Large Scale Public Projects

By Ilya Minevich

After our class discussion on Poland’s A2 Motorway, I thought more about other ways to arrange participants to better align interests.  A fundamental question was whether risks inherent in the 2 major project phases (construction and operation) could be compartmentalized and assigned to different principals who had a comparatively superior skill set in each stage.

The confluence of several factors we discussed in class made me think that a private entity would not be the desired owner during construction. First, uncertainty about the revenue streams in the operational stage created a lot of upfront risk for the equity owner and also affected the amount that commercial banks could initially lend for construction.  Second, project cash flows were also interdependent with unpredictable macroeconomic and political risks.  Finally, there was a long construction period prior to any cash flows. With these factors in mind, AWSA no doubt priced in a much higher return in its bidding to try to create more buffer for risks that it largely couldn’t control.

To be clear, I’m not suggesting that private entities are never right to undertake large scale public projects.  A quick comparison to energy project construction illustrates how projects regularly get built by private entities.  With a shorter construction time and also increasing salvage value during construction, an energy project allows private entities to get favorable terms from commercial banks which consider the loan on an asset basis rather than relying on far in the future cash flows as potential collateral for sizing the debt amount.

These observations lead me to consider the possibility of government ownership during the construction phase.  With the Polish government aligned with EU on this as a model public goods project benefiting trade in neighboring countries, a low interest rate loan from an EU program should be a less expensive financing source which should also largely limit the upfront contribution by the Polish government.  After construction and one year of operating data, a private owner would be in a position to step in and buy the de-risked project at a reasonable yield.  In the operations phase, a private entity will be much more efficient at generating maximum revenue while dealing with risks that it can control such as maintenance of the roads and determining price elasticity for figuring out the right toll price.  Furthermore, by selling a concession for the operation of the project, the initial government funds can be recycled to build out the other phases without need of further capital.  Or if the model reaches a level of standardization, the financial structure could revert to the one in the case in order to be able to build the different phases simultaneously.

For projects of this type, that have several phases to them and are located in countries that don’t yet have the experience of having done these in the past, the model could be set up as: build – transfer to private to recoup capital and learn best practices for operation – and then own after concession is over.

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One thought on “Large Scale Public Projects

  1. Ilya – thank you for this thought provoking piece. I couldn’t agree more that we need to compartmentalize different phases of these complex projects and assign ownership of these phases to parties best able to bear those risks. However, I am skeptical about Government being the best party able to handle the construction phase, due to the following three reasons:
    1. A number of governments are fiscally constrained, hence raising upfront capital for building some of these projects might be a tough ask. (High Speed Rail Phase II in the UK is expected to cost more than £30 billion).
    2. Government bureaucracies’ incentives are not aligned with delivering the project on time and under cost (Boston’s Big Dig being a prime example):
    a. Under PPP models strict liquidated damages and bonuses for timely completion incentivize private parties to construct the project on time; and
    b. Cost-overruns are borne by the private investors.
    3. It might be politically unfeasible to sell operating assets to concessionaires (e.g. opposition to proposed concession of Penn Turnpike).
    I would instead propose a model similar to that being used in the tech industry. There is a class of investors willing to take on risks associated with construction phase for additional return (akin to VCs in tech) and post construction these investors exit the concession by sale to investors looking for a steady revenue stream (akin to institutional investors looking for dividend yield). A simple calculation might be helpful here. Assume a project costs $100 (no inflation); construction period 2 years; concession is for 20 years and has regulated returns with 8% Project IRR. During construction, an investor is able to raise 75% debt at 6% interest. After one year of operations, he is able to sell the project to an investor looking for 12% IRR on his investment and is able to refinance this safer operating asset at 80% debt with 4% interest. Based on my calculation, the construction phase investor would earn a 30% IRR on his exit three years into the investment (happy to share my calculations in detail). This seems like a pretty attractive return for investors comfortable with taking on greenfield risk.
    I believe that this is exactly the model that is beginning to emerge in this space. A class of investors (pioneered by the big Canadian pension plans) has emerged that invest in operating assets. On the other hand another class of investors is emerging that are willing to take on greenfield projects for additional return.

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