When it comes to financing infrastructure in the current economic environment, US state and local governments would benefit from more options.  And private-sector investors are very interested in finding more value-added ways to invest in the sector.

But innovative capitalization options might not fit easily within the public-sector’s current framework of fiscal constraints.  A partnership structure provides open-ended flexibility, but for many assets a full P3 involves too much complexity, transfer of control and cost to be a practical solution. Simple non-profit SPV structures can be effective in expanding the public-sector’s framework, but current versions are limited to traditional financing.

The answer in many cases might be found in the middle — an SPV structure designed to include innovative capitalization options on an unbundled basis, with the capability to develop, evaluate and manage those options.  Here’s an overview of how I think that might work:   Capitalization Management Trust.

There’s much common sense in this column in Politico today. It’s right to say there’s no magic bullet for infrastructure investment. It takes real resources from someone, somewhere to cover the real cost of real assets. Any other view is just a fantasy. That’s the essence – and the dilemma – of funding. You can’t simply create it with talk.

I also completely agree with his point that expanding and improving federal infrastructure loan programs like TIFIA, RRIF and (as he should have included) WIFIA should be one of Washington’s highest priorities. The power of these programs is vastly underutilized, especially with respect to innovative flexible financing to help state and local governments deal with revenue volatility and uncertainty. The nature of loan programs also works well with the federal government’s own budget issues – both political and substantive. A small credit subsidy can support a big volume of relatively low-risk loans, a category that includes most essential public infrastructure. So Congress and the Administration can deliver loan programs with “yuge” volume numbers and potential benefit for state and local governments without doing too much damage to the federal deficit. I’m guessing that this alone will lead to a radical expansion of loan programs when all the other options are proved to be too expensive or controversial. Maybe Rahm is just getting ahead of a parade he sees must come eventually? Not at all surprising for such a political insider – and, as such, actually encouraging.

But he seems to be missing something: Financing (debt from the private sector or loan programs like TIFIA) needs to be repaid from funding (taxes or user fees from someone, somewhere). Although they’re both measured in terms of money, financing and funding are not at all the same. Financing doesn’t actually “pay” for anything. It just shifts the timing of eventual payment, which must be funded. Yes, a low or subsidized interest rate helps lower the eventual funding need a bit, but even if rates are zero, principal repayment is required. So you’re back to the original problem: Where will the funding commitment come from? You could fairly restate Rahm’s sentence at the end of the first paragraph as: “Any plan for financing infrastructure that does not include funding is fairy dust.”

Is Rahm confused about the difference between financing and funding? Blinded by the fairy dust in dreams of gigantic loan programs? Maybe, but I think that’s unlikely for an ex-investment banker and crafty politician. Certainly a subsidized interest rate would help junk-rated Chicago more than most US local governments, but surely he knows that the city would have to find funding to repay a loan from an expanded TIFIA or WIFIA….

…or does it? Perhaps the column’s transition from strong words about funding’s harsh reality to
advocating a politically-realistic expansion of federal loan programs (with some obligatory local chest-thumping in between) is more subtle and artful than it looks.

In a sense, financing always has one intrinsically committed source of in-built funding: default. If you don’t repay a loan, the lenders have in fact paid for whatever was financed, however unintentionally. In the private sector, the lenders naturally then take the asset they paid for and sell it to recoup. But when the lender is the federal government, and the asset is Chicago public infrastructure – well, things are different. Perhaps the loan will be “restructured” with a much longer term and payment holidays. Or forgiven outright. Either way, federal taxpayers who thought they were providing financing will now be the source of real funding, something they would not have agreed to otherwise (but I’m sure Chicago taxpayers and infrastructure users will appreciate).

Rahm’s complaint about RRIF’s “onerous credit rules” is quite telling. A federal financing program without real credit standards indeed becomes a funding option for a borrower with less-than-stellar credit and pie-in-the-sky income projections. If a financed project succeeds and there’s plenty of user fees, or if tax revenue is growing in a revitalized and booming city, the loan gets repaid from abundant local funding. If not (which is more likely), then hardball negotiation begins in a political context. With some nerve, political influence at the federal level and little to lose in terms of reputation (e.g. you’re already junk-rated), chances are I think very good that the erstwhile financing will – without the bother of much political debate — become funding.

Rahm describes the RRIF program as a “massive bait-and-switch” due to program credit standards and perhaps from a borrower’s viewpoint that’s correct if they were expecting something other than financing. But a “massive bait-and-switch” is exactly what federal loan programs without high credit standards and other lender protections will become for federal taxpayers. A bit of sardonic humor?

I was recently asked to provide a little more detail about what I mean when I talk about P3 “innovation”.  Fair question — no simple answers.  But answering it even incompletely helps concentrate the mind.  So here’s some quick thoughts.

