Over the last budget period, Canadian governments were stimulated by federal funding—funding that relied on infrastructure action to inflate the economy. A lot time and effort went into getting “shovel ready” projects started, with less energy spent pursuing P3s as a project delivery model. Now that the Stimulus Fund frenzy has died down, certain industry insiders are seeing a shift in progress on the P3 front.
“We’ve seen the experiences in British Columbia and Ontario and would expect the deals to continue as currently planned by each jurisdiction,” said KPMG’s Brad Watson. “But the entrance of the federal government and the PPP Canada Fund as yet another lever to facilitate infrastructure development is a wild card—the impact of that remains to be seen,” he said.
The federal government has done two P3 projects in the last year and, with the creation of its own P3 agency, is sending a clear message about its support for the model. PPP Canada’s $1.2-billion fund is in its third intake. Arseneau said there’s a growing number of applications [to the Fund] from municipalities and regions of the country that have not had much experience doing these types of projects.
Municipalities are even starting to introduce their own policies around P3s. Calgary City Council adopted guiding principles for P3s in 2008, in part to help evaluate P3 opportunities. New Brunswick also recently created a P3 agency within its transportation department called Partnerships NB. “These are indications of strength in the market,” said Arseneau.
But John McArthur with Bilfinger Berger said, “We’re in a valley for deal flow. It looks like with additional sectors like water and energy—and transport in Ontario—we may be going back up the curve, but we haven’t seen it yet in terms of real deals.”
While companies that only have an interest in more traditional sectors for P3 may be noticing a downward trend—as one attendee pointed out, there are only so many hospitals left—new sectors are opening up opportunities.
While McArthur made a distinction between “rumoured pipeline” and “in the pipeline,” he expressed confidence in the growing pipeline in Canada. In today’s P3 environment, rumoured is often as good as RFQ’d. “I honestly believe that the rumoured deals will become real deals,” said McArthur. “As the business has moved along and the different agencies have delivered transactions, if a deal is rumoured now, it’s very likely that it will come into the marketplace.”
Michael Wolff with TD Securities said he sees more potential projects on the horizon than perhaps others in the private sector because he’s willing to consider non-traditional build-finance deals. Some such deals will come out of the upcoming Pan Am Games in Ontario. Wolff said, “There will probably be five projects, plus the athlete’s village, but they won’t be done as traditional DBFMs, they’ll be done as DBFs. Traditional investors in this space might not be interested in these. But from an advisor’s side, and an underwriter’s side, there’s $1.5 billion in business in the Pan Am Games alone.”
It’s not just the new DBF model that’s challenging the traditional P3. Mark Murphy of Borealis Infrastructure sees potential in the billions of dollars needed to replace the crumbling infrastructure that exists in Canada—a set of assets so far barely touched by P3 proponents.” The focus to date in Ontario seems to be on new buildings and development that only touch the tip of the massive civil infrastructure replacements required. Failing wastewater networks and transport assets are but two examples,” says Murphy.
A much-touted benefit of P3s is the transfer of development risk, but there’s significant renewal risk that cities across Canada would likely love to offload. “You only need to look at the budget statement for the public works department of any major city,” said Murphy. “Look at their 10-year plan for wastewater and potable water expenditures; it’s in the tens of billions of dollars—everybody knows municipalities can’t afford that. Yes, a P3 may be difficult, and may not provide 100 per cent of the solution for all the needs; yes, they’re big tickets and will encourage public debate, but other jurisdictions have done it successfully. We should work with cities and provinces in collaboration to bring affordable and practical solutions to the table.”
Watson argues Canada is likely about five, perhaps as many as 10, years out before this type of long-term renewal contract gets widespread application to rehab projects, but agrees that the P3 model is well-suited to these types of projects. “What underlies the P3 model is the notion of risk transfer and being able to shed the risk associated with the next watermain break or bridge collapse and put that on the shoulders of guys like John [McArthur] enabling City councils to say, ‘This asset is going to be managed for the next generation.’”
