The once frothy municipal bond market used to be a safe haven for US cities to tap for much needed repairs and upkeep.

According to the American Power Public Association in January, tax-exempt bonds have financed USD 2trn worth of new investments in infrastructure over the past decade, including USD 80bn for electric power generation, transmission and distribution.

In the search for private capital to replenish their tax revenues, other municipalities took the route towards privatization, some with mixed results.

Now, amid the COVID-19 lockdown, many US states and cities are wrestling with a huge drop in their tax revenues as a result of record unemployment levels and businesses being shut down, and there is a growing list of examples.

Last week, the state of Illinois was downgraded to one notch above junk bond status by S&P, and in March, there were nearly USD 12bn in outflows from the municipal bond market, and spreads widening to 2.6%, which finally resulted in the Federal Reserve providing a backstop to the market last month.             

Enter Bernhard Capital Partners.

Bernhard in April closed a five-year hunt for the largest private wastewater utility by customer in Louisiana. It plans to combine it with the same community’s public system to build a consolidated sewer system.

Pitching P3

The community, or parish as it is called in Louisiana, made an attempt in 2015 to privatize the wastewater utility, following estimates that the county’s population would grow to 200,000 by 2030 from its then-ratepayer base of 100,000 to 120,000 customers. The process was quashed, however, after only one company, SCS Management, submitted a bid.

Bernhard pitched for the project as a P3 in the spring of 2019 and struck a deal in January on the DBFOM for a new regional sewer system under a 30-year concession.

Local press reported that the total cost of the new wastewater facility would be roughly USD 225m. If all goes according to plan, it should result in a USD 1.5m rebate to the utility’s 17,000 residents over a two-month billing cycle.

Bernhard is now in “active discussions” with 12 other US cities for similar opportunities.

“We are hoping to create private stimulus by offering a rebate to ratepayers,” says Bernhard co-founder Jeff Jenkins in an interview with Inframation.

Bernhard was founded in 2013 by two former Shaw Group executives -- Jenkins and Shaw founder Jim Bernhard -- after CB&I agreed to buy Shaw for around USD 3bn in 2012. It raised two private equity vehicles before launching an infrastructure strategy last year.

The two private equity funds reflect Shaw’s heritage as one of the world’s largest industrial services providers. In recent years, this included an integrated project delivery firm, the Austin, Texas-based Atlas Technical Consultants, which it sold last year for USD 710m.

The infra fund, with a USD 750m target, reached first close in March, and is targeting utility investments in the US Southeast, including both water and wastewater systems, as well as energy plants. Markets of interest include Louisiana, Georgia and Florida, and targeted returns are similar to the dividends paid out by investor-owned utilities which is typically in the 8% to 12% range.

Waiting game

Infrastructure funds have been driving renewable energy development plans with long-term PPAs with electric utilities for some years now. But for heavily regulated utilities, an open-ended fund or a permanent capital provider can often be a better match, given the length of time it can take to work through regulatory approvals and win over public stakeholders.

“Residential water and sewer and power rates and services are inevitably subsidized one way or the other when they are under the direct responsibility and ownership of elected officials. That makes prices artificially low and creates holes in service and capacity that may be hidden until a private contractor unearths them,” said Bernays Barclay, a partner at Rimon Law PC. “Institutional investors in such companies these days are not interested in being associated with negative environmental stewardship, and can be a more effective and direct governor of compliance by their portfolio companies than even the regulatory commission.”

A recent example is Infrastructure Investment Fund (IIF), managed by JP Morgan, which agreed to acquire El Paso Electric (EPE) in Texas last June. Following conditional approval on 31 March, the agreement will still not close until the end of 1H20.

Bernhard has already had experience of what can be a long and drawn out process, after being part of a consortium shortlisted for the privatization of Florida’s Jacksonville utility JEA.

“JEA process was halted, from our perspective due to public outcry over the sale of the utility and whether the current utility management team had the best interest of the city at heart,” says Jenkins.

Despite bidders such as IFM and Macquarie willing to bid up to USD 11bn, according to media reports, the process was canceled in late December. JEA’s then CEO Aaron Zahn was also suspended as a result of alleged accusations of designing a generous bonus package, claim reports.

Utilities smaller to Jacksonville have also sought privatizations in the past year or so, but each carried its own unique brand of local politics.

In a rather acrimonious dispute in Pennsylvania, the city of Chester feuded with the Chester Water Authority (CWA) over the latter's attempts to be privatized. The city of Chester initially approved a bid with Aqua America, but the CWA filed an injunction claiming jurisdiction since the city only represented 22% of its ratepayers. Earlier this year, a Delaware court cleared a privatization process to move forward but barred them from taking any additional action.

Earlier this month, the city of Chester received three responses to its proposals, including a take under proposal from CWA itself which featured a 10% rate increase, instead of a rebate or freeze, to help fund the bid. Rival bidders Aqua Pennsylvania and Pennsylvania American Water proposed multiple rate freezes.

Politics also took center stage when Edison, NJ pursued a take-private of its water systems. The city struck an USD 811m, 30-year concession with a joint venture comprised of KKR and Suez North America in February 2019. However, the city’s constituents voted in favor of a referendum blocking the agreement. The end result was the city taking over its own water system earlier this year.

“The only growth story in utilities is in service areas growing rapidly,” says Jim Gibbs, a principal with San Francisco-based infrastructure advisor Sperry Capital, “where cities might lack the experience to manage capital demands for high growth.”

Don’t depend on DC

US municipalities with capital needs may not be getting relief from the federal government in the form of an infrastructure bill.

The original draft of the USD 760bn proposal had allocated a collective USD 85.9bn towards clean water and water infrastructure, and USD 34.3bn for Clean Energy, but it is currently delayed as politicians seem more in favor of urgent healthcare investment.

“Municipalities need to realize that Washington, DC, is not going to deliver any infrastructure bill anytime soon and there is no capacity to raise taxes,” says Jenkins, adding that the current municipality funding gap is exacerbated by response costs, loss of tax revenue and a contracting bond market.

Jenkins sees Florida, Georgia and Texas as ideal targets for the next wave of privatizations.

These states in particular benefited from lengthy infrastructure investment over the past decade through new build of toll roads and managed lanes, thanks to Spanish developers such as Sacyr and Globalvia, among others. The next wave of stimulus – for their utilities – will also need to come from private developers.

If Bernhard is among them, investments are likely to be structured as concessions in the 30 to 50-year range. Ratepayers would receive a rate rebate structured as either a cash payment that Bernhard pays to the municipality for the concession assets or through savings generated from operational efficiencies shared with customers and freeing the municipality from operating and capital costs associated with the utilities.

The benefit package being proposed to Ascension in Bernhard’s Louisiana agreement is structured in this way and involves the forgiveness of customer sewer payments for a minimum of two months to up to the end of 2020, according to the company.

“We normally work with political leadership to get a feel for communities’ comfort level with rebates. In most cases at a minimum, we make sure we can freeze rates for a period of time,” says Jenkins, adding that “trust and certainty is a major factor in easing concerns”.

Of the dozen cities Bernhard is in discussions with, Jenkins discloses around six are consolidated utilities with electric, water and wastewater services, while the remainder are water and wastewater.

Given the time it may take to complete any one of these transactions the municipal bond market may be in a very different place than today, but the case for private investment in public utilities can only have moved forward a little further at least.