by Emily Thorn­ton
BUSINESS WEEK

Why investors are clam­or­ing to take over America’s high­ways, bridges, and airports—and why the pub­lic should be nervous

Steve Hogan was in a bind. The exec­u­tive direc­tor of Colorado’s North­west Park­way Pub­lic High­way Author­ity had run up $416 mil­lion in debt to build the 10-mile toll road between north Den­ver and the Boul­der Turn­pike, and he was start­ing to worry about the high pay­ments. So he tried to refi­nance, ask­ing bankers in late 2005 to pitch investors on new, lower-interest-rate bonds. But none of the hun­dreds of investors can­vassed was interested.

Then, one day last spring, Hogan got a let­ter from Mor­gan Stan­ley (MS ) that promised to solve all of his prob­lems. The bank sug­gested Hogan could lease the road to a pri­vate investor and raise enough money to pay off the whole chunk of debt. Now Hogan, after being inun­dated with pro­pos­als, is in hot-and-heavy nego­ti­a­tions with a team of bid­ders from Por­tu­gal and Brazil. “We lit­er­ally got responses from around the world,” he says.

In the past year, banks and pri­vate invest­ment firms have fallen in love with pub­lic infra­struc­ture. They’re smit­ten by the rich cash flows that roads, bridges, air­ports, park­ing garages, and ship­ping ports generate—and the monop­o­lis­tic advan­tages that keep those cash flows as steady as a beat­ing heart. Firms are so enam­ored, in fact, that they’re begin­ning to con­sider infra­struc­ture a brand new asset class in itself.

With state and local lead­ers scram­bling for cash to solve short-term fis­cal prob­lems, the con­di­tions are ripe for an unprece­dented burst of buy­ing and sell­ing. All told, some $100 bil­lion worth of pub­lic prop­erty could change hands in the next two years, up from less than $7 bil­lion over the past two years; a lease for the Penn­syl­va­nia Turn­pike could go for more than $30 bil­lion all by itself. “There’s a lot of value trapped in these assets,” says Mark Flo­rian, head of North Amer­i­can infra­struc­ture bank­ing at Gold­man, Sachs & Co (GS ).

There are some advan­tages to pri­vate con­trol of roads, util­i­ties, lot­ter­ies, park­ing garages, water sys­tems, air­ports, and other prop­er­ties. To pay for upkeep, pri­vate firms can raise rates at the toll­booth with­out fear of being penal­ized in the vot­ing booth. Pri­va­teers are also freer to exper­i­ment with ideas like peak pric­ing, a market-based approach to reliev­ing traf­fic jams. And gov­ern­ments are mak­ing use of the cash they’re pulling in—balancing bud­gets, retir­ing debt, invest­ing in social pro­grams, and on and on.

But are investors get­ting an even bet­ter deal? It’s a ques­tion with major pol­icy impli­ca­tions as gov­ern­ments relin­quish con­trol of major pub­lic assets for years to come. The aggres­sive toll hikes embed­ded in deals all but guar­an­tee pain for lower-income citizens—and enor­mous prof­its for the buy­ers. For exam­ple, the investors in the $3.8 bil­lion deal for the Indi­ana Toll Road, struck in 2006, could break even in year 15 of the 75-year lease, on the way to reap­ing as much as $21 bil­lion in prof­its, esti­mates Mer­rill Lynch & Co. (MER ) What’s more, some pub­lic inter­est groups com­plain that the rev­enue from the higher tolls inflicted on all cit­i­zens will ben­e­fit only a hand­ful of pri­vate investors, not the com­mon­weal (see BusinessWeek.com, 4/27/07, “A Golden Gate for Investors”).

There’s also rea­son to worry about the qual­ity of ser­vice on deals that can span 100 years. The newly pri­vate toll roads are being man­aged well now, but own­ers could sell them to other par­ties that might not oper­ate them as capa­bly in the future. Already, the expe­ri­ence out­side of toll roads has been mixed: The Atlanta city water sys­tem, for exam­ple, was so poorly man­aged by pri­vate own­ers that the gov­ern­ment reclaimed it.

