Privatization: The road to wiping out the US deficit
As the USA grapples with its oversized debt, attention is focusing on one resource the nation has in abundance: infrastructure. Could the crisis kick-start the development of what might be one of the biggest ever monetization exercises? Nick Lord reports.
PRESIDENT BARACK OBAMA was in a sombre mood as he delivered his administration’s 2010 budget. Speaking in the Grand Foyer of the White House on February 1, he intoned: "Our government is deeply in debt after what can only be described as a decade of profligacy." Outlining the myriad problems the government faced, he said the solution lay in doing "what families across America do: save where we can so that we can afford what we need".
He concluded: "We simply cannot continue to spend as if deficits don’t have consequences. In order to meet this challenge, I welcome any idea."
One idea that financiers are now openly discussing as the government’s only way out of the perennial budget crisis is the wholesale privatization of US infrastructure assets. And if a wholesale privatization programme can get under way, it could create one of the biggest new markets in the world, while simultaneously bringing US finances back in order. After all, what US families also do when they are in debt is to sell stuff.
Infrastructure privatization in the US has been slow to take off in comparison to continental Europe, the UK, Canada and Australia. The effects of this can be seen in the difference in quality of US infrastructure compared with other developed countries. The immaturity of the market can also be seen in the financial structures that exist in the US and those that are commonplace elsewhere. Public-private partnerships (called P3s in the US and PFI – the Private Finance Initiative – in the UK) have come into play in the US only in the past two or three years. "Europeans are 20 years ahead of us in terms of privately financed infrastructure spending," says Andrew Horrocks, a managing director at Moelis & Co investment bank in New York covering the transport and infrastructure sectors.
According to Horrocks, from 1950 to 1970 the US spent 3% of its GDP on infrastructure. From 1970 to the present day the figure fell to 2%. This has caused an immense backlog, with an estimated $1 trillion needed just to get existing infrastructure up to scratch. Luckily, there is a perfect mechanism for raising that money: the monetization of existing assets.
These assets are extremely valuable. According to the US Department of Commerce’s Bureau of Economic Analysis, in 2008 the total value of US government fixed assets (at a federal, state and local level) was $9.3 trillion. Of this $1.9 trillion is owned by the federal government, while $7.4 trillion is held at the state level.
If one assumes that the federal government will not be selling the navy or the municipalities their schools, there is still an immense amount of assets that can be sold. For instance, the value of all the highways and roads owned by states and municipalities is $2.4 trillion. There are $550 billion of sewerage assets at state and local levels along with a further $400 billion of water assets. Even at the federal level there is $42 billion-worth of amusement and recreation assets. And in the real estate sector, the federal, state and local governments own assets worth $1.09 trillion.
To put these numbers into the context of the budget deficit and the overall debt burden, in 2009 the US government spent $1.4 trillion more than it received in taxes and raised in debt. This year the February 2010 deficit alone is $221 billion and the figure since October 2009 is $650 billion.
These assets have not been monetized before because the US did not need to do so. Yet it has never faced the kind of budgetary pressures that it faces today. Secondly, the public, political and perception problems surrounding infrastructure asset sales have kept the issue away from discussion.
But conditions have changed. The situation that the US now finds itself in is similar to where the UK and Australia were 20 years ago. Public perception has changed, politicians are willing to think the once unthinkable and private-sector money is lining up looking for the long-term stable cashflows that privatized infrastructure can bring. All of the pieces are in place for the market to explode.
"This has been the promised land for so long," says Ben Heap, managing director of UBS’s infrastructure fund in New York, and one of the many Australians now working in the US infrastructure sector. "Is now the tipping point? At some stage we will look back and see that it is."
"There are very few options left. So we will see a gravitation towards new public-private partnership deals"
Senior members of the US political establishment are also betting that the time has come for the market to take off. "I expect to see a big increase in infrastructure assets for purchase by folks like us," says Emil Henry, the chief executive of Tiger Infrastructure Fund, a new vehicle set up with the backing of legendary hedge fund investor Julian Robertson. Henry was assistant secretary of the US Department of the Treasury from 2005 to 2007 and is extremely well connected in Republican circles. "If you look at the data, 40 out of 50 states are currently in record deficit," he says. "And the two levers to fund deficits are increases in taxes or increases in debt. But the environment is such that raising debt or taxes is extremely difficult right now. Therefore, many municipalities and states are looking at monetizing their assets."
