Chapter 4 - Project Finance

Summary:

There are many financing schemes ranging from single purpose appropriations (pay as you go) to innovative, if not exotic financing schemes. In the past, public finance stayed to a conservative course as expected by the purchasers of fixed income instruments. Along with the growing complexity of finance and scarcity of funds, these once conservative institutions have grown bolder and in some cases become downright foolish. This Chapter provides an overview of the typical approaches to California project finance.

 The State of California and its 7,000 local public agencies use a broad variety of finance tools to meet their infrastructure needs. The State has used general funds, specially earmarked taxes (such as gasoline and vehicle taxes) and special funds (lottery earnings), statewide bond issues, local bond issues, land development agreements and exotic financing schemes that may or may not require voter approval at various levels.

 The project finance obligations of California infrastructure are vast and often politically formidable. The State takes a great deal of care in attempting to plan for these projects. The Governor, under California law, is required to provide a five-year infrastructure plan for state agencies, K-12 schools, and higher education institutions, along with a general outline of the methods and amounts of financing required to support these worthy endeavors.

At the outset, infrastructure planners must face stark political realities that often determine whether an agency can raise funds for infrastructure projects. State bonds require a simple majority to pass, while local bonds require a “supermajority” of two-thirds. However, funding for local educational facilities has become a bit more flexible and achievable by local districts, since voters lowered the threshold for passing local school bonds to 55 percent in 2000.

Furthermore, California taxpayers are extremely interested in whether a project is Non-Recourse (limited liability) or Recourse (unlimited liability), the later a type of financing that may subject the public entities’ general fund to substantial financial risk. On the other hand, the investing community will favor those projects where there is a pledge of full faith and credit by the public agency with more generous financing and lower interest rates.

One of the major decisions that a public agency may make at the outset is whether to set up a special purpose agency (such as a redevelopment agency), joint powers authority or other government entity that may limit agency liability, or, where the project is very large, such as a regional transportation system (e.g. the Los Angeles Metropolitan Transit Authority), spread the construction, operating and financing risk across many public entities.

One critical aspect of any financing scheme is the equity or public capital that will be invested in the project at the outset. As with any loan, the greater the ratio of such equity to debt, the better the financing terms that are likely to be obtained from commercial banks and other funding institutions.

A major issue raised in any of these project financing approaches is whether the interest paid on securities will be exempt from federal (See: Int. Rev. Code, § 103 (a)) or state taxation (so called double exempt bonds). This will substantially affect the marketability of the bonds and whether the interest rates paid will be market (nonexempt or taxable interest) or below market (tax exempt interest).

Projects that benefit only a few parties or private interests may not qualify for tax exempt status (See 26 U.S.C. § 141(a) and 26 C.F.R. § 1.141-2 — an interest on a private activity bond is not excludable from gross income under section 103(a) of the Internal Revenue Code unless the bond is a qualified bond.)

A public hearing must generally be held by the sponsoring government agency prior to issuing private activity bonds. This hearing was initially required by the Tax Equity and Fiscal Responsibility Act of 1982 of all industrial development bonds. Another critical aspect of any project financing scheme is the risk management profile of the project (See Chapter 3). The nature of the project, the financial stability and strength of the public agency, the locale of the project, the quality and experience of the project participants, the risk of variations in future revenue and costs, and whether the technology and revenue concept is proven or experimental will strongly influence its “financibility.”

These factors are the subject of in-depth studies of the economics of the region and future projections, the expected revenues of the project and other various risk factors. This information often finds itself becoming part of the Official Statement for the issue. Such a study can also provide substantial guidance regarding which of the following financing methods is right for the project.

§ 4.1 Lump Sum Funding (Pay As You Go)

Simply writing a check for the project expenses is the simplest of the financing strategies. While the State of California can fund very large projects out of its tax revenues, it is rare that a local agency’s cash flow will be able to pay cash for a project of substantial size. In certain instances, a cash payout from the sale of land may result in the money being placed in an escrow account for the sole purpose of a specific project.

In other situations, a large grant or donation, such as to a university, is earmarked for a specific project. In these instances, the capital account can be very substantial and should be held at a very sound financial institution. Ideally, capital accounts should be invested whereby risk is mitigated and there is as close to a 100 percent assurance of the investments as possible.