Calgary City Council, at the very least, would be receptive to that arrangement. In its P3 policy framework (2008), the City reported that it’s facing over $18 billion in identified capital needs over the next decade, over half of which is unfunded. It states: “While the majority of P3 projects tend to be focused on new growth infrastructure, there may also be some opportunities to evaluate P3s for some of the City’s life-cycle needs.”
Goodmans’ Carla Salzman believes the Canadian market will evolve to incorporate these types of deals. “You have to remember where we started with the P3 program in Ontario,” she said. “We started with Highway 407 and at the time, in addition to the issues with respect to public acceptance of the P3 model, there was no standardized approach in place to bring infrastructure deals to market in an efficient manner. These issues have now been addressed and a programmatic approach has evolved. The next step is to get into the real infrastructure work Mark [Murphy] talked about.”
Arseneau, whose agency has so far focussed on more traditional P3s, asked, “Is there an appetite in private industry to do those refurbishment projects?” Many people in the room said absolutely. There was specific mention of a bridge renewal project, a potential P3 that was brewing in 2006. It would have meant a concession to refurbish and maintain about 500 bridges (see “Missouri Bridges,” page 13). But it never went forward as a P3.
Dark days and wide equity
Would that Missouri bridges project have been P3-able? “A properly structured deal will get lender support as well as attract equity and investor interest,” said Watson.
McArthur reinforced that point. He argued that projects don’t fail because of a lack of interest from lenders. The issue, as McArthur sees it, is in the very nature of infrastructure development—that it’s so often seen as a capital project rather than an operating project. In the last few years, some of the provincial P3 agencies introduced major milestone or completion payments into transactions. “That should be applied to the operating life of the program, not the capital,” said McArthur. “When [agencies] offer a major completion or milestone payment, it changes the risk transfer completely, and reduces the amount of equity.” That shifts the focus and makes allocating risk to the appropriate parties much more difficult. McArthur believes that it was a “well intentioned” solution to a problem that had already started to fix itself.
Wolff said substantial completion payments can be useful in some scenarios. They were introduced for the Niagara Hospital deal, on which both he and Murphy worked. “It was right in the middle of the crunch, in 2009. At that point, literally, there was just no money, and Ontario found a way to make that deal happen—the debt size became quite small,” said Wolff.
Those types of crunch-related speed bumps are not entirely in the past. “We’re still feeling the hangover of those dark days in terms of the cost of finance,” said Watson. “We all make the argument that this is about value for money and transferring risk and so on, but it’s so hard to not look at the cost of capital; the cost of borrowing for [the private sector] as opposed to one of those provincial bodies.”
The essential trade-off with a P3 is that the operational efficiency of the private sector will offset the cheaper financing that governments can obtain. But the widening spread between the government and corporate costs of borrowing is making that argument harder to win.
Wolff doesn’t think the spreads are still too high. “There’s no question the spreads are higher for a municipality or province to borrow this way, so it’s always been a decision between risk transfer and the cost of that risk transfer,” he said. Wolff compared the Windsor Casino, completed in 1998, which was done through traditional procurement and went significantly over budget at taxpayer expense, to the Niagara’s Fallsview Casino deal, completed in 2002 as a build-finance, which came in on time and on budget. He argued that while the Province paid a premium for the debt, it was worth it.
“The debt argument will go on for as long as there are P3s,” said Wolff. “There are examples where a hospital has completed a renovation or expansion on time and on budget, but more often than not, the public sector can’t do it as well as the private sector, especially over a 30-year period and with the life-cycle aspects. What’s changed, at least in Canada, is the involvement now of the bond sector. That is relatively new. Up until five years ago or so, this market was generally financed by foreign banks. Now a whole new sector is involved, which is very well suited to lending long, and I think pricing has and will continue to drop. The hangover from 2008/2009 may be still there in spreads, but that’s coming down.”
In the meantime, some municipalities, in particular those with smaller projects, are starting to look at a quiet equity approach, with a reduced amount of long-term debt, because it increases the affordability of a project.
