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Public-Private Partnerships: In Search of a Paradigm Roger D. Stark Partner Kirkpatrick & Lockhart Nicholson Graham LLP (202) 778-9435

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Presentation on theme: "Public-Private Partnerships: In Search of a Paradigm Roger D. Stark Partner Kirkpatrick & Lockhart Nicholson Graham LLP (202) 778-9435"— Presentation transcript:

1 Public-Private Partnerships: In Search of a Paradigm Roger D. Stark Partner Kirkpatrick & Lockhart Nicholson Graham LLP (202) 778-9435 rstark@klng.com

2 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 2 Introduction Is financing predicated on credit capability or revenue reliability of P3 deals? Tax structuring plays a central role in U.S. transactions/requires customized analysis to preserve tax-exempt finance Successful P3s are an amalgam of structures and disciplines WANTED: transactional paradigms

3 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 3 Summary of Presentation Recent Developments Structural Paradigms Risk Mitigation/Document Paradigms The Role of Government Indicative Structures Conclusions

4 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 4 What are P3s? Public-private partnerships (P3s) : Combine private sector capital with public sector commitments (and, sometimes, capital) Procure plant and equipment, improve public services and/or improve the management of public sector assets Focus on public service results, and thereby offer a more cost-effective approach to public sector risk management

5 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 5 Recent Developments (old news) Increased Budget Constraints at the Federal, State and local level Mistrust of merchant projects/market projections Degradation of municipal credit quality Heightened attention to regulatory and political risks

6 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 6 Structural Paradigms

7 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 7 Municipal Finance General Obligation Municipal Bonds (tax exempt, indenture trustee) Lease Purchase Certificates of Participation non-appropriation risk or essential services?

8 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 8 Project Finance Firm, long-term revenues Mitigation of market and regulatory risks Fixed price, on-time, at-spec EPC to mitigate construction risks O&M Agreement to mitigate operating risks

9 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 9 Privatization Models Concession of public services Build/Own/Transfer Sale/Leaseback Contracting Out

10 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 10 Private Finance Initiative (PFI) Project Company/OpCo/D&B Contractor Project Agreement defines construction/operation results and pushes various commercial and financial risks down to private sector participants 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/ProcurementAndProposals/PublicPrivatePa rtnership/PrivateFinanceInitiative/fs/en

11 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 11 Transaction Risk Matrix Allocation of Project Risks/Burdens Financial StructureDevelopmentConstructionFinancingPermittingProject Operation Municipal FinanceGC Entity Project FinanceSponsorsEPC contractor, project entity, sponsors Project entity and sponsors Sponsors, EPC Contractor O&M contractor, project entity, sponsors PrivatizationTransaction Specific PFIProject Company Design/Build Contractor Project CompanyProject Company, Design/Build Contractor Project Company GC Entity= Government controlled entity Project Company= Privately controlled entity

12 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 12 Risk Mitigation Paradigms

13 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 13 Risk Mitigation (Lender Goals) Mitigation of Construction Risk Reliable cash flow/credit quality -- non-appropriation risk? Mitigation of market risk Mitigation of political risk -- essential service? Bilateral contracts that integrate market requirements and mitigate market risks

14 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 14 Risk Mitigation (Documentary Paradigms) Off-take Agreements Service Contracts -- aka Project Agreements Concession Agreements Construction (EPC/Design Build) and O&M Agreements Credit Facility Documentation -- renting money

15 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 15 Determine Available Alternatives for Creating Security Interests What legal structures are available under local/foreign law for creating interests in property? (Assignments/trusts/pledges) Formalities of Execution (public vs. private instruments, recording requirements) Compliance with local law formalities will affect enforceability and determine priority in bankruptcy Understand Enforcement Mechanisms Public Sale Requirement (before Notary Public or Court)

16 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 16 Contract Rights (indicative) FORM OF SECURITY STRUCTURECREATIONPERFECTION 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)) Public deed or private agreement Present assignment vs. assignment effective (but subject to a suspensive condition) 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) Counterpartys consent may be expressly required for assignment Trust: 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) Public deed or, in a few jurisdictions (e.g., Costa Rica), private agreement Generally, notice to counterparty required Pledge: - of Economic Rights (e.g., El Salvador) - of rights of use and leasing (e.g., Costa Rica) 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)

17 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 17 Stock (indicative) FORM OF SECURITY STRUCTURECREATIONPERFECTION Pledge of Shares 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) 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 companys 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 issuers records may be required (e.g., Costa Rica)

18 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 18 Real Property (indicative) FORM OF SECURITY STRUCTURECREATIONPERFECTION Mortgage (Hipoteca de Bienes Inmuebles) Variants: -Antichresis (i.e., mortgage interest in rents and proceeds of real property) (available in Panama) -Pledge of rights of possession (available in Guatemala) 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 Recording with applicable registries Trust Contribution of real property by owner to trust in favor of a third party (e.g., lender) Public deed of transfer to trustee Recording with applicable registries Mortgage Bonds (Cédulas Hipotecarias) (available in Costa Rica) Public deed. Can only be granted if no mortgage has been previously filed in same property Recording required

