It doesn't take a Hollywood executive to know that America's infrastructure is in need of an "extreme makeover." Built predominantly during the middle of the last century, U.S. infrastructure has been pushed to and, in some cases, beyond its limits. The American Recovery and Reinvestment Act of 2009 acknowledged this reality by earmarking over $100 billion of government funds for infrastructure-related spending — a level unseen since the days of FDR. While stimulus funds may provide some relief, a great deal more capital is needed. The American Society of Civil Engineers recently estimated that approximately $2.2 trillion dollars is needed to fund infrastructure over the next five years. Who will bridge the capital gap?
As traditional funding sources, such as increased taxes and public bond financing, have become increasingly difficult to access, private investment has moved to the forefront. Available equity capital for infrastructure from both U.S. and international institutions has skyrocketed from $10 billion in 2004 to $180 billion in 2008. Many observers believe that, despite broader economic uncertainty, investors will continue to flock to the steady yields and inflationary hedge offered by infrastructure investment. Previous successful projects such as the Chicago Skyway and Indiana Toll Road transactions also provide impetus for privatization. Heightened private interest, however, depends on private investors' ability to weigh the associated risks against the potential returns. In the infrastructure arena, the pitfalls and hurdles of privatization can be significant.
The Obstacle Course
Two of the largest and most visible proposed privatizations – the Pennsylvania Turnpike and Chicago's Midway Airport – vividly illustrate the obstacles confronting private investment in infrastructure. The Penn Turnpike transaction proposed a 75-year lease of a 537-mile state-owned highway to a private consortium composed of Citi Infrastructure Investors ("CII"), Abertis Infrastructure, and Criteria CaixaCorp. The Midway deal involved a 99-year lease of Midway Airport, a five-runway hub that handles 300 flights daily, to a joint venture comprised of CII, YVR Airport Services, and John Hancock Life Insurance Company.
Despite the promise of these two projects, neither has closed. The Penn Turnpike privatization collapsed in October 2008. The Midway privatization is now slated to be complete in the first half of 2009, but it has already been delayed once and several hurdles remain. Its failure could deal a major blow to the privatization model. The scuttling of the Penn Turnpike deal and the delays in the Midway deal can be attributed to several factors, which are instructive for private investors evaluating infrastructure opportunities.
Political Opposition. Privatizing infrastructure is politically sensitive. Political opposition often derives from suspicion of turning over public goods to profit-making entities. In this respect, local government budgetary shortfalls are a double-edged sword: even as they prompt governments to pursue privatization, they fuel arguments of opponents who wonder why governments do not simply find a way to reap for themselves the returns expected by private investors. One Illinois politician has compared infrastructure privatization to "selling the furniture to pay the mortgage."
The immediate precipitating factor behind the Penn Turnpike deal's collapse was the Pennsylvania Legislature's failure to grant necessary legislative authorizations. The deal met heavy opposition from Pennsylvania legislators and the Pennsylvania Turnpike Commission. After extending its bid twice to accommodate the legislature, the investor consortium allowed its bid to expire on October 1, 2008. Likewise, in Chicago, the Midway privatization recently met opposition from candidates for a newly-vacant congressional seat.
Credit Conditions. Infrastructure investments are not immune from the factors, such as the credit crunch, wreaking havoc on other deals throughout the economy. For example, with the Penn Turnpike deal structured as 50% equity and 50% bank debt, it is widely speculated that the uncertain credit markets were the most important factor in the investors' decision to let their bid expire. The Midway transaction, which was originally expected to close by the end of 2008, was put on hold after the investor consortium announced in January 2009 that it was seeking additional equity capital, a move that may have been prompted by the need to replace expensive or unavailable debt.
Valuation Difficulties. Infrastructure is a relatively new asset class for private investors, and valuing these assets is still more of an art than a science. To illustrate, the Commonwealth of Pennsylvania's financial advisers and the media estimated the value of the assets would range from $20 billion to upwards of $30 billion, but the winning bid for the Penn Turnpike was only $12.8 billion. For the Midway project, pre-bidding estimates ranged from $1.5 to $3 billion. The winning bid, at $2.52 billion, was within this range, but the range itself was sizable. The novelty of valuing infrastructure assets partially explains the wide fluctuations. Dramatic swings in cost of capital and economic forecasts over the past several years are also factors. What is clear is that wide disparities in valuation, coupled with the lengthy time frames involved in getting privatization deals completed, can derail deals.
Regulatory Approvals. Various regulatory requirements also create obstacles for private investors underwriting and completing these deals. A failure to obtain one of the many required approvals can derail a project in which substantial investment has already been made. Additionally, approval delays afford equity and debt investors opportunities to revalue, renegotiate, and reconsider transactions — a dangerous prospect in the current investment environment. Finally, concessions required to obtain these approvals can affect (generally for the worse) the underwriting of the project.
The Midway transaction, for instance, required the approval not just of Chicago city authorities but also of certain neighboring cities. The privatization is being done pursuant to a national program spearheaded by the Federal Aviation Administration, which must approve the financial terms of the deal. Under the program's terms, 65% of airline tenants also need to approve the transaction. To gain the approval of Southwest Airlines, the investor consortium agreed to freeze carrier charges at 2008 levels for its first six years of operation, followed by limiting fee increases to the rate of inflation for the next 19 years.
Mind The Gap
The future demand for infrastructure capital will outstrip the supply available from public sources. Who will fill this capital gap? While it is undeniable that infrastructure is a highly attractive asset class, that the political momentum is moving toward more infrastructure deals, and that there are successful precedents, investors are well advised to recognize the risks and hurdles presented. Capital alone will not be sufficient to address these obstacles. Success is achievable only with a thorough understanding of both generic and asset-specific obstacles to private infrastructure transactions in today's environment.
Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.
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