Unyoking the Cash Cow: Who Should Own the New Jersey Turnpike?

Derrick Leung, Class of 2008

Advisor: Professor Alain Kornhauser

6 December 2010

ORFE Senior Thesis Presentation

1: Introduction

The New Jersey Turnpike

Interstate 95; 148 miles

Opened in 1951-1952

FY06 toll revenues: $533.4 million

FY06 ridership: 250 million trips

5th most traveled highway (IBTTA)

Current valuation

– $6 billion (Lesniak, Mar. 2006)

– $30 billion (Villaluz, July 2005)

– $40 billion (Edwards, Feb. 2008)

1

Public Benefit Company (PBC)

Privatization Debate

2

For Privatization

Against Privatization

Improved operational efficiency

Innovative tolling

Public sector needs for fresh capital

Incentives to use private equity (leverage)

Uncertain private sector advantage

Conflicting public/private goals

Transaction costs ($30 million to $200 million)

Motivation

3

Public Benefit Company (PBC) Private sector management

Public sector control

Proposed structure of toll increases

Chicago Skyway, Jan. 2005

– $1.83 billion, 99-year lease

Indiana Toll Road, June 2006

– $3.85 billion, 75-year lease

$29.7 billion as of June 30, 2007

– $2.6 billion annual charge

Previous Asset Monetizations

New Jersey State Debt

2: New Jersey Turnpike Valuation Model

Formulation

Modified DCF formulation

Free Cash Flow (FCF) formulation

4

Model Parameters

Valuation timeframe: 75 years (2007-2081)

Inflation measure:3% increase in CPI

Revenues:– Projected using regression of growth rates over past 9 years– Five (5) different tolling scenarios– Price elasticity of traffic:

0 (inelasticity), -0.19 (average), -0.15 (low bound), -0.31 (high bound)

Expenses:– Projected using regression of growth rates over past 9 years

Interest and principal payments; capital expenditures

5

xp

Traffic

Tolling Strategies

Case 1: Status Quo

– Current real toll maintained

Case 2: Leung-Kornhauser Plan

– Initial real toll doubling

Case 3: Break-even Toll Plan

– Calculation of real toll such that net present valuation yields 0

Case 4: Governor Corzine’s Plan (PBC)

– “50% maximum real toll increases in 2010, 2014, 2018, and 2022 plus annual increases, based on CPI, levied to capture the prior 4 years, starting in 2010 and every 4th year thereafter.”

Case 5: Private Entity Plan

– Initial real toll increase that yields optimal (maximum) valuation

6

Data and Projections

7

3: Results

Case 4: Governor Corzine’s Plan (PBC)

8

Functional form of solutionValuation sensitive to more inelastic traffic

PBC Equivalent

PBC Equivalent Cash Flow structure

– Tolling structure of current plan inefficient

– Inspired by Leung-Kornhauser plan

Gains to setting initial three-time (quadrupling) real toll increase

– Greater cash flow in earlier time periods

9

Case 5: Private Entity Valuation

10

Functional form of solutionPrivate Entity Valuation unbounded for elasticity of 0

Valuation Sensitivity to Line-Item Costs

11

Valuation insensitive to individual line-item costs (5%)

Valuation Sensitivity to Cost Basket

12

Material benefit due to cost reductions seen from reduction in cost basket (20%)

4: Conclusion

Valuation Drivers

13

Valuation driven by increased tolls when traffic is price inelastic

High

Valuation driven by cost reductions when traffic is price elastic

The Motorist’s Perspective

14

Relative Toll over Valuation Period

0.0

0.5

1.0

1.5

2.0

2.5

2006 2007 2008 2009 2010 2011

Year

Rel

ativ

e T

oll

Status Quo Leung-Kornhauser PBC

Relative Toll over Valuation Period

0

5

10

15

20

25

30

35

40

45

2006 2011 2016 2021 2026 2031 2036 2041 2046 2051 2056 2061 2066 2071 2076 2081

Year

Rel

ativ

e T

oll

Status Quo Leung-Kornhauser PBC

Arbitrage Gain

15

Arbitrage Gain = High Valuation – Current Valuation

Case 1: Status Quo

– Arbitrage Gain = $0

Case 2: Leung-Kornhauser Plan

– Arbitrage Gain = $9.1 billion

Case 3: Break-even Toll Plan

– Arbitrage Gain = N/A

High

Case 4: Governor Corzine’s Plan (PBC)