19 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 19 Movable Personal Property (indicative) FORM OF SECURITY STRUCTURECREATIONPERFECTION Pledge 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) Importance of formalities in execution (in some countries must be same as underlying contract) 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. Express acceptance of pledge by lender sometimes required (e.g., Guatemala) Pledge variants (available in Panama): - Mortgage (Hipoteca de Bienes Muebles) - General Pledge (Prenda General de Activos) only applicable to assets located outside Panama Public deed General pledge by public deed or private agreement legalized by notary public Recording required

20 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 20 Receivables/Project Revenues/Bank Accounts (indicative) FORM OF SECURITY STRUCTURECREATIONPERFECTION Assignment (e.g., of right to receive payments under a contract (Cesión de Crédito)) Public deed or private agreement Present assignment vs. assignment effective (but subject to a suspensive condition) 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 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) Public deed or private agreement Transfer of title to bank account(s) to pledgee or third party depositor may be required Trust Contribution of bank account(s) by owner to a trust for the benefit of a third party (e.g., lender) Execution of trust agreement (between the owner and the collateral trustee) pursuant to a public deed, with lender holding beneficial interests 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 Pledge of all assets (Prenda de Compañía) (available in El Salvador) Public deed Recording required

21 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 21 Transactional Issues

22 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 22 Transactional Issues – Documentary Paradigms PPAs Fuel Supply Agreements EPCs

23 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 23 Power Purchase Agreement (PPA)

24 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 24 Goals Reliable cash flow Mitigation of market risk Integration of bilateral contract arrangements with the requirements of wholesale market

25 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 25 Key Contract Provisions Term: the term should be as long as tenor of debt financing, plus additional time to permit recovery of force majeure losses; 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);

26 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 26 Key Contract Provisions (contd) 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

27 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 27 Key Contract Provisions (contd) Force Majeure Events: available to fuel suppliers also must be available to Owner under PPA (note civil code issues); Events of Default: Standard of service typically based on 100% availability of the projects committed capacity to the System Operator; Seller defaults should incorporate appropriate cover options and cure periods; avoid non- curable defaults by agreeing upon suitable economic or operational remedies.

28 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 28 Other Material Provisions Operations & Maintenance Billing & Payment Liability/Indemnification Changes in Law

29 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 29 Fuel Supply Agreements

30 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 30 Fuel Supply Contract Basic Goal Key Contract Provisions Other Material Provisions Regulation

31 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 31 Objectives of Contract Reliable supply of fuel Reliable pricing to realize pro forma economic objectives Avoid/mitigate commercial/regulatory risks

32 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 32 Key Contract Provisions Quantity Character of Service Point of Delivery Price Take-or-Pay Term

33 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 33 Quantity Keyed to projected PPA/system dispatch requirements Pipeline fuel/balancing requirements must also be considered

34 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 34 Character of Service Firm, interruptible or quasi-firm Firm service typically required unless project has multi-fuel capability Portfolio considerations if multiple fuel sources contemplated

35 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 35 Point of Delivery Coordination of delivery points/receipt points in Supply and Transportation Contracts Restrict number of delivery points if various suppliers providing gas Title and risk of loss transfers from supplier to pipelines transfers from pipelines to LDCs

36 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 36 Price Risk of fuel prices causing power pricing to exceed applicable normative values Utilize indexed pricing, tracking accounts to mitigate pricing risks and (where feasible) multi-fuel arrangements

37 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 37 Take-or-Pay Significant risk for all projects subject to dispatch (i.e., not captive projects) Seek to mitigate through make-up rights and use of back-up fuels (to the extent consistent with project economics)

38 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 38 Term Financing requirements typically result in term equal to or greater than term of post- construction financing Shorter terms may be feasible if long-term pricing is likely to be out-of-market

39 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 39 Other Material Provisions Supplier Credit Conditions Precedent/ Commencement of Service Force Majeure Default and Remedies Letter of Credit from Project

40 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 40 Other Material Provisions (contd) Representations and Warranties title, quality match to equipment specifications Right to Resell Gas

41 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 41 Pipeline Transportation Service Gas Transportation Service Pipeline Tariff Peak Shaving Regulation

42 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 42 Gas Transportation Service Quantity Point of Receipt/Point of Delivery Quality Rate Balancing Scheduling

43 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 43 EPC Contracts

44 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 44 Key Contract Provisions Scope of Services Standard of Performance Payment Terms Completion and Performance of the Project Warranties

45 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 45 Scope of Services Risk Bifurcation leaves a gap between procurement and construction Combined scope of supplier (off-shore) and constructor (on- shore) provides less than full EPC scope Mitigation Parent guarantee or Coordination Agreement Coordination and integration of both scopes to ensure complete EPC coverage

46 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 46 Scope of Services (contd) Risk Change in required permits triggering change order Contractor Permits definition too narrow triggering change order Mitigation Identify potential areas where required permits may change and negotiate pre-set change order amounts Coordination and integration of both scopes to ensure complete EPC coverage