At a state level, senior officials and politicians are fully aware of the budget problems they face. According to Kris Kolluri – who ran New Jersey’s Department of Transportation under governor Jon Corzine before being appointed the head of the New Jersey Schools Development Authority – the New Jersey Transportation trust fund faces bankruptcy in 18 months and the school system needs $25 billion over the next 10 years. "There are very few options left," says Kolluri, who now runs his own infrastructure and P3 consultancy. "So we will see a gravitation towards new P3 deals."
The irony of this situation is that while the three levels of government in the US have never had less money to invest in infrastructure, there has never been more private-sector money looking to get equity participation in infrastructure. In early 2009 a group of banks, infrastructure companies and lawyers working in US infrastructure convened what they called the Working Group. Comprising 18 companies including Abertis, Morgan Stanley, Carlyle, Freshfields and Allen & Overy, the Group released a report called Benefits of private investment in infrastructure. It says there was "over $180 billion available in private capital [that] can be used to build infrastructure projects". It goes on to note that with a 60:40 debt-to-equity ratio, the amount available actually increases to $450 billion.
Since that report was put together allocations from US pension funds into US infrastructure funds have increased, not just on an absolute level but also as a percentage of their overall asset allocation. "There is a wall of private sector money that wants to invest in US infrastructure," says Nick Butcher, senior managing director and head of infrastructure and utilities, America, at Macquarie in New York. Henry at Tiger Infrastructure agrees. "There has never been more capital available for these assets," he says.
There are five main reasons why the US infrastructure market has not yet taken off: politics, public perception, the unions, the municipal bond market and the gap between buyers and sellers. Each of these problems is either being addressed or has simply stopped being an issue. And it is this removal of impediments that is causing so many to get excited about the prospects.
Perhaps the most intractable problem facing the market has been political opposition to both selling assets and setting up long-term regulatory regimes. Politics is the lifeblood of the US, where every office holder from the president down to the local dog-catcher has to seek election at least every four years. It is extremely difficult to match this electoral timescale with the life cycle of infrastructure assets, which often have a 20-, 30- or 40-year lifespan. Selling assets has been a way to lose elections. "The politics surrounding deals is the hardest thing to manage," says Heap at UBS. "Privatizing assets is simply a way to lose votes." However he thinks that there is a simple equation to understand why the political landscape has now shifted. "The moment the political pain from cutting services is more than the votes lost in selling assets, this market will take off."
There is now abundant evidence that at a grass-roots level that political pain threshold has been reached. In big states such as California, Texas and Florida, P3s are now regularly used whenever new services are needed. Even governor Arnold Schwarzenegger in California has said that state assets from prisons to roads and windfarms are on the block as the state lurches through another budget crisis.
Politicians across the country are looking at states such as Indiana and cities such as Chicago that have been early adopters of privatization of infrastructure. Because Indiana sold the Indiana Toll Road in 2006 to Cintra and Macquarie for $3.8 billion, it is one of only two states in the union that does not have a budget deficit.
In Chicago, mayor Richard Daley has embraced asset sales with a fervour not matched anywhere else. He sold a 99-year lease to run the Skyway in 2005 for $1.83 billion to a consortium also comprising Macquarie and Cintra.
He subsequently tried to sell Chicago’s Midway Airport for $2.5 billion in 2008 and in 2009 successfully sold the city’s parking system in a deal that raised $1.1 billion. The success of that deal has led mayors across the country to look at similar parking deals, with transactions now reportedly under way in Hartford, Harrisburg, Indianapolis, Pittsburg, Las Vegas and Los Angeles. Politicians realize that the political cost in not doing this is greater than in doing it. The tipping point has been reached.
But there is still political pain to be negotiated. The Chicago parking deal was a huge success in every way but one: the transition from public to private ownership caused massive disruption and a public outcry from residents. Managing such transitions better will be the key duty for politicians looking to engage the private sector in infrastructure.
Despite these issues, public perceptions of the monetization of infrastructure are increasingly positive, and changing directly as a result of the economic and political crises of the past few years. In June 2009 investment bank Lazard commissioned a national infrastructure poll among likely voters. The results make extremely encouraging reading for anyone involved in the infrastructure sector.
"It is a strategic and economic priority for the country to provide long-term bank debt to build the nation’s infrastructure"
George Bilicic, Lazard
According to the poll results, the economy is the greatest concern for most people and as a result the "majority of likely voters want their elected officials to pursue non-traditional means of addressing their states’ fiscal problems, including private investment in infrastructure".
The poll went on to indicate a high level of aversion to increases in taxes and debt levels. This is mirrored by an increase in support for private investment in infrastructure. Specifically as a result of the crisis, the poll shows that support for private investment in infrastructure has increased by 9% over the past year alone, with nearly 60% of the respondents saying they favoured it, compared with 34% who opposed it.
