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Third-Party Financing of Federal ProjectsBudgetary pressures have spawned a new approach to financing federal projects. Rather than relying on regular appropriations or other traditional forms of federal financing, agencies have arranged for private parties to fund various infrastructure projects, such as housing on military bases, government office buildings, and electric-power facilities. Agencies have been able to arrange such financing by making long-term commitments, either explicit or implicit, to use the resulting facilities (or related services, such as electric power). Since 1998, third parties have borrowed roughly $12 billion to fund federal projects, the Congressional Budget Office (CBO) estimates. Third-party transactions are generally structured in such a way as to try to justify recording investment costs in the federal budget over the life of a project instead of in full when the investment is made--as would be the case with normal appropriations. Treating investment costs as an annual operating expense may make it easier to get projects funded by eliminating the need for substantial up-front appropriations. However, such budgetary treatment is at odds with established principles of federal budgeting, which require agencies to record the costs of government investments when they are made. Third-party financing arrangements have a number of negative consequences. In general, projects are more costly to the government when they use such financing. In addition, if agencies do not initially record the full cost of governmental activities, the budget understates the size of the federal government and its obligations at the time when those obligations are made. Third-party arrangements may also skew decisions about how to allocate budgetary resources by giving preferential treatment to investment projects on the basis of their method of financing rather than their relative merits. Finally, third-party financing allows agencies to raise capital in private markets without the full scrutiny of the Congressional appropriation process and without reference to the statutory limits on borrowing that exist for some agencies (such as the Tennessee Valley Authority and the Bonneville Power Administration). This brief describes some of the financing methods that agencies use to raise capital through third parties and discusses why, in most cases, the costs of the projects should be included in the budget when they are undertaken.
What Is Third-Party Financing?The idea behind third-party financing is that an intermediary other than the U.S. Treasury can raise money in private capital markets on behalf of a federal program as long as private financiers are confident that they will be repaid--on the basis of some kind of long-term federal commitment. Agencies have used at least three different third-party methods, which provide different forms of security for investors:
Such financing arrangements involve multiple parties. Sponsors usually create a special-purpose entity (SPE) for each project to serve as the locus of the agreements supporting the financing. Major investment firms typically manage the financing on behalf of the SPE, and various other firms--consultants, insurers, developers--provide additional support. Money is often raised by selling bonds (issued by states, localities, nonprofit organizations, or private parties) or other forms of debt.(1) Relying on third-party financing generally increases costs to the government. Each intermediary charges a fee for its services, which together can add at least 2 percent--and in some cases more than 50 percent--to the costs of a project.(2) Interest rates on projects' debt usually exceed interest rates on Treasury bonds by anywhere from 1 to 3 percentage points, depending on the terms negotiated by the parties. Some agencies believe that they can realize savings through third-party financing by avoiding certain construction costs that would be incurred if the government undertook a project itself. If such savings are possible, they can be obtained through changes to federal construction practices without imposing higher costs on taxpayers through third-party financing. Third-party financing arrangements are largely exempt from traditional spending controls--such as appropriation laws, which limit the amount, purpose, and time for which funds are available. The ability to use third-party financing depends instead on an agency's broad statutory authorities to enter into various kinds of contractual agreements.(3) Those contractual authorities are used to assemble a package of agreements that is sufficient to secure private funding. Because of the open-ended nature of such authorities, agencies have wide latitude in deciding what projects to undertake, how much to spend, and how and when to report the projects' costs.
Budgetary Principles for the Treatment of Projects with Complex FinancingThe way in which an activity should appear in the federal budget depends on the nature of the activity, not its method of financing. Under the principles that govern federal budgeting, budgetary treatment should be based on the answer to the question, Is the activity governmental (that is, initiated, controlled, and funded largely by the government for governmental purposes), or is it an initiative of the private sector (driven by market forces independent of the government)? An investment that is essentially governmental should be shown in the budget whether it is financed directly by the U.S. Treasury or indirectly by a third party that is borrowing on behalf of the government. When budgetary classification is ambiguous, analysts often consult the 1967 Report of the President's Commission on Budget Concepts. That report established a comprehensive conceptual framework for the federal budget, addressing what should be included and how costs should be measured. According to the commission, the budgetary treatment of a transaction should depend on its economic substance: who controls the program and its budget, who selects the managers, who provides the capital, and who owns the resulting entity. When doubt exists, the commission advised, "borderline agencies and transactions should be included in the budget unless there are exceptionally persuasive reasons for exclusion."(4) Likewise, spending financed by all forms of agencies' borrowing, including debt not backed by the full faith and credit of the U.S. government, should appear in the budget. The commission considered--and expressly rejected--the concept of treating spending on durable assets (such as infrastructure projects) differently from other federal spending. As a result, the commission intended that the costs of federal capital projects should be recorded in the budget when the investments are made. In terms of third-party financing, the commission's guidelines indicate that decisions about budgetary treatment should:
Applying those guidelines means that activities do not have to be conducted by a federal agency to be classified as governmental and included in the budget. A number of programs not directly administered by federal agencies appear in the budget, such as the Universal Service program (intended to expand the availability of telecommunications services), the activities of the Public Company Accounting Oversight Board, and the Coal Industry Retiree Health Benefit program. The federal budget also includes entities that are jointly owned by the government and the private sector, such as the Rural Telephone Bank.
