Tuesday, July 6, 2010

The Elixir of Privatization for Infrastructure

 Blueridge Parkway Tunnel Construction 1935 (In the Public Domain)

Along with the nostrum of austerity in the midst of severe recession, the pedlars of financial patent medicines are offering the magical elixir of privatization as the cure for infrastructure needs around the globe. Today's Financial Times carried a lengthy article focused on America's needs, including advice from one famed investment banker who as noted saved New York City some years ago. And just now happens to be working for a firm "which has a big infrastructure business" and, perhaps, stands to make a shipload of money from successfully closing such deals. A bit of signaling from the FT in those six words?

Not only are the sums required great -- an estimated US$2 trillion. But there is a deeper problem.
"We are almost broke wherever you turn," Mr. Rohatyn said.
 How can we solve this conundrum?

Private investors, including kindly foreigners, stand ready to step up to bail out beleaguered and bankrupt local US governments if only small minded impediments can be removed. If achieved, local governments will be able to sell existing assets and get cash now. To apply the teaching of the famous commercial "It is my money" and "I want it now". And as well turn over costly new projects for private development.  An apparently free lunch, economically speaking.

Imagine the economies and efficiencies of having private industry in charge, not wasteful, spendthrift governments. Or the enhanced sharply focused management of assets and resources. One only has to look at the track record of the private sector in the financial sector, the oil and gas sector (perhaps with a focus on offshore drilling), mineral extraction (coal mining springs to mind) to see how well the profit motive can sometimes be married with careful stewardship.

The price for all this is rather modest. All that's required is the agreement to pay a fair return on the capital provided, a rate set by the "market". What could be fairer than that? Well, maybe just a few extra "bits" to top off things: some tax breaks and perhaps rights to develop adjacent or adjoining real estate. A small price indeed when one considers all the benefits promised to accrue.

Like the chimera of the efficacy of self-regulation, however, the reality is a bit less rosy than promised. Private capital generally is looking for returns in excess of 12%. On top of that one will have to compensate the diligent managers of that capital with management fees and carried interest for their time, hard work, and value creation. Anything less would be unfair. Anyways it will be a "market" rate. Then, of course, some one will have to bear the cost of the services of famed and not so famed investment bankers who help put the deals together. But no doubt (well at least among its advocates) still cheaper than wasteful government spending on a purely public project which is done as we all know on "non market" terms.

Suddenly, that "free lunch" appears a bit more costly than that in the public service diner. With privatization citizens will pay the price in terms of higher usage fees and/or less service. Or will give up value through the sale of "their" existing assets at prices low enough to give private capital its required market based rate of return. "Their assets"? Well, ultimately what are local governments except those citizens? Much as the shareholders of a private company are essentially the company itself.   I am for the sake of economy in my argument ignoring the many and repeated "agency problems" in the public sector.  A sad event which happily does not occur in the private sector.

So the choice is between paying taxes to the Government (an inherently bad thing as any good American can tell you) or paying fees to the private sector (an inherently patriotic and soundly economic thing to do). A remarkably easy choice it seems.

That the fees to the private sector may in the final analysis be higher (because of all the worthy mouths that need be to be properly compensated) is a rather small detail. The provenance of the small minded.  Another real benefit is that these schemes allow politicians to engage in the time honored and election savvy practice of inter temporal shifting. Provide a benefit today and shift the cost burden to the future when it will be someone else's election and problem. A fact which largely explains why investments in infrastructure have been deferred causing the current problem. 50 years or more of neglect. Until the water mains start popping like champagne corks, their condition is out of sight and out of mind. Instead money can be spent on more pressing universally recognized public goods like tax cuts.

Many will no doubt protest that such analysis smacks of dangerously leftist ideas. Indeed!

For such an analysis let's turn to the radicals at Blackstone Infrastructure Partners.
In a guest editorial for Infrastructure Investor magazine, Blackstone's Michael Dorrell, David Tolley and Trent Vichie point out that the Dow Jones Utilities Index could be used as a benchmark of performance for long-term, US-listed infrastructure returns. That index has delivered 9.5 percent compounded returns per year since 1970, and private infrastructure funds should take stock of this return:

"By simply levering the Index to customary infrastructure fund leverage levels, one would increase the return to 12 percent. That is, on a leverage-equivalent basis, private market funds must provide net returns of 12 percent simply to match the historical performance of the Dow Jones Utilities Index," Dorrell, Vichie and Tolley write in their editorial.

To provide a 12 percent net return, Dorrell, Vichie and Tolley point out that funds will likely need to provide internal rates of return in the range of mid-teens, taking into account several different fee structures.

Carried Interest
Management Fee10%20%
1%14.1%15.2%
2%15.2%16.3%

 
"The analysis demonstrates clearly that a low double-digit return hurdle, which is somewhat common among private infrastructure funds, is too low to generate any meaningful outperformance against publicly-listed infrastructure, and provides investors no compensation for illiquidity," they conclude.
The simple answer is to raise the required return to attract the capital. Those with a belief in traditional economic theories of demand/supply equilibrium might be forgiven for assuming that raising a non trivial US$ 2 trillion might perhaps exert some "slight" upward pressure on the required rate of return.

Now AA is not advocating that private capital has no role in helping fund public infrastructure. It has but in the context of the proper understanding of what a public good is. And the value – both direct and indirect – of service franchises. Plus critically their importance in the wider context. One only has to think of the myriad of benefits and the knock-on effects that accrue to a locality from improved transport. So-called positive externalities. Sadly often overlooked by those selling public assets and public franchises. With the result that no examination is made of how higher private market pricing might in itself adversely impact those externalities to the detriment of aggregate wealth.  If I'm not mistaken, a famous Austrian political and economic thinker attributed such rent seeking behavior to "girly men" capitalists.  But then I suppose I could have the citation wrong.

Anthony Shorris, former head of The Port Authority of New York and New Jersey, discusses some of these issues along with others in this rather useful article. As above, this is a good juncture to note that as a former public employee, his agenda might reflect some personal interest just as that of famed and not so famous investment bankers might.

Finally, to complete the discussion, it might be worthwhile to muse on relative rankings of government expenditure. Some expenditures it seems are by common agreement and definition more worthy than others. More worthy of spending. More worthy of incurring debt to be paid by one's grandchildren.   And perhaps in some cases one's grandchildren's grandchildren's grandchildren.

Perhaps the simplest solution to the infrastructure crisis in the USA is to redefine the need as an integral part of national defense. From potentially futile attempts at nation building in inhospitable foreign climes to a bit of nation building "at home".  A new twist on "Homeland Security" if you will – a phrase that just might catch on.

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