Did we underwrite for that?
Investors, managers and everyday people are always talking about risk — construction risk, government risk, currency risk, interest rate risk, lots of other risks. But a lot of the talk seems more theoretical than real: “Yes, we’re aware of all those risks, but we’ve already accounted for them, so full speed ahead.”
Then something happens that brings the risk out of the theoretical into the real. It might be a great financial crisis that completely obliterates all underwriting assumptions.
It might be a summer wildfire burning out of control in Grant’s Pass, Ore., forcing brides to scurry to find new venues for their ceremonies and receptions (congratulations Jessie — both on getting married and on surviving a 48-hour reality-show-worthy dash to relocate the festivities).
Or it might be the operator of the Detroit-Windsor Tunnel filing for bankruptcy.
It’s this type of event that illustrates why no one — investor or municipality or owner — wants to take on the demand risk in an infrastructure deal. It’s just too hard to forecast demand for the 10, 15, 20 or even 30 years that these deals encompass.
Back in 2006, when American Roads took over the Detroit-Windsor Tunnel and four toll bridges in Alabama, as well as $800 million in debt, the forecasts for growing demand were rosy. The operating company’s owner, infrastructure investment firm Alinda Capital Partners, felt confident it was involved in a relatively low-risk investment with strong demand characteristics.
Seven years later, a great recession, volatile gas prices and high local unemployment rates have combined to reduce travel and discretionary spending; Detroit’s population has continued the downward trend that started in the 1950s (it was around 1.8 million then; it now stands at 700,000 and falling); and, in the case of the Alabama toll bridges, environmental disasters such as the BP oil spill and several years of exceptionally severe (meaning tornadic) weather have had a negative effect on the tourist traffic in the region. Traffic volume in the tunnel and on the bridges has fallen far short of projections made in 2006, and American Roads is seeking court protection because it is unable to service the debt.
What happens when American Roads restructures? The company may very well come out stronger since it won’t have all that debt to worry about, but those who invested in the deal — specifically the Mellon Bank, which provided long-term debt in the form of $500 million of bonds due in 2026—- will be weaker. And, if I were them, much less likely to invest in infrastructure again.
American Roads management has stated the bankruptcy will not affect operations, and it will continue to operate the tunnel and bridges as before. It expects to continue to partner with Windsor and Detroit despite this little blip. (Nothing to see here, folks, just keep moving.) Of course, with Detroit in receivership, anything could happen — the trustee could force Detroit to sell its interest in the tunnel, but American Roads would probably continue to operate the tunnel under any new ownership. (Did anyone underwrite for Detroit itself going bankrupt when the public-private partnership was proposed?)
So, once again, it appears the operating company will do fine. The cities will do OK because they will continue to receive the contracted payments. And the investors will end up with the short end of the stick.
Is it any wonder that investors are hesitant when it comes to PPPs? Except for the continued decline in Detroit’s population, the other factors that blew up the traffic forecasts would have been nearly impossible to predict 10 years out.
The rationale for PPPs look so good on paper — municipalities need long-term cash-infusing investment in infrastructure, pension funds need long-term, cash-producing investments — but it always seems that the investor is the one left holding the bag when things implode. And while implosion is unusual, it’s not rare.
One of the more infamous failures was the PPP involving the London tube system. In 2003, the city entered into a 30-year agreement with two private companies to operate, upgrade and maintain the metro system. Four years later, the firm responsible for two-thirds of the system filed for bankruptcy and the city took over those operations. By 2010 — just seven years into a three-decade contract — the city bought out the remaining private firm and the entire system was back in public hands.
Public-private partnerships are a relatively new investment phenomenon, and it is to be expected that mistakes will be made as the industry figures out workable structures and pricing that protect everyone. After all, it took a while for institutional real estate to find its sea legs.
The difference, however, is in timing. Some 25 or 30 years ago, when real estate was first being proposed for institutional portfolios, the United States had a young workforce. Large waves of retirees were, well, 25 to 30 years off. If mistakes were made in real estate while everyone figured what to expect from the asset class, there was plenty of time to recoup any losses. Today’s pension funds don’t have the luxury of making mistakes with their investment portfolios.
Infrastructure is an emerging diversified asset class that can provide stability and cash to an institutional portfolio. But to make investors comfortable with the class in these early days, GPs are going to have to provide more protection for the LPs — or better underwriting for everyone. When that happens, we’ll see a lot more pension funds with infrastructure as part of their real assets allocation.
Sheila Hopkins is managing director – Europe and infrastructure with Institutional Real Estate, Inc.