How to Tell Whether a Project Is GovernmentalFederal agencies have used third-party financing to carry out hundreds of projects, including more than 40 military-housing privatization projects, numerous enhanced-use leasing projects, hundreds of performance-based contracts, and a variety of other leases, lease-leasebacks, and alternative arrangements (see Box 1 below). Given the extent of federal control over and economic support for such projects, most are not private endeavors; rather, they are governmental activities financed by private-sector intermediaries that act on behalf of the government. Although individual examples of third-party financing vary in their details, they share some common features that suggest that the activities are governmental, not private-sector initiatives. In most cases, the government:
As a general rule, the conditions that make projects viable for investors are usually some of the same features that suggest that the projects should be classified as governmental activities. To secure private financing, agencies must demonstrate the government's long-term economic interest in the asset or service. Likewise, many of the contractual conditions that agencies seek in order to protect the government's interests in a project give the government ultimate control over the activity. Project Initiation and SelectionProjects undertaken with third-party financing usually start like other federal procurements: with an agency soliciting proposals to implement a project according to the agency's specifications. In the case of third-party financing, the government typically couples a transfer of federal property with directives on how the property may be developed. Common parameters include specifications about the size, location, use, and potential customers for the facility. Agencies also negotiate the terms of the project's legal structure, cost, and financing and help market the project by participating in meetings with private financiers and credit analysts to explain the government's support for the project. Economic Ownership InterestIn many instances of third-party financing, a project is created as a stand-alone entity, sustained by the cash flows generated by its assets. Such a project is generally not "owned" in the traditional sense of the word. Instead, it is a collection of agreements--usually signed concurrently--that ensure that the project can be developed, financed, and operated without legal recourse to the assets of the parties involved. Developers typically create a limited liability company (LLC), partnership, or other special-purpose entity specifically for each project. In many cases, the government itself is a member of the LLC or the beneficiary of the SPE. That mixed-ownership structure has been used extensively by the Army and Navy for military housing projects and by the Department of Veterans Affairs (VA) for its enhanced-use leasing projects. Ownership interests may also derive from a long-term economic interest in the project, even if the legal ownership appears to reside with a private entity. When the government contributes or conveys assets at the start of a project in exchange for future compensation from the project's operations (in the form of in-kind services, profit sharing, rental subsidies, the right to reacquire property, or other economic returns), it has an ongoing economic interest in the risks and benefits of the project. Governmental ControlIn most cases of third-party financing, the government exercises significant control by imposing conditions on the agreements used to implement a project. For example, the ground leases for military-housing projects usually obligate the developer to adhere to various government-approved plans, including a construction management plan, rental rate management plan, unit occupancy plan, property operations and management plan, facilities maintenance plan, capital repair and replacement plan, and reinvestment plan. Agreements governing facilities built for VA and the General Services Administration have also included controls over a project's construction, budget, uses, and management practices. In addition, the government generally maintains control over the land and other assets of a project. Entities leasing federal property cannot sell, transfer, sublease, license, or grant any other possessory interest in the asset without the government's approval. Similar restrictions have been imposed even when title to the land has been conveyed, in part because the government usually retains the right to repurchase the land. Moreover, the government usually owns or controls the disposition of any infrastructure improvements after the project's debts have been repaid. Source of CapitalThe source of capital for such projects is the income that will be generated by their operation, which usually comes from federal spending. Bond proceeds or repayable equity investments are means of financing a project--not the ultimate source of capital. The assurance of future cash flows from the government is especially important for project financing because sponsors will not have recourse to the assets of other firms if the project hits a snag. As a result, investors carefully examine the use agreements in place when a project is approved (such as leases, occupancy rights, or purchase contracts) to determine whether the project's income will be sufficient to cover its costs. For most of the third-party projects carried out so far, credit assessments make it clear that the government is the only or dominant user identified in the agreements--and hence, the only or dominant source of capital.(5) Consequently, those assessments focus primarily on the essentiality of a project to the government, historical trends in appropriations for such activities, and other collateral agreements and management actions that demonstrate the government's commitment to the project. Existing third-party projects have been rated as investment-grade, suggesting that sponsors have given lenders sufficient evidence of the government's intention to use, and thus pay for, the projects.(6)