"Our poll shows that now, across the board, the US public is very supportive of bringing private capital into US infrastructure," says George Bilicic, chairman of power, utilities and infrastructure at Lazard in New York. "This really foreshadows the huge opportunities that are now here."
The change in public perception will underpin the development of the market. However, interest groups still need persuading. And the most vociferous interest group that has opposed privatized infrastructure is the unions. Unions have traditionally relied on state and local provision of infrastructure as a way to secure jobs and contracts for their members. And this cosy relationship between politicians and unions has stymied many infrastructure deals in the past.
Yet even the unions are now showing signs of coming around to the idea of privatized infrastructure. The unions not only control jobs and contracts but also large amounts of capital through their investment pools. This money has increasingly been finding its way into infrastructure funds: while the unions might complain about jobs losses, they still want to benefit financially from privatized infrastructure. Nick Butcher at Macquarie says that a quarter of the assets of the $4 billion, North American-focused Macquarie Infrastructure Partners Fund has come from union pension funds.
The unions are even co-investing directly in infrastructure deals in a way that would have been unthinkable three years ago. In November 2009, Carlyle closed a $178 million deal to buy and then develop 23 highway service stations in Connecticut in a transaction in which it co-invested with the Service Employees International Union (SEIU). The support of the union, logistically and financially, was crucial to its success. "We are proud to be part of this important project, which will benefit our state and create good jobs for our members," said Kurt Westby, the SEIU’s regional chairman, at the time of the deal.
This deal is small but has been seen by the market as a new model for winning over sceptical unions in a way that can be replicated in future deals. Along with these co-investment opportunities, new investment vehicles are being developed that specifically target union investment.
Cost of capital
With the rapid changes in public, political and union attitudes, it all boils down to one thing: money. The US municipal finance market is a unique institution that allows states and municipalities to sell bonds where the investors do not pay tax on the income they receive. This huge market has been the way that most US infrastructure has been financed over the past 30 years. If a city in the Midwest was looking to build a new bridge or highway, all it had to do was issue muni bonds. But that option no longer exists. One of the biggest casualties of the financial crisis has been the muni market. "The municipal bond market was so deep and liquid that there just was not any necessity to find other funding sources," says Horrocks at Moelis. "But now there simply isn’t the money there any more and the market is still basically closed or lacks depth after it shut down in 2007."
Over the past few years new financing structures have been developed such as the Tifia (named after the Transportation Infrastructure Financing and Innovation Act of 2008), PAB (Public Activity Bonds) and most recently BABs (Build America Bonds), that replicate some of the tax advantages of the municipal bond market for issuers and investors alike. They also provide some credit enhancement and other financial inducements. These financing developments, along with the decrease in the availability of municipal finance, are being embraced by the public sector.
"We want to use P3s as a means of delivering vital state infrastructure on time, on or below budget, and with greater accountability"
Samara Barend, New York State Asset Maximization Commission
"The cost-of-capital argument has hindered the P3 market as traditional, tax-exempt finance is often perceived as cheaper than private financing with no regard for life-cycle costing benefits," says Samara Barend, executive director of the New York State Commission on State Asset Maximization. "But structures such as Tifia and PAB have shown that you can lower the cost of capital, while gathering the benefits of P3."
With public support, political will, union acquiescence and new sources of finance all that is missing are deals. And deals have perhaps been the sector’s own worst enemy. In 2008, as the crisis hit, the market was desperate to see some large, transformational deals. Not only did these deals not happen but those that were expected to happen caused a stink.
The most pernicious of the transactions was the failed leasing of the Pennsylvania Turnpike. This deal involved a consortium of Citi Infrastructure Investors and Spanish infrastructure company Abertis agreeing to pay $12.8 billion to lease the road system. Yet the deal, even though agreed, did not get approval in the Pennsylvania state legislature. Local politicians regarded the Turnpike as a cash cow for handing out jobs and favours to constituents in return for votes. The Turnpike Commission itself was lobbying against the deal. In the end it was a catastrophe not just for the winning consortium but for the infrastructure market as a whole.
The sale of Midway Airport in Chicago also collapsed a few months later, this time not through political obstinacy but because the winning bidder – again Citi Infrastructure Investors – could not raise the finance for its high-priced purchase. The fact that Citi’s municipal bond desk was actively pitching against the deal while its infrastructure investment arm was bidding shows that the conflicts are not limited to politicians but can involve the financial institutions doing the deal.