Safe investments traditionally include U.S. Treasury Bills, municipal bond funds, or Money Market Accounts. Generally, the large sums of money required for a specific project will be beyond the FDIC limits on insurable accounts. The account should be segregated from any other finances of the agency. Extreme care should be undertaken to preserve the capital during the course of the project as the budget for the entire project likely depends on the amount contained in the lump sum account.

§ 4.2 Grants

Professional grant writers say that for every human need, there is a grant out there waiting for a well written proposal or application. Grants can be from private or public institutions but come with restrictions, conditions and outside auditing and control. Most agencies maintain lists of grant institutions and government programs where they regularly apply for funds. As a general rule, grants can be easily lost through inadvertence or carelessness in the application process. Certain grant institutions will also look for specific types of agencies and projects. The key is knowing the institution and its policies, rules, timelines and biases.

§ 4.3 Renting and Leasing

The simplest way for a public agency to obtain office space is simply renting space in a private commercial office building. This is the most expeditious and rapid method for obtaining access to capital facilities.

While there are typical procurement restrictions on leasing activities, they are usually straightforward and require a minimal amount of capital outlay by the public agency. The private sector appreciates the creditworthiness and the cash flow of public agencies, so the investment comes from the private side with little involvement by the public agency. However, leasing existing facilities is not as flexible (unless it is a long term build to suit) and may not extend to other types of facilities and infrastructure desired by a public agency (e.g. a bridge).

Nevertheless, the essential structure of a long term lease can be used to satisfy a broad range of infrastructure needs, including the bridge example set forth above. As these are essentially capital expenditures by another name (while the commitment is a lease, not a note or bond), special care must be taken to ensure the legality of the transactions. However, private companies are willing and able to provide design, build, lease, operate, and transfer of virtually any size of facility.

At the end of the day, the use of private leasing and capital results in two costs that the agency may wish to avoid. First, the interest cost of private loans is higher than that of public capital, due in part to the taxability of interest from private investment, as opposed to the generally tax exempt interest of public agency debt. Second, the private investment will come with an expected return on investment for the private company (or profit) that may be considerably higher than the agency thinks is appropriate. However, as public agency overhead is generally higher than private companies, the comparison may result in a wash on the basis of actual costs.

§ 4.4 State Bonds

Bond financing is the most common form of infrastructure financing in California and typically involves borrowing money to be paid back over time with interest to build or acquire infrastructure or other improvements.

The bond market relies upon an established network of investment firms, law firms, and institutional investors who participate in an active market for public bonds, often called fixed income assets (as they bear fixed rates of interest).

The bond market for investors is far from a stable environment, as the value of bonds rises and falls with moves in the prevailing interest rates. When a bond carries a fixed rate of 4 percent, it becomes more valuable when prevailing rates dip below 4 percent and its value falls when prevailing interest rates rise above 4 percent. The demand for bonds also varies with the general economic climate, particularly whether stocks are rising, or whether other fixed assets, such as real estate or precious metals, are in high demand.

The value of bonds is also affected by the rate of inflation which has a tendency to erode the value of bonds as well as reduce their net rate of return. Agencies are also affected by the credit rating of the State of California (which has recently suffered due to runaway deficits and unbalanced budgets) and the credit rating of the specific agencies involved in the bond. (As mentioned earlier, in February 2009, Standard and Poor’s (S&P) lowered the State’s General Obligation (GO) bond rating to A from A+. Fitch then lowered the rating to BBB in July 2009. As of July 2015, the State’s S&P rating was AA-. The State’s Fitch rating in August 2019 was AA.) There are insurance facilities available to insure the repayment of bond issues; however, these come at a price to the agency and a reduction on the rate of return for the investors. As such, the financial health and safety of the bond market (which can vary from moment-to-moment during the trading week) plays a considerable role in whether a project can be effectively financed in the public markets.

In its simplest form, agencies raise capital funds by selling bonds to investors (generally through intermediary financial institutions). In exchange, the agency pledges to repay the money with fixed interest, according to specified schedules set forth in the bond documents.

The resulting interest that the state and most public agencies have to pay investors on the bonds issued for public infrastructure is exempt from the investor’s federal and (California) state income taxes, thereby reducing the state’s interest costs on these bonds. Bonds are also considered a safer investment than investing in private companies’ stock, corporate bonds or lending to real estate or other businesses. The majority of California Bonds are known as general obligation bonds. These types of bonds are approved by the voters of the State of California and their payment is guaranteed by the State of California’s general taxing power.

