Banking on contractors
February 1, 2012 by Jim Barnes
Public-private partnerships (P3s) are here to stay. In this infrastructure-procurement model, many new entrants are finding themselves well outside their comfort zones-especially in terms of finance and risk. “Anybody who comes into it for the first time has a very steep learning curve,” says Steve Nackan, president, AECON Concessions, Toronto. Risks, security and even the costs of bidding can be surprisingly different from conventional jobs.
The P3 model has been established in Canada for at least a decade. In essence, a private consortium bids on a government project that includes the design, building, financing, maintenance and operation of a public facility for a given term, say 30 years. As well, it assumes virtually all risk for the project over its life cycle.
Typically, the consortium includes a concessionaire (the equity partner), a design-builder (DB) and a facilities management company (FM). In principle, risk is allocated within the consortium to the party best able to manage it. In some cases, the DB and FM may be equity partners as well.
This model allows governments at all levels to control their costs and get infrastructure built quickly and competently. “The Government of Canada believes that public-private partnerships offer an efficient, cost-effective option to build public infrastructure,” says Caroline Grondin, senior communications advisor at Infrastructure Canada, Ottawa.
Asset management is one theme. “You are going to see the municipalities move into the asset-management space. The mid-sized contractors now need to know how this model works,” says David Bowcott, senior vice-president and national director, Large Strategic Accounts-Construction and Infrastructure, at Aon Reed Stenhouse Inc., Toronto.
In essence, asset management focuses on maintaining the value of an asset over its life cycle. Much of that responsibility is being shifted to the private sector. “That’s the beauty of alternative financing and procurement (AFP),” says Jim Cahill, senior vice-president, Project Finance, Infrastructure Ontario (IO), Toronto. “You’re prescribing hand-back requirements and the buildings are going to look much nicer and be in much better shape after 20 or 30 years, depending on the term of your concession.”
There are additional costs for a P3, including private financing, additional fees and consultants, notes Cahill. On a pure cost basis, these projects are more expensive than conventional ones, but the value of the risk transfer offsets that, he says. Governments often justify these projects using a value-for-money approach (VFM). VFM attempts to bring the value of risk transfer into the equation in determining whether a P3 offers taxpayers value. IO’s board of directors will not approve an AFP project unless positive value for money has been demonstrated, according to Cahill.
For contractors who are newer to P3s, the biggest changes are probably a greater degree of risk transfer and less pass-through of risk in the contract, says Nicholas Hann, a board member of the Canadian Council for Public Private Partnerships. (Hann is also executive director, Macquarie Capital Markets Canada Ltd.) “There is often a higher level of due diligence on the project prior to pricing than might otherwise be the case,” he notes.
These are serious issues. “You really need to understand those risks and be able to mitigate them. If you don’t, the potential liability can be catastrophic for a contractor,” says Jim Dougan, president, Central and Eastern Canada, PCL Constructors Canada. The cap on your liabilities in terms of indemnities on these projects is significantly higher than it would be in a conventional project.
Financing is a very significant risk-lenders may withdraw under certain circumstances. That happened on a couple of projects in Ontario during the credit crisis. New lenders were found, but substantial additional costs-including legal and bank fees-were borne by the contractor, according to Cahill.
“It is so early in the life of P3s that we don’t really understand the long-term risks. We have not seen a 30-year project through its life cycle yet,” says Paul Charette, chairman of the board, Bird Construction Inc., Toronto.
“In terms of limitations in this environment, these [contract] documents are iron-clad. And they are very complex and intertwined,” notes Charette, adding that contractors should be aware of the need for long-term retention of documents. These projects can be very expensive to participate in. “You can spend millions of dollars, just bidding them,” says Dougan. Standardized documents can help somewhat with this situation.
That standardization comes from heavy use of templates in some jurisdictions, including IO. “We basically stay with the same template right across asset classes, with minor differences depending on the asset. Once [contractors] have been through it once, it’s easier,” says Cahill. “Once they and their lawyers spend the time to understand the documents-the RFQ and RFP and bidding documents and schedules and our project agreement… it’s cheaper for them to bid on a contract.”
Contractors are getting more heavily involved in debt negotiations, our contacts agreed.
“Contractors can tell the story on design, construction and even operational risk better than almost anyone else at the table. Why not utilize their expertise in finance negotiations?” asks Bowcott. Contractors can walk lenders through specifics on a deal. If risks were manifesting on a job, contractors can point to solutions.
