public-private partnerships: in search of a paradigm roger d. stark partner kirkpatrick &...

Public-Private Partnerships:

In Search of a Paradigm

Roger D. StarkPartner

Kirkpatrick & Lockhart Nicholson Graham LLP(202) 778-9435

[email protected]

© 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 2

Introduction

Is financing predicated on credit capability or revenue reliability of P3 deals?

— Tax structuring plays a central role in U.S. transactions/requires customized analysis to preserve tax-exempt finance

— Successful P3s are an amalgam of structures and disciplines

WANTED: transactional paradigms


Summary of Presentation

Recent Developments

Structural Paradigms

Risk Mitigation/Document Paradigms

The Role of Government

Indicative Structures

Conclusions


What are P3s?

Public-private partnerships (P3s) :

Combine private sector capital with public sector commitments (and, sometimes, capital)

Procure plant and equipment, improve public services and/or improve the management of public sector assets

Focus on public service results, and thereby offer a more cost-effective approach to public sector risk management


Recent Developments (old news)

Increased Budget Constraints at the Federal, State and local level

Mistrust of merchant projects/market projections

Degradation of municipal credit quality

Heightened attention to regulatory and political risks


Structural Paradigms


Municipal Finance

General Obligation Municipal Bonds (tax exempt, indenture trustee)

Lease Purchase

Certificates of Participation

“non-appropriation risk” or “essential services”?


Project Finance

Firm, long-term revenues

Mitigation of market and regulatory risks

Fixed price, on-time, at-spec EPC to mitigate construction risks

O&M Agreement to mitigate operating risks


Privatization Models

Concession of public services

Build/Own/Transfer

Sale/Leaseback

“Contracting Out”


Private Finance Initiative (“PFI”)

Project Company/“OpCo”/D&B Contractor

Project Agreement defines construction/operation results and pushes various commercial and financial risks down to private sector participants

“Private consortia, usually involving large construction firms, are contracted to design, build, and in some cases manage new projects. Contracts typically last for 30 years, during which time the building is leased by a public authority.”

UK Dept. of Health Website: http://www.dh.gov.uk/ProcurementAndProposals/PublicPrivatePartnership/PrivateFinanceInitiative/fs/en


Transaction Risk Matrix

Allocation of Project Risks/Burdens

Financial Structure Development Construction Financing Permitting Project Operation

Municipal Finance GC Entity GC Entity GC Entity GC Entity GC Entity

Project Finance Sponsors EPC contractor, project entity, sponsors

Project entity and sponsors

Sponsors, EPC Contractor

O&M contractor, project entity, sponsors

Privatization Transaction Specific

Transaction Specific




PFI Project Company

Design/Build Contractor

Project Company Project Company, Design/Build Contractor

Project Company

GC Entity= Government controlled entity

Project Company= Privately controlled entity


Risk Mitigation Paradigms


Risk Mitigation (Lender Goals)

Mitigation of Construction Risk

Reliable cash flow/credit quality -- non-appropriation risk?

Mitigation of market risk

Mitigation of political risk -- “essential service”?

Bilateral contracts that integrate market requirements and mitigate market risks


Risk Mitigation (Documentary Paradigms)

Off-take Agreements

Service Contracts -- aka “Project Agreements”

Concession Agreements

Construction (EPC/Design Build) and O&M Agreements

Credit Facility Documentation -- “renting money”


Determine Available Alternatives for Creating Security Interests

What legal structures are available under local/foreign law for creating interests in property?

− (Assignments/trusts/pledges) Formalities of Execution (public vs. private instruments, recording

requirements)

− Compliance with local law formalities will affect enforceability and determine priority in bankruptcy

Understand Enforcement Mechanisms

− Public Sale Requirement (before Notary Public or Court)


Contract Rights (indicative)

FORM OF SECURITY STRUCTURE CREATION PERFECTION

Assignment (e.g., of (i) all rights and obligations, or (ii) right to receive payments under a contract (Cesión de Crédito), or (iii) all or some rights only (not obligations))

Public deed or private agreement

Present assignment vs. assignment effective (but subject to a “suspensive” condition)

Upon execution by all parties (i.e., assignee, assignor and counterparties) or, if signed only by assignee and assignor, upon notice of assignment to counterparty

Execution plus recording (e.g., Costa Rica and Guatemala recording required)

Counterparty’s consent may be expressly required for assignment

Trust:

Contribution of contract rights by holder thereof to (foreign or domestic) trust for the benefit of a third party (e.g., lender). Availability contingent on applicable law (e.g., Salvadorean law does not provide for creation of trusts)

