America's crumbling infrastructure: can private capital save it?

In a room somewhere in Washington, DC, in late 2010, Gao Xiqing, president and chief investment officer of the China Investment Corporation (CIC), China's huge sovereign wealth fund, sat facing mayors from the US cities of Orlando, Chicago, Los Angeles, Phoenix and Denver. The purpose of the meeting was simple: the mayors were pitching for investment in their local infrastructure; Mr Gao was looking for a profitable home for CIC funds.

The meeting had been brokered by US think tank The Brookings Institute, and was also attended by a representative from the federal government and one or two investment bankers. When Mr Gao told the gathered few that the US had a “socialist infrastructure”, the irony was not lost on his audience. Neither was the slight; this was not intended as a compliment.

Improvements needed

US infrastructure certainly needs improving, something which the Obama administration recognises with its support for a national infrastructure bank. Many of the country's roads, bridges, airports and other infrastructure are crumbling, while its owners – state and municipal governments – do not have the money for repairs. Neither does the federal government, which suffered the ignominy last month of having its AAA rating placed on negative watch by Standard & Poor's. As emerging economies power into the 21st century with 21st century infrastructure, some fear that the US will be left behind, its economy hobbled by ageing assets.

Many argue that the US has no other option than to embrace further privatisation, but here the country has rather a chequered history. Compared to Europe, for example, few US assets have been sold or leased, and such proposals are often met by resistance from politicians and the public.

The outcome of the Washington meeting is unknown (things are still “percolating” says one attendee) but for some, the event conjures up the US's worst fears. Instead of a constructive meeting of capital and project, it is seen as a face-off between the powerful Chinese and an increasingly weak US. Here are assets built on American blood, sweat and tears being sold to faceless investors – and foreigners – at rock-bottom prices when the country is as vulnerable as it has ever been.

The topic has become so explosive that hundreds of column inches in local press and national media have slated the notion of privatisation and highlighted the perceived failings of individual transactions. In an article for popular US website slate.com, Bethany McClean, a contributing editor for Vanity Fair famous for her exposé of US energy firm Enron, sees many failings in the industry and dangers for America, including poor privatisation models, and the twin roles of banks as advisors and owners of infrastructure funds.

She suggests that the creation of a national infrastructure bank could be as disastrous as the National Partners in Homeownership, a public-private partnership (PPP) between the Clinton administration and banks, which many have argued led to the boom in sub-prime lending. “What's good for the banks isn't necessarily good for the rest of us”, she writes.

Fiscal black hole

This is about more than just headlines. It is a sign of what a political hot potato privatisation is in the US. And it makes finding a solution for the country's ailing infrastructure more of a problem.

Nobody disputes the need for investment. A special report published last year by the American Society of Civil Engineers 'The Infrastructure Roundtables: Seeking Solutions to an American Crisis', estimated that the investment needed to upgrade the nation's infrastructure to a “satisfactory” level is about $2200bn. The report says, for example, that one in four of the country's bridges are structurally deficient (with 6000 bridges in Pennsylvania alone in need of structural repair). The report even suggested that infrastructure problems could “threaten [the American] way of life if they are not addressed”.

Equally, nobody thinks the US has the public resources to fund a fraction of this investment. The federal government – scolded in April by the international Monetary Fund for lacking a credible debt reduction strategy – has told states not to come to Washington for handouts. The government, which narrowly avoided a 'shutdown' in April when Republicans and Democrats reached a last-minute agreement on cuts to budget spending, is fast approaching its congressionally mandated debt limit of $14,300bn. If law makers do not agree to increase it, the US could face potential default as early as July. 

The states themselves are in a fiscal straightjacket. According to Washington research group the Centre on Budget and Policy Priorities, 44 US states face a combined $140bn in budget deficits for the next fiscal year, and 22 states are already projecting budget shortfalls totalling $70bn for fiscal year 2013, with that number likely to rise. This is compounded by a huge pensions hole: a study by the University of Rochester and Northwestern University says that US cities, counties and states face a $3600bn gap between their pension assets and the benefits they have promised retirees.

More talk than deals

It is unsurprising, then, that state governors and city mayors are looking to monetise existing brownfield assets, or bring in private capital to fund new greenfield assets. But if parts of the media are suggesting that the US is selling everything and anything, nothing could be further from the truth. Very few deals are being done.

“There has been a lot of discussion about whether state and local government should sell off brownfield assets as a way of raising capital to meet other government needs, but it hasn't happened that much, except in a few isolated cases,” says George Bilicic, vice-chairman of investment banking and global head of power, energy and infrastructure at investment bank Lazard.

