Public-Private Partnerships: In Search of a Paradigm Roger D. Stark Partner Kirkpatrick & Lockhart Nicholson Graham LLP © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved (202) 778 -9435 rstark@klng. com
Introduction n Is financing predicated on credit capability or revenue reliability of P 3 deals? — — n Tax structuring plays a central role in U. S. transactions/requires customized analysis to preserve tax-exempt finance Successful P 3 s are an amalgam of structures and disciplines WANTED: transactional paradigms © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 2
Summary of Presentation n Recent Developments n Structural Paradigms n Risk Mitigation/Document Paradigms n The Role of Government n Indicative Structures n Conclusions © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 3
What are P 3 s? Public-private partnerships (P 3 s) : n Combine private sector capital with public sector commitments (and, sometimes, capital) n Procure plant and equipment, improve public services and/or improve the management of public sector assets n Focus on public service results, and thereby offer a more cost-effective approach to public sector risk management © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 4
Recent Developments (old news) n Increased Budget Constraints at the Federal, State and local level n Mistrust of merchant projects/market projections n Degradation of municipal credit quality n Heightened attention to regulatory and political risks © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 5
Structural Paradigms © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 6
Municipal Finance n General Obligation Municipal Bonds (tax exempt, indenture trustee) n Lease Purchase n Certificates of Participation n “non-appropriation risk” or “essential services”? © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 7
Project Finance n Firm, long-term revenues n Mitigation of market and regulatory risks n Fixed price, on-time, at-spec EPC to mitigate construction risks n O&M Agreement to mitigate operating risks © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 8
Privatization Models n Concession of public services n Build/Own/Transfer n Sale/Leaseback n “Contracting Out” © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 9
Private Finance Initiative (“PFI”) n Project Company/“Op. Co”/D&B Contractor n Project Agreement defines construction/operation results and pushes various commercial and financial risks down to private sector participants n “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/Procurement. And. Proposals/Public. Private. Pa rtnership/Private. Finance. Initiative/fs/en © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 10
Transaction Risk Matrix Allocation of Project Risks/Burdens Financial Structure Development Construction Financing Permitting Project Operation Municipal Finance 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, Design/Build Contractor Project Company GC Entity= Government controlled entity Project Company= Privately controlled entity © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 11
Risk Mitigation Paradigms © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 12
Risk Mitigation (Lender Goals) n Mitigation of Construction Risk n Reliable cash flow/credit quality --appropriation risk? n Mitigation of market risk n Mitigation of political risk -“essential service”? n Bilateral contracts that integrate market requirements and mitigate market risks © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved non 13
Risk Mitigation (Documentary Paradigms) n Off-take Agreements n Service Contracts -aka “Project Agreements” n Concession Agreements n Construction (EPC/Design Build) and O&M Agreements n Credit Facility Documentation -money” © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved “renting 14
Determine Available Alternatives for Creating Security Interests n What legal structures are available under local/foreign law for creating interests in property? − n Formalities of Execution (public vs. private instruments, recording requirements) − n (Assignments/trusts/pledges) Compliance with local law formalities will affect enforceability and determine priority in bankruptcy Understand Enforcement Mechanisms − Public Sale Requirement (before Notary Public or Court) © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 15
Contract Rights (indicative) FORM OF SECURITY STRUCTURE Trust: Public deed or private agreement 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) 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)) CREATION Present assignment vs. assignment effective (but subject to a “suspensive” condition) Counterparty’s consent may be expressly required for assignment Public deed or, in a few jurisdictions (e. g. , Costa Rica), private agreement Generally, notice to counterparty required 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) 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) Pledge: - of Economic Rights (e. g. , El Salvador) - of rights of use and leasing (e. g. , Costa Rica) © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 16
Stock (indicative) FORM OF SECURITY STRUCTURE Pledge of Shares CREATION 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) PERFECTION 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) © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 17
Real Property (indicative) FORM OF SECURITY STRUCTURE Mortgage (Hipoteca de Bienes Inmuebles) CREATION Variants: - Antichresis (i. e. , mortgage interest in rents and proceeds of real property) (available in Panama) 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 - PERFECTION Recording with applicable registries Public deed of transfer to trustee Recording with applicable registries Public deed. Can only be granted if no mortgage has been previously filed in same property Recording required Pledge of rights of possession (available in Guatemala) Trust Contribution of real property by owner to trust in favor of a third party (e. g. , lender) Mortgage Bonds (Cédulas Hipotecarias) (available in Costa Rica) © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 18
Movable Personal Property (indicative) FORM OF SECURITY STRUCTURE Pledge CREATION 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. Importance of formalities in execution (in some countries must be same as underlying contract) Express acceptance of pledge by lender sometimes required (e. g. , Guatemala) Public deed Recording required General pledge by public deed or private agreement legalized by notary public Pledge variants (available in Panama): - Mortgage (Hipoteca de Bienes Muebles) 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) PERFECTION - General Pledge (Prenda General de Activos) only applicable to assets located outside Panama © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 19
