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Thursday, October 29th, 2009

Principles of Privatization – Part 2: Value Levers

Continuing with my series on privatization of government services, today I look at the question of how privatization creates value. You can also read part one on the types of transactions.

While a few people just don’t like the government doing things on principle, most of the time privatization – again, undertaken by both Democrats and Republicans – is touted has having benefits to the tax payer. There are three basic ways this can happen: new revenues, reduced cost, or improved service.

New Revenue

Many governments are attracted to privatization to raise funds. When Indiana and Chicago leased their toll roads for 75 years, they received billions in return. That’s a pretty powerful incentive for cash strapped governments. But we shouldn’t just assume a cash payment represents net revenues. We need to ask ourselves why someone would be willing to pay a bunch of money to take over a government asset or service. According to newspaper reports, Citzens Gas made an offer of $1.8 billion to buy the Indianapolis Water Company. Sounds like a great deal. But why would a company pay $1.8 billion for a utility that doesn’t make any money today? They some how need to raise new revenues themselves or reduce costs to justify that payment. Where is the real financial value being generated in the transaction?

On the revenue side, the way you boost revenue is to either raise prices or sell more units. It should come as no surprise that most privatization transactions that result in large cash payments to the government involve significant price increases. In our toll road example, tolls were raised considerably. Rates quadrupled in the Chicago parking meter lease. Part of the logic here is that prices had been set artificially low because of political demand. The lure of the big upfront payday helps politicians justify raising prices to the public.

In terms of selling more units, I haven’t seen that play a major role in most cases. Indeed, with things like water usage, we actually want to encourage people to conserve and consume less.

In some cases, straight-up asset sales – such as shares in a nationalized company or surplus property – simply convert value from one form to another, turning hard assets into cash that can be spent on other things.

Cost Reductions

In many cases we are told that a private company can provide a service more cheaply than the government. In theory, this would be straightforward to determine. You simply compare the cost of private bids for a service to the cost of doing it yourself.

The challenge is that it can be surprisingly difficult to calculate the internal cost of producing something. In fact, there’s an entire diabolical field of accounting called cost accounting that deals with this.

One of the big problems is that in addition to the direct costs of providing a service – the crews who are assigned to road maintenance, for example, along with their equipment and supplies – there’s a large amount of “overhead” services that go into it. Examples include legal services, shared facilities and office space, payroll processing, etc. Often these are provided on a “shared services” basis where they are pooled across departments so determining what amount should be charged back to a particular service can be difficult. In fact, some places might not even try, so a lot of the cost of a service is unknown. Many of the costs, likewise, are fixed in some regard. If the government owns an office building, the cost of office space might not be removed from the books even if a service that uses it is outsourced. And there are all sorts of contingent, deferred, and unknown costs. Most notably, the salaries collected by government employees don’t include all of the real costs because public sector pensions are generally so radically under-funded, so labor costs are probably understated.

On the other side, what someone else can charge to provide a service isn’t the whole cost either. The government still needs an oversight function and has to be accountable to the public for the results in most cases. So retained costs can’t be ignored.

I worked in the outsourcing business in the private sector (on both sides of the house). So in terms of one company outsourcing to another, I can tell you how we created value through costs savings:

  1. Labor Arbitrage. Yes, that means replacing employees here with cheaper employees in an offshore location. I hate it too.
  2. Centralization. Rather than having people scattered all over doing, for example, technology support, most functions are centralized in service centers to enable the benefits of pooling resources, standardized processes, and specialization through increased division of labor instead of generalists. You can also achieve purchasing power benefits this way.
  3. Economies of Scale. This is fundamentally about substituting fixed costs for variable costs and using large volumes to deliver superior unit cost performance. For example, someone in the invoice processing business can invest in high capacity scanners and automated workflow systems if volume from multiple clients is high enough.
  4. Arms Length Relationship. If you outsource a service there is a contract with agreed on payment terms and service levels. The person managing that contract for the vendor is on the hook for delivering financial results. That makes him very motivated to stick to the letter of the contract and not provide higher service levels and un-contracted for services. Also, he’s very motivated to push through any cost cutting or restructuring ideas he can come up with. Contrast this with an internally provided service. It can be very difficult to say No to service requests that originate inside your own organization, particularly when they come from highly placed people. Everyone understands the vagaries of organizational politics. Plus, since everything comes out of corporate “funny money” budgets, there’s no reason not to demand unlimited services unless you are in some sort of hard chargeback model. But if you’ve got an external vendor and have to pay for the things you want in green money, it is amazing how the definition of “need” can change. A third party can provide needed discipline to an organization in many cases. Call it outsourcing resolve, or in the public sector, outsourcing political will.
  5. Best Practices. Specialty providers in a given service area who do it as their core business can be expected to do it better than someone to whom it is merely an ancillary concern.

