Chapter 7: Private Source Financing Foreword At the beginning of this study ECS and RJR realized that the source of capital financing was a key variable when analyzing alternative methods of providing new school facilities in Ontario. Until recently, School Boards and the Province relied on traditional financing instruments such as debentures to capitalize new schools. However, in the past few years, the private sector has emerged as an alternative source of financing. Numerous private sector parties are now offering, either independently or as part of BOOT-type proposals, financing packages that are said to be advantageous to the Boards. Given the magnitude of how much needs to be spent in the Province for new school construction over the next 25 years, the possibility that the private sector may have financing vehicles that are more economical merits serious consideration. Yet, validating the claim that private sector financing is less costly to the Ontario taxpayer is difficult. Each private sector group proposes different packages with different terms and conditions. In Canada, very few agreements have been signed between Boards and the private sector, while some are still under negotiation. The feedback received from the Boards and the private sector on specific agreements is sometimes contradictory. Because of all these factors, it is somewhat difficult to draw general conclusions. To clarify the topic, ECS and RJR reuested the input of a third party more familiar with the opportunities, issues and concerns related to private source financing of public infrastructure projects. The following section of the report was prepared by the Centre for Government group of the accounting firm KPMG (Toronto office). Introduction Virtually any form of public infrastructure can be financed using private capital on a limited or non-recourse basis, schools being no exception. However in developing viable financing options and approaches to capital funding, care must be taken to ensure that the solution fits the problem. In our experience, the most long-lasting solutions are ones based on sound fundamental economics with a clear and compelling internal and external logic for the solution. Solutions lacking this clear and compelling logic often fail during final formulation or even worse, during project implementation. Private Source Financing Analysis of Capital Funding for School Facilities Page 7-1
The essential prereuisite for effective private infrastructure finance is the creation of an independent entity to operate, manage and make decisions regarding a particular project. In the absence of the creation of this entity, the financing is essentially reduced to general government borrowings and none of the monetary benefits are likely to be received. This entity must be able to be held accountable for failures in service delivery, but conversely, must be able to earn a rate of euity return commensurate with the level of risk it accepts. It is important when comparing interest rates to also compare covenants on an apples-toapples basis. A stream of payments coming from a school board or municipality, relating to services performed, carries with it more risk, i.e., failure to perform results in an interruption in the stream. In order to compare this to municipal debenture borrowing, one has to take into account the fact that the municipal borrowing is a charge on the municipal credit, and comes to the lender whether or not the contract has been performed adeuately or not. Off-Book vs. On-Book Financing Generally, the funding of school projects has been provided approximately 60% from the Provincial Government and 40% from the local municipality or rate-payer base. The uest for alternate financing is coming primarily from the school boards, developers and the Province, which are seeking other ways to finance their educational infrastructure, because of reduced provincial transfer payments and reduction in the capital support of the Province. At the same time, the municipal ability to pay has shrunk because of the decline in development and thereby a lack of development charges. In order to ensure repayment of the interest and capital used to finance programs, regardless of the mechanism, a stream of predictable and durable cash flow must be available. The nature of this stream can determine whether the financing is on the school board s or the municipality s books or not. Generally, a mortgage will be on the books, because it reuires a covenant by the municipality to pay the principal and interest when due (i.e., when the lender has some form of recourse to the municipality). In the case of a lease, it may be off-book if it is a true operating lease as opposed to a capital lease. An operating lease creates some risk for the school board in that the lessor has the right to retain the property at the end of the term, unless the school board may repurchase it at market value. There are refinements to this option, however, it can sometimes be uite difficult to justify an operating lease. Private Source Financing Analysis of Capital Funding for School Facilities Page 7-2
