in a municipal bond financing. It also offers a much longer-term financing horizon. You can compare a traditional 30-year financing for a revenue bond asset like the Skyway to the 99-year lease for the Skyway and what's proposed now to be a 75-year lease for the Indiana Toll Road. Third, there are some tax advantages with private ownership of infrastructure assets that just don't factor in at all with tax-exempt bonds because you're really not able to take the benefits of depreciation or other tax benefits. The Skyway is an example of where the purchase price is really attributed to tax benefits that flow back to the private owners.

Let's delve into the recently announced agreement between Cintra of Madrid, Macquarie of Australia, and the state of Indiana on the $3.8 billion underwriting of the toll road network for that state. How was that funding structured?

JS: It's the same equity team that acquired the rights to the Chicago Skyway – Cintra Concessiones, which is a Spanish firm and one of the biggest construction firms and operators of infrastructure in the world, and Macquarie, which is an Australian firm that is primarily a financial institution and has been the most active player in promoting privatized infrastructure in the world. Just recently Gov. Daniels of Indiana announced that they had put in the winning bid of for the right to operate the Indiana toll roads for 75 years.

These are very big deals and they typically involve a consortium that includes financial participants and also operators. In the case of the Indiana Toll Road, the state started back in September by asking who was interested in possibly bidding and asked them to submit their qualifications and then the state made a judgment on who was qualified. Qualified teams were then provided complete information on the Toll Road. They also engaged engineers and their own traffic experts who do projections. We work with them on making sure that they understand the proposed terms of the 75-year lease and they were required to put in binding bids about two weeks ago. The Cintra/Macquarie deal still has to be approved by the Indiana Legislature, but, if all goes well, it will close soon and the state of Indiana will get the $3.8 billion around June 30.

Elaborate on the public approval process. What must elected leaders consider when they entertain privatization, and what laws must be changed to make these transactions more possible?

DN: With the Skyway, the most important requirement was the passage of an ordinance by the Chicago City Council. Given the city's broad home-rule powers, state law did not need to be changed. The city owned the Skyway and the Council had the right, with the passage of an ordinance, to authorize the transaction.

This leads to an important point about timing: At what point in the process do you obtain required legislative approvals? There was a conscious decision in Chicago that the matter would only be brought to the City Council for approval once there was a specific deal to present. The mayor did not seek "pre-approval" or "authorization in concept." Some people have said that could only work in Chicago because of the strength that the mayor has vis-à-vis the City Council. But Gov. Daniels in Indiana has basically followed the same approach – he decided that he would not present the transaction to the Indiana Legislature until he had a specific deal to present.

If you're presenting in the abstract, you probably end up having people think about allocating the proceeds from the transaction in the abstract. They don't really know what they're debating. The debate will more focused if you know how much you expect to receive for the asset in question. Whether the politics works in every jurisdiction to proceed with the transaction and only bring it to the legislative body when there is a deal to present, of course, is very much a local matter, but it certainly worked in Chicago and Indiana.

Chicago is largely a Democratic city, and Indiana is now a Republican state. What, then, are the politics of privatization of infrastructure? Give us some insight into the politics that impact the public approval process.

JS: It's clearly not a partisan issue. We've had a Democratic mayor do it, and now we have a Republican governor doing it. We have a Democratic governor in New Jersey, Jon Corzine, who has said he is interested in the possibility of privatizing the New Jersey Turnpike. Interestingly, his Republican opponent in the recent gubernatorial election opposed it.

I suppose in a general way people tend to think Republicans are more likely to support privatization as a general concept because it has tended to be thought of as more of a Republican or conservative idea. One other thing that can play into this thinking is the attitude of unions, which may have a stake in the jobs. In the case of the Skyway, though, the deal provided that anyone who had been working on the Skyway that didn't want to work for the new private operator could move into other city jobs. There's no reason you couldn't do a deal like this and require the private operator to assume the existing employees. Notwithstanding that, I think there is a sort of instinctive feeling on the part of some unions to oppose privatization.

One other element of it is that this is new to the U.S., and the private operators who come in are almost inevitably going to be foreign companies. In Chicago and Indiana we have an Australian firm and a Spanish firm; the other bidders in Indiana were all primarily or exclusively foreign firms. Some of the resistance in the press recently in Indiana has asked how we can turn over an asset of the state to a foreign company.