A flurry of failed or cancelled parking deals is a case in point. In early 2010, four cities – Hartford, Los Angeles, Indianapolis and Pittsburgh – looked to follow Chicago, which closed what became a controversial parking concession in early 2009, in privatising parking assets. But a year later, only one of the deals has reached financial close. And the successful deal was not in Los Angeles or Hartford, which both face budget deficits; nor in Pittsburgh – which is in such dire fiscal straits that its finances are being overseen by the Pennsylvania state government. It was in Indianapolis, the only city of the group enjoying a budget surplus.

While investors are keen to invest in such deals, it is often difficult to get them approved. In Pittsburgh, for example, the competitive process to lease its parking assets – which awarded a 50-year lease to JPMorgan Asset Management in September last year for $452m – was rejected by the city council in October as being a quick fix with no long-term gain.

“With governments at all levels running deficits, you would think they would embrace involving private capital in infrastructure right now. But there is still considerable political opposition to doing this on a large scale, and public acceptance of privatisations lags what has happened in the UK, Australia and even Brazil,” says Chris Beale, a founding partner at infrastructure investment fund Alinda.

Falling foul of politics

The US market is highly fragmented; each state, city or municipality owns its own assets, and deals have to be done on a case-by-case basis. This is compounded by greater enthusiasm for privatisation at state level than at the local level – yet this is where many of the brownfield assets, such as parking meters, garages or local toll roads reside.

Deals sometimes fall foul of friction between politicians. For example, the Pittsburgh parking deal looked perfect on paper. The parking garages were in a poor state of repair and investors had agreed to their refurbishment as part of the deal. The city has one of the most underfunded pension schemes in the country, but did not have the headroom to raise taxes or cut services. Moreover, the police and fire service unions were behind the deal, because at least part of the proceeds would be used to reduce the pension deficit. But bankers close to the deal say it was rejected because of antipathy between the mayor (who proposed the deal) and city councillors.

A similar dynamic continues to prevent a deal in the Pennsylvania city of Harrisburg. A $215m parking concession, signed by the city's parking authority and won in a blind bid by developer Lambda Star, was rejected by the city council in 2008. Despite facing insolvency (the city missed two bond payments totalling $35m in October 2010 and required a $4.8m injection of Pennsylvania state funds to make a debt payment the month before), the city's mayor has not yet been able to persuade the council to approve the bid – which is still on the table.

There are often different agendas in play. “For example, a mayor could be focused on solving a budget deficit while city council members are primarily interested in an entirely different objective. Disagreements are not always along partisan lines; sometimes they reflect different public policy priorities. Either way, agreement on these key policy issues can be difficult to reach,” says Perry Offutt, head of infrastructure banking for the Americas at Morgan Stanley.

Some bankers argue that one of the biggest obstacles to sealing more privatisation deals is the lack of PPP legislation in many states. This gives no certainty to bidding consortia, which can spend millions of dollars putting together a binding bid for a multi-billion dollar PPP transaction – only to have the deal scotched at a later stage of the process.

This means that private capital is flowing to other markets. “We've identified more than $200bn of infrastructure equity ready to be deployed in US infrastructure assets,” says Rob Collins, head of Americas infrastructure advisory at investment bank Greenhill & Co. “Currently this is being targeted to other jurisdictions because investors are unwilling to take US political and legislative risk.”

Political dysfunction

Lazard's Mr Bilicic says the US infrastructure market is suffering from “political dysfunction”. With a market spanning 50 states, one commonwealth, three territories, the District of Columbia, 3300 counties and hundreds of cities, he believes that US infrastructure development is mired in political and bureaucratic complexity. Moreover, he says the public sector lacks the expertise to facilitate good projects.

“There is very little experience and learning among government officials about privatisations. The public sector has not developed to put together the kinds of projects that the US needs today, and that investors will want to put their money into,” says Mr Bilicic. “These are bureaucratic entities that are not really in tune with the commercial aspects of today's complex privatisation deals.”

Mr Bilicic is not alone in believing that the public sector needs a helping hand. Inspired by the meeting in Washington between the CIC and city mayors, Brookings has joined with Lazard to hold a conference in October. The idea is to bring local politicians together with potential investors and to 'matchmake' capital to projects.

“We can no longer afford to be abstract about the type of infrastructure that we need. We are at the point where we need to work out how to get it done,” says Robert Puentes, senior fellow in the Metropolitan Policy Program at Brookings. “The event will try to identify what projects are needed and work out how to get them funded. We want it to be tangible, not high level. Until now, the thinking and planning has been stuck in the bureaucratic sphere; we need to get it working in the real world.”