Public deed or, in a few jurisdictions (e.g., Costa Rica), private agreement

Generally, notice to counterparty required

Pledge:

- of Economic Rights (e.g., El Salvador)

- of rights of use and leasing (e.g., Costa Rica)

Pledge agreement, typically by public deed or in some countries (e.g., El Salvador), private agreement (with signatures authenticated by a notary public)

Recording with applicable registries may be required (e.g., Costa Rica)


Stock (indicative)


Pledge of Shares Public deed or if private agreement, with signatures authenticated by a notary public. In some countries (e.g., Panama), pledge must be executed with the same formalities as underlying contract (e.g., loan agreement)

Typically, “possession” of share certificates required (i.e., physical delivery to pledgee)

- or delivery of share certificates to a third party trustee (e.g., Panama)

- or delivery of share certificates plus endorsement thereof and recording of pledge in the issuing company’s share registry - (e.g., Costa Rica and El Salvador)

Trust:

Contribution of shares by shareholder to a trust for the benefit of a third party (e.g., lender). Availability contingent on applicable law (e.g., Salvadorean law does not provide for creation of trusts)

Generally, trust agreement by public deed, or, (e.g., in Costa Rica) if private agreement, with signatures authenticated by a notary public

Delivery of share certificates to trustee

- Formal legal title to shares transferred to the trustee (e.g., Panama)

- Endorsement of share certificates and recording in issuer’s records may be required (e.g., Costa Rica)


Real Property (indicative)


Mortgage (Hipoteca de Bienes Inmuebles)

Variants:

- Antichresis (i.e., mortgage interest in rents and proceeds of real property) (available in Panama)

- Pledge of rights of possession (available in Guatemala)

Written agreement in a public deed (typically only if real property to be mortgaged is duly registered)

If property is unregistered, holder of possessory rights may pledge such rights (e.g., Guatemala) in private document

Recording with applicable registries

Trust

Contribution of real property by owner to trust in favor of a third party (e.g., lender)

Public deed of transfer to trustee Recording with applicable registries

Mortgage Bonds (Cédulas Hipotecarias) (available in Costa Rica)

Public deed. Can only be granted if no mortgage has been previously filed in same property

Recording required


Movable Personal Property (indicative)


Pledge Public deed or private agreement. Public deed required in a few jurisdictions (e.g., in Costa Rica, for assets required to be registered (e.g., vehicles, ships, aircrafts) and in El Salvador)

Importance of formalities in execution (in some countries must be same as underlying contract)

Possession required (i.e., delivery of movable property to pledge)

Recording in lieu of possession where recording is required or in the case of “registered” assets.

Express acceptance of pledge by lender sometimes required (e.g., Guatemala)

Pledge variants (available in Panama):

- Mortgage (Hipoteca de Bienes Muebles)

- General Pledge (Prenda General de Activos) only applicable to assets located outside Panama

Public deed

General pledge by public deed or private agreement legalized by notary public

Recording required


Receivables/Project Revenues/Bank Accounts (indicative)


Assignment (e.g., of right to receive payments under a contract (Cesión de Crédito))

Public deed or private agreement

Present assignment vs. assignment effective (but subject to a “suspensive” condition)

Upon execution by all parties (i.e., assignee, assignor and counterparties) or, if signed only by assignee and assignor, upon notice of assignment to counterparty

Pledge of funds in bank account(s) and, in some jurisdictions (e.g., Panama), in future deposits. Availability contingent on applicable law (e.g., pledge of bank accounts not recognized in Costa Rica)

Public deed or private agreement Transfer of title to bank account(s) to pledgee or third party depositor may be required

Trust

Contribution of bank account(s) by owner to a trust for the benefit of a third party (e.g., lender)

Execution of trust agreement (between the owner and the collateral trustee) pursuant to a public deed, with lender holding beneficial interests

Transfer of title to bank account(s) to trustee may be required

In some jurisdictions (e.g., Guatemala) notice of assignment of receivables must be served on each of the respective payors, or alternatively, their consent and acknowledgment must be obtained

Pledge of all assets (Prenda de Compañía) (available in El Salvador)

Public deed Recording required


Transactional Issues


Transactional Issues – Documentary Paradigms

PPAs

Fuel Supply Agreements

EPCs


Power Purchase Agreement

(“PPA”)


Goals

Reliable cash flow

Mitigation of market risk

Integration of bilateral contract arrangements with the requirements of wholesale market


Key Contract Provisions

Term: the term should be as long as tenor of debt financing, plus additional time to permit recovery of force majeure losses;

