Durham Region Courthouse project has insignificant equity investment
More on the Durham Region courthouse project. In this post, I'm considering something else I've noticed. The private partnership building this courthouse in Oshawa for the Ontario government has kicked in just over 6% of the cost of the project. As it happens, this is a extremely low contribution, and a study I've found states the obvious.
When you don't have much at stake, you have little reason to work too hard to be successful. Even less reason when your partner is likely to go to extraordinary lengths to make sure the project succeeds for political reasons.
In other words, did Dalton McGuinty's government make the mistake of letting the private partners sign on with virtually no skin in the game? Is that is what happening in Sarnia, where another P3 project for the construction of a hospital has been revealed to have more than doubled in cost.
In reading the confidential offering memorandum for the Durham Region courthourse project, a private-public partnership (P3 or PPP) between Dalton McGuinty's Liberal government in Ontario and the consortium Access Justice Durham, I keep finding all sorts of little gems. The problem is that the document is nearly 200 pages long, and lot of the financial stuff is so much Greek to this engineer.
But this chart makes sense:
Financing Structure
Access Justice's final financial structure is summarized as follows:
Debt - Bonds* -- $214,062,000 (93.57%)
Equity** -- $14,710,018 -- 6.43%
TOTAL -- $228,772,018 -- 100%* Face value
** Equity is committed to be contributed to the Project approximately 30 months following the Closing Date, or on such other date as the parties to the Equity Purchase Agreement may agree. The Equity will consist of common shares, preferred shares, preferred subordinated debt or a combination of such securities.
What this chart is telliing us is that Access Justice has kicked in $15 million of its own money, or just under 6.5% of the total projected cost, to build this courthouse. Conversely, nearly 94% of the money will be raised on the bond market, via a bond that pays interest at significantly higher a rate than used by Ontario Savings Bonds. That interest to be paid to the investors will be charged back to the Ontario government, and so back to us.
Now is this ration normal? Warren Buffet coined a phrase: "skin in the game". It refers to CEOs and other managers investing their own money in the companies they run or the projects they manage. With their own money at stake, the theory holds that they will be more careful and so more successful.
Makes a certain sense.
Now does 6% constitute a lot of "skin"?
Apparently not. According to this report from the Harvard Business School, P3 projects usually see 30% equity invested by the private partners:
It is true that the average project company has an initial debt-to-total capitalization ratio of 70 percent, though the ratios range from 50 percent to 90 percent or more.
[High] leverage does its disadvantages. Obviously, it can increase the probability of bankruptcy. It can also create incentive problems. When equity holders have too little "skin in the game," moral hazard (the idea that people drive rental cars more recklessly than they drive their own cars) becomes a real danger. Project sponsors may take excessive amounts of risk knowing the debt holders will bear most of the downside, yet will share almost none of the upside. Infrastructure projects such as toll roads, telecommunications systems, and water projects are particularly prone to this problem because host governments are reluctant to let them fail. Knowing the host government is more likely to restructure the project (e.g., to allow unscheduled increases tariffs or tolls), sponsors of infrastructure projects have an incentive to minimize equity contributions knowing they are likely to get bailed out. For regulators and politicians, the challenge is to structure contracts that deter reckless behavior prior to default and ensure efficient operations after default.
I've highlighted the more relevant sentence.
So according to this, putting in 6% equity into a P3 project makes this deal between Dalton McGuinty's Liberal government and Access Justice Durham one of the wild outliers. Nowhere close to the average of 30% equity. Because Durham Region is experiencing an significant increase in caseload, and because of the big splash when the P3 project was announced, the Liberal government is not going to let this project fail.
Access Justice Durham knows that. This is exactly the situation described by the HBS report. Access Justice Durham knows there will be a bailout of there is any trouble.
I wonder how much equity was put in by the private group building the Sarnia hospital:
Dalton McGuinty continued his frontrunner-style campaign yesterday by shrugging off questions about spiralling costs at a privately-built Sarnia hospital.
