Infrastructure Finance and Development: The Private Equity Solution

Private equity in a collaborative effort with local government is vital to America's economic revitalization and expansion of water infrastructure.

By Hu Fleming, Ph.D., P.E., and Manuel H. Lazerov

Ask the American public sector how they expect to fund infrastructure upgrades, and the answer has historically been municipal bonds, which is the conventional wisdom. Securities Industry and Financial Markets Associates indicate that borrowing requests are $500 billion for 2011, compared to $411 billion in 2010. But yields on AAA-rated municipal bonds rose from 3.86 percent to 4.66 percent between Nov. 1 and Dec. 30, 2010 — 21 percent in just seven weeks. The Build America Bond program expired in 2010, ending $185 billion available to municipalities since April 2009.

The few options can be summarized as follows: private equity for build / own/ operate (i.e., the Santa Rosa, Calif., wastewater treatment plant approach); the city of Milwaukee, Wis., model (leasing the utility over a period of time to private investors); sale of an equity position to a private investor; and Santa Claus. Realistic options involve private investment in a way that will help reduce immediate and long-term fiscal shortfalls, generate increasing revenues, stimulate local job growth and opportunities, maintain programs and meet growing regulatory requirements and unfunded mandates.

Capitalizing on this opportunity is essential in moving America forward. The American Society of Civil Engineers estimates that decades of deferred infrastructure maintenance and necessary upgrades over the next five years equals $2.2 trillion.

Acknowledging that the private equity solution can provide a swifter and more differentiated solution takes into account the ongoing decline in tax revenues; increasing tensions over fiscal decision-making and spending priorities; the need to meet current and future obligations in a realistic and sustainable manner; the reduction and outright elimination of many stimulus programs that have been the principal mainstay of local government finance; and vast changes in overall accessibility to the capital markets, especially for our smaller- and medium-sized jurisdictions.

Private equity's financial and development services, its expedited funding process, competitive rates and negotiated and flexible legal arrangements add greater value by combining those derived through synergies in design, construction and operations. Such arrangements remove spending out of the political cycle and away from annual budget considerations, putting projects on a more economically sustainable footing.

Mounting anxieties over outstanding municipal bonds and market direction, and weakening investor confidence, is expressed via the recent widespread sales of bond funds and individual issues, accompanied by the steep decline in new offerings. This deterioration will intensify when a small portion of predicted defaults occur. For many state and local governments, this could not come at a worse time.

Proposed legislation of a National Infrastructure Bank (NIB) is unlikely and impractical. If enacted, NIB would be an underfunded, cumbersome, multi-layered and overlapping bureaucracy, so as not to replicate the Fannie Mae-Freddie Mac experience. Congressional concerns over mounting deficits and the use of NIB assets and guarantees for leveraging private money would simply insulate private equity and other financial institutions from loss (what, again!) and would enable government to avoid "full-cost pricing," contributing to deeper structural deficits.

EXAMPLE 1: Existing Water Private Equity Project. An American city of 500,000 needs a major expansion of its water treatment facilities and distribution pipelines. There is a 20-year DBOOT (design-build-own-operate-transfer back to the city after 12 years) agreement. The financier / vendor is retained for operation. The result is a $105 million capital program becomes fully operable in under 24 months, with more than 12 years of successful operation, and at no cost to the municipality!

EXAMPLE 2: Capital Expenditures Required. A U.S. city of 800,000 requires a major wastewater capacity expansion, with associated piping. The projected capital cost is $140 million, and financing is unavailable. The private equity / developer provides the capital, design and finance and constructs the plant for the city, with a long-term concession for repayment, or contracts with the equity / developer to operate the facilities and receives the revenues from operations.

EXAMPLE 3: Insufficient Funds for Continued Utility Operations. A city of 400,000 does not require expansion of its water utility. Funds are insufficient for continued operation. A private equity / developer would pay the city for the fully depreciated assets, allowing the city to monetize their value.

The developer could either own and operate the utility over a period of years, lease the asset and / or eventually return ownership of the asset to the municipal authority.

EXAMPLE 4: Rural Municipality. A rural municipal authority of 15,000 inhabitants requires expansion of their water and wastewater utilities. No funds are available for a $22 million expansion. A private equity / developer can provide the design, financing, construction and ongoing operation of the water / wastewater utility on a long-term concession basis to the municipality. The municipality avoids issuing bonds altogether. There are no loans, enabling it to preserve its borrowing capacity for projects elsewhere.

These are but a small sample of the types of collaborative arrangements possible. There are several concerns expressed by local government officials, which can be overcome. These are: 1.) fear of loss of control / ownership, 2.) attractive alternatives or 3.) nonspecific options.

First, the view that giving up ownership is giving up control is not accurate. Private equity / developer structures can be created, and terms negotiated, allowing for short- or long-term control by the municipality. Second, is private equity available at competitive rates to replace diminished municipal bonds and other subsidized financing? Yes, but funds are not unlimited. Third, vendor financing is provided by equipment firms in order to sell equipment. Private equity is strictly solution-based.

The utilization of private equity in a collaborative effort with local government is both a challenge and an opportunity. Revitalizing and expanding our infrastructure is vital to America's economic expansion and to increasing our international competitiveness.

Hu Fleming, Ph.D., P.E., is the global director for Hatch Water. He may be contacted at hfleming@hatch.ca.Manuel H. Lazerov is the managing member for American Infrastructure Investors LLC. He may be contacted at lazerov@americaninfrastructureinvestors.com.