Roads to riches

By Emily Thornton

updated 6:54 p.m. ET April 30, 2007

Steve Hogan was in a bind. The executive director of Colorado's Northwest Parkway Public Highway Authority had run up $416 million in debt to build the 10-mile toll road between north Denver and the Boulder Turnpike, and he was starting to worry about the high payments. So he tried to refinance, asking bankers in late 2005 to pitch investors on new, lower-interest-rate bonds. But none of the hundreds of investors canvassed was interested.

Then, one day last spring, Hogan got a letter from Morgan Stanley that promised to solve all of his problems. The bank suggested Hogan could lease the road to a private investor and raise enough money to pay off the whole chunk of debt. Now Hogan, after being inundated with proposals, is in hot-and-heavy negotiations with a team of bidders from Portugal and Brazil. "We literally got responses from around the world," he says.

In the past year, banks and private investment firms have fallen in love with public infrastructure. They're smitten by the rich cash flows that roads, bridges, airports, parking garages, and shipping ports generate — and the monopolistic advantages that keep those cash flows as steady as a beating heart. Firms are so enamored, in fact, that they're beginning to consider infrastructure a brand new asset class in itself.

With state and local leaders scrambling for cash to solve short-term fiscal problems, the conditions are ripe for an unprecedented burst of buying and selling. All told, some $100 billion worth of public property could change hands in the next two years, up from less than $7 billion over the past two years; a lease for the Pennsylvania Turnpike could go for more than $30 billion all by itself. "There's a lot of value trapped in these assets," says Mark Florian, head of North American infrastructure banking at Goldman, Sachs & Co.

There are some advantages to private control of roads, utilities, lotteries, parking garages, water systems, airports, and other properties. To pay for upkeep, private firms can raise rates at the tollbooth without fear of being penalized in the voting booth. Privateers are also freer to experiment with ideas like peak pricing, a market-based approach to relieving traffic jams. And governments are making use of the cash they're pulling in—balancing budgets, retiring debt, investing in social programs, and on and on.

But are investors getting an even better deal? It's a question with major policy implications as governments relinquish control of major public assets for years to come. The aggressive toll hikes embedded in deals all but guarantee pain for lower-income citizens—and enormous profits for the buyers. For example, the investors in the $3.8 billion deal for the Indiana Toll Road, struck in 2006, could break even in year 15 of the 75-year lease, on the way to reaping as much as $21 billion in profits, estimates Merrill Lynch & Co. What's more, some public interest groups complain that the revenue from the higher tolls inflicted on all citizens will benefit only a handful of private investors, not the commonweal.

There's also reason to worry about the quality of service on deals that can span 100 years. The newly private toll roads are being managed well now, but owners could sell them to other parties that might not operate them as capably in the future. Already, the experience outside of toll roads has been mixed: The Atlanta city water system, for example, was so poorly managed by private owners that the government reclaimed it.

Such concerns weigh on the minds of public officials like Hogan. He intends to negotiate aggressively with corporate suitors and has decreed that the buyer must share future toll-hike revenues with the local governments that built the highway. But with the market for infrastructure still in its infancy, every deal is different. The ideal blend of up-front payment, toll hikes, and revenue sharing hasn't been found.

Flood of money
The nascent market in roads and bridges in the U.S. follows the shift toward privatization in Europe and Australia that began with British Prime Minister Margaret Thatcher in the 1980s. It took longer to develop in the U.S. because of the $383 billion municipal bond market, which has been an efficient source of capital for governments over the years.

But with the explosion of money flowing into private investments recently, fund managers have been exploring the fringes of the investing world in search of fresh opportunities. Now a slew of Wall Street firms — Goldman, Morgan Stanley, the Carlyle Group, Citigroup, and many others — is piling into infrastructure, following the lead of pioneers like Australia's Macquarie Group. Rob Collins, head of infrastructure mergers and acquisitions at Morgan Stanley, estimates that 30 funds are being raised around the world that could wield as much as $500 billion in buying power for U.S. assets.

Many investors think of infrastructure investing as a natural extension of the private equity model, which is based on rich cash flows and lots of debt. But there are important differences. Private equity deals typically play out over 5 to 10 years; infrastructure deals run for decades. And the risk levels are vastly different. Infrastructure is ultra-low-risk because competition is limited by a host of forces that make it difficult to build, say, a rival toll road. With captive customers, the cash flows are virtually guaranteed. The only major variables are the initial prices paid, the amount of debt used for financing, and the pace and magnitude of toll hikes—easy things for Wall Street to model. "With each passing week, there are more parties expressing unsolicited interest in some kind of a financial transaction that will involve one of our assets directly or indirectly," says Anthony R. Coscia, chairman of the Port Authority of New York & New Jersey.

Firms are even beginning to market infrastructure to investors as a separate asset class, safe like high-grade bonds but with stock market-like returns—and no correlation with either. The Standard & Poor's 500-stock index has returned about 10% a year, counting dividends, since 1926. Bonds have returned about 5%. Firms say infrastructure will beat both, and without having to sweat out market dips along the way. That's a huge selling point at a time when stock, bond, and commodity markets around the world are becoming increasingly interconnected.

Investors can't get in fast enough. They recently deluged Goldman Sachs with $6.5 billion for its new infrastructure fund, more than twice the $3 billion it was seeking. "We're using [infrastructure] as a fixed-income proxy," says William R. Atwood, executive director of the Illinois State Board of Investment, who plans to invest $600 million to $650 million, or 5% of its portfolio, in infrastructure funds over the next three years. "We're hoping to get 11% to 12% returns and lower risk." Pension funds in particular like the long-term investment horizons, which match their funding needs well. Infrastructure "delivers similar yield expectations to high-yield bonds and real estate, with less risk," says Cynthia F. Steer, chief research strategist at pension consulting firm RogersCasey.

On the other side of the bargaining table from the investment firms sit struggling governments suddenly amenable to the idea of selling control of assets to solve short-term problems. The burden of maintaining roads, bridges, and other facilities, many built during the 1950s, is becoming difficult to bear. Federal, state, and local governments need to spend an estimated $155.5 billion improving highways and bridges in 2007, according to transportation officials, up 50% over the past 10 years. And that's hardly the only obstacle they face. In 2006 alone, states increased their Medicaid spending by an estimated 7.7%, to $132 billion. And state and local governments could be on the hook for up to $1.5 trillion in retiree liabilities, estimates Credit Suisse. At the same time, politicians find it difficult to raise taxes. Chicago's former chief financial officer, Dana R. Levenson, sums up the situation: "There is money to be had, and cities need money." U.S. Representative Chaka Fattah, a Pennsylvania Democrat who is running for mayor of Philadelphia, proposes to privatize the Philadelphia International Airport and use the proceeds to fund poverty programs—a much easier sell than a tax increase.

The combination of eager sellers and hungry buyers is shaking loose public assets across the country. The 99-year lease of the Chicago Skyway that went for $1.8 billion in 2005 was the first major transaction. Last year came the Indiana deal. Now states and cities are exploring the sale of leases for the turnpikes in New Jersey and Pennsylvania, a toll road in Texas, Chicago Midway Airport, and several state lotteries. Suddenly politicians around the country are wondering how much cash they might be sitting on. Based on the going rate of about 40 times toll revenues, the iconic Golden Gate Bridge could probably fetch $3.4 billion were California interested in selling. The Brooklyn Bridge? If permission were granted by New York City to charge the same tolls as the George Washington Bridge, a private owner might shell out as much as $3.5 billion for it.

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