I think there’s actually two broad paths that are likely to emerge, depending on how the infrastructure asset (or its recapitalization) is being funded:

• For tax-funded social infrastructure where P3s are mainly in form of availability-payment P3s, innovation will occur in the actual contractual and capitalization structure of the transaction. This is necessary so that AP-P3s better dovetail into the actual fiscal constraints that US state and local governments face – and there’s a lot of scope for improvement so innovation can make AP-P3s more useful (hence more uptake). This is really the point of the column I have in Governing on the topic and a one-pager about a “built-in rainy day fund” for AP-P3s.

• For user-fee funded economic infrastructure (e.g. toll roads, ports, airports and similar “active business” operations) I think the necessary innovation is not fundamentally in the transaction itself.  Current forms work well, since they’re really modeled on private-sector business, and there’s less need to dovetail into specific fiscal constraints.  Instead, critical innovation is needed in the way that the public sector measures and communicates the value of monetizing the user-fee income stream. This has to be anchored squarely in the public sector’s general fiscal context, not just project-level cost efficiency or risk transfer. It’s always necessary to do a project-level Value for Money analysis to assess potential cost savings from a P3. But a lot of the current interest in P3s and asset-recycling comes governments facing fiscal constraints. So assessing the cost of those constraints – and the potential benefit of P3s in mitigating them – requires an additional evaluation approach beyond the project level. This is of course the general objective of the Stanford ‘Value for Funding’ initiative for improving measurement of P3 value.

For an example of the second path, revenue volatility and uncertainty in general is a real problem for the public sector now – it causes all sorts of additional (and mainly hidden) costs like deferred maintenance and unfunded pension obligations. When these costs are included, the value of a relatively volatile stream of income (like tolls or airport revenues) is reduced. A private sector investor/operator like a toll road investor doesn’t have these type of public-sector constraints and hence doesn’t incur such costs – so the revenue stream is more valuable. Even if every other cost parameter is equal, and even though the public sector’s cost of capital is generally lower than any private-sector company, it still might increase economic efficiency and social welfare for the public sector to monetize volatile income streams. This type of measurement is the concept behind the “Cyclical Accrual” methodology (though that was mainly done for simple, low-risk social infrastructure the  methodology is pretty much the same).

There should also be “innovation” – more like simple improvement or expansion – in the federal programs and policies like TIFIA, WIFIA, PABs, reprising BABs and federal rules in general. But in general I think federal policy/programs/rule reform don’t lead but follow increased demand for P3s (unless there’s a huge subsidy involved like the 2009 ARRA programs – not likely in current federal budget/political environment). So I think the innovation will be driven by the private sector in the two areas above.

Audio version here – view as a slide show and it will auto-run from the beginning.

I’m beginning to see infrastructure P3s not as a product or tool per se but simply as a contractual framework that can allow the public sector to operate outside their normal range of efficiency, risk preference and fiscal constraints.  A blank canvas in effect.

Depending on the public sector’s objectives, different “modules” of capability can be added – should be un-bundled, ‘a la carte’ choice, just enough to fulfill the local objectives.

For example, if a large private equity investment and managerial control really deliver significant cost saving and risk transfer compared to public sector, then the classic P3 model makes sense. Works for bigger, complex, high-risk assets with a lot of business-type risk (airports, ports, maybe some tolls roads). But for a lot of simple/low-risk social infrastructure funded by some sort of taxes, the classic module may be overkill.

At the other extreme is the 63-20 or lease type P3 (like NDC or PFG’s “New American Model”) where the contractual framework basically serves as a locus for efficient outsourcing contracts which are outside the normal rules and for off-regulatory/ statutory balance sheet debt. No equity. Very simple, cheap and apparently pretty efficient for social infrastructure with respect to some constraints. But not many – bit of underkill?

The extremes show that the P3 contractual framework is in fact quite flexible. I think the path for P3 innovation – and more widespread adoption – is in developing additional specific modules that can be added to efficiently address specific public sector issues.

As you can tell from this site, InRecap’s focus is on financing modules:

• Built-in rainy day financing: provide some fiscal flexibility during downturns, but disciplined repayment during upturns. Lenders could include project finance banks, debt funds and – ideally – federal/state infrastructure loan programs.

• Social Impact Bond: provide performance-contingent financing for green tech or other aspects of the infrastructure with ESG characteristics. Basic concept is that SIB investors value the ESG aspects more than the local public sector – so transfer makes economic sense

• Dedicated environmental mitigation fund/financing (full credit to Dan Carol of Georgetown University for this idea): concentrate funding/financing resources for environmental permitting/remediation to allow separate optimization (which might be very different than the rest of the project capitalization)

I think the key to module innovation will be involving expertise/investors that are outside the P3 mainstream – the P3 framework really is flexible and expandable, and the public sector faces a huge range of issues – why not keep the scope of possible solutions and inputs as broad as possible?