Most general obligation bonds are serviced through payments from the General Fund, however some are paid off by designated revenue streams such as mortgage or water contract payments, for which the General Fund provides the only back-up security. The State has since issued general obligation bonds to help finance its budget deficit. However, the General Fund ends up paying this amount through its increased share of Proposition 98 educational funding even though their debt service is paid for by an earmarked one-quarter cent local sales tax.

Proposition 55 in 2004 and Proposition 1D in 2006 provided $16.8 billion in K–12 school facilities funding. Over the same time frame—from 2004 to 2016—local school districts proposed 1,018 bond initiatives and voters passed 83% of them, approving $91.1 billion in funding of their own. In November 2016, the citizens of California passed Proposition 51 (55% yes, 45% no), a statewide school bond measure that authorized $7 billion in general obligation bonds for the construction and modernization of public school facilities (and $2 billion for community college facilities).

The second type of California bonds are the lease-revenue bonds, which are authorized by the Legislature. Lease-revenue bonds are services from lease payments (primarily financed by the General Fund) by state agencies using the facilities they finance. These bonds, in contrast, do not require voter approval and are not guaranteed. As a result, they have somewhat higher interest rates and costs than general obligation bonds.

§ 4.5 Municipal Bonds

California’s local public agencies (local governments, school districts and special districts) have the authority, like the State government, to issue a wide variety of debt instruments. In addition, like the State government, their ability to issue debt depends on the relationship between the state of the local economy, tax receipts and voter approvals.

However there are three fundamental differences. First, to repay and secure its debt the State has a wider array of revenue options, especially from income and sales based taxes. As a result, local governments issue proportionately less general obligation debt than does the State. Local governments have no income based tax and are constrained statutorily and financially from using local sales taxes. On the other hand, local governments and school districts may issue debt secured by real property; a source unavailable to the State.

Property based taxes may be used to repay bonds either on the basis of value (ad-valorem) or acreage (parcel tax). California’s local ad-valorem based general obligation bonds are highly valued by investors because voters commit themselves and future property owners to raise property taxes sufficient to repay the outstanding debt.

Local public agencies issue a greater variety of debt instruments than does the State. Part of this is the historical fact that local agencies have been considered less creditworthy than the State of California. Due to the expense of local bond campaigns and elections, as well as other factors, local agencies, with the exception of school districts, issue General Obligation (GO) bonds less frequently than has the State.

Municipal governments and school districts’ GO bonds are property based and require a 55 percent approval vote after Proposition 39 reduced what had previously been a two-thirds threshold. In contrast, State GO bonds required a two-step approval process. First, the GO bond must be approved by two-thirds of the Legislature, or alternatively the initiative process. Next, the State GO bond must acquire a 50 percent vote in order to become effective.

§ 4.6 Certificates of Participation

The Certificate of Participation is a financial tool used in conjunction with a municipal government or other government entity bond issue. The investor receives a return based on the lease revenues associated with the offering, not a traditional interest rate. If the municipality defaults, the COP provides investors with the ability to assume control of the facility.

§ 4.7 Traditional Revenue Bonds

These also finance capital infrastructure projects, but are not supported by the General Fund. Rather, they are paid off from a designated revenue stream usually generated by the projects they finance — such as bridge tolls, parking garage fees, or water contract payments. These bonds normally do not require voter approval.

For example, the State of California currently uses traditional revenue bonds to fund seismic bridge safety projects. These revenue bonds are funded by bridge tolls paid by motorists who use the bridges. As another variation, general obligation bonds can be supported by funding sources other than the General Fund, such as user fees, or by a combination of funding sources of which the General Fund is one source.

User fees may be an appropriate source to fully or partially fund bonds in cases where there is a clearly an identified group of parties that benefit directly from the bond expenditures. This is an application of the “beneficiary pays” funding principle that can be used to guide the allocation of a project’s costs among funding sources. For instance, property owners who benefit directly from flood control infrastructure could pay a fee that would be used to partially repay bonds issued for flood management purposes. A number of infrastructure funding proposals under recent consideration by the Legislature and the administration have included a user fee component.

