May 31, 2012 | Q&AEvent Highlights

The Perils and Promise of Public-Private Partnerships

Lynne Sagalyn, director of the School’s Paul Milstein Center for Real Estate, lays out the benefits and challenges facing the private and public sectors when they team up to undertake large-scale development and infrastructure projects.

Topics: Real Estate

The term public-private partnership, or PPP, is widely used to cover a range of real estate development and redevelopment projects, to the point where almost any large-scale project has come to be called public-private. What is truly a public-private partnership and what is not?

PPP is an approach to delivering good and services — whether it be social services or hard services like sewers or roads — that seeks to combine the economic efficiency of the private sector, the private sector’s capacity to execute, and the private sector’s capacity for management innovation with the territorial scope and service mandate of the public sector, including efforts at economic development. PPP is not a municipality offering tax abatements for redevelopment projects — that’s a public subsidy of a private initiative.

The promise of PPP is that it offers advantages in collaboration — it is a resourceful approach in a fiscally constrained environment, and it realigns risk so that neither sector takes on all the risk. Many PPP ventures present an alternative to the traditional public sector procurement process, which sometimes involves the public sector agency competing for the RFP. In short, PPP is a whole set of ideas aimed at increasing resource productivity and the efficiency of goods and services, be they hard infrastructure products or softer ones, and where both sectors take risk jointly in a project.

There are some types of projects that lend themselves more easily to PPP. Toll parkways are relatively easy to do as PPPs because road boundaries are easily identifiable and service delivery and fees within those boundaries are easily measurable. Water and sewer systems are less than ideal because they tend to be viewed as essential goods, which brings up policy questions of quality and income capacity: are you really going to charge the going market-rate for essential, life-supporting services to someone who is poor?

You’ve touched on some promises of PPP, like efficiency and shared risk. What are the perils?

These are complex contractual agreements centering on risk-sharing that are difficult to design and negotiate, which means that the public players need to have institutional skills and technical knowledge, as well as the political savvy to effectively negotiate with private contractors if they are to secure the best outcomes for the public at large. And quite often there is a skill imbalance between the public and private sectors. The private sector is likely to be more skilled at negotiating the technical and institutional and terrain than the public sector because private players are in the business of doing these types of projects on a repetitive basis whereas for the public-sector they are typically one-off initiatives.

There are three complex economic problems: One is the potential attenuation of value when private firms have to meet stringent regulatory or policy objectives — such as constraints on rate setting or moratoriums on job losses, job guarantees, or where there is detailed regulatory oversight. If a PPP venture requires extraordinary public benefits that create lower private investment value, there are potential efficiency losses.

Two, you often get low levels of competition from a small field of bidders. The public sector requires bidders to have certain technical expertise as well as resource capacity for these projects. Layer on that the policy objectives of the public sector, such as accountability and information disclosure, and that may make some private sector partners withdraw from considering the bid competition. If that occurs, the public sector may face a quasi-monopoly situation — and another potential loss of efficiency.

Three, bidders will add a risk premium to their bid to account for contractual guarantees they have to offer to the public sector and for expected penalties if there are delays in delivery. Also, the public sector often has difficulty in specifying clear outputs or standards of performance that are often required by the private sector, and that can lead bidders quite rationally to adjust by putting in a risk premium.

Take an initiative where the public sector has privatized the construction, operation, and maintenance of prisons. Paying bills to a private contractor often has to be run through many different layers of public sector bureaucracy, which takes time. The contractor is not going to get paid in 30 days — it may get paid in 90 days, but it could take four or five months depending on the bureaucratic structure of the entity. So any contractor has to build in the time value of money to account for how long it takes to get paid.

Doesn’t the public sector face risks in these projects as well?

Of course, there are a number of risks for the public sector, and those tend to be political risks. Try explaining a complex risk-sharing project to a city council or state legislature. New Jersey and Pennsylvania both tried and failed to privatize their turnpikes. Now those may have failed for other reasons but they are also complex transactions with long-term implications that could not easily be undone if things did not work out as anticipated. So, yes, there are big stakes for the public in many of these PPP initiatives. In addition, in the United States, PPP ventures aren’t common enough to be easily understood, and each brings unique complexities into play.

The public sector may end up choosing the wrong contractor, who then goes bankrupt or fails, and that gives a big black eye to the whole public sector and the PPP approach. Cities or states might be overly generous in offering economic incentives and then get called for leaving too much on the table. Conversely, the public sector could frame a project as a PPP but then end up taking most of the risk, through financing, with obvious political consequences.

The issue for both sides is to learn how to co-manage these risks. PPP is not just selling an asset for the public sector with the private sector getting everything it wants.

One challenge you alluded to earlier is the need for stronger skills on the part of the public sector. How can that be addressed?

With capacity building, which starts in grad school, teaching about these kinds of projects and challenges in a very practical way. We’ll be teaching a new course at Columbia called Social Impact Real Estate. We’ll cover projects in that course that will be, by definition, PPP. There are also industry and trade group training and continuing education seminars.

One of the real issues is that if a government is only doing one PPP project, they really don’t have the ability to build capacity — they have to hire expertise in the form of consultants. Then you have to know how to spec contracts for consultants.

Why is now the time to be looking closer at PPP?

The United States is ahead on some aspects of development, like city building, where it has strong model and protocols developed over the past several decades. But we are way behind Europe and Asia and emerging-market countries when it comes to infrastructure PPPs.

We’re trying. We face the same fiscal constraints. There are PE firms in this field trying to do PPP infrastructure deals, raising money, and Wall Street has raised fund money for these types of ventures. There is investor appetite. The problem is at the political level, not at the investor level.

What are the top-line best practices that partners in PPP should embrace?

We need to deal with better procedures for accountability and transparency: What kind of information does a private company have to disclose and when? We need better processes for stakeholders who are affected by PPP projects. We need performance audits and procedures that protect the public interest and don’t merely privatize the public sector. Those are ideals, and this is an evolving field.

What are some examples of outstanding PPPs and what makes them great?

Battery City Park in New York City is one of the most outstanding examples of public-private development. Its planning process and agreements for public sector and private sector responsibilities are still models for large-scale city building.

Indiana sold a 75-year lease concession on the Indiana toll road for $3.8 billion, but it’s viewed as a success because they took the monies and reallocated them to transportation in the counties that had sections of the toll road. It was a neat policy loop of harvesting value and reinvesting it locally. From a policy perspective, it is a good practice to keep that nexus between the public-private benefit. If the public sector is getting funding from the private sector for selling a concession, where does the money go? Where should it go? If it goes back into transportation and enhances delivery for stakeholders, that’s good practice. It’s not good practice if you use the funds, for example, to plug a hole in the operating deficit of a state or municipality.

What are the big future questions around PPP?

PPPs have not been around very long, and we still know very little about how they really work, whether the promises of performance actually materialize. And there is never enough public money or willingness to do all we need to do to rebuild the physical infrastructure of our economy, the bridges, mass transit, sewer systems, or roads that undergird productivity. So how do PPPs work in practice? What’s the empirical evidence of the performance, delivery, design innovation, and balance between private profitability and public policy objectives? That’s the type of research we need to pursue in this area.

Lynne Sagalyn is the Earle W. Kazis and Benjamin Schore Professor of Real Estate in the Finance and Economics Division and director of the Paul Milstein Center for Real Estate at Columbia Business School.

Read the Research

Lynne Sagalyn

"Public-Private Engagement: Promise and Practice"

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