by William G. Reinhardt, PWF editor
A month ago, the plan of finance for the Automated People Mover DBFOM project at Los Angeles International Airport was based on private activity bonds (PABs), just like 19 other large public-private partnership (P3) projects financed over the years. Alarmingly, the House version of the tax reform bill would have eliminated use of PABs as senior debt on all future P3s. The industry quickly rallied, and PABs were not eliminated in the conference bill. That victory, plus the steep reduction in the tax rate on corporate earnings, seemed to make the new tax law a big win for P3s.
Largely unnoticed by P3 developers, however, the tax bill also reduced the deductibility of net interest expense on debt from 100% to 30% of a company’s “adjusted taxable income”—Ebitda—starting Jan. 1. Moreover, starting in 2022, the law further penalizes equity in the most highly leveraged project financings by keeping the 30% deductibility rate before interest and taxes, but after depreciation and amortization expenses, which results in a much smaller number against which interest can be deducted. The change applies to “special purpose vehicles” (SPV) set up by equity investors for all past and future P3 projects and across all types of infrastructure.
“How come people didn’t wake up and have a heart attack?” says a project finance banker. “This is a big, broad issue, and banks didn’t lobby their case at all. The tax shield on debt is gone and that’s going to have a material impact.”
Who’s affected? “All types of off-balance-sheet leveraged finance. It’s a concern for solar and wind project companies,” he says, “but most of the impact will be felt on all types of infrastructure P3s, which are the most highly leveraged deals in the project finance market.”
Highly indebted companies often have a low credit rating, and therefore, pay higher interest rates. This made the 100% deductibility of interest expenses highly valuable to these companies. “But now it is getting partially gutted,” wrote Diane Vazza of S&P Global.
“I’m not sure this is what DJ Gribbin [President Trump’s infrastructure advisor] anticipated at the beginning of 2017 when the discussion in Washington focused on the need to provide tax incentives for P3s,” says a state DOT executive.
How the new tax law will play out on specific deals is still murky. In general, once the alarm was sounded, a consensus emerged that the negative effect on equity returns from the deductibility change would overwhelm the positive impact from lower corporate taxes, resulting in higher prices for P3 projects. Because they carry so much debt, availability pay P3s will take the biggest hit.
“The sky is falling on closed AP deals,” says a P3 financial advisor. That universe includes 11 road and rail projects financed in the U.S. since 2009 with about $9 billion in debt and $996 million equity committed at financial close (see chart). Three social infrastructure projects are also immediately affected—UC Merced, Long Beach Courthouse, and Long Beach Civic Center, all in California. Together, about $2.4 billion was raised to finance these projects, most of it debt.
Going forward, Plenary Group CEO Brian Budden sees other problems. “We believe that there is some uncertainty regarding the application of the new interest deductibility provision, in particular, to AP deals. If the interest deductibility limitation does apply, there would be a significantly negative impact on IRR.”
Further, he says, under the new tax bill, use of Net Operating Losses (NOL) in construction accounting is restricted to 80% of income (House bill was originally 90%), therefore accelerating cash taxes on projects. The NOL restriction applies to all projects, whether AP or otherwise.
Taken together, “The interest deductibility provision, coupled with the 80% NOL limitation, will mean projects would become cash taxable starting within the first few years,” Budden says. “It would be helpful if the Joint Committee on Taxation issued favorable guidance in their “bluebook. We understand this will be published this summer.”
Joint Tax is considering providing interim guidance related to the new tax bill this summer, but more typically produces an annual blue book covering laws passed in each new session of Congress. If it chooses that route, any new guidance on P3s from Joint Tax would appear in mid-2019.
The new tax law retains the 100% deductibility of interest payments for corporate debt held by real estate companies, and some advisors believe it may be possible to obtain legislation or guidance from Joint Tax that some, possibly all, infrastructure P3s qualify for that real estate carveout.
Further, one public advisor speculates that revenue risk highway P3s may more logically qualify for the real estate carveout than availability pay P3s because the right-of-way for tolled projects is leased from public owners, so arguably could be a real estate business. Also, revenue risk deals are less leveraged than AP projects, which is the main goal of the new tax law.
AIAI, the Association for the Improvement of American Infrastructure, is leading the legislative effort to fix the problem, either in a technical corrections bill related to the tax reform bill or in separate legislation. The small number of availability pay P3 projects and the relatively small amount of equity invested in them won’t carry much weight in Congress.
(1) The small number of P3 projects that are immediately affected means that fixing the tax problem won’t have much impact on the federal budget, and
(2) Restraining the P3 industry takes much of the leverage out of President Trump’s $1.5 trillion infrastructure program, and will generally raises the cost of large public works projects.
Without favorable guidance, tax decisions will be made on a case-by-case basis by the IRS. Each project will be different. For revenue risk P3s, for example, the three largest toll concession developers in the U.S. are foreign owned, a U.S. developer points out, and their tax impact may be different from that of U.S. companies.
Any tax impact will fall on equity, not public sponsors, says a state DOT project official on Denver’s Central 70. “There are no pass-through provisions on the Central 70 agreement to make this type of action a relief event. This expense falls to the Concessionaire (Kiewit / Meridiam).”
New P3 Models
Equity is wedded to the project finance model, and debt is the heart of that model. It may be time to consider alternatives:
Governments could increase the retainage from the 5% typically withheld on conventional projects to 20-30% for P3 projects, with the private funds paid back based on life-cycle performance over 30 years.
Governments could reduce leverage by increasing milestone payments during construction. This is already happening: to get the lifecycle benefits of a P3, the public sponsors of the Howard County courthouse in Maryland are funding 60-70% of the construction cost with AAA-rated county debt and making a large milestone payment at the completion of construction. Private debt and equity will make up the balance. “You can transfer a lot of performance risk, even with 30-40% debt,” says a P3 lawyer working on that deal.
Governments in Canada have used a “wide equity” model, which replaces all private debt with 80-85% public funding paid as progress payments. The balance is private equity paid back over the concession term starting at completion of construction.
From a 2011 presentation by Plenary’s Mike Marasco, the advantages of the wide equity model include:
- Eliminating senior lenders reduces cost of financing during construction.
- No interest or commitment fees paid during construction.
- No debt service reserve account funding (lenders typically require a six-month debt service reserve during operations).
- No upfront underwriting fees (typically in the area of 2.5% of total debt).
- Equity Investors have more “skin in the game” than in a typical DBFM.
- Wide equity projects have been financed with 15%- 20% equity, instead of the usual 8%-10% for DBFMs in Canada.
Under the current P3 model in th U.S., a project’s internal rate of return could be reduced from 12.5% to 10%, says a U.S. P3 developer. “That’s not the end of the world,” he says. But the class of investors now active in the U.S. P3 market may change, he says.
A financial advisor to governments predicts, “You will have very demotivated equity investors. Tax-exempt funds may step in and find lots of opportunities in an equity fire sale.”
Alternatively, perhaps the sky isn’t falling. A major investor in P3 projects says it is optimistic the new tax legislation will not have significant impacts. If “under certain circumstances” there are cost impacts, it says “they can be priced into future bids.” Further, any price increase “would still be significantly outweighed by the benefits P3s offer in terms of overall risk transfer, accelerated delivery, cost certainty, long-term lifecycle optimization and avoidance of deferred maintenance.”