(Source: Legislative Analyst.)

§ 4.8 Local Option Sales Taxes

During the last 25 years, residents of 20 California counties have voted to raise local sales taxes by half or one percent to pay for local and regional transportation improvements. Such measures include TransNet in San Diego and Measure M in Orange County.

Together, these county-based taxes generate about $3 billion per year and are the fastest growing source of revenue for funding new transportation projects in California, such as streets and roads, highways and rail/transit.

§ 4.9 Mello-Roos Bonds

Mello-Roos Community Finance Districts (CFDs) and Assessment Districts are often associated with residential subdivisions. Typically, a real estate developer seeks financing of public infrastructure such as curbs and gutters, streets, sewer, water and public safety. If a CFD or Assessment District is created, ultimately each property owner in the subdivision will pay a tax/assessment which, collectively, are then collected and pledged to make payments on the bonds issued to pay for the corresponding public infrastructure improvements.

Both Assessment Districts and Mello-Roos districts issue municipal bonds to pay for needed public infrastructure improvements and services. Although the developer or investor can pay for improvements out of pocket, the cost of construction loans is usually greater than the interest rate on municipal bonds. This typically reduces the cost of property in a subdivision or leases in a commercial development.

§ 4.10 Redevelopment Agencies and Bonds

Under California law, the purpose of a redevelopment agency is to finance and manage improvements in blighted areas. Typically, redevelopment agency bonds are funded by the capture of increased property taxes in the redevelopment project area: a mechanism known as tax increment financing. Any redevelopment plan funded by public monies must include a low-income housing set-aside so that affordable housing is part of the equation.

In addition, redevelopment efforts can focus on: 1) revived retail business areas; 2) revitalized downtowns; 3) repair and renovation of homes in rundown neighborhoods; 4) reduced crime; 5) infrastructure improvements and beautification; and 6) construction or renovation of public amenities such as community centers, parks and libraries.

§ 4.11 Subdivision Development Bonds

While this topic is only tangentially related to public finance, it is mentioned in this section because it is a common source of confusion to many participants in the land development and public finance area. A subdivision development bond is a private surety’s guarantee that a developer will provide those roadway, utility, sewer, water and related utilities that the developer committed to perform under a planned unit development, subdivision agreement or other land development contract with a public entity.

When the developer fails to provide those improvements, the public entity gives notice to the surety for the purpose of collecting the penal sum of the bond, or the cost of the improvements, whichever is less.

§ 4.12 Arbitrage of Project Funds

The concept of arbitrage in public finance is simple: raise public funds using bond financing with very low interest rates, then invest the proceeds in high yielding investments until the public or the project actually needs them. A great theory, but not so reliable in practice.

Under the Tax Reform Act of 1986, state and local governments must “rebate” or remit to the U.S. Treasury Department interest earned on any portion of gross bond proceeds (bond proceeds plus funds segregated and pledged to pay debt service) that was invested at a higher yield than the original reoffering yield on the bonds to the public, with certain exceptions.

Even if there was no rebate, or interest paid for that matter, a large fund for capital expenditure poses special investment and safety risks. As it turns out, public officials are not unfailingly careful or abundantly prudent with the investment of public funds.

The massive bankruptcy of Orange County on December 6, 1994 was largely caused by the speculation in derivatives by Orange County’s Treasurer of 24 years, Robert Citron. The sudden unwinding of the transactions in progress upon the filing of bankruptcy contributed to $7.6 Billion in frozen funds and an eventual $1.6 Billion loss.

Not only did the late Mr. Citron invest in exotic securities he reportedly did not fully understand, he borrowed nearly 2-to-1 against the general fund pool to achieve previously high returns for the County and other local agencies. (See: “When Government Fails: The Orange County Bankruptcy,” and The Second Annual California Issues Forum, “After the Fall: Learning from the Orange County Bankruptcy,” Sacramento, California, March 18, 1998.)

As such, extreme care should be undertaken to avoid risky investments and preserve the capital during the course of the project.

§ 4.13 Selection of Bond Counsel and Financial Advisors

The selection of trusted and respected bond counsel, investment advisors and other professionals and financial representatives is a crucial decision in the public finance process. The experience of these firms varies with the type and size of the transaction in mind, so it is important to match the firm and the advisors with the specific financing assignment. The following subsections outline a few of the “leading roles in a municipal bond or finance transaction.

