Balfour Beatty Fires First Salvo In U.S. Infrastructure Consolidation

Balfour Beatty PLC’s acquisition of U.S.-based privately owned Parsons Brinckerhoff Inc. could well mark the beginning of a signifiant consolidation of the evolving U.S. infrastructure delivery landscape. Indeed, with the U.S. market for infrastructure experiencing fundamental shifts on the buy-side as state and municipal governments look to change the way they procure everything from highways to schools, it seems a good time to consider last month’s merger in the context of what will be needed in the U.S. in an age of increasingly scarce public sector resources.

Balfour Beatty, already the largest construction and engineering concern operating in infrastructure in the U.K. and one of the top three in PPP investments, knows what it is doing in both areas. An early and significant participant in major U.K PFI projects, BB has built up one of the most successful track records in the delivery of PFI projects and one of the largest portfolios of investments in the sector in the U.K.

The company has also been steadily building up its U.S. infrastructure activities in rail transport and military accommodation, most recently with the acquisition in April 2008 of GMH Military Housing for $350 million. But the acquisition of Parsons Brinckerhoff for $626 million puts BB into a whole new league, positioning it to challenge the biggest players in the U.S. just as budget pressures are forcing states and municipalities to turn to the private sector to fund, deliver, operate and maintain infrastructure.

It’s increasingly obvious that governments at all levels in the U.S. will need to ramp up their use of alternative long-term financing to get big infrastructure projects off the ground, particularly in transportation. There are some 27 states that have enabled the use of PPP as a means for delivering infrastructure assets, with Arizona and Massachusetts becoming the latest two to enact state legislation – and that was just over the summer. The speed with which PPP is moving to the forefront of state and municipal thinking now is an important, if little noticed trend in the U.S. market for infrastructure, especially considering that a framework for the use of PPP in the U.S. was first put in place as far back as 1995.

PPP is a model for infrastructure procurement that involves public authorities selecting through a competitive tendering process a consortium of private sector developers and their financial backers for the design, delivery, operation and maintenance of a public asset. In return for the providing the financing necessary to build or restore the asset, the private consortium earns the right to recoup its investment and earn a share of long-term revenue through the charging of tolls or from tax revenue for its operation. It has been in use in the UK since 1992, and has seen increasing acceptance in countries in Europe, Canada, Africa, Asia and Australia.

One clear area where businesses operating in public sector contracting in the U.S. need to adjust their models is to accommodate a market where PPP plays a significant, if not dominant role in the delivery and long-term management of public infrastructure. Among the new skills that these companies will need to develop will be to manage the life-cycle demands of contracts that will typically run 30 years or longer. It is a challenge to do without greatly expanding the size of a business, though developing or acquiring those services can be very rewarding because the work produces steady and reliable revenue flows that help to reduce the notorious boom-and-bust cycle of traditional contracting work.

What BB has successfully achieved in its home market, and what the Parsons Brinckerhoff acquisition moves it towards achieving in the U.S. (and to a significant extent in other nascent markets for PPP around the world) is to give the combined company both critical mass and a leading position among the relative handful of active project management service providers in the U.S. that can offer the full range of skills that are needed to build, operate and maintain these big projects throughout their life-cycle. In particular, Parsons Brinckerhoff brings its own extensive experience with alternative financing learned from international activities, which should make for a healthy cultural fit with BB as they work to grow the business in the U.S. But it also brings excellent, well-established long-term relationships with public authorities and people in policy-making positions. This strength is not to be ignored in a country where foreign company motives are continually viewed with suspicion, and where their participation in large projects can lead to unpredictable and unfortunate outcomes. (Consider the furore over the Trans-Texas Corridor and failed effort to lease the Pennsylvania Turnpike)

Besides helping to quell suspicions of foreigner intentions, Parsons Brinckerhoff brings to Balfour Beatty a particular strength in U.S. domestic transportation infrastructure development that could prove decisive to winning much of the coming wave of projects that go to tender. It brings not only experience, and an operating margin that is roughly twice that of its acquirer, but size to a business where size really matters. Unlike the U.K., distances in the U.S. tend to be much larger, so that questions about the capabilities of bidding consortia are never far from the minds of decision-makers. The combined business takes BB’s U.S. revenue base to 32% from 29% immediately and significantly towards its goal of a 40% U.S., 40% U.K. balance, and towards taking the perception of dependency on U.K. sources off the table once and for all.