Such con­cerns weigh on the minds of pub­lic offi­cials like Hogan. He intends to nego­ti­ate aggres­sively with cor­po­rate suit­ors and has decreed that the buyer must share future toll-hike rev­enues with the local gov­ern­ments that built the high­way. But with the mar­ket for infra­struc­ture still in its infancy, every deal is dif­fer­ent. The ideal blend of up-front pay­ment, toll hikes, and rev­enue shar­ing hasn’t been found.

FLOOD OF MONEY
The nascent mar­ket in roads and bridges in the U.S. fol­lows the shift toward pri­va­ti­za­tion in Europe and Aus­tralia that began with British Prime Min­is­ter Mar­garet Thatcher in the 1980s. It took longer to develop in the U.S. because of the $383 bil­lion munic­i­pal bond mar­ket, which has been an effi­cient source of cap­i­tal for gov­ern­ments over the years.

But with the explo­sion of money flow­ing into pri­vate invest­ments recently, fund man­agers have been explor­ing the fringes of the invest­ing world in search of fresh oppor­tu­ni­ties. Now a slew of Wall Street firms—Goldman, Mor­gan Stan­ley, the Car­lyle Group, Cit­i­group, and many others—is pil­ing into infra­struc­ture, fol­low­ing the lead of pio­neers like Australia’s Mac­quarie Group. Rob Collins, head of infra­struc­ture merg­ers and acqui­si­tions at Mor­gan Stan­ley, esti­mates that 30 funds are being raised around the world that could wield as much as $500 bil­lion in buy­ing power for U.S. assets.

Many investors think of infra­struc­ture invest­ing as a nat­ural exten­sion of the pri­vate equity model, which is based on rich cash flows and lots of debt. But there are impor­tant dif­fer­ences. Pri­vate equity deals typ­i­cally play out over 5 to 10 years; infra­struc­ture deals run for decades. And the risk lev­els are vastly dif­fer­ent. Infra­struc­ture is ultra-low-risk because com­pe­ti­tion is lim­ited by a host of forces that make it dif­fi­cult to build, say, a rival toll road. With cap­tive cus­tomers, the cash flows are vir­tu­ally guar­an­teed. The only major vari­ables are the ini­tial prices paid, the amount of debt used for financ­ing, and the pace and mag­ni­tude of toll hikes—easy things for Wall Street to model. “With each pass­ing week, there are more par­ties express­ing unso­licited inter­est in some kind of a finan­cial trans­ac­tion that will involve one of our assets directly or indi­rectly,” says Anthony R. Cos­cia, chair­man of the Port Author­ity of New York & New Jersey.

Firms are even begin­ning to mar­ket infra­struc­ture to investors as a sep­a­rate asset class, safe like high-grade bonds but with stock market-like returns—and no cor­re­la­tion with either. The Stan­dard & Poor’s 500-stock index has returned about 10% a year, count­ing div­i­dends, since 1926. Bonds have returned about 5%. Firms say infra­struc­ture will beat both, and with­out hav­ing to sweat out mar­ket dips along the way. That’s a huge sell­ing point at a time when stock, bond, and com­mod­ity mar­kets around the world are becom­ing increas­ingly interconnected.

Investors can’t get in fast enough. They recently del­uged Gold­man Sachs with $6.5 bil­lion for its new infra­struc­ture fund, more than twice the $3 bil­lion it was seek­ing. “We’re using [infra­struc­ture] as a fixed-income proxy,” says William R. Atwood, exec­u­tive direc­tor of the Illi­nois State Board of Invest­ment, who plans to invest $600 mil­lion to $650 mil­lion, or 5% of its port­fo­lio, in infra­struc­ture funds over the next three years. “We’re hop­ing to get 11% to 12% returns and lower risk.” Pen­sion funds in par­tic­u­lar like the long-term invest­ment hori­zons, which match their fund­ing needs well. Infra­struc­ture “deliv­ers sim­i­lar yield expec­ta­tions to high-yield bonds and real estate, with less risk,” says Cyn­thia F. Steer, chief research strate­gist at pen­sion con­sult­ing firm Rogerscasey.

