The New World of Construction Procurement The P3 Model

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1 The New World of Construction Procurement The P3 Model Charles Halam-Andres, Managing Director October 1, 2012 Table of Contents 1. Introduction 2. Public Private Partnerships 3. Non-Recourse Financing 4. Due Diligence 5. Operations Period 6. Conclusion NICC 1

2 Introduction The Public Private Partnership ( P3 ) Procurement Model was introduced in Canada in 2003 o Since that time, over 170 projects have been procured by governments in Canada using this model Under the traditional method of procuring and financing projects, owners often found that the assets procured were: o more expensive than budgeted; o not provided on time; o not of the quality anticipated; or o did not have the useful life anticipated The P3 Procurement Model provides a solution to these challenges and offers numerous benefits to all parties involved Thus, as this method becomes more popular, an understanding of the P3 Procurement Model is necessary for all those who provide services to the construction industry including insurers because the application of this model could lead to better constructed and maintained projects thereby reducing insurance claims and premiums 2 Public Private Partnerships The P3 Procurement Model Under the P3 Model, a private sector, special purpose entity ( SPV ) enters into a project/concession agreement with a government entity to design, build, finance, operate and maintain a public sector asset for a period of between 20 and 30 years In order to undertake these obligations, the SPV will: o enter into a fixed price, date certain, turn key design build agreement with a reputable contractor whereby the contractor takes on all design and construction risks o enter into a fixed price, full term operation and maintenance agreement with a reputable service provider, whereby the service provider takes on all operation and maintenance risk o raise non-recourse debt financing to fund approximately 85% to 90% of the entire capital cost of the project o raise equity (typically from the project sponsors) to fund the remaining capital cost of the project Each of the parties who is best able to perform their allocated obligations, and bear the associated risk, is contracted to do so NICC 2

3 Public Private Partnerships The P3 Procurement Model Lenders Equity Investors Direct Agreement Direct Agreement Bond Indenture Senior Debt (90%) Rated A+ to A- Equity Contribution Agreement Equity (10%) Project Co Project Agreement Design, build, finance, operate, maintain Public Authority Construction Risk O&M Risk Design-Builder Design Build Agreement Fixed price Fixed schedule Turn key Interface Agreement Facilities Maintenance Provider Facilities Maintenance Agreement Fixed-price, partially indexed Term equal to length of Project Agreement 4 Non-Recourse Financing In Canada, P3 financing is provided by both Canadian banks and dealers o Canadian banks provide short term financing o Canadian dealers underwrite and sell bonds to institutional investors to meet long term funding needs Under the P3 Procurement Model, the integrity of the asset is more important than the creditworthiness of the issuer o Non-Recourse Financing is only repaid from the revenue generated by the asset o The type, scope and intensity of due diligence focuses exclusively on the asset being procured Lenders and underwriters typically study the following aspects of the Design/Build and the Operations/Maintenance components: o Who is the contractor engaged to design and build or operate and maintain the asset? What is their track record? o If time or cost overruns or deductions occur, does the contractor have the financial resources to absorb the overruns or deductions? o Does the contractor have the capacity to focus on and complete the project? o Who are the material subcontractors? o What performance support/security is the contractor providing? NICC 3

4 Due Diligence Under the P3 Model, detailed due diligence is completed during the bidding process to ensure the design, construction and operation phases of a project are procured as prescribed in the output specifications Type Description Technical Technical due diligence is undertaken on behalf of lenders and investors by an independent engineer or Lenders Technical Advisor The independent engineer is an expert in the asset class being procured and acts as a second set of eyes for the lenders and investors Financial The lenders and underwriters will undertake financial due diligence by reviewing the financial statements of key players involved, assessing their financial well being and their ability to sustain losses if unanticipated events arise Legal The lenders and underwriters engage legal counsel to ensure the contractual integrity of the transaction It is imperative to engage experienced counsel who can create the contractual structure necessary to implement the project Insurance The lenders and underwriters engage an insurance advisor to review all of the risk mitigation measures that the contractor/spv is obliged to put in place Insurance policies are highly scrutinized and tailored to meet specific project risks 6 Operations Period Operations and Maintenance In conjunction with the construction of the project, the government authority also contracts for the operation and maintenance of the asset for a term of between 20 and 30 years post construction o In virtually all situations, the government agrees to make monthly service payments to the SPV in exchange for the operation and maintenance of the project as per the output specifications o The revenue that is earned during the operations period is used to repay debt over the term Life Cycle and Hand Back Obligations The life cycle and hand back obligations are imposed by the government authority on the private sector SPV to ensure that the asset is maintained at a defined level throughout the operational term These requirements often drive the construction inputs o Because the SPV knows it will have to hand the asset back to the government authority in an agreed condition, they are incented to use high quality materials and best construction practices The due diligence and monitoring that lenders perform during the Operations Period ensures that the asset is properly maintained and that it is in a sound condition when it is returned to the government authority NICC 4

5 Conclusion The P3 Procurement Model marries construction and operational requirements Governments are incented to adopt the P3 Model versus the traditional design build model because o it places the risk of construction overruns and delays on the private sector; and o it ensures, through the private sector SPV s obligation to design, build, finance, operate and maintain the project, that high quality assets will be developed and maintained over their useful life Lenders and underwriters undertake significant and detailed due diligence to ensure that the project is designed and constructed to the required standards and that the project is appropriately monitored and maintained throughout its operational life The result is that there is independent review to ensure high quality assets are constructed and maintained The benefit of this model to insurers is that property damage/business interruption claims should be reduced during the construction and operation of an asset developed and operated using this model thereby reducing both administrative and financial burdens for insurers 8 Legal Notices TM Trademark of The Bank of Nova Scotia. Used under license, where applicable. Scotiabank, together with Global Banking and Markets, is a marketing name for the global corporate and investment banking and capital markets businesses of The Bank of Nova Scotia and certain of its affiliates in the countries where they operate, including Scotia Capital Inc., Scotia Capital (USA) Inc., Scotiabank Europe plc; Scotiabank (Ireland) Limited; Scotiabank Inverlat S.A., Institución de Banca Múltiple, Scotia Inverlat Casa de Bolsa S.A. de C.V., Scotia Inverlat Derivados S.A. de C.V., Scotiabank Colombia S.A., Scotiabank Brasil S.A. Banco Multiplo all members of the Scotiabank Group and authorized users of the mark. The Bank of Nova Scotia is incorporated in Canada with limited liability. Scotia Capital Inc. is a Member of the Canadian Investor Protection Fund. Scotia Capital (USA) Inc. is a registered broker-dealer with the SEC and is a member of FINRA, the NYSE and SIPC. The Bank of Nova Scotia, Scotiabank Europe plc, and Scotia Capital Inc. are each authorized and regulated by the Financial Services Authority (FSA) in the U.K. Scotiabank Inverlat, S.A., Scotia Inverlat Casa de Bolsa, S.A. de C.V., and Scotia Derivados, S.A. de C.V., are each authorized and regulated by the Mexican financial authorities. The ScotiaMocatta trademark is used in association with the precious and base metals businesses of The Bank of Nova Scotia. The Scotia Waterous trademark is used in association with the oil and gas M&A advisory businesses of The Bank of Nova Scotia and some of its subsidiaries, including Scotia Waterous Inc., Scotia Waterous (USA) Inc., Scotia Waterous (UK) Limited and Scotia Capital Inc. - all members of the Scotiabank Group and authorized users of the mark NICC 5