The Bluewater Health hospital was slated in 2006 to cost $140-million, though the tab keeps rising. Health minister George Smitherman visited Sarnia Friday to say that $276-million is a “guaranteed price.”
But the Sarnia Observer reported the next day on a leaked government spreadsheet which pegs the actual cost at almost $320-million.
Another $180 million required, and the Ontario government will have no choice but to make the funds available. If the equity stake was 6%, then the private partners contributed a little more than $8 million to help complete this $140 $276 $320 million hospital.
Heck, even if George Smitherman threatened to fire the private partners, I suspect the private group would just laugh. It's just not that much money to justify going to extraordinary lengths to keep Smitherman happy.
The real joke is that Smitherman and McGuinty must know that. If the same equity ratio is holding, then they know the government is a very weak partner in this P3 model. If the Durham Region courthouse project goes over budget (if?), just how worried is Access Justice Durham going to be? With just $14 million in the $214-million pot, the consortium just doesn't have much skin in the game. These guys would walk away and leave the money behind if the government tries too hard to hold the consortium's feet to the fire in case of an overrun.
Is that what is happening in Sarnia right now? Instead of shrugging off the questions, perhaps Dalton McGuinty could provide some concrete numbers.
You get the feeling Dalton McGuinty has allowed us to get suckered?
Addendum: I say that the consortium will leave the money on the table. What money? Note that according to this agreement, that consortium doesn't have to kick in its anemic 6.43% contribution for 30 months. That is after the courthouse is built and delivered! So really, these guys have no reason to worry at all when it comes to schedule and budget problems.
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Comments
Follow the money! Are these 'investors' buddies of Dulton? Who else would get such a sweetheart deal? As usual, the taxpayer is responsible for everything. "Our government increasing hospitals"? After all, "we are all in this together"--to quote an election statement of the lyin' Liberals. They get a big raise, we pay for it--guess that is togetherness? We build hospitals, their buddies get a big payday--togetherness? Wonder how many brown envelopes got passed?
Posted by: George at October 9, 2007 06:57 AM
Well, you have been outed now - we all know about you ($$$$)
“In his new book, Harper's Team: Behind the Scenes in the Conservative Rise to Power, party strategist Tom Flanagan notes the Tories' innovative use of blogs in the 2006 election campaign.
He cites in particular two members of the Blogging Tories, Steve Jank and Stephen Taylor, who write highly partisan blogs on federal politics.
(how do you sleep at night?)
Mr. Flanagan writes that campaign manager Doug Finley "appointed people to monitor the blogosphere and to get out stories that were not quite ready for the mainstream media."
These bloggers "amplify and diversify our message," he wrote.”
Posted by: Sam at October 9, 2007 09:43 AM
Great investigative reporting, Steve. Where is the traditional media on this? No wonder National Post and The Globe are losing readers.
Their reporters are too lazy to dig for stories like you do. Even their blogs are pathetic.
I seem to recall in a previous posting that you outed Fengate Capital Management, a small Hamilton operation and Liberal contributor and LIUNA, another Liberal contributor, and local Ontario labour union, with ties to a questionable US parent, as key beneficiaries of these P3 Projects. You mentioned that this Liberal-connected group was part of a consortium ( sometimes including Ellis Don of Sarnia Hospital fame) which won 5 out of about 14 P3 projects. Something is rotten in the state of Denmark. How about Fengate-gate?
The RCMP and Provincial Auditor should be investigating these scandals and putting a stop to these crooked P3 deals before the taxpayers are further hosed.
These Liberal P3 deals will make Adscam seem marginal.
Steve, what we need is a contest to name this new scandal.
I am sure you have a lot of creative readers out there.
How about:
Fengate-gate
P3 Payoffs
P3 Ponzi
Do You Want to Steal a Billionaire Dollars? (or $990 million US)
The Rise of Dalton Soprano, the Ontario Family
P3 Hospitals Destroy Ontario's Financial Health
P3 Robberies and the Dalton Gang
The Don (Ellis Don) and the Dalton Gang- United at Last
Keep up the great work.