On the other side of the bar­gain­ing table from the invest­ment firms sit strug­gling gov­ern­ments sud­denly amenable to the idea of sell­ing con­trol of assets to solve short-term prob­lems. The bur­den of main­tain­ing roads, bridges, and other facil­i­ties, ma
ny built dur­ing the 1950s, is becom­ing dif­fi­cult to bear. Fed­eral, state, and local gov­ern­ments need to spend an esti­mated $155.5 bil­lion improv­ing high­ways and bridges in 2007, accord­ing to trans­porta­tion offi­cials, up 50% over the past 10 years. And that’s hardly the only obsta­cle they face. In 2006 alone, states increased their Med­ic­aid spend­ing by an esti­mated 7.7%, to $132 bil­lion. And state and local gov­ern­ments could be on the hook for up to $1.5 tril­lion in retiree lia­bil­i­ties, esti­mates Credit Suisse. At the same time, politi­cians find it dif­fi­cult to raise taxes. Chicago’s for­mer chief finan­cial offi­cer, Dana R. Lev­en­son, sums up the sit­u­a­tion: “There is money to be had, and cities need money.” U.S. Rep­re­sen­ta­tive Chaka Fat­tah, a Penn­syl­va­nia Demo­c­rat who is run­ning for mayor of Philadel­phia, pro­poses to pri­va­tize the Philadel­phia Inter­na­tional Air­port and use the pro­ceeds to fund poverty programs—a much eas­ier sell than a tax increase.

The com­bi­na­tion of eager sell­ers and hun­gry buy­ers is shak­ing loose pub­lic assets across the coun­try. The 99-year lease of the Chicago Sky­way that went for $1.8 bil­lion in 2005 was the first major trans­ac­tion. Last year came the Indi­ana deal. Now states and cities are explor­ing the sale of leases for the turn­pikes in New Jer­sey and Penn­syl­va­nia, a toll road in Texas, Chicago Mid­way Air­port, and sev­eral state lot­ter­ies. Sud­denly politi­cians around the coun­try are won­der­ing how much cash they might be sit­ting on. Based on the going rate of about 40 times toll rev­enues, the iconic Golden Gate Bridge could prob­a­bly fetch $3.4 bil­lion were Cal­i­for­nia inter­ested in sell­ing. The Brook­lyn Bridge? If per­mis­sion were granted by New York City to charge the same tolls as the George Wash­ing­ton Bridge, a pri­vate owner might shell out as much as $3.5 bil­lion for it.

PAVEMENT PRICING
But there’s a down­side to the quick cash: planned toll hikes that are usu­ally quite aggres­sive. Chicago’s Sky­way could see car tolls rise from $2 in 2005 to $5 by 2017. For some per­spec­tive, if a sim­i­lar scheme were applied to the Penn­syl­va­nia Turn­pike dur­ing its 67 years of exis­tence, the toll for trav­el­ing from the Delaware River to the Ohio bor­der would be as much as $553 now instead of $22.75. Mac­quarie, which teamed up with Spain’s Cin­tra to pur­chase the Chicago Sky­way and the Indi­ana Toll Road, under­scored the gov­ern­men­tal trade-off dur­ing a pre­sen­ta­tion at the recent White House Sur­face Trans­porta­tion Leg­isla­tive Lead­er­ship Sum­mit: “More Money or Lower Tolls.” In an extreme sce­nario, gov­ern­ments could begin to sell prop­er­ties that aren’t tolled to pri­vate own­ers who will impose fees.