Aborted deals such as these have harmed infrastructure’s potential as much as any political or union opposition. In particular they created expectations on behalf of both buyers and sellers that the current market cannot support. The price of assets has been in flux as a result of the crisis. Selling states and municipalities have been keen to match the kind of prices that were achieved in pre-crisis deals such as the Chicago Skyway, but bidders have been unable to offer those kinds of prices.
Even so, as the economy starts to pick up that buy-sell gap has narrowed. "The gap between buyers and sellers was very large, even last year," says UBS’s Heap. "This year we are seeing buyers willing to move up much more. They were unrealistically expecting to get hold of fire sales in 2009."
What more can be done?
With the market seemingly ready to take off, it is wise to look at what more needs to be done to ensure that it does. One idea that has been floating around for a while is the creation of a National Infrastructure Bank (NIB), modelled along the lines of the European Investment Bank.
The idea was originally put forward by veteran financier Felix Rohatyn in 2005 and enthusiastically received by members of the incoming Obama administration. However, politicians have now got their fingers into this and an unseemly battle is under way to see who can control it. Specifically, two rival senate committees, one on transportation and one on banking are both seeking to get oversight, which could give the politicians on the winning committee power over extra hand-outs to their states and districts.
Clearly such a structure would serve almost no purpose. The bank would need to be above factional politics and be an efficient allocator of the long-term finance that infrastructure needs. Moreover, it could serve as a brains trust for the new P3 models that are being developed while allowing the US government to retain investment in assets that are being privatized. "The NIB could be a brilliant institution, especially if it is more than just a source of cheap debt," says Heap. "It would be an educator, a centre of excellence and would be able to keep the private sector in check."
The provision of long-term bank finance is also desperately needed if the US infrastructure market is to take off. The US has no real domestic project finance market per se, largely because banks make more money from their capital in other activities. But this could be addressed by changing the capital treatment of infrastructure-related loans or other such financial incentives. "It is a strategic and economic priority for the country to provide long-term bank debt to build the nation’s infrastructure," says Bilicic. "The domestic project finance market has to be developed."
One further idea being promoted is the creation of a body to help public pension plans invest directly in infrastructure deals. This model – called Partnerships USA – has successfully been used in the UK, Australia and various Canadian provinces. It allows pension plans to get around the problem inherent in investing in infrastructure funds that have a lifespan shorter than the asset they are buying and fees that do not match their return profiles. The idea is being promoted by Brian Chase, who works at specialist consultancy Castalia and used to work at Carlyle. "
We need to involve the public pension plans more much directly in infrastructure investing," he says. "As they move to a defined contribution system from a defined benefit system, they will need to generate consistent returns of 7% to 8% a year. Partnerships USA would be a way for them to do so without the costs of investing in funds."
What is clear, however, is that the market will not develop in one way. However much central leadership is provided by new institutions, it will be locally developed deals and structures that will ensure its success.
Kolluri is adamant that the market needs to go forward in this local, incremental way. While he was at the New Jersey DOT, he was intimately involved in an ambitious plan by governor Corzine to fully monetize all of the state’s transport assets and use the proceeds to directly pay down state debts. The deal never got off the ground despite two years’ work and hundreds of town hall meetings. Although the scheme was brilliant in its intellectual audacity, it failed to win the people over. "The painful lesson from the past is that big deals encounter a buzzsaw of opposition," he says. "My advice now is that we need to take the incremental approach."
Even so, incremental approaches do not mean that politicians can escape public scrutiny. One lesson that seems to have caught on is that if an asset is monetized, it should be linked to a specific spending plan or even tax cut. If the money just disappears into the pot of general funding, it will be gone forever – as happened with the billions of dollars the states received from the tobacco settlements in the 1990s. "When monetizing existing assets, the public sector has to explain to the electorate that the money is going to be used sensibly," says Butcher at Macquarie.
Barend at the New York State Asset Maximization Commission concurs. "We don’t want to monetize critical assets to close a short-term budget gap," she says. "We want to use P3s as a means of delivering vital state infrastructure on time, on or below budget, and with greater accountability for the performance of the asset."
But there is no getting away from the fact that the assets are there and people want to buy them. And the conditions have never been this propitious to support a whole new vibrant market. With hundreds of billions and potentially trillions of dollars at stake, this could be the biggest emerging market in the world. In years to come president Obama could be crowing about the persistent budget surpluses, surpluses provided by the successful monetization of one of the US’s greatest resources, its infrastructure.
A brief history of US infrastructure