“Wide equity was the last thing I wanted to hear about in British Columbia,” said McArthur. It was only around for a short period and he hopes it won’t reappear. His objection is that equity actually costs more than debt. “There is a cost for skewing the risk profile because of the amount of equity relative to the amount of debt in a billion-dollar transaction.”
Watson agreed. “Too often, the case against P3 is the cost. It was easier to refute that argument prior to the credit crunch, but this has become more difficult now. This is in part why we’re seeing more of the DBF-type model, as well as deals with milestone payments throughout construction. But there’s significant value in transferring risk from a whole-life perspective, and that just doesn’t get enough attention.”
Too much is too much
According to Arseneau and McArthur, municipalities represent a great opportunity for future P3s. But, once again, it comes down to cost.
“The reality is the cost to do a transaction is quite high,” said McArthur. “There’s a point of diminishing return where the amount of equity that you would put into a deal plus the cost to actually undertake the transaction and bring it to close financially is [too high].”
“By the nature of the structure of this type of transaction, it’s complicated, and you have many parties and legal documents associated with it,” said McArthur. “Shortening the procedure might make it more attractive.”
Arseneau said there has, in fact, been documentation standardization in markets like British Columbia and Ontario that is actually driving down some of those transaction costs—“you don’t have to reinvent it every time now.”
McArthur cautioned against trying to overrefine the model. Borealis has an office in the United Kingdom. McArthur said, “If you talked to [Bilfinger staff] they would tell you that the model there a few years ago wasn’t perfect, but it was pretty good. Continual refinement has made it a total mess. To a certain extent it has to do with the level of competition there, which is fierce, but I think continual tweaking has tweaked it right out of the realm of reality.” He observed that the process in the United Kingdom takes significantly longer than in Canada.
Salzman agreed. “The model may not always be an exact fit for particular deals, and may require adjustment from time to time, but we have general market acceptance because we have a well developed base from which to work.”
“If you look south of the border, there have been so many start and stops,” said Watson.
Salzman said that’s because the United States hasn’t developed the kind of systematic approach to getting deals to market that Canada has.
Arseneau said the next big change won’t be to the model or the process, but it will involve how governments plan purchasing—and that will involve changes in attitude and perception on the part of some governments “It is a huge shift for government procurement to move away from cost to performance as the key factor. We’re starting to see more and more jurisdictions collaborating on a single project—the models of governance on the government side are going to be interesting.”
Arseneau pointed to a massive P3 project being undertaken as a collaborative effort between three Atlantic provinces, facilitated by PPP Canada. “There are big lessons there about how to cooperate on the buyer side.”
Watson isn’t convinced. “It’s easy to say these three provinces are moving forward; it’s easy to say that municipalities could work together. But let’s face it: projects involving multiple governing bodies will be viewed as more risky by the developer community, especially at the municipal level or for those who are pursuing a P3 transaction for the first time. It is expensive for developers to pursue these projects and those with political risk associated with the procurement process will be viewed less favourably.”
CG/LA’s Norman Anderson put it all in perspective: “This is an incredibly depressing conversation for an American—it would never happen in the United States. There’s no cluster, there’s no sense that we’re all going in one direction, there’s no consensus, and it’s killing us,” he said. “The market you’re talking about is probably ten times bigger in the United States but there’s no chance in hell that a developer’s going to get in. So, I’m very impressed.”
Special thank you to our participants:
Editor, ReNew Canada
John McArthur, Senior VP, Asset Management, Bilfinger Berger Project Investments
Michael Wolff , Manager, Corporate and Investment Group, TD Securities
Carla Salzman , Senior Partner, Goodmans LLP
Mark Murphy , VP, Borealis Infrastructure
John Arseneau, VP Business Development, PPP Canada
Norman Anderson, President and CEO, CG/LA Infrastructure
Brad Watson , Partner, Global Infrastructure Advisory Services, KPMG