Public Private Partnerships: No Silver Bullets

Public Private Partnerships (P3s) are the new rage inside the capital beltway. They are the new buzzword of officialdom.
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Public Private Partnerships (P3s) are the new rage inside the capital beltway. They are the new buzzword of officialdom.

One of the few bills that actually passed the Congress last year and was signed into law by the President was the Water Resources Reform and Development Act. This bill contained another bill called the Water Infrastructure Finance and Innovation Act (WIFIA). This new law promotes the use of P3s by offering financial incentives for their use in water infrastructure projects. It seems that wherever you see the word "innovation" nowadays, especially "financial innovation," you see the concept P3.

On January 16 of this year, the White House announced the creation of a new Water Infrastructure and Resiliency Finance Center at EPA. The government's announcement said: "The Center will support communities and explore creative and innovative financing practices, including public-private partnerships."

On the more practical side, Prince George's County, Maryland - right outside of DC - has actually been trying to get a stormwater infrastructure P3 off the ground for the last several years.

Before we get totally carried away in P3 euphoria, let's get a few things straight.

First, a Public Private Partnership isn't a finance mechanism; it is simply a legal structure, in this case, one for implementing infrastructure projects. Second, P3s aren't new. They've been around as long as government and the private sector have co-existed. Third, they aren't necessarily innovative or creative. When a village hires a local trucking firm to pick up the garbage, this is a Public Private Partnership. But it is hardly brilliant, or creative, or innovative.

On the other hand, there are some brilliant and creative P3s. Take certain toll roads, for example. Not the usual toll roads; but some of the new ones where there are two lanes of traffic going in the same direction. One is a toll lane; the other is free. When traffic is slack and the free lane is virtually empty, the toll lane costs little or nothing. But at rush hour, when the free lane starts to choke up, the toll lanes start getting very expensive. The more dense the traffic in the free lane, the higher the charge in the toll lane. This works very well. It works well when the income stream supporting the P3 is very elastic. After all, you may not want to pay $10-15 dollars to get home at a reasonable hour, but unless you really love sitting in traffic, you're going to do it.

This isn't the case, however, with most infrastructure projects. There the income streams are anything but elastic. The day of pay toilets has come and gone. Think water rates. Think sewer rates. Think stormwater fees or charges.

The recent twist on P3s is this relatively new association with finance. P3s are looked upon as some magic, silver bullet to produce money out-of-nowhere for infrastructure projects. The hidden assumption here is that the "out-of-nowhere" is actually some secret sources of money in the private sector. This is a very dangerous idea.

Government has a moral mandate to provide infrastructure at the lowest possible cost to the people. So, the finance question with P3s is: which of the Ps is bringing the money to the table for the project. Is it the public P, or the private P? This question is crucial.

If the public P brings the money, then the financing will generally be done through the tax-exempt municipal bond market. This enormous, $3.6 trillion market assures that the lowest possible interest rates and the longest possible terms will be available. This means the lowest possible cost for the people.

For example, $10 million of green infrastructure for Prince George's County in today's world might result in a $10 million municipal bond with a 30-year term and a triple-A interest rate of 3.5%. This would cost the county taxpayers $544,000 per year. A very low cost for such a project.

But if the private P brings the money to the party, that can be an entirely different story.

Whether a P3 meets the moral mandate to produce the lowest possible cost all depends on the private P's appetite for Return on Investment (ROI) and term or exit strategy, i.e. how fast they want their money back.

If the private P is a charity or other donor, then, no problem. The ROI is 0% and the project will, indeed, carry the lowest possible cost. But very few private Ps are charities.

If the private P wants an ROI north of 15% and wants out after 5 years, the project will be very, very expensive. As of May 19, 2015, the U.S. Treasury reports that the most recent yield on its 30-year bonds is 3.02%. So, at a time when Treasuries are a hair over 3%, what crooks, what criminals, what villains, what charlatans, would demand a 15+% ROI? Some Wall Street pirates, no doubt!

How about the California Public Employees Retirement System? Yep, the government employees in California!

The California Public Employees Retirement System, better known as CalPERS, is the largest pension fund in the United States. It has $294 billion of assets. $31.3 billion, or a little over 10% of which, is invested in "private equity." CalPERS reported that it's benchmark return rate for its private equity investments for the fiscal year ending June 30, 2014 was 15.4%. What's more, private equity investors usually want out after 5-7 years.

So, if CalPERS had financed the Prince George's County P3 at 15.4% for 5 years, it would have cost the county taxpayers $3,011,000 a year. If you were on the Prince George's County Council and you had to vote on either CalPERS money or municipal bond money, which would you choose: $3,011,000 per year, or $544,000 per year? Ouch!

What about CalPERS "other" money? What about the 90% of their assets that aren't tied up in "private equity" investments? Sure, CalPERS will accept less than 15% on its other investments. It all depends on the risk involved as well as the term.

So, let's say the Prince George's P3 put together an investment scheme that looked pretty conservative. Almost like a municipal bond, but not a municipal obligation.

In this case CalPERS or any other retirement fund, or sovereign wealth fund, or life insurance company might accept, say, a 6% rate of interest. But they wouldn't want their money tied up for more than 10 years. Most of the non-government debt market is 10 years or less. So, let us say a $10 million P3 financing at 6% for 10 years. This would result in an annual cost to Prince George's taxpayers of $1,359,000 per year. Again, if you were a County Council member, what would you vote for: $1,359,000 or $544,000?

So, P3s definitely have their uses. They are great for garbage collection. They work well when the income stream supporting them is very elastic as in toll roads or some airports. But, the majority of infrastructure projects are supported by fixed payment streams. In this case: beware of P3s. They are no silver bullets.

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