There has been great debate as to why public sector entities so often undervalue what a project will be worth long-term to a private buyer. Some indicate the public sector understands how asset valuation is done but fails to account for private sector desire to garner first mover advantage in a new market. Others think the public sector lacks the information and the means to control the underlying drivers of asset value. Ashton et al. take these hypotheses further. In this paper, they propose the structured financial techniques (specifically debt swaps, sweeps, and raising internal valuations) used by private investors alter revenue estimates favorably for investors and lead to bid inflation. The research suggests a presence of informational asymmetries and structural power imbalances within the bargaining context. The authors use the examples of the Chicago Skyway and parking meter privatization to show how this happens in real-world situations.

The authors outline the historical development of privatization in the United States. Initially, private bidders, or concessionaires, treated infrastructure as the only source of revenue, with the payment made in traditional forms of debt. The asset performance was tightly monitored and public authority had more say in the management. Existing assets were seldom privatized, and if they were it took much longer than did privatization of new, non-tolled projects and involved a legal framework. A shift began to occur in 1988 when Virginia signed the Highway Corporation Act, which authorized private toll roads and led to the creation of the Dulles Greenway. This was the launching point for infrastructure privatization in the United States, which has been spurred by two key trends: stress in municipal and state finances leading to pressure on the sell side, and the expansion of investment banks contributing to the increase in asset leases. When banks and investors were unable to sustain profit rates, they began investing in real estate and the built environment. The introduction of these new private players led to an uneven distribution of power in negotiations between private and public entities.

As previously indicated, bid prices climbed quickly as privatization gained popularity. A cursory glance at the numbers seems to imply these deals are beneficial for public entities. For instance, when Chicago privatized its parking meters, it received a bid price of 15% more than the city anticipated. However, there is another side to this story. The public sector cannot control the concessionaire’s capital structure. It is difficult for them to monitor the complex financial institutions surrounding these deals. These techniques are defined as follows:

•  Interest Rate Swaps involve custom derivatives used to transform bonds with variable interest rates into fixed-rate loans, thus lowering the cost of borrowing.
•  Discount Rate Adjustments allow the infrastructure funds to adjust the present value of their concessions by raising or lowering the discount rate used to weigh an investment’s risk.
• Refinancing and Equity Cash Outs involve refinancing, much as one does a mortgage, then cashing out to produce short-term equity payouts. Chicago did this with its Skyway project.

 Investors anticipate they will use these financial engineering techniques and have their own internal asset valuation. Though these increase returns to investors, they pose serious risks to the public sector, including: increased investor indebtedness, higher annual revenues needed to cover costs, and the potential to encumber the public sector with responsibility to creditors.

In order to test the above theory, the authors performed a study comparing several theoretical projects with different “basic deals,” along with some that had financially engineered deals. The results indicated some important results for public-private partnerships in infrastructure. Some basic deals have negative effects on deals for the public sector. For instance, if a lease length is longer than anticipated, there is a slight increase in asset value. An investor’s ability to manage transportation infrastructure further increases bid prices, but aggressively raising tolls has the greatest impact on the “basic deals.” However, the true difference was seen when deals involved financial engineering. This gap is often hundreds of millions dollars, indicating that private companies see profit opportunities the public sector does not. In order to combat this, the public entity may benefit from structuring profit-sharing partnerships. Further, policies should be implemented that give public entities a more even playing field for negotiation. One way of doing this would be to create a federal infrastructure bank that provides funding to municipalities that give them an equity stake in a deal and give them a more equal footing in negotiations.