Of course, tolls won’t go to the moon if they result in dra­matic reduc­tions in traf­fic. For exam­ple, invest­ment firm NW Finan­cial Group esti­mates that if the Chicago Sky­way pric­ing scheme were applied to New York’s Hol­land Tun­nel over its 80 years, it would cost $185 to travel through it instead of the cur­rent $6. “No one will pay that much,” says Mur­ray E. Bleach, pres­i­dent of Mac­quarie Hold­ings (USA) Inc. “It’s just not going to happen.”

Still, Indi­ana leg­is­la­tors became so alarmed by promised hikes that they changed the terms before the toll road lease was com­pleted. The state set aside $60 mil­lion to pay the dif­fer­ence in tolls for up to two years or until the buy­ers install elec­tronic tolling equip­ment. After that, the fee for cars with elec­tronic toll cards will rise to $4.80 over the full 157 miles, while the fee for cars with­out the cards will soar to $8. After 2010, both rates will rise each year by 2%, the pace of infla­tion, or the rate of eco­nomic growth, whichever is highest.

The cer­tainty of future toll hikes doesn’t jibe with the uncer­tainty of ser­vice qual­ity. Assets sold now could change hands many times over the next 50 years, with each new buyer feel­ing increas­ing pres­sure to make the deal work finan­cially. It’s hardly a stretch to imag­ine ser­vice suf­fer­ing in such a sce­nario; already, the record in the U.S. has been spotty. In 2003 the city of Atlanta ended a lease of its water sys­tem after receiv­ing com­plaints about every­thing from billing dis­putes to water-main breaks. The city wres­tled with the owner, United Water Inc., over basics like the per­cent­age of water meters it should mon­i­tor. Both par­ties acknowl­edge that the con­tract lacked specifics. In the end, “we didn’t believe we were get­ting per­for­mance,” says Robert Hunter, com­mis­sioner for Atlanta’s Dept. of Water­shed Man­age­ment. “I don’t believe the city will ever look at pri­va­tiz­ing essen­tial ser­vices again.” United Water says the con­tract wasn’t finan­cially fea­si­ble because Atlanta’s water sys­tem was in worse shape than the city had represented.

A CHAMPION’S PERSPECTIVE
States are wrestling with other pub­lic pol­icy issues, too. Bankers say New York could reap a com­bined $70 bil­lion for long-term leases on a bunch of assets, includ­ing the state’s lot­tery, the Tap­pan Zee Bridge, and the New York State Thruway. New York state offi­cials have looked into the option of leas­ing the lot­tery, which itself might com­mand $35 billion—a sum that could sub­stan­tially upgrade, say, New York’s higher edu­ca­tion sys­tem. The down­side? The state would prob­a­bly have to remove con­straints on the lottery’s mar­ket­ing designed to dis­cour­age peo­ple from gam­bling more than they can afford. If the state insists on keep­ing the con­straints in place, it could reduce the value of sell­ing it.

Chicago’s expe­ri­ence shows the pos­si­bil­i­ties and the pit­falls of pri­va­ti­za­tion. For­mer CFO Lev­en­son has been one of the movement’s biggest cham­pi­ons. He was an archi­tect of the Sky­way deal, which kicked off the mar­ket. Then he sold con­trol of park­ing garages to Mor­gan Stan­ley for $563 mil­lion. Next, he started shop­ping around a lease for Mid­way Air­port that could fetch as much as $3 bil­lion. And soon the city hopes to auc­tion off rights to oper­ate some recy­cling plants. Lev­en­son dis­misses crit­ics who argue that he has dumped prized assets. “This is not like where a per­son goes in and buys a loaf of bread from a store and walks out with that loaf of bread,” he says. “Some entity, we expect, will make an offer to lease the Mid­way Air­port for 75 to 99 years, and the fol­low­ing day I’m pretty sure it will still be there.”

