“Perfect Storm” Could Accelerate Privatization Trends

MuniNet Guide Interview with Reason's Leonard Gilroy

On October 8, the Chicago City Council unanimously approved a historic $2.5 billion 99-year lease of Midway Airport, setting the stage for the first long-term lease of a U.S. airport (assuming federal approval). While others have leased portions of their facilities or have contracted with third-party vendors to provide certain services, the Midway deal is likely to go down in the history books as the first large-scale privatization of a public airport in the United States.

The Reason Foundation’s Annual Privatization Report 2008 identifies Chicago as a “hotbed of local privatization,” with the Midway transaction being preceded by the lease of the Chicago Skyway lease as well as several downtown parking facilities. The city is also currently pursuing a long-term lease of its downtown parking meter system.

Is privatization looming as large in other parts of the country? Could the increasing trend to form public-private partnerships gain momentum in light of this country’s economic downturn?

Leonard Gilroy, Director of Government Reform at Reason Foundation and editor of the Annual Privatization Report for the past three years, says the answer to both of those questions is “yes.” In the interview that follows, he shares his many insights on privatization, and why we’re likely to see more of it.

MuniNet: Reason Foundation’s Annual Privatization Report has been around for the past 22 years. Can you highlight some of the findings from this year’s review?

Gilroy: Perhaps the most notable statistic set forth in the 2008 Annual Privatization Report is that over the past five years, the federal government’s competitive sourcing efforts have saved U.S. taxpayers $7.2 billion. This involves the government allowing public employees to pool together and bid against private sector companies to provide services that are currently performed by the public sector.

While federal employees have ended up winning roughly 80 percent of the jobs completed during that period, the taxpayers have benefited from the increased efficiency and reduced costs that have resulted from the mere introduction of competition.

And while the political shifts in Congress have put somewhat of a damper on federal privatization over the last two years, state and local government officials – regardless of party affiliation – seem to be increasingly open to privatization and public-private partnerships.

Democrats like Chicago Mayor Richard Daley, Virginia Governor Tim Kaine, and Pennsylvania Governor Ed Rendell have all been remarkably proactive in pursuing privatization, as have been Republicans like Texas Governor Rick Perry, Indiana Governor Mitch Daniels, and Georgia Governor Sonny Perdue. Pragmatic policymakers like these seem less interested in ideology and more interested in what works.

MuniNet: What effect do you think the downturn in the economy might have on privatization trends going forward?

Gilroy: Privatization is likely to increase in spite of – or maybe even because of – the financial crunch. Here’s why:

  • With rampant spending and declining property values and tax revenues, state and local governments are experiencing increasing budget shortfalls. As a result, state and local governments face challenges in funding the projects that have already been promised.
  • Governments generally raise capital to fund infrastructure and other public projects through taxes or bond issues. In today’s economic climate, neither is a very viable option; few elected officials would even consider raising taxes, and increasing interest rates make it even more expensive to pursue bond financing. So you’ll have less and less money to spread around to a growing number of needs.
  • Therefore, governments will be increasingly seeking alternative ways to finance these projects. Turning to the private sector, as many European countries have done for decades, provides a viable option.

MuniNet: But isn’t it more expensive for private companies to raise capital to fund these projects?

Gilroy: Opponents of privatization often argue that the public sector, because of its access to tax-exempt financing, can borrow money at lower interest rates than the private sector. Privately financed projects typically use a mix of debt and equity – typically 20-25% equity and the rest debt.

So the critics argue that since equity providers require a much higher rate of return – generally between 8-15% – than debt providers and since the private sector can only issue taxable debt (which carries a higher interest rate than tax-exempt debt), then the weighted average cost of capital (WAAC) will be much higher for a privately financed project.

But this analysis ignores something very significant. The federal government has created financing tools designed to provide incentives for private companies to invest in public infrastructure projects – roads, bridges, highways – that help level the playing field between public and private financing.

Take the example of a new toll road project. A governmental body might be entitled to a tax-exempt interest rate of, say, 5% to borrow funds to finance that project. In the past, a private sector firm would have a tough time securing that same low interest rate.

However, over the last decade, the federal government has stepped in. In 2005, with the passage of the Transportation Infrastructure Finance and Innovation Act (TIFIA) established a program through which the U.S. Department of Transportation provides affordable loans, lines of credit, and other financing tools to eligible participants, including private companies, for infrastructure improvements.