The response of the mayor in Chicago and the governor in Indiana has been that if a foreign company wants to pay us more than any domestic company, there's no reason why we shouldn't allow a foreign company that is qualified and experienced to operate one of these assets. The budget director in Indiana was quoted the other day as saying that if we declare war on Australia, we can take back the Indiana toll road. But he doesn't think at this point we that need to worry about providing assistance to any foreign power.

Nothing is ever as good as it sounds or as bad. With the privatization of infrastructure, what are the risks officials must be wary of? One example in the press was Macquarie's problem in Sydney with the privatization of a toll road tunnel, which surprised the community because the restrictions that went along with it weren't known when the deal went through. Elaborate on the downsides of taking infrastructure investments out of the public domain.

DN: It is very important that the mechanism and requirements for increasing tolls be clear. There are some similar issues to the ones you were just alluding to up in Ontario with a toll road privatization – where there was confusion and ambiguity about how tolls were going to be set and some real consternation resulted.

The Skyway transaction, by contrast, set very clear periodic milestones, for basically 20 years after the transaction closed, for structured increases in tolls and then for the remaining term of the concession tolls can be increased only in accordance with a pre-determined formula. You also have to have good contract management oversight during the length of the concession so that if you build into the contract operating and maintenance and capital improvement standards, they can be maintained and you get the agreement that you negotiated with the private operator.

What about restrictions on public competition with toll roads?

JS: In the case of the Chicago Skyway, the city didn't agree to any restriction on any competitive activity. In theory, the city could decide tomorrow to build a new road and bridge across the Calumet River and connect with the Indiana Toll Road and there would be no violation of the agreement with the private operators. I think the most important reason the private operators were willing to proceed on that basis is the practical reality that nobody's going to spend the money to build a bridge of that magnitude across the Calumet River.

In the case of the Indiana Toll Road, the state has agreed to a very limited provision that says that under certain circumstances the state would have to compensate the private operator if the state were to build a new limited access minimum two lanes in each direction road that were to run for more than 20 continuous miles within ten miles of the current Indiana Toll Road. It's not a scenario that anyone really views as realistic and I don't think the state thought it was giving up very much but it gave the private operator and the lenders who have to come up with $3.8 billion some added degree of comfort.

I think the question raises a very important question because there clearly have been situations where public entities have agreed to competitive restrictions that have been a source of enormous subsequent tension. The famous one in California was when Orange County agreed to allow a private operator to build a new toll way within the median strip of a road and agreed that they wouldn't do anything to expand the existing free lanes. The result was that the traffic got increasingly congested on those three lanes to the point where pressure built and Orange County ended up having to buy back the private toll road. I think because of that lesson, there has been a real attitude of not agreeing to any restrictions, at least any that are in any real way going to affect the ability of a state or city to do things that they think public policy might require over a long period of time.

Share how these two deals might serve as models for other infrastructure financing in California.

DN: One of the fundamental reasons that Indiana and other states are looking seriously at privatization of infrastructure assets is to raise the capital that they need to improve their infrastructure over a long period of time. A number of states are tapped out on their transportation trust funds or the equivalent. There is an enormous disinclination to raise gas taxes, and the amount of money that's going to come from the federal government is inevitably going to be limited. We need enormous amounts of money to improve and replace America's infrastructure and privatization is going to be one way to provide the capital that the states need.

Clearly the Mayer, Brown team and those of you who have been involved in these two model deals for the country have something to share with the State of California as it puts together its $200-plus billion infrastructure plan for the next decade. If you were writing an open letter to California lawmakers, what would you advise?

JS: I would advise that there is enormous potential to raise capital needed for meeting transportation needs by looking at existing revenue-generating assets.

I also think it's absolutely critical that anything that is going to be done has to be done on a completely open and transparent and competitive basis because we're talking about enormous amounts of money. You know, $3.8 billion is a lot of money. One question is, "Why shouldn't it be $4.5 billion?" The answer to that can only be that you've conducted an open and competitive process in which you've given full information to all the potential private operators, and you have to conduct that process in a way that gives the public confidence that a private operator is not taking advantage of the situation.

Good lawyers are part of it but it also has to be done with an attitude on the part of public officials that this is going to be done in a way that is going to give the public confidence.


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