From a business diversification perspective as well, the acquisition makes great sense for BB, which faces not so much the risk, as the certainty of seeing its U.K. public sector project pipeline shrink. This is due in part to public spending cuts, but also to the reality that government spending on big PFI projects in healthcare and transportation are now moving towards completion. Indeed, with 50% of BB’s current group earnings coming from the public sector, and 25% linked to U.K. public sector work, a move to diversify geographically would appear to be well-timed.

The overwhelming enthusiasm that has greeted the Balfour-Parsons deal should logically lead one to ask who might be next to go. The question has special relevance now, while the weak dollar would seem to favor companies making a play out of Europe or Australia. Parsons Brinckerhoff occupies a fairly special place in the firmament of leading U.S. project management service providers, but there are others. There are publicly traded companies in the sector with international expertise, but these are generally of a size that would make them too big to swallow. However, the shifting landscape of procurement in America could shake up thinking at Fluor Corp., KBR Inc, and Jacobs Engineering Group Inc. And it certainly will cause companies with similar profiles to Parsons Brinckerhoff to consider their future as part of something larger. With eight times 2008 earnings the new standard by which they might expect their businesses to be valued, it seems likely there will be more tie-ups of the Parsons Brinckerhoff variety in the very near future.

Arizona Wrestles With its Fiscal Gremlins

By Henry Teitelbaum

State budget problems are a fact of life across America these days. In this regard, Arizona is no different than California, Michigan or Florida, to name just  a few. It’s all just a matter of degree. But what tests the mettle of a state government most in times of fiscal stress is how creatively they go about addressing the  budget shortfalls that accompany these downturns.

For Arizona, the government response has been decidedly mixed. In one month, the state governor signed well-considered  legislation that could set the standard for the nation in planning for the development and long-term care of essential assets.  But little more than a month later,  the governor hastily approved a ruinous short-term response to the fiscal crisis that runs totally against any concept of good governance, while virtually guaranteeing that the budget crisis weighs on state finances for years to come.

In July Governor Jan Brewer in July signed into law HB 2396, a bill granting the state contractual authority to enter into virtually any project delivery arrangement with private developers and their financial backers  As a result, the state will have the flexibility to choose the best model for procuring all future infrastructure assets from among a wide range of options. These include public-private partnership models that vary from granting concessions on existing assets to innovative DBFO, DBFOM, and other arrangements that ensure the selection of the most efficient long-term financing solutions while also addressing the need to repair and maintain public assets over their life-cycle. Critically at a time of economic stress and budgetary shortfalls, the government has gained the right to do procurement deals that engage private financing resources now, when they are needed most, and on terms that will ensure that repayment can be managed to coincide with a recovery in the the state’s finances as the economy recovers.

What’s more, the bill allows Arizona to introduce innovative solutions that clear away many of the issues that have hobbled PPP in other states, such as the past relinquishment of eminent domain rights over property needed for new development, concerns over “double-taxation” on existing roads, and non-compete agreements with existing privately developed roads.

But no sooner has the ink dried on this piece of innovative legislation than the state sets forth plans to sell and then lease back up to 32 properties, including state capitol buildings, on highly disadvantageous terms, to try to close a $3 billion budget deficit. Governor Brewer, who signed the bill allowing the sale of state buildings on Sept. 3, still has to decide what to sell and lease back, but it already looks like he has sent up the white flag, and is willing to surrender the  keys to the state capitol to anyone with $735 million in cash to spare and a desire to double that sum over 20 years, (with no risk to principal and no responsibility for anything, not even  repairs and maintenance for the buildings in question).

