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)