There are other challenges. “We are grappling with a lot of issues we don’t have to worry about in our regular business. But that is just a fact of life, as more and more projects are procured with financing,” says Nackan. “Besides the logistics of putting financing together, we have accounting issues, where you might be consolidating the debt that you raise for these projects into your balance sheets.”
An array of financing options is available to P3 consortia, including long bullet bonds in the capital markets and amortizing bonds, says Cahill. There is more and more appetite all the time from both debt and equity players. “We are seeing better financial rates and the underlying Canada bond yields have come down since the credit crisis… We have a strong banking community and a strong insurance community in Canada for long financing,” he says.
“We are seeing more credit-enhancement products provided by people who would otherwise be making long-term investments in a P3, to perhaps enhance the completion risk of a project and achieve more effective financing. We are seeing things like subordinated debt or junior debt to help support the completion risk and we are also seeing short-term equity structures as well,” says Hann.
When projects are financed through bonds, ratings agencies necessarily come into play. You have to work with the ratings agency and ensure that they have a good understanding of your project risk to get the best possible rating. It’s about giving them the confidence that you are taking care of things, according to Dougan. “They will want to understand the basis for your estimate and your schedule. They’ll want to know whether you have allowances for weather delays-any contingencies that you might have. They want a pretty thorough overview.”
What can you do to make your project look good to lenders? According to Smith, your track record is a huge factor. The size of your company and your balance sheet are also keys. And they will want to look at your execution capabilities.
“They’ll look at the construction as an unknown risk,” says Smith. They’ll have analysts investigate the deal. They will do comparisons to what’s on the market and what’s off-market. There will likely be in-depth intervi
ews and reviews, says Smith. This emphasis on construction risk is often overplayed, he says. “I am often surprised that people zero in on construction as such a risky proposition. If you did an analysis of defaults on construction projects in Canada, you’d find that the rate of default is quite low, on a project basis.”
One thing P3 contractors must get used to is liquid security. Contractors usually have had to provide support in the form of a letter of credit or cash retention, instead of-or as well as-conventional surety bonding.
“The move to liquid security seems to be an evolution of that kind of financing. Over the past few years, it has kind of become the new normal,” says Tim Smith, senior vice president, Toronto area manager, EllisDon Corp., Mississauga, Ont.
Lenders still feel that the overall risk of the project revolves around the construction, he adds. “They are pushing for more and more liquid security, including letters of credit. They are looking less and less favourably on traditional construction security bonds…Basically, they want cash, and a surety bond is essentially a performance guarantee.”
A letter of credit is a “very painful” instrument for a general contractor, he adds. “That’s a tough thing for medium-sized contractors. You can’t pledge your cash to everybody. Outside of the P3 market, we need our balance sheets to be as strong as possible, to retain our bonding capacities.”
The sureties have tried to innovate in response, “One of the big surety companies recently came out with what they describe as a liquid surety bond,” says Hann. Most of the contractors we contacted said that “P3 bonds” have not had an impact in the market yet, with lenders still requiring letters of credit.
Experience is key to success. “P3s are not that complicated, once you have been through one of them,” says Hann. “More mid-sized Canadian contractors are preparing themselves to work in this area. Many of those may be participating in P3s in joint ventures with other players.” After a couple of projects, some of these companies are stepping up to lead P3s in their own rights. “They develop contacts of their own and they are familiar with the procedures to be followed,” he says.
“The face of the contractor has really evolved over the past decade. We now have structured finance staff who understand how structured finance works. We also have expert facilities management people on staff so that we fully understand what that business is about and what the life cycle issues that we need to manage are,” says Dougan.
Staff is a key consideration, our contacts emphasized. “I can’t overstate the number of people it takes to run a bid and then run one of these projects successfully,” says Smith. “You have to satisfy a lot of different people in a very short period of time. You are designing, you are chasing permits and you are satisfying reporting requirements to the government, to lenders and to the client.”
Smaller contractors must do a great deal of homework to be profitable in this market. “There is a huge opportunity to participate in the Canadian market and internationally, especially in the U.S.-and a huge opportunity to diversify revenue streams in terms of getting involved in asset and facilities management and maybe even long-term equity,” says Hann.
Jim Barnes is a contributing editor to On-Site. Send comments to email@example.com.
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