Sick and Tired in the GTA
Posted by: Sick and Tired in the GTA at October 9, 2007 10:48 AM
Well, you have been outed now - we all know about you ($$$$)
(how do you sleep at night?)
I sleep just fine. That despite the fact that I don't get a dime from anyone to blog (except what I earn through advertising, mostly Google Adsense) because goodness knows I could use the money. But no one has ever offered me money to blog about this story or that. Still, I keep plugging away.
Posted by: Steve Janke at October 9, 2007 11:58 AM
Sam--unlike you Liberals, some people in this country do not need brown envelopes to inform the citizens. I am not a member of the CPC, but even I can see the criminality of Liberal moves, both federally and provincially. Remember the "no development on Oak Ridges Morraine" promise made by McLiar? Well there is now development, but only by a close buddy of McLiar. You don't have to belong to any political party to smell the rot in this province.
Posted by: George at October 9, 2007 12:06 PM
Steve, I think you are correct in your comments about the thin capitalization, but the debt rate is not unreasonable. I meant to comment on your prior post, comparing the ~5% rate on the project bonds to OSB rates of 3.7-4.25%: note that the bonds have a ~32 year term, while the OSBs quoted have a term of 3-4 years. By comparison, the Bank of Canada quotes 2-and 3-year rates of 4.25% and 4.0% on Government of Canada instruments, but the long bond maturing June 1, 2033 yields 5.75%. By that standard, the financing rate is attractive, since the Province (by definition) cannot borrow at a better rate than the GoC.
On the other hand, when I was involved in financing a tolling power plant (which is probably a slightly higher risk than a courthouse, but is still a pretty reliable investment) we found that the lowest-equity capital structure generally acceptable to the market was on our balance sheet (AA-) to commercial operation, and then 25-30% equity thereafter. Access Justice is obviously nowhere near that level of equity thickness.
Posted by: Deaner at October 9, 2007 12:18 PM
Thanks Deaner. I'm not an economist, and what you're saying sounds right. But is the bottom line cost the same? As I recall, OSBs and other government bonds pay 3% for the first few years, than a higher return the longer you hold them, going up to some limit. These AJD bond is paying 5.015% across the entire 30 year lifetime of the bond. I have to think this is more expensive. Maybe I can crunch some numbers later (once I figure out what formulas to use).
Posted by: Steve Janke at October 9, 2007 01:42 PM
Steve - I didn't bother to calculate the effective yield (or cost, depending on whether you are the issuer or the buyer) on the OSBs, since (at least the current issue you cited) is pretty short-term - three years, I think. The problem is refinancing risk in three years if you are the P3 builder (or a government) that tries to finance long-term assets with short-term paper. It would probably be cheapest to rely on floating rates over the whole term - but if you can't stand an interest rate spike when you are back in the market that becomes pretty unattractive - think of the home mortgage market, where people are routinely willing to trade (slightly) higher rates for longer term rate certainty.
Even if the OSBs had a long tenor, over the term of the P3 financing or the long Canada (32 years and 25 years, respectively) a low rate for a couple of early years won't affect the overall rate too dramatically (although now I am itching to build a spreadsheet...). The important point is that the anticipated P3 funding is roughy competitive with (actually, slightly better than) GoC rates over a similar term, which means that there is no "built-in" high cost funding. If there was more equity in the capital structure their borrowing rate might go down (lenders like an equity cushion, too), but the overall cost of capital would probably go up, since equity is expensive.
Posted by: Deaner at October 10, 2007 11:44 AM
Deaner:
You make some valid points about the financing. The issue that you have not addressed and Steve has not addressed is that the bondholders who bought this bond, bought this bond as if this was secure and safe like highly-rated government paper. Recall the bond is being issued by a special purpose company, set up for this purpose, with relatively no equity and just an interest in the contract between the government and the project when the project is completed and operating.
In the bond financing is an interest reserve to take into account the interest on the bond until the project is completed.