The problem will become increasingly acute if the province reduces the grants for capital works and moves towards an annual grant that will provide funds to cover the debt service reuirements on its share of the load. With regard to the municipalities, there can be opportunities to move to an off-book position by utilization of development charges on an assigned basis, or other forms of revenue that can be assigned or securitized. The development charges are ideal as they do not represent a diminution in the tax base of the municipality. A portion of the tax base, i.e., the education portion, could be assigned to lenders; however, negotiation would be reuired with the rating agencies to determine if they would consider this off-book for credit rating purposes. There is also the issue of the debt ceiling reuired by the Ministry of Municipal Affairs and regulated through the Ontario Municipal Board. The on-book/off-book distinction does not apply for these purposes. Revisions have been made to this legislation that now permit capital transactions with public assets, where previously that was difficult. Very few transactions have occurred to date, although a number are under consideration. Cost of Capital Versus Availability of Capital Most of the analysis to date on the methods of financing for school construction have focused on the cost of capital. The cost of capital must be considered in conjunction with the availability of capital as part of the financing process. In many cases the availability of capital can be a more serious and challenging issue to resolve. The cost of capital, while relevant at the macro level, is substantially less important at the level of the individual project. Macro vs. Micro Solutions In addressing the funding/financing issues the Ministry faces today there are two distinct perspectives that need to be considered: The financing of individual independent projects. The financing of multiple projects or aggregate reuirements. Private Source Financing Analysis of Capital Funding for School Facilities Page 7-3
Independent Projects The first perspective focuses on the economics of individual projects and risk management at the project level. Focusing on individual projects could reduce the need for centralized administrative functions to a certain extent but it tends to increase transaction costs at the project level. The need for a comprehensive macro solution is not addressed and there remains a need for finding an overall framework for decision-making. This type of solution must exist within a broader Ministry wide policy framework that needs to be created out of this work. Aggregate Reuirements The second perspective focuses on the economics of a portfolio of different projects and different credit risks. It reduces substantially the project level transactions costs but has the potential to reuire increased central administration infrastructure. While each school board is most familiar with its own needs, a more centralized financing function could make for greater efficiencies from a staffing and expertise point of view. Centralization would eliminate the learning curve reuired by Trustees and staff on often complex financing issues. It is reasonably inefficient for the boards and their staff individually to become expert in the various financing techniues, when they only use them a few times a year. Small boards might use them only a few times a decade and it is unlikely that meaningful continuity of expertise could be maintained. Large boards, on the other hand, would be better able to justify developing and maintaining the expertise, particularly if individual project financing became the norm. The value of centralization must factor in the costs of centralization, and the ability to recover these costs. Transaction Costs There are a wide variety of transaction costs that will need to be borne in the financing of the school construction. It should be the objective to minimize transaction costs to the greatest extent possible consistent with the establishment of independent financing for school developments. The transaction costs that are relevant at the macro level include legal fees, financial agency fees, engineering fees, commitment fees, among others. These fees can be Private Source Financing Analysis of Capital Funding for School Facilities Page 7-4
substantial at the project level and care must be taken to design a financing approval and implementation process that minimizes these expenditures. Transaction costs also exist within the Ministry and these transaction approval costs can also be significant. The objective should be to minimize both sets of transaction costs. New Directions in School Financing There are three fundamental approaches in devising financing mechanisms, each with its own variations. These approaches may be classified as follows: Financing on an individual school basis ( Project Financing ). Financing of multiple projects or aggregate reuirements ( Pooled Borrowing Facility ) whereby municipalities and/or school boards form and support a central agency which borrows funds in the market and then lends funds to its participants for school construction or capital repairs. Financing arranged by individual municipalities or school boards ( Municipal Level Financing ). The purpose of this paper is to explore the issues arising out of private infrastructure financing, the discussion which follows therefore focuses on project financing only. Project Financing Project financing includes debt instruments secured by the school property and/or euity instruments representing ownership of the land and/or school building. The key factor underlying any form of Project Financing is that a school is a special-use property and accordingly there must be an arrangement in place which assures a return on, and a return of the investor s capital. The obligee could conceivably be the school (in the case of a private school), the school board, the municipality or the province, depending on the investor s reuirement for credit uality. Private Source Financing Analysis of Capital Funding for School Facilities Page 7-5