Character of Service: Consider distinction between selling to captive adjacent customer and selling into or via wholesale markets. If selling via the wholesale market, plant efficiency and dispatch patterns will determine fuel usage. (Consider issues re excess energy, energy trading and energy marketing);


Key Contract Provisions (cont’d)

Price: Traditional capacity/energy pricing may not be viable in sales to wholesale markets;

— Traditional capacity/energy pricing may not be viable in sales to wholesale market

— Contracts that track market pricing will provide lower leverage ratios

— “Associated Energy” or “Energy Block” contracts may provide alternative structures for optimizing financial leverage


Key Contract Provisions (cont’d)

Force Majeure Events: available to fuel suppliers also must be available to Owner under PPA (note civil code issues);

Events of Default:

— Standard of service typically based on 100% availability of the project’s committed capacity to the System Operator;

— Seller defaults should incorporate appropriate cover options and cure periods; avoid non-curable defaults by agreeing upon suitable economic or operational remedies.


Other Material Provisions

Operations & Maintenance

Billing & Payment

Liability/Indemnification

Changes in Law


Fuel Supply Agreements


Fuel Supply Contract

Basic Goal



Regulation


Objectives of Contract

Reliable supply of fuel

Reliable pricing to realize pro forma economic objectives

Avoid/mitigate commercial/regulatory risks



Quantity

Character of Service

Point of Delivery

Price

Take-or-Pay

Term


Quantity

Keyed to projected PPA/system dispatch requirements

Pipeline fuel/balancing requirements must also be considered


Character of Service

Firm, interruptible or “quasi-firm”

Firm service typically required unless project has multi-fuel capability

“Portfolio” considerations if multiple fuel sources contemplated


Point of Delivery

Coordination of delivery points/receipt points in Supply and Transportation Contracts

Restrict number of delivery points if various suppliers providing gas

Title and risk of loss

— transfers from supplier to pipelines

— transfers from pipelines to LDCs


Price

Risk of fuel prices causing power pricing to exceed applicable normative values

Utilize indexed pricing, tracking accounts to mitigate pricing risks and (where feasible) multi-fuel arrangements


Take-or-Pay

Significant risk for all projects subject to dispatch (i.e., not “captive” projects)

Seek to mitigate through “make-up rights” and use of back-up fuels (to the extent consistent with project economics)


Term

Financing requirements typically result in term equal to or greater than term of post-construction financing

Shorter terms may be feasible if long-term pricing is likely to be out-of-market



Supplier Credit

Conditions Precedent/ Commencement of Service

Force Majeure

Default and Remedies

Letter of Credit from Project


Other Material Provisions (cont’d)

Representations and Warranties

— title, quality

— match to equipment specifications

Right to Resell Gas


Pipeline Transportation Service

Gas Transportation Service

Pipeline Tariff

Peak Shaving

Regulation


Gas Transportation Service

Quantity

Point of Receipt/Point of Delivery

Quality

Rate

Balancing

Scheduling


EPC Contracts



Scope of Services

Standard of Performance

Payment Terms

Completion and Performance of the Project

Warranties


Scope of Services

Risk

“Bifurcation” leaves a gap between procurement and construction

Combined scope of supplier (off-shore) and constructor (on-shore) provides less than full EPC scope

Mitigation

Parent guarantee or Coordination Agreement

Coordination and integration of both scopes to ensure complete EPC coverage


Scope of Services (cont’d)

Risk

Change in required permits triggering change order

“Contractor Permits” definition too narrow triggering change order

Mitigation

Identify potential areas where required permits may change and negotiate pre-set change order amounts

Coordination and integration of both scopes to ensure complete EPC coverage


Standard of Performance

Potential Risk

Local practices and standards may differ from international standards required by debt and equity investors

Mitigation

Services to be performed in a “workmanlike” manner, in accordance with local law, applicable int’l standards and prudent utility practice


Payment Terms

Potential Risk

Insufficient liquidity to complete project due to dispute; payments disproportionate to value received

Mitigation

EPC price should be fixed, subject only to agreed change orders; retainage of 5%-25% withheld to ensure performance; payments keyed to project “milestone” events


Completion & Performanceof the Project

Potential Risk

Completion delays

Mitigation

Well-delineated standards for establishing project completion; liquidated delay damages keyed to interest costs on project construction debt


Completion & Performanceof the Project (cont’d)

Potential Risk

Project fails to perform at desired levels

Mitigation

Testing protocols to measure project performance (e.g., output, heat rate); liquidated damages for failure to attain specified performance levels


Warranties

Potential Risk

Latent defects in design, construction not discovered until after final completion