How to Show a Project's Costs in the BudgetPolicymakers rely on budget estimates in making trade-offs among programs competing for federal funds.(7) As they compare programs--whether financed through third parties or conventional means--decisionmakers need complete and consistent information about the long-term budgetary consequences of each one. The conceptual framework outlined above is meant to ensure the integrity and transparency of budget estimates. When proposed legislation would authorize transactions involving third-party financing of governmental activities, CBO's cost estimate for the legislation shows the full cost of the project up front and treats that cost as direct spending (since the authority for the full cost is not provided in advance in appropriation acts). That treatment reflects the types of transactions that agencies currently use to secure financing by third parties, which is equivalent to exercising borrowing authority for federal activities. Recent examples include CBO's cost estimates for legislation authorizing the acquisition of aircraft-refueling tankers from Boeing, the construction of military housing, energy savings performance contracts, and various public/private partnerships.(8) Executive branch agencies, by contrast, classify virtually all of those projects as private-sector initiatives and treat the government's use of the assets or services as an operating lease or other type of annual discretionary expense. Agencies often base their budgetary treatment on one or two features of a project instead of evaluating the project as a whole. For example, the Department of Defense characterizes military-housing projects as a landlord/ tenant relationship between developers and individual service members, discounting the extensive contractual relationship between the developers and the government and the fact that the projects' cash flows depend on an increase in appropriations for basic housing allowances for personnel living in "privatized" military family housing. Likewise, agencies commonly treat building projects as operating leases, discounting other contractual agreements that support the projects' financing, such as federal debt guarantees, renewal options, use agreements, and penalties for cancellation. Viewing those transactions as operating leases ignores the government's concurrent role as lessor or owner of the facilities. In characterizing their projects, agencies also frequently focus on narrow legal constructs instead of on the economic substance of the transactions. In one instance, an LLC composed of the Army and a private developer circumvented statutory prohibitions on federal guarantees of agencies' borrowing by creating another LLC to handle the financing. The Administration approved the guarantee to the parallel LLC although the project is being developed, managed, and operated by the Army's LLC. Multiple layers of LLCs have also been used to secure various tax benefits. In another case, VA argued that its lease of a regional headquarters building did not include a renewal option because the SPE operating the project--of which VA was the sole beneficiary--could, in principle, reject the agency's request for renewal. Agencies often exclude investment costs from the budget because a private party shares some of the risk of a project. Sharing risk can blur distinctions between federal and private roles, but it may not materially change the governmental nature of an activity. Risk is just one of several factors that must be considered when deciding whether an activity is governmental. Moreover, projects pose different kinds of risk, many of which have a negligible effect on the economic substance of the transactions.(9) Transferring risk to private parties generally increases a project's financing costs, because investors seek a rate of return that is high enough to compensate them for whatever risk they take. Thus, the government--as the primary user and source of cash flow for the project--is likely to bear most of the cost of the risk. Sometimes, third-party projects are characterized as privatization of a federal activity. True privatization, however, involves a genuine sale of assets and termination of a federal activity. In two cases of actual privatization--the sales of the United States Enrichment Corporation and the Elk Hills Naval Petroleum Reserve in the late 1990s--the government was paid several billion dollars for the assets, and the laws and regulations that governed their operations were repealed. In contrast, projects financed by third parties are being undertaken to fulfill ongoing missions of the government, and the government remains heavily involved in the projects. Furthermore, the federal assets being transferred for those projects are not truly being "sold" because the private parties cannot transfer, sell, or assign rights to the land or improvements without the government's approval.(10)
ConclusionTo properly measure the scope of the federal sector, the budget should record obligations and expenditures for projects financed by third parties the same way that it records costs for other federal programs. Thus, amounts obligated and expended by intermediaries on behalf of the government should be recorded in the budget when they occur. Such treatment would provide the most accurate and timely measure of the net costs to taxpayers and would discourage the use of costly third-party financing mechanisms.
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