It wouldn’t be so galling that the government is being short-sighted with future taxpayer revenue if the sale/leaseback deal wasn’t being done for assets already purchased with taxpayer money. The fact that maintenance of the increasingly dilapidated assets will still have to come from public coffers, while the state pays $60,000 a month in rent  only  adds insult to the taxpayers who will have to foot the bill.

It’s a study in contrasts when one takes the time to craft intelligent PPP legislation to safeguard and respect taxpayer interests over the long-term, only to blow it on silly short-term giveaways that waste their money, invite abuse, and undermine the state’s long-term interests. Just don’t blame the private sector for what happens next.

P3 Investment Model Ensures Market Stability Where Regulation Can’t

It is by now broadly acknowledged, even by market regulators, that signals were ignored or misunderstood about the nature of the systemic risks that were mounting due to the unfettered sale of toxic investment instruments. But the remedies that are so far attracting the most attention in trying to restore stability; tightening up risk procedures at banks, shifting OTC derivatives onto multilateral clearing facilities, and improving accounting for off-balance sheet investment vehicles, suggest they still don’t appreciate the full nature of the problem.

In particular, they need to examine the buy-side conditions that led to such explosive growth in markets for these inherently dangerous engineered financial tools. If they did so, they would quickly find that among the fundamental pre-conditions for the crisis was a chronic structural shortage of liquid, high-yielding, and widely available assets for long-term investors.

For more than 10 years, while interest rates and government bond yields remained at historically low levels, easy credit terms allowed mortgage borrowing to expand to unprecedented levels. In the near absence of  safe, high-yielding alternative investments, mortgage-backed securities and then the newly engineered CDOs became almost the default investment for banks, insurers, hedge funds and others in search of yield. It is to a large extent because investors could find no safer, higher quality long-term assets to buy that the market for these instruments became so large, so quickly.

Going forward, regulating markets will certainly have a role to play, but what financial markets and society need even more to restore stability is a wider choice of liquid long-term investments, particularly ones that encourage and reward value creation, rather than just those that cater to opportunist instincts. Indeed, if alternative investments had been identified and made available to investors during the early stages of the credit boom, the same low interest rates that lured investors into the real estate bubble might have drawn some of that money into financing alternative energy projects, rebuilding highways and bridges or other more stable, long-term assets.

And it’s by no means clear that markets are yet structuring the kinds of assets that will attract that investment in the future. There are funds that make equity investments in infrastructure projects, and these are increasingly widespread. But the amount of equity available to date in these projects is far too little to meet the demands of large pension funds, life insurers, university endowments and other institutions with long-term Liability-Driven Investment (LDI) needs. Nor has infrastructure equity, particularly through the recent equity market decline, demonstrated any of the presumed non-correlated performance that many were expecting.

Elsewhere, prospects for creating investable assets for these institutions are no better.  In the U.S., for example, neither federal, nor state, nor municipal authorities can any longer be relied upon to develop public assets on a scale that they did in previous decades. The federal deficit is over 12% of GDP and rising after the bailouts and stimulus program, while the municipal bond market, traditionally a key source of infrastructure financing, is under scrutiny as never before as states absorb the impact of job losses and a collapsed housing market. It’s not by accident that Moody’s Investor Service has warned that municipal credits face their first-ever across-the-board downgrade following the credit crisis.

From a long-term investor perspective, this has deep meaning. In a world already short of investable opportunities for pension fund investment, it’s hard to see how muni bonds, the new Build America Bond program or any other government-sponsored investment vehicle can be relied upon to supply the size of issuance that is needed to keep them invested. Considering the already diminished capacity for borrowing that states face for years to come, can municipal bond issuance even begin to cover a nationwide infrastructure deficit that the American Society of Civil Engineers recently revised upward to $2.2 trillion?