Mitigation

“Standard” warranties (1-2 yrs) of design, mat’ls, workmanship

“Suitability” warranty taking into account the intended use of the project


Other Provisions

Force Majeure

Defaults and Remedies

Scope Changes

Insurance


Force Majeure

Potential Risk

Unforeseen events that excuse contractor performance and/or increase project costs

Mitigation

Events available to contractor must also be available to Owner under PPA and fuel contracts

Special concerns re labor disputes

Must be conformed to civil code definitions of force majeure


Defaults & Remedies

Potential Risk

Material non-performance by the contractor

Mitigation

Defaults should be crafted with regard to local labor and lien laws

Owner remedies to include taking over the project (including all contractor work and subcontracts)


The Role of Government


Checklist for Government Support Arrangements

Authorization to do Business

Determinable Tax Liabilities (“PILOT” Agreements)

Credit Support for Governmental Obligations

Assistance in Obtaining Governmental Permits/Approvals

Mitigation of Change of Law Risks

Mitigation of Uninsurable Force Majeure Risks

Priority or Parity on State-Controlled Transportation Facilities (e.g., port facilities)


Assistance in Obtaining Governmental Permits/Approvals

Defining the Scope of Necessary Permits/Approvals/Regulatory Exemptions

Government Support to Facilitate Processing of Approvals

Applicability to Extensions and Renewals

Combine with due diligence of procurement rules and Franchise/Concession Requirements


The Way Forward: Role of Government

Traditional Government Financing

Governmental grants/Revolving Funds/“63-20” corporations to attract private capital

P3 Structures

Transaction-specific innovation


Some Indicative Structures

Federal/State Agency

Commercial Lenders

ProjectCompanyBorrower

Indenture/NotePurchase

Agreement

LoanAgreement

LoanAgreement

Capital MarketsOffering

Lead CommercialBanks

as Agents/Underwriters

Syndicate ofCommercial Banks

Collateral Agent/Trustee

CommonAgreement

LoanAgreement

CollateralTrust

Agreement

Credit Support

InstrumentCredit Support Entity

Security Agreements:Cash Collateral Agreement

Pledge AgreementAssignment Agreement

Mortgage

Typical Co-Financing Transaction

Credit Default Option

Counter Party Bank

Project Lender

Project Company

Municipal

EntityBPS = Basis Points

CEP = Credit Event Payment

$

$

$

Services

CEP

Zero

Fee x BPS

No credit event

Credit event

Credit Linked Note

Counter Party Bank

Project Lender

Project Company

Municipal

Entity

CEP = Credit Event Payment

$

$

$

Services

CEP

Principal

Interest on note

No credit event

Credit event

Principal

Legal Counsel

Design Engineer

Investment Banker

Revenue Modeler

Accountants

Rating Agency(ies)

Interconnection/GasDistribution Services

Provider

Parent Guarantor

O&M Provider

Sponsors Senior LendersTerm Notes -Banks -Public -Institutional InvestorsBank Revolver/LC Facility

-Subordinated Lenders

Subcontractors

Equipment and Material Suppliers

EPC Contractor

Parent Guarantor

WarrantiesPerformance Guarantees

Typical Energy Project Financing

Equity InvestmentShareholders Agreement

Fuel Supply ContractFixed PriceEPC Contract

Offtake AgreementO&M Agreement

Guarantees or

Support

PayingAgent

CollateralAgent

Funding Company

Passive EquityInvestors

Insurers

Fuel Supplier

Legal Counsel

Independent Engineer

Power and Natural GasConsultant

Insurance Consultant

Project Company

Power Marketer*

Power Purchaser(s)

ParentGuarantor*

ParentGuarantor

Transmission/ Services Agreement

Interconnection/Transmission Ag’t**

*Project company power marketer and its parent guarantor may be affiliated.

**May be provided by power offtaker in “tolling” (energy conversion) agreement.

Typical PFI Structure

Procuring Authority

Project Company’sShareholders

Project CompanyProject Company’s

Lenders

D&BContractor

OperatingContractor

Lender’s DirectAgreement

Loan andSecurityDocuments

Key: = contract = flow of money

Project Agreement

Conclusions

Estimated infrastructure needs exceed several hundred billion dollars

Without suitable mitigation, structural, legal, and regulatory risks may reduce flow of private capital to infrastructure projects

Governmental support central to overcoming investor concerns

Existing paradigms -- structures, documents, risks -- must be adapted to accommodate market demands

public-private partnerships: in search of a paradigm roger d. stark partner kirkpatrick &...

Documents

court slide

money slide

risk mitigation paradigms

entity project company

sponsors project entity

notary public

public authority

public sector commitments