I recently had a conversation with Edgemoor’s Neal Fleming to get his views on the state of public-private partnerships (PPP) in the U.S. and the lessons Edgemoor has learned in its own PPP projects. Mr. Fleming is a Principal of Edgemoor and provides executive leadership for all of Edgemoor’s pursuits. With more than 35 years of experience in construction and real estate development, he began his career at The George Hyman Construction Company and was a founding member of OMNI Construction, which later merged to form The Clark Construction Group, Inc.
Until recently, a government agency in the United States that wanted to build public infrastructure—for example, a university building, courthouse or road—had only one project-delivery choice. Federal, state and local public contracting laws mandated a slow, cumbersome and often arcane process involving innumerable detailed steps and rigid requirements for each step. This traditional “design-bid-build” process required the agency first to complete its design and engineering (often involving a separate process of RFPs, bidding and award approval) to a degree of completion adequate to allow competing contractors to bid on fixed-price construction contracts (again pursuant to a lengthy process of RFPs, bidding and award approval).
Not only has this process led to inefficiency, delays and high costs, it also is not uncommon for public facilities to suffer from deferred maintenance and substandard operating performance due to reduced appropriations.
In recent years, the Federal government and many states have enacted statutes that, to varying degrees, allow departures from the traditional design-bid-build process and allow public agencies to utilize the more collaborative and streamlined “design-build” approach, where a single private entity provides unified design, engineering and construction services, and, in some cases, also provides financing for the project and/or facility maintenance and operation services through a long-term lease.
This movement toward government collaboration with the private sector in delivering and operating public facilities has given rise to the “public-private partnership” (often referred to as PPP or P3) phenomenon. One private company that has been at the leading edge of the PPP wave in developing government buildings and other public infrastructure is Pillsbury client Edgemoor Real Estate Services, an affiliate of Clark Construction Group, LLC, of Bethesda, Maryland. Pillsbury worked with Edgemoor on two PPPs recently: the University of California-San Francisco Neurosciences Building and the Governor George Deukmejian Courthouse in Long Beach, CA.
Defining PPP and the Risk Spectrum
SNYDER: Neal, thanks for making time to join me. From your point of view, what is a “public-private partnership”?
FLEMING: Many people say the term “public-private partnership” only applies to performance-based or availability-based infrastructure projects, following the Canadian model. However, I disagree. A public-private partnership exists any time the public sector and the private sector join in a collaborative effort to get a project done outside the usual design-bid-build process. So I would call a government design-build project in its finest form a kind of public-private partnership because, obviously, a design-build project has to be very collaborative and the government body has to place a lot of trust in you.
SNYDER: Don’t PPPs require the private party to invest or have attributes of ownership, even if it’s just taking some of the risks that usually go with ownership?
FLEMING: While some PPP structures have private financing or ownership of the asset, it is not a requirement. Private investment is only one aspect of PPP, and, more often than not, the best solution does not include private financing. Regarding risk, frequently the public entity goes after a PPP thinking it will shift all of the risk to the private sector, but that rarely ends up happening. There are varying levels of risk that the private partner can take on. First, you have design-build, which is at the low end of risk for the private side. The next would be design-build-operate with government financing, where the private party develops the project and operates it for a term, but the project is ultimately financed with a public financing structure. The UCSF project falls into this category. We analyzed multiple structures—including private financing—but determined in the end that public financing through a non-profit entity was the most cost-effective solution for our client. Frequently, the public entities start out thinking the deals will use private financing, but, when you start analyzing the numbers, it’s hard to beat tax-exempt financing. The notion that the private party comes with the money is not always the case; it comes with tons of risk—risk of delivery, risk of performance—but not necessarily the financing risk.
The notion that the private party comes with the money is not always the case; it comes with tons of risk—risk of delivery, risk of performance—but not necessarily the financing risk.
The Long Beach courthouse deal was a design-build-operate-private finance deal, the next type on the risk spectrum. That deal was a “performance-based” or “availability-based” lease, as in the Canadian model. The private party guarantees not only on-time delivery of the project at a fixed price, but guarantees the project’s availability and performance to agreed standards over the term of the lease. If the project is late, the private party pays a penalty, and, if certain performance criteria aren’t met, the rent is partially or wholly withheld. This model is the riskiest form of PPP for the private party and the least risky for the public side.