Receivables/Project Revenues/Bank Accounts (indicative) FORM OF SECURITY STRUCTURE Public deed or private agreement Assignment (e. g. , of right to receive payments under a contract (Cesión de Crédito)) CREATION Present assignment vs. assignment effective (but subject to a “suspensive” condition) Public deed or private agreement 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) Trust Contribution of bank account(s) by owner to a trust for the benefit of a third party (e. g. , lender) Pledge of all assets (Prenda de Compañía) (available in El Salvador) PERFECTION Execution of trust agreement (between the owner and the collateral trustee) pursuant to a public deed, with lender holding beneficial interests Public deed 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 Transfer of title to bank account(s) to pledgee or third party depositor may be required 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 Recording required © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 20
Transactional Issues © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 21
Transactional Issues – Documentary Paradigms n PPAs n Fuel Supply Agreements n EPCs © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 22
Power Purchase Agreement (“PPA”) © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 23
Goals n Reliable cash flow n Mitigation of market risk n Integration of bilateral contract arrangements with the requirements of wholesale market © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 24
Key Contract Provisions n Term: the term should be as long as tenor of debt financing, plus additional time to permit recovery of force majeure losses; n 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); © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 25
Key Contract Provisions (cont’d) n 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 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 26
Key Contract Provisions (cont’d) n Force Majeure Events: available to fuel suppliers also must be available to Owner under PPA (note civil code issues); n 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 noncurable defaults by agreeing upon suitable economic or operational remedies. © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 27
Other Material Provisions n Operations & Maintenance n Billing & Payment n Liability/Indemnification n Changes in Law © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 28
Fuel Supply Agreements © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 29
Fuel Supply Contract n Basic Goal n Key Contract Provisions n Other Material Provisions n Regulation © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 30
Objectives of Contract n Reliable supply of fuel n Reliable pricing to realize pro forma economic objectives n Avoid/mitigate commercial/regulatory risks © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 31
Key Contract Provisions n Quantity n Character of Service n Point of Delivery n Price n Take-or-Pay n Term © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 32
Quantity n Keyed to projected PPA/system dispatch requirements n Pipeline fuel/balancing requirements must also be considered © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 33
Character of Service n Firm, interruptible or “quasi-firm” n Firm service typically required unless project has multi-fuel capability n “Portfolio” considerations if multiple fuel sources contemplated © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 34
Point of Delivery n Coordination of delivery points/receipt points in Supply and Transportation Contracts n Restrict number of delivery points if various suppliers providing gas n Title and risk of loss — transfers from supplier to pipelines — transfers from pipelines to LDCs © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 35
Price n Risk of fuel prices causing power pricing to exceed applicable normative values n Utilize indexed pricing, tracking accounts to mitigate pricing risks and (where feasible) multi-fuel arrangements © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 36
Take-or-Pay n Significant risk for all projects subject to dispatch (i. e. , not “captive” projects) n Seek to mitigate through “make-up rights” and use of back-up fuels (to the extent consistent with project economics) © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 37
Term n Financing requirements typically result in term equal to or greater than term of postconstruction financing n Shorter terms may be feasible if long-term pricing is likely to be out-of-market © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 38
Other Material Provisions n Supplier Credit n Conditions Precedent/ Commencement of Service n Force Majeure n Default and Remedies n Letter of Credit from Project © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 39
Other Material Provisions (cont’d) n Representations and Warranties — — n title, quality match to equipment specifications Right to Resell Gas © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 40
Pipeline Transportation Service n Gas Transportation Service n Pipeline Tariff n Peak Shaving n Regulation © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 41
Gas Transportation Service n Quantity n Point of Receipt/Point of Delivery n Quality n Rate n Balancing n Scheduling © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 42
EPC Contracts © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 43
Key Contract Provisions n Scope of Services n Standard of Performance n Payment Terms n Completion and Performance of the Project n Warranties © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 44
Scope of Services Risk Mitigation n “Bifurcation” leaves a gap between procurement and construction n Combined scope of supplier (off-shore) and constructor (onshore) provides less than full EPC scope n Parent guarantee or Coordination Agreement n Coordination and integration of both scopes to ensure complete EPC coverage © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 45
Scope of Services (cont’d) Risk Mitigation n Change in required permits triggering change order n “Contractor Permits” definition too narrow triggering change order n Identify potential areas where required permits may change and negotiate pre-set change order amounts n Coordination and integration of both scopes to ensure complete EPC coverage © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 46