Getting public buy-in

But if projects are to get approval, then politicians will have to sell them to the voting public. And there is a yawning gap between public expectations of what services should be provided to them – at what cost and by whom – and what makes a deal attractive and economically viable for investors.

This is particularly true when it comes to the monetisation of brownfield assets, says DJ Gribbin, managing director for government relations at Macquarie and formerly general counsel to the US Department of Transportation. “There is a natural public scepticism about monetisations in particular. In essence, the public see incentives that are not wholly aligned – in that a government is going to be recompensed based on payments that will be made well outside their term of office,” he says. “The public sector has to work hard to explain the value of the transaction and why the asset is worth more in the hands of a private operator than it is in public hands.”

Public acceptance has been undermined by some transactions. For example, critics say the company operating Chicago's parking meters stirred controversy by failing to balance price and service delivery. Chicago Parking Meters (the company created by the winning consortium led by Morgan Stanley Infrastructure Partners) raised the price per hour from 25c to a dollar; but it did so before installing electronic meters (as agreed in the concession), meaning that drivers had to carry around large amounts of small change; then, the old style meters quickly filled up so drivers were unable to pay and got charged a penalty fee.

To make matters worse, as the financial environment deteriorated and city revenues declined, the $1.16bn paid by the lease holders was sucked up to cover the City's operating deficit instead of being reinvested to replace the lost revenues from the parking meters as planned.

A spokesperson for Chicago Parking Meters stresses that prices are set by the City of Chicago, and that the increases and their timing were part of the concession agreement. “Between April 2010 and December 2010, Chicago Parking Meters completely modernised the system and invested $33m to install approximately 4000 state-of-the art pay boxes for 33,000 metered spaces. However, this work was completed 18 months ahead of the schedule outlined in the concession agreement,” she says. The gap between price rise and replacement gave plenty of time for public sentiment to fester. 

Fundamentally, the public struggles to accept the economics of this, and other, transactions. A 2009 report by the City's Office of the Inspector General, then headed by David Hoffman, whipped up public outcry with a damaging report, which concluded that Chicago had been underpaid by almost $1bn. Others have slated the punitive clauses in the concession – such as payments from the city council if roads containing meters were closed for holidays or festivals.

The consensus in the industry, however, is that the city got a good price, achieved by competitive auction, and decent terms. Mr Hoffman (who, when he wrote the report was, coincidentally, about to run for the US senate) suggests the city could have kept the meters, increased the rates itself, and earned close to $2bn over the life of the 75-year concession.

“The problem with that is that the city could never have raised the rates – and that was required in order to achieve the profit margin Mr Hoffman suggested. And any private company would be expected to be compensated if its business is disrupted by a public policy,” says John Schmidt, partner at US law firm Mayer Brown, who is based in Chicago. “This deal only became controversial because the money didn't go where it was supposed to and the rates went up before the new meters went in.”

Institutional investors also argue that the public has not got to grips with the real cost of infrastructure – nor accepted that it has historically been heavily subsidised or poorly maintained in order to keep costs low.

“The cost of repair is rarely budgeted for and most cities cut back on maintenance as a result, while private investors include such costs in the transaction,” says Leo de Bever, CEO of the Alberta Investment Management Corporation, the Canadian state's pension fund. “And the danger with [cities] doing nothing is that infrastructure breaks down and assets become less investable from a private capital perspective, or the project cost – and cost to the public – rises.”

Getting privatisation right

There are steps that sellers and buyers can take to make deals flow more easily. Morgan Stanley's Mr Offutt says that the deals which the public often finds easier to accept are greenfield projects, and those where the use of the proceeds is transparent from the outset. This was the case for Indianapolis' successful privatisation of parking meters last year, where proceeds were used to repair crumbling streets and sidewalks.

“Projects that build new infrastructure, which would not have existed without private investment, have tended to be easier for the public to support than the monetisation of an existing asset,” he says. “However, brownfield concessions become easier when the public can see the value delivered by a privatisation and appreciate how the proceeds are going to be used.”

Tying projects to job creation – and ensuring they minimise any impact on stakeholders – is another key element of successful deals, says Mr Collins. For example, the 2006 Indiana toll road transaction – a $3.85bn, 75-year concession awarded to Macquarie and transport infrastructure developer Cintra – has enabled Indiana to be the only US state with a fully funded transport programme. People still complain about toll rises, but Indiana governor Mitch Daniels says the subsequent creation of 60,000 new long-term jobs in the state is directly related to the programme.

