Thread by @kevin_degood

1/ Everyone wants to talk asset recycling (i.e., brownfield lease P3s). Ok let's look at the Bayonne, NJ water concession to understand why asset recycling (AR) is an expensive form of financing often tied to terrible contract provisions. 🧵

2/ The deal transfers responsibility for some capex and O&M for 40 years to the Bayonne Water Joint Venture (initially United Water & investment firm KKR). This lousy deal is shot full of holes. I'll focus mostly on water rates and the lack of risk transference.

3/ The Bayonne Municipal Utility Authority (since absorbed by City of Bayonne) had an aging system & lots of debt backstopped by the City, which dragged down the City's credit rating. For instance, this issuance from 2001 where City pledges to cover any water revenue shortfalls:

4/ The City's main goal with the P3 was to get out from under the Water Authority's debts. The concessionaire agreed to make a big upfront payment to "defease" the authority's outstanding debts. The City's credit rating improved as a result. But...

5/ This rating improvement has come at a steep price. Water rates have increased by **50 percent** since 2012. Depending on the measures, this is ~3x faster than inflation. GDP chained inflation since 2012 is 16%. CPI estimate is 20%. Bayonne residents are getting hammered.

6/ Why are water rates rising so much faster than inflation? Because that's what the contract **requires​.** Rates are the function of a formula, which is set well above inflation. (Pic 1 is a summary. Pic 2 is the actual contract language.)

7/ But surely in exchange for guaranteed rising rates the concessionaire is taking on a big, complicated, and risky project? Nope. Just upgrades/O&M for drinking water distribution pipes & wastewater pipes and 9 pump stations.

8/ Why is the deal so narrow? Because Bayonne gets drinking water from North Jersey District Water Supply Commission and wastewater services from the Passaic Valley Sewerage Commission.

The P3 is local pipes and pumps. That's it.

9/ Yet, the P3 contract ensures Bayonne ratepayers are on the hook for lots of risk, including 11 categories of "unforeseen events" such as force majeure, strikes or labor disputes, changes in law, or judicial orders, etc.

So much for risk transference.

10/ Don't worry. It gets worse. The concessionaire must spend $2.5M each year on "incremental capex" (i.e., upgrading pipes/pumps).

If the actual cost of upgrades exceeds $2.5 million - you guessed it - rates must go up even more the next year. "Revenue...Adjustment Event."

11/ Part of how United Water/KKR sold the deal to Bayonne was convincing them the contract terms would lock in stable annual rate increases after first year 8.7% hike. (see graph). The contract actually locks residents into paying for anything unexpected (see headline). Whoops.

12/ And when I say unexpected costs, I don't mean a meteor hitting the system but basic issues like water main breaks, which are standard for an old water system. No matter, under the terms of the agreement, the concessionaire bears no risk. Costs are passed on to ratepayers.

13/ Basically, private equity took advantage of a municipal authority with distressed assets and heavy debts to negotiate a brutal 40-year contract with steep rate increases and little risk.

And how did that work out for KKR? Uh, not bad.

14/ As it turns out, KKR sold the contract and earned a "gross internal rate of return of 36 percent and a 2.8 times gross money on invested capital..." Pretty sweet* for replacing some old pipes.

*Not actually sweet.

15/ How much would Bayonne's leaders (or residents) give to have never signed this deal and instead to have waited and refinanced their outstanding debt at today's low rates? I'm guessing a lot. Unfortunately, the concession precludes taking advantage of lower interest rates.

16/ Asset recycling is attractive to PE investors because infrastructure assets are monopoly or quasi-monopoly goods. The lack of substitutes allows for rent extraction. In this case, ratepayers are on the hook to binding contract terms until 2052.

17/ There are much better ways to pay for needed infrastructure upgrades than asset recycling/brownfield lease deals.

And when it comes to the cash from an upfront lease payments, there is no free lunch. Let's stop pretending otherwise.