These tools have helped the private sector to take advantage of highly competitive costs of capital for the debt component of the financing, making it almost equivalent to the government’s cost of capital. Now it’s certainly true that private financing could potentially incur a slightly higher cost of capital overall (once you factor in both debt and higher returns on the 20-25% equity invested). But we’re seeing private firms in recent years come very close to matching the WACC available to public sector entities.

So a major difference in cost of capital between the two options should no longer be taken seriously as an argument. What should be considered instead are the trade-offs involved and the value proposition the private sector is really offering – a new source of capital to supplement public funds increasingly spread thin, upfront payments to the public partner (or a share of ongoing revenues); corporate taxes paid by concessionaires (not paid by public entities); superior cost efficiency and private-sector operational expertise; and rigorous performance standards with financial penalties for underperformance (which you practically never get with public sector projects), just to name a few.

MuniNet: Does the current fiscal climate encourage or discourage private sector infrastructure financing? Given the recent credit crunch and market downturn, many people would assume that Wall Street banks have left the table.

Gilroy: While some skeptics might believe that the turmoil in the financial markets could dampen enthusiasm for public/private partnerships, I’d argue the opposite. There seems to be a general consensus in the financial community that infrastructure public/private partnerships remain an attractive investment in the “flight to quality” that we’re seeing in the markets.

The flight to quality refers to capital flowing to solid, safe, and tangible investments. Despite the rise and fall of the economy, people are still going to drive, fly, and consume goods. That means that roads, airports, seaports, and other types of infrastructure will likely remain good long-term investment prospects. In addition, these are brick and mortar assets, a far cry from the credit default swaps, mortgage-backed securities and other types of derivatives that few could really understand.

Further, financial firms and public pension funds raised over $150 billion to invest specifically in infrastructure last year, and recent reports have indicated that infrastructure investment funds are trying to raise another $100 billion in 2009.

Now it’s reasonable to expect that the private sector may become more selective about project opportunities to pursue and more conservative in their project risk evaluations. But generally speaking, there seems to be at least as much investor interest in infrastructure today as six months ago, if not more so. And it’s not just Wall Street banks. Public pension funds (like CalPERS) and insurance companies are also dedicating billions to invest in infrastructure. Cash-strapped governments will be hard pressed not to consider tapping into those vast pools of equity capital as their revenues dry up.

MuniNet: The privatization of public infrastructure – roads, bridges, etc. – has cropped up frequently in recent headlines. In what other sectors are we seeing an increase in public private partnerships?

Gilroy: Infrastructure encompasses all elements of a community’s foundation, which includes – but is not limited to – roads, bridges, water, etc. There’s a great deal of experience now in using partnerships to expand and modernize roads and water/wastewater systems, and now we’re starting to see those models extended into airports, seaports, and other types of big ticket assets.

The U.S. military is using all sorts of public-private partnerships for non-combat-related purposes; replacing the entire stock of U.S. Army on-base housing – over 70,000 units in total – is just one example.

Social infrastructure – educational facilities, parking structures and hospitals, for example – is another area in which we are starting to see increasing interest in privatization.

Policymakers in several states are also considering privatization of state-run psychiatric hospitals as a way to improve often appalling conditions and substandard quality of care. Florida has used this approach in recent years to modernize – or even completely replace – four of its psychiatric facilities with tremendous results and quality of care improvements.

MuniNet: What’s next?

Gilroy: Governments are becoming increasingly open to revisiting other types of more “traditional” privatization, including contracts for services like vehicle fleet maintenance, landscaping, information technology, etc. Roughly a dozen states over the last year have started seriously exploring considering public/private partnerships to run state lotteries. And I suspect that partnerships to modernize and expand our nation’s energy infrastructure will attract a tremendous amount of interest in the not-too-distant future.

MuniNet: Do you think that the recent Chicago Midway transaction foreshadows a wave of change in the public sector?

Gilroy: The fact that Chicago’s Mayor Daley announced the landmark multi-billion dollar agreement in the thick of the financial crisis says something extremely relevant: public/private partnership mega-deals are still getting done in this economic climate.

Furthermore, our nation is currently in the midst of a “perfect storm,” characterized by declining government tax revenues, growing budget shortfalls and increasing costs of government debt. Privatization, public-private partnerships, and private infrastructure financing offer powerful, proven tools to deliver high quality services and infrastructure – while reducing pressure on government budgets.

Stay tuned: this trend is going to be one to watch!