Recent press reports have indicated that the shortlisted bidders for the 51 per cent equity stake in Sydney Motorway Corporation (SMC) being sold by the NSW Government, are now in the process of preparing final binding bids scheduled for the second half of July.
There is no doubt that this will be a fiercely competitive process as the likes of Transurban, IFM, Plenary, Cintra, CIMIC, fight it out under the watchful scrutiny of Goldman Sachs. And I can predict that the forthcoming press release will claim a great outcome for NSW. But it will not that easy to assess value for money beyond the quantum of the initial payment.
The initial strategy behind WestConnex was that after the failure of numerous tollroads, such as Lane Cove Tunnel and Cross City Tunnel, Government needed to step in and intervene and take away the uncertainty of traffic risk. So the logic was that Government should build the tollroad, impose the toll and allow the traffic to ramp up and stabilise, and then sell the equity as brownfield operational infrastructure.
The benefit of WestConnex was that delivery of the project could be staged, with the first two stages, M4 Widening and Extension and M5 Duplication, having the potential to be sold with capital being recycled to help fund the more difficult third stage, M4/M5 Link. This approach could try and match the availability of private finance to acceptance of traffic risk.
However, the Government is now proceeding to sell 51 per cent in the entire project through SMC, even though most of WestConnex remains under construction apart from the M4 Widening. According to leaked traffic reports obtained by the Sydney Morning Herald, patronage on the widened M4 is performing well, so early signs are positive, but it is not unreasonable to expect the prospective investors to be cautious in assessing the forecasts for the sections of road still under construction. This caution might manifest itself in two ways.
Firstly, investors might apply a healthy discount on forecast traffic. Citi suggested a discount of 10 per cent might be reasonable in a research report. By contrast in the bidding frenzy on the last suite of transactions brought to market pre-GFC, traffic forecasting was massively overly optimistic. Lane Cove Tunnel experienced only 40,000 cars a day compared to the forecast 100,000, implying a discount of 60 per cent in hindsight would have been wise.
Secondly, investors might seek a higher equity return reflecting the uncertainty of traffic risk. Recent indications from Europe indicate that investors require a premium in the order of 200 to 300 basis points depending upon the assessment of this risk. And Citi in its research report assessed 15.1 per cent as being an appropriate equity cost of capital for WestConnex reflecting the mix of greenfield and brownfield assets.
In order to enhance the attractiveness of SMC and encourage a competitive auction process, certain commercial features have been included:
Concession term extends to 2060. This permits SMC to collect tolls for over 40 years. By contrast the Concession Term on Lane Cove Tunnel was for 30 years. The logic for extending the concession term is based on providing a longer time period for the investors to collect tolls and amortise capital. However, given the high discount rates applied by private financiers related to uncertainty and time line, the net present value of the incremental revenues could be regarded as marginal. The present value of $1 collected in 25 years time is only 3 cents based on a 15 per cent discount rate.
Tolls escalate at the greater of 4 per cent or CPI for the first 20 years, reverting to CPI thereafter. This provision has been included in some but not all of the past concession contracts. For example, it was not included under Lane Cove Tunnel but was included under Cross City Tunnel with a 4 per cent floor and NorthConnex, albeit at a much lower floor of 1 per cent. In the current low inflation environment, the 4 per cent ratchet becomes effective, negatively impacting the affordability of tolls by entrenching real price escalation. Government has alleviated this pressure by allowing frequent toll payers to claim an offset against motor vehicle registration but this imports an ongoing future financial cost to Government, whilst providing a free kicker to SMC.
SMC is required to share upside revenues when a 130 per cent threshold above the base case is achieved. In the case of M7 the upside sharing hurdle was fixed at 105 per cent. This means that in the event that a higher level of toll revenue is earned in excess of 105 per cent of the initial base case forecast, then the Government shares in the upside in accordance with an increasing scale. Between 105-110 per cent, Government receives a revenue share of 10 per cent, progressively increasing to 30 per cent for revenues above 130 per cent. By contrast SMC retains 130 per cent of upside for its investors before being required to share with Government, according to leaked documents obtained by the Sydney Morning Herald; Government stands to realize little benefit. This begs the question why Government felt it necessary to raise the sharing threshold to 130 per cent for SMC, compared to other precedents.
