PRIVATE SECTOR PUBLIC SECTOR PARTNERSHIPS - HOW THEY WORK
by GERRY HWAY, Vice President, Corpfinance International Limited
(Explanatory letter to Alan Dickie, writer for the Globe & Mail)
Before we discuss how Private Sector Public Sector Partnerships, or P3’s, work, we should explore why the need. We must acknowledge that the modern proponent of P3’s was Margaret Thatcher. Upon taking office and faced with a burgeoning deficit, an over taxed constituency with key nationalized industries accumulating mounting losses and a country faced with an inability to attract foreign investments because of perceived or an otherwise inefficient workforce, she got the engine running by privatizing many of the government-owned companies. For this and many other reasons, Britain is today a country with a strong economic outlook.
Similarly, our three levels of government are faced with many of the same issues and have turned to the private sector to invest in many of the much needed capital projects that would normally require raising debt in the capital markets and/or raising taxes, two options that are not considered prudent given the circumstances of the day.
So, how does a P3 work? Let’s say for example that a school board determines a need for an elementary school and decides to have the project undertaken by the private sector. Stage 1 is a proposal call for an Expression of Interest, where an information meeting is held and the project is outlined in an information package. Those parties interested will respond with sufficient detail on their syndicate so that the school board can make an evaluation of the proponents’ experience, financial capabilities, legal entity, vision of the project and managerial organization i.e. key firms, principals and respective roles of the project team.
After evaluating the submissions, a Request for Proposal will be requested from 3 to 5 proponent groups who will be given more specific requirements/specifications which the School Board will want to include in the School, i.e. recreational component.
Normally, proponents will respond on what is known as the BOOT principle. The successful group will Build, Own, Operate and Transfer ownership after, say, a 20 year period. The School Board will enter into an operating lease with payments made over the predetermined period and can take ownership at the end of the period.
What the Market expects?
The private sector is accustomed to the forces of competition and all things considered, the most economical submission meeting the requirements of the School Board will be selected. The market therefore is expected to take risks, to own, to operate, and to make a profit on the transaction. Our company, Corpfinance has been engaged in financing projects, not too dissimilar to what we are talking about. For the past eleven years we have provided financing to operators who supply hydropower to Provincial Hydro Commissions. Known as Independent Power Producers, they undertake to build dams on river sites and produce hydro energy which is purchased by the Province’s hydro utility.
These HydroPower Generating Stations are typically in the project size of 10 to 30 Mega Watts and $20 to $75 million. These projects can be more economically built, financed and more efficiently operated by the Private Sector Partner given the size. From the Utility’s point of view, no capital outlay is required or operating costs to contend with. Their only commitment is the purchase the hydro generated at a pre-determined price per kilowatt for an extended period. This Purchase Agreement forms the basis for the operator to arrange the debt financing. So you see, it has all the earmarks of a P3, in that the proponent will build, own and operate the facility and depend on its operation to make a profit while, at the same time, doing everything more economically than the Hydro Authority could do.
What are the challenges in this relatively new way of public business?
The challenge is not to spend time spinning your wheels. It is key that a syndicate be formed with highly competent entities who have a reputation for performance and expertise in their fields. We are talking about a composite of the developer, the contractor, the architect, the engineers, the lender, the accountant, the tax specialist, the law firm, the equity partners and the financial advisors.
The group must look at the project, given the long’ tenure, to mitigate risk and ensure a reasonable return on investment. Risk, however, is multi-dimensional such as Ownership Risk, Operational Risk, Financial/Economic Risk and provision must be included in the contract for unforeseen factors, i.e. taxation changes. Each component must be evaluated at the outset because to not do so leaves potential for a poor investment and, believe me, this can and will happen.
Since the primary difference in the public sector ownership versus private sector lies in the transfer of risk, this risk must be managed to ensure that the investment is intact and the product delivered consistent with performance expectations by government until the final date. Because of this transfer of risk, a pricing premium is warranted on the debt financing as well as an acceptable rate of return on equity for the developers. It must be recognized that the cost of capital for the Private Sector can never be raised as cheaply as the Public Sector, but risk must be rewarded and, of course, in the process business taxes, property taxes, and income taxes must be paid which adds additional cost of private vs. public financing even though these taxes go back to the government coffers.
Gerry’s thoughts on the process
At the outset there was a certain amount of skepticism in both camps although the Canadian Council has contributed to bringing the two sides to work more closely with each other by establishing acceptable guidelines to work within. If it is the intention of Government to down size and to govern, regulate and provide its constituents with the necessary services, without undue involvement and capital spending, the public-private partnership is the arena in which to accomplish its objectives. After all, the wealth of the nation lies in the free enterprise system and the ability of its entrepreneurs to take risk provided they are rewarded appropriately.