Examples of structure for financing on the micro level are: Mortgages The conventional method of financing real estate would generally be on book as direct security would be taken on public assets. Repayments would likely come from the school board, municipality or the Province or both. If dedicated payment streams could be assigned, an off-book structure might be achievable. Generally, the more complex a structure, the higher the interest cost as opposed to direct municipal or Provincial borrowing. There may be legislative changes reuired to permit mortgage security. One benefit of mortgage financing is that long-term fixed-rate financing with long amortization s can be achieved, i.e., up to 35 years. The most simple form of credit would be a mortgage loan issued by a special purpose company and secured by the school property and an assignment of a lease obligation. Depending on the uality of the lease covenant, the loan could be for as much as 100% of the cost of the school. Such financing is generally referred to as a credit mortgage reflecting the fact that the loan terms are based on the credit of the obligee/lessee/user and not the property. The terms of this type of financing would be substantially comparable to a direct financing by the user. However, this approach may have a financial reporting advantage, i.e., potentially a lease instead of a obligation. A variation of this approach could be to have the special-purpose company own a number of school properties subject to identical leases with the designated lessee. The specialpurpose company could then issue mortgage debt of a single large issue instead of a series of smaller issues. Sale-Leaseback s Developers and financial institutions will provide sale and leaseback structures. The substance of such an euity investment is not substantially different from the mortgage arrangement described above, as the investor would reuire that the lease provide a full or virtually full return of its investment and the school or municipality would wish to recover ownership upon termination of the lease. These can be on an operating-lease or capital-lease basis. Operating leases can be offbook but the buy-back option at maturity is at market and for long-term assets like schools, can be uite expensive. Capital leases are just another installment financing format with the asset reverting to the school board on maturity. Private Source Financing Analysis of Capital Funding for School Facilities Page 7-6
A sale-leaseback arrangement which is in effect an euity financing, may have accounting implications which make it more or less competitive than a debt arrangement. A potential advantage of an euity financing could be the tax advantage of capital cost allowance (CCA) to the lessor if a lease arrangement could be structured which is not a capital lease for tax purposes. The tax shield resulting from CCA would have the potential to lower the reuired cash return on euity. Euity could be placed privately with one or more taxable institutions or syndicated broadly through a tax conduit vehicle such as a Real Estate Investment Trust or a Limited Partnership. The effectiveness of this approach would depend on the net impact on federal and provincial tax revenues. The tax effects of operating leases can erode the Provincial and Federal tax bases. It is our understanding that the Province appears prepared to live with this on new projects but not for existing assets. The potential advantages are limited as most tax shelter loopholes have been closed. However, operating leases provide some attraction if the board is not paying too much on maturity to recover the asset. If recovering the asset is not an issue the private sector would be in a position to provide 10 to 20-year leases of multi-purpose buildings that can be recycled to other uses at the end of the term. Structured Financing Mortgages, bonds, debentures and leases can be back-end loaded. By reducing the payments in the early years, inflation or growth can increase cash flow to meet rising payments. For example, the York Separate School Board suffered some adverse comment on such a structure because of the cost of such structuring relative to the real risk. Some officials object to this format because the principal balance owing actually rises in the early years. Other Structures Generally as variations on the above, there are various financing and ownership structures which have been developed in the market by a variety of financing sources and financial agents. Some of these structures may have applicability to school financing. These possibilities need to be reviewed and analyzed from the points of view of: Applicability and adaptability. Relative risks and rewards. Tax expenditure effects. Depth of financial market appetite. Private Source Financing Analysis of Capital Funding for School Facilities Page 7-7