Government and its advisers will be mindful of giving away too much potential return and upside to the SMC investors and will be exploring options to obtain the right balance. One possible strategy is for the private sector to provide additional payments to Government beyond the upfront equity purchase payment, linked to future actual outcomes. Another approach might be to agree a mechanism for a future reset of the base case financial model based on actual traffic outcomes to that point. Some adjudication of appropriate rates of return for the changing risk profile of SMC might be warranted implying a need for incorporating flexible future regulation rather than trying to fix all conditions up front in a 40-year contract.
Government is intending to retain a 49 per cent stake, which provides scope for retention of value uplift, as the risk profile of WestConnex is gradually mitigated with the completion of construction and the ramp up of traffic. However, Government will need to grapple with the conflicting interests of, on the one hand, maximizing profit from its investment in SMC and, on the other hand, safeguarding the affordability of tolls. This raises the question as to what future corporate governance rules will apply to SMC, such as how Government can be provided with adequate voting rights, notwithstanding potential misalignment of shareholders’ interests. In addition, investors may look to Government to provide a shield for some of the construction risks not passed onto contractors such as on M4/M5 Link. It is inviting unreasonable risk premiums to be proposed by prospective SMC investors, if they are required to take cost risk on roads being built by third parties outside their control. What type of protection might Government be willing to offer?
And the Federal Government has an interest as provider of the $2 billion concessional loan. The concessional loan has been provided on highly attractive off-market terms including subordination, low interest rate, extended interest capitalisation and long loan maturity. Prospective SMC investors would like the Federal Government to continue to provide long-term cheap patient capital, but the Federal Government may be looking itself for earlier opportunities to recycle its capital, and be less comfortable in providing deeply subordinated debt to an SMC entity controlled by the private sector.
The level of the implied return bid by prospective SMC investors is a better indication of value, as the price paid is a function of forecast projected net cashflow and the investor yield. Whether this provides a premium over the equity capital invested to date by Government, will grab the headlines. But assessment of value also needs to consider the tollroad assets made available to SMC, which have been delivered by other parties at no cost to SMC. The old M4 and M5 tunnel are part of that inheritance, contributing significantly to SMC revenue. And the reversion of the current M5 South West Concession in 2026, represents another valuable asset transferring into the SMC pool.
Finally, one of the unfortunate consequences of selling off SMC with entrenched Concession Contracts extending to 2060 is the prospect of needing to deal with change and renegotiate with SMC in the future. It is not unreasonable to assume that at some stage there will be a need to alter the tolling regime. For example, there may be a requirement to introduce time of day tolling, other forms of congestion pricing or amend the rego rebate currently proposed to improve the affordability of tolls.
The standard approach in these contracts is for investors to be kept financially harmless and to be provided with the same return originally forecast. This opens up possible claims for compensation and preservation of the status quo. Cashback on the current M5 South West has many critics but lives on. The ultimate protection is an early termination of the Concession Contract but at the cost of fair market value reflecting private financiers’ original return requirements. A better approach might be to build on the earlier reference to the potential updating of the base case financial model and the use of a regulated return in these circumstances.
In summary, the competitive auction process will force up the sale price of SMC equity, but inevitably the risk/return equation will reflect market reality. The other side of the coin is that investors are taking on risk and face potential gains or losses depending upon the outcome of construction and ramp up risks. As an illustration, if the assumed equity return for investing in a brownfield operational tollroad is say, 9 per cent, investors may add 250 basis points for construction risk and 250 basis points for traffic risk, resulting in a required return of 14 per cent.
Simplistically, if prospective SMC investors subscribe $1 billion at a required return of 14 per cent, and WestConnex construction and ramp up risks are successfully resolved in accordance with the assumptions in the financial model, then the investors may look to sell the SMC equity at a 9 per cent return and reap a capital gain of $555 million. This is the reward for taking the risk. Now assume that in the land of optimism SMC traffic beats the base case forecast and reaches, but does not exceed, that 30 per cent upside sharing hurdle. The 30 per cent uplift in revenue might simplistically translate to 60 per cent earnings uplift, assuming SMC is 50:50 geared. This could result in the original SMC investors’ $1 billion equity now being worth $2.5 billion.
SMC should not be perceived as a potential goldmine but investors need to have the prospect of reward for taking on significant risk.
Martin Locke is an Adjunct Professor at the University of Sydney Business School.