It is here where I see a singular opportunity for investors in a market for the delivery of public infrastructure through public-private partnerships. PPP, or P3, involves the public tendering of the design, delivery, operation and maintenance of public infrastructure over the long- to very long-term through the use of private sector investment, expertise and risk management. By its very structure, it involves long-term commitments from all sides; on the part of the private sector partner for the initial financing, operation and maintenance of the assets, and on the part of the public sector partner for the repayment of the initial investment, plus interest. The model, which has been used successfully for more than 15 years in the U.K. and is being rolled out in nations around the world, has a proven track record of delivering projects on-time and on- budget. Moreover, the experiences of governments with the P3 model at all levels are extensively and publicly documented.

P3 creates investable assets of a size and credit quality that can be sufficient to meet the long-term structural investment needs of many institutions. The debt of such assets is not only secured by highly reliable cash flows linked either to the asset’s use or directly to the government’s tax revenue, it tends to be indexed to the rate of inflation, which allows pension funds to more easily match their long-term  commitments to providing for people’s retirement needs.  That’s true as well for life insurers and other institutions with LDI requirements.

But a program of P3 investment does more than just incentivize long-term investment from pension funds. Construction companies and their sub-contractors, who build or maintain P3 assets, themselves become invested in the long-term success of projects, whether through the flow of maintenance work that they are eligible to win, or through a share of equity in the project. Increasingly, contractors are looking to mandate renewals and equity investments to produce the long-term revenue streams that help smooth the notoriously cyclical construction business. Whether its cleaner healthcare facilities, well-functioning schools facilities, or safer, well-maintained roads, they too are incentivized to think long term and to work towards delivering the best outcomes for the people they serve. Other private sector participants in P3 projects are drawn towards a long-term view of the service they deliver, whether its in facility maintenance or risk management.

Not to be overlooked in this virtuous circle of long-term investment are the many benefits of P3  to the public sector, which has often been forced by what might be called the “tyranny of the ballot box” into taking too short-term an approach to its long-term investments. We have all seen or read about projects that came in way over budget or were never delivered; where the investment was too much or too little, or the asset that was built was unusable. Too often, this is the result of inadequate planning. In today’s political reality, if public money isn’t spent soon after it’s been budgeted, there are other administrative bodies that will be all too happy to have it reallocated to their own departments.

Through P3, public servants can instead of hastily using public money just to have control over it or procure assets mainly with a view to the next election cycle, choose the best solution from among a variety of design proposals and project delivery partners. P3 takes  the risks of under-delivery, late delivery or spiraling costs off the public sector’s hands and places them with private sector partners, who are better able and better incentivized to manage and mitigate them.

In the wake of the worst financial disaster since the Great Depression, public sector authorities can no longer afford business as usual. Public sector unions need to understand this. After stimulus spending programs run their course, there will be little in the way of major public sector contracting work available for years to come as governments at all levels rebuild their balance sheets. Unions need to adapt to the changes that are underway in the market for their skills, or risk becoming irrelevant. The jobs created through P3 programs will require the trade skills of every unionized public employee that transfers to the private sector and a whole lot more. Public sector authorities and private sector contractors must do everything in their power to encourage broad acceptance of the P3 model, whether it is by guaranteeing public sector pensions, providing work guarantees or offering membership in private sector trade unions. Public sector pension funds can also play a role in encouraging participation in delivering P3 projects by investing directly in the equity and debt generated through the financing of P3. This would link a portion of their union members’ retirement benefits to the performance of the assets they help to build – yet another way to incentivize long-term oriented behavior.

One way or another, innovative solutions need to be found for all aspects of the way our markets operate, and government has a responsibility to set an example by incentivizing long-term investment and the creation of long-term asset management solutions.

P3 is  a model that mobilizes the private sector to play a larger and increasingly indispensable role in financing, delivering and maintaining  the public infrastructure that will be needed for all of society to function and thrive.

(This article appeared in American Banker and Global Pensions magazine, October 2009)