There are other structures you could call “public-private partnerships,” including complete privatization of a government facility or long-term leases of government property for non-governmental use. But the three main categories are design-build, design-build-operate-government finance, and design-build-operate-private finance.
Benefits to the Public Agency
SNYDER: Why do government agencies want to do public-private partnerships? What’s in it for them?
FLEMING: What we hear over and over again is, number one, it allows them to fix their costs early, and that is clearly a benefit. The bidders on a design-build project have the conceptual plans and some degree of specifications, and they bid on the design, engineering and construction of the project up front. So the public agency can lock in its costs many months, maybe years, before it could have under the old design-bid-build scenario.
Another benefit is having a single point of responsibility: if you have one private entity designing, building and operating the facility, there’s no finger-pointing. And then there’s the Long Beach courthouse rationale: that agencies often have difficulty maintaining capital assets over the long-term, but in a performance-based social infrastructure deal, such as the courthouse, the private sector is incentivized to maintain that building 30 years from now with the same degree of quality it has on the day it delivers it.
As budgets are cut, the first thing that’s cut is maintenance budgets on buildings, roads, etc. So one of their motivations is to lock in a high level of maintenance over the term of the lease. That assures they get a far better building over the life of the lease than if they were to maintain it themselves. And that includes capital equipment replacement and capital expenditures, whether it’s a new roof, new chillers, all of that is included in the pricing on the Long Beach courthouse deal.
Time and cost go hand in hand, so they’re very motivated to overlap activities at the private sector’s risk to ensure that things are done timely.
One other big benefit of public-private partnerships: time. You know, if you do things in the traditional way that governments procure things, first it’s land acquisition and then it’s program development, then you put out a solicitation for architects and you get those in, and you pick an architect, and you do design, and after the design is complete you get the permits, and after the permits are complete you solicit for a contractor. It’s all very linear. And it’s so linear that it can take three years from concept to completion of design and solicitation of proposal, whereas we’re doing it in six months. In six months, we’re basically doing a preliminary design and we’re taking the risk for everything else and on all the other steps we’re going to overlap. Time and cost go hand in hand, so they’re very motivated to overlap activities at the private sector’s risk to ensure that things are done timely.
Assessing the Likelihood of Success of a PPP
SNYDER: What do you look for when you evaluate a potential public-private partnership?
FLEMING: Everybody wants to look at this as a magic pill—public-private partnerships can make something happen that otherwise government couldn’t do. And so we see a lot of solicitations that agencies put out there that aren’t going anywhere, but people are going to spend a lot of money and time on them. So the criterion we look at, first and foremost, is does the procuring agency have legal authority to do a public-private partnership. There are instances where states have put out solicitations for public-private partnerships, and, after firms spend a lot of money responding to them, the procuring agency says, “you know, we really haven’t passed the legislation yet.”
The second thing we look at is, regardless of how important somebody says the project is to them, is there a strong market need for that facility? Whether it’s a jail, a courthouse, a university building—is there truly a strong market need? If there is no strong market need we think that there’s a better than 50-50 chance of the project being delayed or abandoned. The third key criterion—is there a passionate political champion pushing this thing forward? The UCSF project could have died because its passionate political champion retired. Then the leadership of the new chancellor combined with the passion of a lot of important scientists pushed the deal forward. You want to have the governor support it, you want to have the legislature support it, you want to have all those things, but really there has to be one key person that says, “I’m going to make sure this is going to happen.”
SNYDER: Do you think the “Canadian model” of performance-based infrastructure projects is catching on in the U.S.? FLEMING: In a traditional U.S. lease, you rent your space and if the electricity goes out, or if the space is not cleaned, it doesn’t matter. You still pay rent. You write a letter that you’re angry, but you still have to pay rent. In an availability lease, which is this PPP model out of Canada, once the building is complete and the private party is operating it, if there’s a performance problem—if the temperature isn’t within two degrees of what it’s supposed to be, if there’s graffiti on the bathroom walls, if the security system malfunctions, there’s a whole long list of things—if any of those occur, they don’t pay rent or the rent is reduced.
SNYDER: In the U.S., where lenders are used to leases with no right to abate rent, that kind of deal would be tough to finance.