§ 4.13.1 Municipal Bond Issuers

Municipal bonds are issued by states, cities and counties, or their agencies (the municipal issuer) to raise funds. The methods and practices of issuing debt are governed by an extensive system of Federal and California laws and regulations in California which are intended to protect both the public agencies and investors (bondholders).

§ 4.13.2 Underwriter’s Counsel

The typical duties of Underwriter’s Counsel include, guiding and protecting the investment banking institution at each critical juncture, including the structuring, purchasing, and re-selling of the municipal securities to its retail and institutional clients.

Underwriter protection duties can include: reviewing (and many times, preparing) disclosure statements and agreements, such as the continuing disclosure agreement; preparing and reviewing the bond purchase contract; preparing and reviewing agreements among multiple underwriters; determining the lawfulness of municipal securities offerings; reviewing (and many times, preparing) the official statement or other offering or reoffering memorandum; investigating or reviewing the representations of issuers in disclosure documents; ensuring that the underwriter’s due diligence obligations are met; preparing due diligence opinions addressed to the underwriter; and ensuring regulatory compliance.

§ 4.13.3 Trustee’s Counsel

The typical duties of Trustee’s Counsel include: developing and reviewing indentures and trust agreements, collateral and security matters, including revenue pledges, tax and assessment liens, site leases and the like; investment strategies and investment agreements; opinions on compliance with state and federal bank laws and trust agreement guidelines; procedures such as redemption provisions and amendments to the indenture; definitions of default and acceptable remedies; letters of representation; and all matters relating to the management of funds generated by the bond offering.

§ 4.13.4 Disclosure Counsel

The typical duties of a Disclosure Counsel include: preparing the official statement or other offering memorandum disclosing all information pertinent to a potential bond investor; drafting the necessary SEC 10(b)(5) antifraud opinions; identifying potential changes and incorporating them into the official statement; reviewing all documentation prepared by the issuer, bond counsel, underwriter and financial advisor; assisting with the issuance and sale of bonds; reviewing and reporting on all applicable law; participation in informational meetings with ratepayers, developers and other such project stakeholders; ensuring that all IRS, SEC, MSRB and other such regulatory agency requirements are met; and working with public entity’s manager and chief financial officer on all matters related to the public offering.

§ 4.13.5 Trustee

A Trustee Bank is designated by the issuer as the custodian of funds and official representative of bondholders. Trustees are appointed to ensure compliance with the contract and represent bondholders to enforce their contract with the issuers.

§ 4.13.6 Underwriter

A financial institution (investment bank or commercial bank) purchases a new issue of municipal securities for resale. The underwriter may acquire the bonds either by negotiation with the issuer or by award on the basis of a competitive bidding.

§ 4.13.7 Municipal Bond Insurer

Various companies offer policies that insure against the risks of municipal bond default or municipal financial failure. For example, on October 21, 2008, the New York State Insurance Department licensed Municipal and Infrastructure Assurance Corporation (MIAC) as, “a new financial guaranty insurer. MIAC will be authorized to write financial guaranty insurance policies for municipal and infrastructure bonds.”

§ 4.13.8 Rating Agency

An independent financial services firm rates the creditworthiness of public agencies and rates particular bond issuances. The bond rating represents the quality of the bond and the approximate risk of default of the bond or the public agency issuer.

§ 4.13.9 Investment Community

The purchasers of the municipal bonds and other financial instruments are called the bondholders. As they often bear fixed interest rates, these bondholders are often categorized as fixed income investors. These institutions may purchase the bonds directly from the public agency issuers (primary market) or from the municipal bond market or traders (secondary market).

Institutional investors, such as pension funds, insurance companies and mutual funds are the biggest buyers of municipal bonds. During the banking crisis of late 2008, “… the municipal market (came) to a standstill because of lack of liquidity and uncertainty in the market” said Rob Collins, a Dallas public finance attorney at law firm Vinson & Elkins.

However, those markets have generally healed and the onslaught of federal infrastructure money should buttress this area of institutional finance.

*Definitions of public finance counsel duties were summarized from the web site of Weist Law Firm, Scotts Valley, CA (www.weistlaw.com).