“The substance of PPP dialogue is changing from 'privatisation' to 'partnership'; the Chicago meter deal was seen as the former; the next deal is likely to be more of the latter,” he says, adding that a new dynamic is emerging that is less about maximising up-front cash and more about capturing a deal's delta. “This can include revenue sharing over time or securing milestone investment from private investors for greenfield projects.”

As an example of win-win deals, he cites the possible return of the Chicago Midway airport PPP, a $2.5bn, 99-year partnership which fell through in 2009 because of the deterioration in credit markets. “The two biggest unions are keen to resurrect the Midway PPP deal because it creates greater job growth and pension security,” says Mr Collins, who believes that the time is ripe for the deal to get back on the table.  “The market opportunity for Chicago to close the deal has never been better.”

Cause for hope

Part of Mr Collins' optimism is related to a regime change in one of the industry's key positions.

Three years ago, when then Pennsylvania governor Edward Rendell (now an advisor at Greenhill) wanted to lease the Pennsylvania Turnpike, James Oberstar, chairman of the House Transportation and Infrastructure Committee, sent a letter to every governor, state legislature and transportation department in the country condemning PPPs. The agreement to lease the 864-kilometre Turnpike to an investor group led by Citigroup and Spanish toll road operator Abertis for $12.8bn stalled in the state legislature, where lawmakers argued that the price was too low, and unsuccessfully tried to add tolls to an interstate highway instead. Citi and Albertis withdrew their offer four months later.

In January, Republican politician John Mica replaced Democrat Mr Oberstar as chairman, and he is much more positive about the role of private investment than his predecessor.

A recent aviation bill passed by the (Republican) House of Representatives is an early indication of a fresh approach. If passed by the (Democrat) senate, it will double the number of pubic airports that could be leased or sold from five to 10. It will also make the privatisation process easier by eliminating the need for an airport to get 65% of the airlines serving the airport to agree. Under new rules – which might still be eliminated before the final bill reaches president Barack Obama for signature – owners would only have to “consult” with the airlines.

Chicago's Midway, two small airports in Georgia and Florida, and Puerto Rico's Luis Munoz Marin International Airport in San Juan occupy four of the five slots in the existing privatisation programme.

San Juan's test flight

Mr Schmidt – whose law firm represented the City of Chicago in its unsuccessful bid to privatise Midway the first time around and is now representing the government of Puerto Rico in its current project (for which the request for quotation is “imminent”) – says that airlines are increasingly aware of the benefits that privatisation can bring.

“This happened at Midway, when Southwest [Airlines], which has 80% of the traffic, came to the view that privatisation would be good for it and the airport,” he says. “The same is true for the airlines that serve San Juan, which are very positive about what the transaction could do for them.”

Many believe that a successful deal in San Juan will unlock other transactions. Moreover, Puerto Rico's approach to PPPs – which also includes toll roads – offers a model for improving deal flow.

“Puerto Rico is a 'petri dish' to accelerate PPPs,” says Greenhill's Mr Collins. “It saw the broken glass in the US PPP market and decided that the way to avoid the same fate in Puerto Rico was to pass broad PPP legislation to let the world know it is open for investment. In doing so, it is establishing a 'legislative glide path' to land current and future PPP transactions that others may follow.”

In another positive sign for the sector, several new toll roads have already been built or are in process. These include: the I-595 in Florida; the LBJ Expressway and the North Tarrant Expressway in Dallas, Texas; Presidio Parkway in San Francisco, California; and the Port of Miami Tunnel in Florida. “In the past three to four years, several bridge and road transactions have been done, and most of them have involved some form of private capital,” says Mr Schmidt.

Further, there are signs that fiscal pressure at state and local level is overcoming traditional resistance to privatisation. It has created a sharp uptick in interest in terms of the number of governments that are looking at new ways to address existing or build new infrastructure. 

For many, PPP offers the best way to bridge the gap between the commercial objectives of the private sector and the local policy objectives of government. “These are two different cultures and you do get cultural clashes. The public sector gets frustrated with the private sector's lack of understanding of the political rational of the project, and the private sector is frustrated with the lack of understanding about the commercial aspects and the risk allocation of the projects. But PPP is a great marriage between the public sector that needs to provide services, and the private sector which can provide it efficiently,” says Mr Gribbin, who has occupied both sides of the divide.

There is a growing understanding that the old US model – of federal government raining money on the states – is not feasible any more, says Brookings' Mr Puentes. “More importantly, there is a realisation that US infrastructure is falling behind; that not only is the condition of existing infrastructure not good enough, but that we do not have the right kind of infrastructure to compete in the 21st century. This will lead to change.”