47 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 47 Standard of Performance Potential Risk Local practices and standards may differ from international standards required by debt and equity investors Mitigation Services to be performed in a workmanlike manner, in accordance with local law, applicable intl standards and prudent utility practice

48 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 48 Payment Terms Potential Risk Insufficient liquidity to complete project due to dispute; payments disproportionate to value received Mitigation 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

49 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 49 Completion & Performance of the Project Potential Risk Completion delays Mitigation Well-delineated standards for establishing project completion; liquidated delay damages keyed to interest costs on project construction debt

50 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 50 Completion & Performance of the Project (contd) Potential Risk Project fails to perform at desired levels Mitigation Testing protocols to measure project performance (e.g., output, heat rate); liquidated damages for failure to attain specified performance levels

51 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 51 Warranties Potential Risk Latent defects in design, construction not discovered until after final completion Mitigation Standard warranties (1-2 yrs) of design, matls, workmanship Suitability warranty taking into account the intended use of the project

52 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 52 Other Provisions Force Majeure Defaults and Remedies Scope Changes Insurance

53 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 53 Force Majeure Potential Risk Unforeseen events that excuse contractor performance and/or increase project costs Mitigation Events available to contractor must also be available to Owner under PPA and fuel contracts Special concerns re labor disputes Must be conformed to civil code definitions of force majeure

54 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 54 Defaults & Remedies Potential Risk Material non- performance by the contractor Mitigation Defaults should be crafted with regard to local labor and lien laws Owner remedies to include taking over the project (including all contractor work and subcontracts)

55 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 55 The Role of Government

56 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 56 Checklist for Government Support Arrangements Authorization to do Business Determinable Tax Liabilities (PILOT Agreements) Credit Support for Governmental Obligations Assistance in Obtaining Governmental Permits/Approvals Mitigation of Change of Law Risks Mitigation of Uninsurable Force Majeure Risks Priority or Parity on State- Controlled Transportation Facilities (e.g., port facilities)

57 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 57 Assistance in Obtaining Governmental Permits/Approvals Defining the Scope of Necessary Permits/Approvals/Regulatory Exemptions Government Support to Facilitate Processing of Approvals Applicability to Extensions and Renewals Combine with due diligence of procurement rules and Franchise/Concession Requirements

58 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 58 The Way Forward: Role of Government Traditional Government Financing Governmental grants/Revolving Funds/63- 20 corporations to attract private capital P3 Structures Transaction-specific innovation

59 © 2006 Kirkpatrick & Lockhart Nicholson Graham LLP. All Rights Reserved 59 Some Indicative Structures

60 Federal/State Agency Commercial Lenders Project Company Borrower Indenture/Note Purchase Agreement Loan Agreement Capital Markets Offering Lead Commercial Banks as Agents/Underwriters Syndicate of Commercial Banks Collateral Agent/ Trustee Common Agreement Loan Agreement Collateral Trust Agreement Credit Support Instrument Credit Support Entity Security Agreements: Cash Collateral Agreement Pledge Agreement Assignment Agreement Mortgage Typical Co-Financing Transaction

61 Credit Default Option Counter Party Bank Project Lender Project Company Municipal Entity BPS = Basis Points CEP = Credit Event Payment $ $ $ Services CEP Zero Fee x BPS No credit event Credit event

62 Credit Linked Note Counter Party Bank Project Lender Project Company Municipal Entity CEP = Credit Event Payment $ $ $ Services CEP Principal Interest on note No credit event Credit event Principal

63 Legal Counsel Design Engineer Investment Banker Revenue Modeler Accountants Rating Agency(ies) Interconnection/Gas Distribution Services Provider Parent Guarantor O&M Provider Sponsors Senior Lenders Term Notes -Banks -Public -Institutional Investors Bank Revolver/LC Facility - Subordinated Lenders Subcontractors Equipment and Material Suppliers EPC Contractor Parent Guarantor Warranties Performance Guarantees Typical Energy Project Financing Equity Investment Shareholders Agreement Fuel Supply Contract Fixed Price EPC Contract Offtake Agreement O&M Agreement Guarantees or Support Paying Agent Collateral Agent Funding Company Passive Equity Investors Insurers Fuel Supplier Legal Counsel Independent Engineer Power and Natural Gas Consultant Insurance Consultant Project Company Power Marketer* Power Purchaser(s) Parent Guarantor* Parent Guarantor Transmission/ Services Agreement Interconnection/ Transmission Agt** *Project company power marketer and its parent guarantor may be affiliated. **May be provided by power offtaker in tolling (energy conversion) agreement.

64 Typical PFI Structure Procuring Authority Project Companys Shareholders Project Company Project Companys Lenders D&B Contractor Operating Contractor Lenders Direct Agreement Loan and Security Documents Key: = contract = flow of money Project Agreement

65 Conclusions Estimated infrastructure needs exceed several hundred billion dollars Without suitable mitigation, structural, legal, and regulatory risks may reduce flow of private capital to infrastructure projects Governmental support central to overcoming investor concerns Existing paradigms -- structures, documents, risks -- must be adapted to accommodate market demands


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