In the public sector there may be one more source of cost savings: taxes. Since governments don’t pay taxes, they get no tax benefit from depreciation, whereas a private company can. I mentioned this before in terms of sale/leaseback transactions. But a private company also has to earn a profit and pay taxes on profits, which would certainly affect its ability to pass on savings to the customer.

So when looking at a privatization transaction, let’s ask if any of these apply. For example, let’s consider the water utility privatizations that are being evaluated by Chicago and Indianapolis. Clearly, no jobs are going offshore. How many could be simply eliminated? Probably some, but probably not big numbers either. You can’t centralize core functions. For example, you couldn’t have a big, giant water company build one use plant in the center of the country and pipe water to customers from there. On the surface there isn’t much opportunity for variable to fixed cost conversion in the core either. Clearly, some functions like billing could potentially benefit, however. There are probably some best practices that could be brought to bear, but given that utilities, unlike say invoice processing at most companies, is actually a core function of most governments, Indy and Chicago already likely have plenty of expertise. There is likely some value in having an arms length relationship, though government contractors are likely to always be cozier with officials than a vendor would be in the private sector.

So while I can envision lots of ways that efficiencies could be gained and costs conceivably reduced, I am not seeing the opportunity for game changing reductions. Certainly not $1.8 billion worth.

So where would the value in the gigantic payoff come from? I would like to suggest as a rule of thumb that if it is not intuitively obvious where the value in a lump sum privatization is coming from, then there either a) is no value, and the transaction is primarily about capitalizing a future revenue stream or b) is a major price embedded in the deal.

Remember, capitalization is like that lottery payoff. You can take X per year for 20 years or get a big lump sum now that is lower than the total of the payments in the other option. There’s nothing wrong with taking the money now, but remember, if you do, all of those future cash payments disappear. If you were counting on those to balance your budget, you now have a big hole to fill. That is why, for example, when leasing the parking meters in Chicago, the city put a portion of the money into an investment account whose proceeds will replace the normal money the city would have collected from meters.

My gut tells me that when it comes to water utilities, to justify numbers like $1.8 billion, rates are going to be headed up – a lot.

In fairness, I should note that numbers like $1.8 billion are probably the gross, not net amount. Meaning a lot if it is just an assumption of debt by the buyer. For example, when a Citigroup led consortium was going to lease Midway Airport in Chicago, they were paying $2 billion, but there was only $1 billion in net proceeds since the other $1 billion was going to repay the city’s airport debt. (This deal was never closed).

Improved Service

Again, I should note that in the private sector, outsourcing is often about reducing service levels, or at least making sure that the targeted service levels aren’t exceeded. This can leave a lot of the rank and file unhappy but make the CFO very happy. In the public sector, where the top executives are elected officials who have to face voters regularly, this is obviously not something they want to do.

Still, you can get better service if you outsource at times. Gmail is far better than any email system I could host for myself, for example. For things like toll roads, if people don’t drive them, the concessionaire doesn’t make any money. So they’ve got a big incentive to keep it as motorist friendly as possible.

At the end of the day, this would have to be looked at on a case by case basis and we would need to have some reason to believe service would improve. Sometimes you don’t know until you try.