Standard of Performance Potential Risk n Local practices and standards may differ from international standards required by debt and equity investors Mitigation n Services to be performed in a “workmanlike” manner, in accordance with local law, applicable int’l standards and prudent utility practice © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 47
Payment Terms Potential Risk n Insufficient liquidity to complete project due to dispute; payments disproportionate to value received Mitigation n 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 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 48
Completion & Performance of the Project Potential Risk n Completion delays Mitigation n Well-delineated standards for establishing project completion; liquidated delay damages keyed to interest costs on project construction debt © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 49
Completion & Performance of the Project (cont’d) Potential Risk n Project fails to perform at desired levels Mitigation n Testing protocols to measure project performance (e. g. , output, heat rate); liquidated damages for failure to attain specified performance levels © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 50
Warranties Potential Risk n Mitigation n “Standard” warranties (1 -2 yrs) of design, mat’ls, workmanship n Latent defects in design, construction not discovered until after final completion “Suitability” warranty taking into account the intended use of the project © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 51
Other Provisions n Force Majeure n Defaults and Remedies n Scope Changes n Insurance © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 52
Force Majeure Potential Risk n Unforeseen events that excuse contractor performance and/or increase project costs Mitigation n Events available to contractor must also be available to Owner under PPA and fuel contracts n Special concerns re labor disputes n Must be conformed to civil code definitions of force majeure © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 53
Defaults & Remedies Potential Risk n Material nonperformance by the contractor Mitigation n Defaults should be crafted with regard to local labor and lien laws n Owner remedies to include taking over the project (including all contractor work and subcontracts) © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 54
The Role of Government © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 55
Checklist for Government Support Arrangements n Authorization to do Business n Determinable Tax Liabilities (“PILOT” Agreements) n Credit Support for Governmental Obligations n Assistance in Obtaining Governmental Permits/Approvals n Mitigation of Change of Law Risks n Mitigation of Uninsurable Force Majeure Risks n Priority or Parity on State. Controlled Transportation Facilities (e. g. , port facilities) © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 56
Assistance in Obtaining Governmental Permits/Approvals n Defining the Scope of Necessary Permits/Approvals/Regulatory Exemptions n Government Support to Facilitate Processing of Approvals n Applicability to Extensions and Renewals n Combine with due diligence of procurement rules and Franchise/Concession Requirements © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 57
The Way Forward: Role of Government n Traditional Government Financing n Governmental grants/Revolving Funds/“ 6320” corporations to attract private capital n P 3 Structures n Transaction-specific innovation © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 58
Some Indicative Structures © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 59
Typical Co-Financing Transaction Indenture/Note Purchase Agreement Loan Agreement Project Company Borrower Capital Markets Offering Commercial Lenders Loan Agreement Federal/State Agency Common Agreement Loan Agreement Collateral Trust Agreement Collateral Agent/ Trustee Lead Commercial Banks as Agents/Underwriters Syndicate of Commercial Banks Credit Support Instrument Security Agreements: Cash Collateral Agreement Pledge Agreement Assignment Agreement Mortgage © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 60 Credit Support Entity
Credit Default Option Fee x BPS Counter Party Bank Project Lender Zero No credit event CEP $ $ $ BPS = Basis Points Project Company Municipal Services Entity CEP = Credit Event Payment © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 61
Credit Linked Note Principal Counter Party Bank Interest on note CEP Principal Project Lender Credit event No credit event $ $ $ Project Company Municipal Services Entity CEP = Credit Event Payment © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 62
Typical Energy Project Financing Sponsors Guarantees or Support Funding Company Collateral Agent Equity Investment Shareholders Agreement Paying Agent Senior Lenders Term Notes -Banks -Public -Institutional Investors Bank Revolver/LC Facility Legal Counsel Independent Engineer Power and Natural Gas Consultant Insurance Consultant Subordinated Lenders Passive Equity Investors Parent Guarantor Warranties Performance Guarantees Insurers EPC Contractor Fuel Supply Contract Project Company Fixed Price EPC Contract Equipment and Material Suppliers Parent Guarantor Subcontractors Fuel Supplier Parent Guarantor* Parent Guarantor Power Marketer* Power Purchaser(s) Legal Counsel Interconnection/Gas Distribution Services Provider Design Engineer Investment Banker Revenue Modeler O&M Provider O&M Agreement Accountants Offtake Agreement Rating Agency(ies) Interconnection/ Transmission Ag’t** *Project company power marketer© 2006 parent guarantor may be Nicholson Graham LLP. All Rights Reserved and its Kirkpatrick & Lockhart affiliated. 63 **May be provided by power offtaker in “tolling” (energy conversion) agreement. Transmission/ Services Agreement
Typical PFI Structure Lender’s Direct Agreement Procuring Authority Project Agreement Project Company’s Shareholders Project Company Loan and Security Documents Project Company’s Lenders Operating Contractor D&B Contractor Key: = contract = flow of money © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 64
Conclusions n Estimated infrastructure needs exceed several hundred billion dollars n Without suitable mitigation, structural, legal, and regulatory risks may reduce flow of private capital to infrastructure projects n Governmental support central to overcoming investor concerns n Existing paradigms -- structures, documents, risks -must be adapted to accommodate market demands © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 65
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