Angry in the Great White North

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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