Wear­ing a crisp suit and styl­ish eye­glasses, Lev­en­son looks like the Wall Streeter he once was, work­ing for Bank One Corp. and Bank of Amer­ica Corp. (BAC ) before tak­ing the Chicago city job in 2004. In April he returned to bank­ing: As a man­ag­ing direc­tor at the Royal Bank of Scot­land Group (RBS ), he now beats the bushes for infra­struc­ture deals. Lev­en­son doesn’t under­stand how local gov­ern­ments can afford not to put pub­lic works up for sale. Thanks to the 99-year lease for the Sky­way, Chicago has paid off its debt and handed over $100 mil­lion to social pro­grams like Meals on Wheels. Plus, says Lev­en­son, it’s earn­ing as much in annual inter­est on the $500 mil­lion it has banked from the trans­ac­tion as it used to earn from run­ning the Sky­way ($25 million).

In some ways, Lev­en­son argues, the city still has con­trol over the high­way. The agree­ment with the new own­ers spells out guide­lines in mind-numbing detail, dic­tat­ing every­thing from how quickly pot­holes must be filled (24 hours) to how rapidly squir­rel car­casses must be removed (8 hours). If Mac­quarie and Cin­tra vio­late those con­di­tions, the city can take back the road.

So far, the buy­ers have strictly adhered to the rules. At 7 a.m. on a Wednes­day in March, five work­ers begin another day at the Chicago Skyway’s Snow Com­mand. On their to-do list are pot­holes to be checked and cracks to be sealed. Juan Rodriguez used to patrol the free­way for Chicago city. Today, he cruises the road for pri­vate own­ers. He dis­cov­ers some pot­holes have grown unac­cept­ably large because of salt that was spread the pre­vi­ous night. There’s some tire debris that must be removed, and a dis­abled vehi­cle hold­ing up traffic.

A SMOOTH
RIDE?
In the past, Rodriguez says, he had to write out a ticket for each prob­lem, which would be added to a long list of chores. Address­ing prob­lems often took days, Rodriguez recalls. But by 10:25 a.m., all of this morning’s issues on the Skyway’s 7.8-mile stretch of pave­ment are resolved. “The new own­ers are tak­ing the Sky­way to a whole new level,” he says.

They’ve cer­tainly spent money on improve­ments. The mes­sage “a clean work­place is a happy work­place” is scrawled on a white­board in a freshly painted and ven­ti­lated garage where work­ers meet. There’s elec­tronic tolling, which didn’t exist before. A bunch of new lanes are under con­struc­tion. The invest­ments seem to be pay­ing off: Since tak­ing over two years ago, the Skyway’s oper­a­tors esti­mate traf­fic has risen 5%.

It’s all encour­ag­ing, except that Chicago “prob­a­bly could have got­ten more with­out pri­va­tiz­ing,” accord­ing to Den­nis J. Enright, a prin­ci­pal and founder of NW Finan­cial. His firm’s analy­sis shows that Chicago could have done a lot bet­ter by han­dling the whole deal itself. It could have raised tolls and sold tax-exempt munic­i­pal bonds backed by the sched­uled hikes. That would have given the city the up-front cash it needed while pre­serv­ing some of the income from the toll hikes. Instead, that money will go to Mac­quarie and Cintra.

Mean­while, the higher tolls will take a big bite out of lower-income people’s wal­lets. “You have to ask your­self if you want roads that used to be con­sid­ered a pub­lic ser­vice to be rationed by income class,” says Prince­ton Uni­ver­sity eco­nom­ics pro­fes­sor Uwe E. Rein­hardt. Chicago says it hasn’t received any for­mal com­plaints from cit­i­zens, though two dif­fer­ent dri­vers recently went to extremes to avoid tolls, says Sky­way main­te­nance man­ager Michael S. Lowrey. When the new own­ers intro­duced free tow­ing for broken-down vehi­cles, the dri­vers called the Sky­way for help, claim­ing to be stranded. After work­ers hauled the vehi­cles past the toll­booths, they hopped in their cars and sped away.

