Cost of Capital
Comparing Cost of Capital Spreads
The cost of capital (the return expected by investors for funding your project) for a government issued financing can be significantly lower than the cost of capital for a private P3 issued financing. Generally, state and local governments finance 100% of the project with debt, while a typical P3 financing would see a 70%/30% project finance mix of debt to equity investment. The finance mix can drop to 50%/50% or lower for demand risk projects or rise to upwards of 90%/10% for secure availability payment projects. Government debt financing enjoys a 100 to 400 basis points spread (100 basis points = 1%) over private debt (varies by credit worthiness of both parties and whether access to tax-exempt private activity bonds exists for the private contractor). Government infrastructure project credit ratings average AA while private sector debt financing can see BBB ratings or lower, again depending on the security of the revenue stream. One financial industry leader interviewed identified being able to reduce public private partnership debt financing spreads based upon a high profile project with secure availability payments and strong demand projections to between 20 and 90 basis points.
On the equity side of the P3 equation, private equity investors are generally looking for returns on equity of between 8% to 20%, with the spread based upon the relative risk characteristics of a project’s projected revenue stream (i.e., the higher the infrastructure completion risk, cost escalation risk and demand risk, the higher the required return). As noted above, the higher the risk profile for the project, the higher percentage of equity that will be required by the debt lenders, which increases the overall cost of capital spread.
Assuming a relatively secure and low-risk project with a 70%/30% debt/equity split, 100 basis point public/private debt spread (based on a recent public infrastructure financing with an all in interest cost of 4%) and an 8% equity return requirement, the total cost of capital spread between government finance and private participant finance would equal 190 basis points. With a less secure and higher risk project with a 50%/50% debt/equity split, 200 basis point public/private debt spread and a 16% equity return, the total cost of capital spread for the project would equal 700 basis points. This negative capital cost spread affecting the private sector participant does not take into account the impact of taxes on the private equity investor, which generally would not apply to the government participant (i.e., income taxes, property taxes, sales taxes).
In some instances, governments face structural limitations on their ability to issue project debt (e.g., fiscal rules that limit debt or cap borrowing, referendum approval requirements) or limitations on their cost of capital and market access (e.g., low bond ratings, bankruptcy, other priority debt financing needs like unfunded pension liability). In those instances, the cost of capital spread may favor private capital. Although Andy Rose of the Global Infrastructure Investor Association states, “If the starting-point is to keep a commitment off public-sector balance sheet, it’s hard to negotiate a good deal.” (The Economist, April 2017)