FLEMING: That is the main issue. U.S. banks, when they look at financing a lease deal, they say, “Well, it’s hell or high water and you’ve got to pay rent.” If I’m a European bank—and there were five or six of them on the Long Beach deal—they looked at us and said, “Look, the risks in this deal of the design-builder not performing, those have to go to the design-builder, and the design-builder has to have enough skin in the game to guarantee performance or pay penalties, liquidated damages.” When we get the building up and operating, they look to the operator to have enough skin in the game to guarantee performance, and the operator has a contract that says if any of those events occur, they will be responsible for loss of rent. So the lenders get to a hell-or-high-water level of comfort by a combination of factors; it’s not just the government lease, but it’s the financial strength of the design-builder and of the operator. Ultimately I think that everybody will figure out a way to do it, but right now it’s just so different from how they’ve financed deals in the past that the financing for performance-based deals is coming from European banks right now.
Our observation is, “Once you’ve done one public-private partnership, you’ve done one.”
Our observation is, “Once you’ve done one public-private partnership, you’ve done one.” Each one is unique as to what the particular state or municipality allows and what the particular public client is looking for. There’s no single formula. In Canada, they put together an infrastructure trust fund on a national basis, and, in order to get funds from that fund, a provincial or local government body has to adhere to uniform contract guidelines. And so, as a result, as different provinces wanted to borrow money from this national infrastructure trust fund to build hospitals or prisons or courthouses, they had to adhere to the same contract standards. That makes things more predictable for everybody in the process. They know what to expect and how the risks are allocated.
So now, government agencies in the U.S. say this is an attractive model. It’s well thought out, and it includes the guaranteed maintenance, and it includes the availability payment concept, so that, if the building isn’t properly maintained, they pay less rent. So let’s bring it to the United States. But here, of course, every state, every local government, every county—they all function differently, they all have their own particular rules. For instance, on UCSF, we were basically writing a contract from scratch for the first time; there was no model for them to follow, no model for us to follow, no document you could pull off the shelf. It’s extremely complicated, I would say, to put these deals together, because there isn’t a model contract. Whether it’s Texas or Pennsylvania or Florida, everybody’s going to want to do it “their way.” And that means that every deal, in my opinion, is very different, very unique. I think it’s important for people to know that public-private partnerships, although you can have a goal in mind and a general form of where you want to go, a deal will evolve to suit that particular entity’s needs and wants and how much risk it wants to share and how much control it wants to have. And so I push back when people tell me that the wave of public-private partnerships is going to look exactly like the Canadian model.
Lessons Learned and Secrets to Success
SNYDER: So, based on your experience with public-private partnerships, what are the key lessons for private companies that want to succeed in that arena?
FLEMING: Having firms that have done it before as your consultants. That would be high on my list, both on the public and private side. This is not an arena where you can figure it out on the fly, unless you want to incur huge legal costs on both sides of the fence. So it’s important to use people that have done it before, that can bring some history and some direction to the process and can help identify the risks and really think them through.
You also need to allocate risks appropriately between the public side and the private side. No matter what risk you ask a private party to take, they’re going to include it in their price—this is the tradeoff. I think that the party that’s best able to control the risk should take the risk. So if it’s about entitlements or zoning or possibly even utilities, I think governmental agencies are better suited, in a better position, to take those kinds of risks because they can manage them. And if it is a construction-related risk, the design-builder is in a better position to take that risk. When the government agency says “I don’t want to take any risks at all,” they’re going to find that the private sector will price it accordingly and that’s not necessarily in anybody’s best interest.
Finally, one of the most important things the private sector can bring to public projects is creative ideas and problem-solving. For instance, on the Route 28 limited access freeway PPP project near Dulles Airport, the local landowners had decided to form a district to tax themselves to pay for road improvements to increase the value of their land. After the initial road construction, the landowners planned to build ten additional interchanges over a 20-year period with the Commonwealth of Virginia paying 25% and the landowners paying 75% of the cost. We recognized that the income stream from the taxes could be monetized and submitted a PPP proposal to undertake this scope of work. Our proposal allowed the construction of the interchanges to occur at today’s costs, and we made all improvements to the corridor in less than 10 years. The landowners’ land values increased, and they were able to attract office tenants and hotels and all the other development they had envisioned sooner rather than later. This entrepreneurial approach created a win-win situation for the Commonwealth, local government, private landowners and the traveling public.