For work­ers, the pri­va­ti­za­tion wave has wrought many changes. Sky­way toll tak­ers used to be full-time city employ­ees with rich ben­e­fits. Now most are part-time inde­pen­dent con­trac­tors with­out ben­e­fits. Brian Rainville, exec­u­tive direc­tor of the Chicago Team­sters Joint Coun­cil 25, helps man­age the union’s pen­sion fund. When he lis­tened to a recent pitch from a pen­sion con­sul­tant about infra­struc­ture funds, it sparked a real­iza­tion: The returns he might gen­er­ate for his pen­sion­ers could be can­celed out by the union’s shrink­ing num­ber of con­trib­u­tors. “It’s pretty obvi­ous that it’s not sound fis­cal pol­icy for the [pen­sion] fund to under­cut the peo­ple it’s serv­ing,” Rainville says.

Push­back against pri­vate investors is now play­ing out in dif­fer­ent ways else­where. In Penn­syl­va­nia, the state turn­pike com­mis­sion is going head-to-head with pri­vate bid­ders for the right to oper­ate the state’s 537-mile toll road. Penn­syl­va­nia des­per­ately needs cash to repair its nearly 6,000 struc­turally defi­cient bridges. Some pun­dits expected Penn­syl­va­nia Gov­er­nor Edward G. Ren­dell to pro­pose hikes in gas taxes and other fees to fund the projects. But in Decem­ber, Ren­dell unex­pect­edly announced plans to pri­va­tize the turn­pike. Tim­o­thy J. Car­son, vice-chairman of the com­mis­sion, scram­bled to sub­mit an expres­sion of inter­est for the turn­pike to con­tinue to run itself. His pro­posal is being judged against many oth­ers, includ­ing those from big Wall Street firms.

Car­son isn’t dis­suaded by argu­ments that investors are bet­ter qual­i­fied to run turn­pikes prof­itably. “There’s no magic here,” he says. “These [deals] are largely dri­ven by one fac­tor: the per­mit­ted toll increases.” Car­son says the state doesn’t need to hand over the turn­pike to pri­vate own­ers. His­tor­i­cally, he says, the state wanted the turn­pike to col­lect only enough money to break even. But it could just as eas­ily adopt its own toll-hike sched­ule. The state could also charge tolls on more roads. In other words, the pub­lic could remain in con­trol sim­ply by chang­ing the turnpike’s mis­sion. That would ensure that the ben­e­fits of the toll hikes were spread through­out the pop­u­lace, says Carson.

Pennsylvania’s isn’t the only turn­pike author­ity explor­ing the pos­si­bil­ity of bid­ding for roads. The North Texas Toll­way Author­ity cal­cu­lated in March that it would have val­ued a par­tially con­structed 25-mile stretch of high­way near Dal­las 26% more than a pri­vate investor had bid. Now it’s con­sid­er­ing mak­ing a for­mal bid. And on Apr. 11, the Texas House of Rep­re­sen­ta­tives passed an amend­ment by a vote of 134 to 5 to impose a two-year mora­to­rium on pri­va­tiz­ing state toll roads. “We need to put the brakes on these pri­vate toll con­tracts before we sign away half a cen­tury of future rev­enues,” said rep­re­sen­ta­tive Lois W. Kolkhorst, who pro­posed the bill. A sim­i­lar bill was passed in the state sen­ate on Apr. 19.

With so much money at stake and so many options avail­able to states, it’s impos­si­ble to know how the great infra­struc­ture craze may play out. But this much is cer­tain, says Pennsylvania’s Car­son: “Peo­ple are will­ing to pay more than they are cur­rently being charged. The only ques­tion is to what extent you’re will­ing to take advan­tage of that.”

Thorn­ton is as asso­ciate edi­tor for Busi­ness­Week.