How the Indiana Toll Road Lease Created Value

So let’s put it all together and look at how the Indiana Toll Road and Chicago Skyway leases generated almost $6 billion in value. It’s a combination of several factors:

  • Tolls went up. That is, prices were raised significantly
  • The hedge paid off – big time. I mentioned in the previous installment that by paying a fixed price up front for 75 years, the toll road concessionaire took on a huge amount of risk about future revenues and costs that the government used to have. In turned out that they are getting far less traffic than predicted and they are taking a bath on the deal. In short, they vastly over paid. You can’t hang your hat on this happening every time, but it is nice when it does.
  • Some cost savings, but probably not a major amount
  • Some customer improvements such as electronic toll collection

Principally, it was about raising prices and then getting lucky when the vendors radically overpaid. Indiana had one additional lever. Chicago had already leased the Skyway. The only way to get to the Skyway is via the Indiana Toll Road. Indiana could have jacked tolls through the roof and cut off the supply to traffic to the Skyway whenever it wanted. As a result, the same consortium that leased the Skyway almost had to pay whatever it took to win the Indiana Toll Road. Mitch Daniels had them over a barrel.

Both Indiana and Chicago were able to realize further benefits through the way they spent the proceeds. They were able to put a lot of the money to use on capital improvements that otherwise would not have happened for a long time if ever. So they avoided years of construction cost inflation and pulled forward the benefits of those projects. However, that type of logic would not have justified doing the leases on its own if they weren’t otherwise such good deals.

Evaluating the Deal

So, as cities and public look at these potential deals, they need to understand the type of transaction or transaction bundle being considered, and examine how that deal is generating value. If it is not intuitively clear where the value is coming from, red flags should be raised. Next, I’ll look at the uses to which the funds can and should be put.

More in This Series

4 Comments
Topics: Public Policy

4 Responses to “Principles of Privatization – Part 2: Value Levers”

  1. cdc guy says:

    Aaron, a couple of factors in Indy:

    Indianapolis’ water company has never been municipally operated, so the “core operation” concept is invalid here. Prior to the city purchase (with Veolia’s private operating contract) earlier this decade, IWC was an independent company, and then a subsidiary of NIPSCO.

    The PUC has roundly criticized the municipal oversight of the water utility since the city bought the pipes and plants. Having never run a water company, the city apparently didn’t know how to contract it out.

    Citizens Energy is a not-for-profit trust, so its cost of funds is not as high as a for-profit buyer’s would be. Plus, it already has in-house meter-reading, customer service, billing, and pipe-service operations, so savings are more plausible than with other purchasers.

    And finally, per-gallon water rates are absurdly low. We pay more to send water down the drain than to get it out of the faucet. It wouldn’t hurt to increase rates to promote conservation; even in Central Indiana clean fresh water is not an unlimited resource.

  2. Paul says:

    I would be very interested in finding an analysis of the financial structure behind the “investments” in existing infrastructure. My gut instinct is that the purchases/leases of the Skyway and Indiana Toll Road were heavily leveraged affairs, dependent on “carry trade” financing. My hunch is that the purchaser (led by Macquerie Group) borrowed Japanese Yen to finance much of the deals betting that the Yen would remain weak and continue to exhibit extremely low interest rates. A return on investment of only 2 or 3 percent could be quite profitable if you paid only 1.5 to 2 percent interest and as long as the yen remained weak. Given Japanese sensitivity to maintaining exports in the face of growing Chinese and Korean competition, they had every reason to expect that the Japanese would be sensitive to appreciation of their currency.

    Were these deals, in part, a form of long term currency speculation, a bet that Japan could not escape from the liquidity trap it found itself in after its property bubble burst in 1990?

    More to the theme of this blog though, I can say that the transactions involving the Toll Road and the Skyway made a new user of the South Shore out of me. What worries me though is that private control of the Toll Road and Skyway will be (yet another) source of corruption in Indiana politics, with the consortium controlling these improvements quietly working to blunt improvements to service on the South Shore interurban between South Bend and Chicago.

  3. Alon Levy says:

    Paul, corrupt public interests are as capable of blocking competition as corrupt private ones. In New York, much of the disinvestment in the subway over the decades came from the dominance of Robert Moses, a public appointee, who preferred to invest in roads.

  4. Paul, I wouldn’t be surprised if this were a carry trade transaction either. I just read in the Journal this morning that Macquarie is restructuring its infrastructure funds, including highways. Not sure on the full rationale, but they clearly got burned.

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