What happens when this project goes wildly out of control and over budget, as will inevitably happen? There is not sufficient funds in reserve to pay the interest on the bond financing. The issuer Access
Durham does not have any funds to pay the interest and Babcock Brown the financial sponsor is long gone and will not pay another cent. Secondly, there are not sufficient funds to complete the project. This bond could go in arrears, and the bondholders will have the right to seize the assets which may include the project'a assets.
The scandal here is that this bond is being over rated like the poorly rated non bank ABCP paper that is being held by investors like the OFA and the Caisse and all kinds of other so-called smart investors. If the project gets into trouble, and the Ontario govt has to put up additional millions of dollars, the govt should then cancel existing agreements, and then take over the project. In doing so, the expectation that the Ministry of AG will provide funds to Access Durham who will then pay the bondholders may be out the window and the bondholders may not receive their payments.
My point is that the rating agency did not properly take into account the risks inherent in this deal and the fact that this is not a government project so the bondholders do not have recourse to the Ontario Government.
If I was an investor in this bond, I would get out now. Think sub prime mortgage meltdown. Think ABCP meltdown. Get out now.
Better still, stop these type of poorly structured P3 deals before more taxpayers and bond investors get hurt.
Posted by: Mad in the GTA at October 10, 2007 01:17 PM
...the bondholders who bought this bond, bought this bond as if this was secure and safe like highly-rated government paper.
My heart bleeds not for institutinoal investors. They are big boys who can read a prospectus on their own, or at least get paid like they can.
Posted by: Deaner at October 10, 2007 01:45 PM
Deaner:
I am not upset about or sympathetic to the bondholders. However, if the bondholders bring legal action against the assets of Access Justice Durham, then the Ontario Govt may be drawn into this whether it likes or not and may be the Ont govt may have to settle with the bondholders, which means more good govt expenditures or taxpayer money being thrown out the window at badly structured projects.
That is my point.
Posted by: Mad in the GTA at October 10, 2007 06:16 PM
then the Ontario Govt may be drawn into this whether it likes or not
Depends on the lease agreement. IF (and that is a big question mark) it is drawn properly, the bondholders will end up underwater if the performance of the asset is bad enough to wipe out the equity holders. The way is should work is that the bondholders would end up owning the facility, which would still be subject to the existing lease to the Government of Ontario with the same responsibility to maintain and operate it. In that case, the public interest is still protected, and we neither know nor care whether it is the (original) equity holders or the debtholders who own the building.
...and may be the Ont govt may have to settle with the bondholders
But the bondholders will have (or should have) no claim against the Ontario government - only against the borrower, AJD. I agree that if AJD's equity is wiped out the bondholders may claim againt the Government, and will certainly try to negotiate some kind of deal to provide them with funds and protect their investment: they will have no alternative, and legal costs will be trivial compared to the bath they might be taking. Competent legal advice at the outset of the deal would ensure that they could not be successful, and that they would have no negotiating position (which still does not guarantee that there would be no government bail-out).
Obviously, the wording of the lease, and the terms of any postponement or priority agreement entered into now are critical: if those issues are not addressed it is evidence either of incompetent lawyering (which is unlikely - a deal of this size will get very senior counsel) or of a political decision that the bonds be a riskless investment to allow the equity holders to get away with such a de minimus equity committment. I suspect that to be the case; charging ~GoC yields for a 15:1 capital structure suggests that the fix is in. If the deal agreements are public (which would surprise me), they will need a great deal of scrutiny - if not, I think the taxpayers of Ontario should be concerned.
Posted by: Deaner at October 11, 2007 11:58 AM
Deaner:
I am very impressed. You are a credit to the legal profession.
I think we both agree that for political and public relations purposes the Ontario government cannot allow national, American or foreign bondholders to be taken to the cleaners in these infrastructure financing deals, no matter how good the legal paperwork is. Bad consequences in these bonds have a way of adversely affecting good Ontario government paper. Again the subprime mortgage meltdown seems to be affecting good credit everywhere.
The Durham Courthouse deal is just one of many deals that will blow up in Infrastructure Ontario's face.
You heard it hear first, Deaner.
Posted by: Mad in the GTA at October 11, 2007 08:07 PM
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