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Southern California City Enters Into P3 for its Water and Sewer Systems

DEC 6, 2012 6:04pm ET
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SAN FRANCISCO – Rialto, Calif. is handing over its water and sewer utilities to a public-private partnership.

The city, 50 miles from Los Angeles with a population of 100,000, finalized an agreement last week to outsource its municipal water and sewer systems for 30 years to the new partnership, Rialto Water Services LLC.

The P3, formed primarily with the private equity firm Table Rock Capital, allows the city to shed responsibility for upgrading and managing the utilities and removes some of the political turmoil caused by raising rates.

“City council, which ran the wastewater and water enterprises, didn’t think water and sewer services were our core competency...that we weren’t good at it,” said Robb Steel, assistant to Rialto’s administrator and former head of the city’s redevelopment agency. “At the end of the day they just thought somebody could do a better job at providing services and capital project delivery.”

Public-private partnerships – joint funding efforts between governments and private business - are rare in comparison to other forms of public infrastructure financings in the United States, and P3s for municipal utilities even more so.

“This kind of asset has really not appeared before, or so in very limited ways, as an asset in a P3 transaction, so that is quite interesting and novel,” said Roger Davis, head of the public finance practice at Orrick, Herrington & Sutcliffe LLP, which represented RWS. “It may be a signal for more to come.”

Most partnerships are in the transportation, health care, leisure and government buildings, according to a recent Standard & Poor’s report. But utility P3’s are not unheard of.

Struggling Nassau County, N.Y. has explored raising money through a P3 for its sewer system.

In  Bayonne, N.J., the city recently formed a P3 to manage its water and sewer systems with United Water and private equity firm Kohlberg Kravis Roberts. The Rialto agreement is similar. 

The concession agreement gives RWS the right to operate, manage, maintain and collect revenue from the city’s water and sewer facilities. In return, it must upgrade the system s over the first five years, with an option to do any subsequent needed improvements. The city will keep ownership of all of the assets.

RWS gets a monthly fee that includes a charge to support debt service and return on equity, operating and management costs and an escalating service fee. Table Rock will handle the financing.

The P3 arrangement is not a complete break with precedent for Rialto -- a subsidiary of French giant Veolia Environnement has operated the city’s wastewater system since 2002. Under the P3, the  water and sewer services will continue to be subcontracted to Veolia.

The financing for RWS includes a $146 million private placement of notes and a $26 million equity stake by Table Rock and other investors, according to Steel.

Part of that money will be used to retire all of the city’s outstanding debt tied to the two utilities: $27.4 million, according to the concession agreement approved by Council in March.

The private placement was arranged by Barclays and Goldman Sachs, which together sold the 30-year notes at 5.5% to five investors that include pension and insurance companies, Steel said.

RWS will spend $41 million of the money raised on capital improvements, while the city will get an upfront payment of $30 million it can use for other projects, according to the concession agreement.

The partnership chose to privately place notes after initially considering tax-exempt bonds because of time constraints and tight spreads between tax-exempt bonds and the taxable notes, according to Davis.

Davis said the legal side of forming the new type of P3 was challenging and unearthed dozens of financial and legal issues. Overall, the city took around three years to form the partnership, which Steel called “quite a tortured path.”

The City Council initially deadlocked on the first proposed agreement in June 2011, and it wasn’t until nearly a year later in March they voted 4-1 in favor of the P3.

Davis said the consortium originally included American Water Operations and Maintenance, the largest private operator of water and sewer systems in the country, instead of Veolia, even though Veolia had been running the wastewater utility since 2002.

Then the city ran into union problems, which Steel said spilled over from employee issues American Water had been having. Eventually the decision was made to drop American Water.

Steel said one of the side effects of the deal is that Rialto will have to raise rates, which will start in January for both utilities and then will go up each following year to pay for the capital improvement program other costs.

One of the positives of the agreement is that council must raise the rates according to the contract, easing the possibility that political problems could stall rate increases and thus impede needed upgrades, Steel said.

Both Steel and Davis said they expect to see other municipalities form P3s for utilities, after Rialto’s test case.

“I think we were sort of the pioneer,” Steel said. “I do expect other cities to decide to outsource their non-core services, especially these days when we are all struggling just to provide core services.”

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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