Conclusion The need for new capital investment is becoming increasingly acute at the very same time as traditional financing practices are reaching their limits in terms of ability to raise needed capital - especially when compared to the magnitude of capital investment that must be secured to continue offering a high uality of service in Ontario. Reliance on private market finance would not necessarily be more expensive traditional public funding. While government can generally borrow at lower rates of interest than other institutional borrowers, the favourable rates of interest extended to the government are only possible because the government does not default on its loans - it is large enough to absorb its own risk. The rate differential is largely a measure of the risk not covered by the government when a project is financed by the private sector. Effective risk management allocates particular risk to the party best able to deal with them. Project costs will rise if the private sector is asked to bear risks it is unable to manage effectively - the risk of failure will be priced into the cost euation. Similarly, if the size of the loss that could occur is larger than the private sector party can withstand, then failure will again be priced into the euation. While the assessment of risk has potentially the greatest impact on cost of financing, the other factors discussed above such as the potential advantages of the Capital Cost Allowance of an operating lease (which could yield improved IRR s to investors and potential savings to the public agency or lessee) could also have a significant impact and should be considered in any infrastructure financing. The financial models which follow illustrate potential benefits for both the public sector agency and the investors. Conseuently, in developing viable financing options and approaches to capital funding, care must be taken to ensure that the solution fits the problem and does not simply follow fashion or trends. Financial Models In Canada, government agencies have the ability to borrow funds at relatively low rates of interest in the capital markets. In order to determine the feasibility of an infrastructure financing concept that does not involve direct borrowing by a government agency ( an alternate financing arrangement ), it must be demonstrated that both the government agency and the private capital investor realize some benefit from such an alternate financing arrangement. Private Source Financing Analysis of Capital Funding for School Facilities Page 7-8
For purposes of this analysis, a simple financial model was created to simulate the anticipated cash flow to an investor who uses private funds to construct the proposed facility and in turn leases the facility to the government agency by way of an operating lease. This analysis was compared to a conventional benchmark - the government agency issuing a bond in the capital markets to raise funds to construct the proposed facility for $10 million (a Government Bond Issue ). Scenario 1 - Operating Lease with a 5% After-Tax IRR In the first scenario, we have assumed that the funds reuired for construction are provided by an investor who in turn leases the facility to the government agency under an operating lease. To ensure the analysis is compared to a Government Bond Issue on a consistent basis, the inherent lease rate is assumed to be the same as the interest rate applicable to the Government Bonds (7.5%). In doing so, the present value of the costs to the government agency under a Government Bond Issue and this scenario are identical. The operating lease is assumed to have a residual purchase option at the end of twenty years eual to approximately 40% of the original capital cost. This rather large residual is reuired in order to classify the financing as an operating lease. As a result, under an operating lease structure, annual payments are approximately $100,000 less per $10 million in capital cost when compared to a Government Bond Issue. While the overall IRR is the same, there are cash flow savings on an annual basis until the residual is paid. This scenario results in an after-tax IRR of approximately 5% for the investor as a result of being taxable entity and having the ability to utilize capital cost allowance to shelter part of the lease revenue. For comparison purposes, if the investor had purchased the bonds issued by the government agency directly, the after tax yield would have been approximately 4.5% (7.5% pre-tax). Therefore, the government agency is no worse off while the investor is ahead by approximately 0.5%. Scenario 2 - Operating Lease with a 4.75% After-Tax IRR In order to demonstrate an improvement to both the government agency and the investor, Scenario 2 assumes that the investor receives an IRR of 4.75% (midway between the straight bond purchase and leasing the facility with no benefit to the government agency). In this scenario, the residual purchase price was reduced to give effect to a reduction in the overall IRR from 5% to 4.75% and the annual payments under the operating are assumed to be eual to the debt service payments. Private Source Financing Analysis of Capital Funding for School Facilities Page 7-9
Instead of redeeming the bonds for their face value of $10 million after twenty years, the government agency need only pay the residual reuired to generate the proposed 4.75% IRR to the investor. In this case the residual payment is reduced by in excess of 20% of the capital value. Therefore, the investor improves his return by.25% over a straight bond purchase while the government agency reduces its capital cost by 20%. Private Source Financing Analysis of Capital Funding for School Facilities Page 7-10