– Arbitrage Gain = $31.5 billion

Case 5: Private Entity Plan– Arbitrage Gain = ∞

Recommendation: The Buyer’s Perspective

16

Implement PBC Equivalent: 3x initial increase of real toll

5: Case Study: Pennsylvania Turnpike

Background

Pennsylvania Turnpike is America’s oldest toll toad (1937), 537-mile route

Operated by Pennsylvania Turnpike Commission

– Powers to construct, operate, and maintain the Turnpike System and issue revenue bonds, repayable solely from tolls and other Commission revenues

Pennsylvania population: ~12 million

Vehicle trips (May 2007)

– Passenger: 160 million

– Commercial: 25 million

– Total: 185 million

Gross fare revenue (May 2007)

– Passenger: $323 million

– Commercial: $295 million

– Total: $618 million

17

Operations (FYE May)

18

132 136 139 141 150 156 164 163 161 160

19 20 21 2322 23 24 25 25 25

0

50

100

150

200

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Veh

icle

Tri

ps (

in 0

00s)

Passenger Commercial

151 156 160 163 173 179 188 188 186 185

$186 $192 $195 $200 $213 $219 $230$303 $329 $323

$160 $170 $184 $178 $175 $180 $190

$258$279 $295

$0

$100

$200

$300

$400

$500

$600

$700

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Gro

ss F

are

Reve

nue

(in 0

00s)

Passenger Commercial

$346 $362 $380 $378 $388 $400 $420

$561$607 $618

88 87 87 86 87 87 87 87 86 86

12 13 13 14 13 13 13 13 14 14

0 %

25 %

50 %

75 %

100 %

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Veh

icle

Tri

ps (

% S

plit

)

Passenger Commercial

54 53 51 53 55 55 55 54 54 52

46 47 49 47 45 45 45 46 46 48

0 %

25 %

50 %

75 %

100 %

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Gro

ss F

are

Reve

nue

(% S

plit

)

Passenger Commercial

Source: Pennsylvania Turnpike Commission 2007 Comprehensive Annual Financial Report

Vehicle Trips Gross Fare Revenue

Vehicle Trips (% Split) Gross Fare Revenue (% Split)

(in

$m

m)

Toll History

Erosion of real toll value over the years has led to severe lack of profitability of the Turnpike (like many toll roads)

Variable costs and interest rates increase every year by inflation, so tolls should also increase by inflation to preserve the integrity of the toll road’s cash flows

But the act of raising tolls is difficult from a political perspective

19

$15.31

$6.69

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

$16.00

1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Nominal Dollar Nominal Toll

Source: www.InflationData.com

Illustrative Value of $1.00 from 1940

Timeline

November 2006: Study by the Pennsylvania Transportation Funding and Reform Commission (PTFRC) note critical need for annual investment of $1.725 billion to fund maintenance, repair and expansion of state roads

May 2007: Morgan Stanley report analyzes various alternatives including a long-term lease, public corporation/leverage, and a PTC proposal

– Sources indicate $12-18 billion as an indicative valuation range for a lease

September 2007: Governor Ed Rendell solicits qualifications for potential bidders for the Turnpike in anticipation of a lease

May 2008: Final winning bid announced

– Abertis / Citi consortium offers $12.8 billion

– Goldman Sachs / Transurban consortium offers $12.1 billion

September 2008: Financial crisis deepens with collapse of Lehman Brothers

20 Source: For Whom the Road Tolls: Corporate Asset or Public Good (An Analysis of Financial and Strategic Alternatives for The Pennsylvania Turnpike

Valuation

Winning bid of $12.8 billion also contemplates an additional $1.7 billion to fund the beginning of operations (total consideration of $14.5 billion)

Purchase price funded by mixture of equity and debt

– Critics noted the use of leverage for the investment was more conservative than structures typically used at the time (ex. 80% or even 90% debt for infrastructure assets like the Turnpike)

Capital structure of winning bid:

– $8.5 billion of debt, including

a $250 million capex facility

– $6.0 billion of equity

Bid perceived to fall short of goal

Valuation = 35x EBITDA

– 365 million (2007)

– Relatively low compared to

Skyway and ITR transactions21 Source: InfraNews

Criticism

Winning bid anchored by foreign investor

– Abertis is a Spanish transportation and telecommunications firm (founded in 2003 after a merger of two companies founded in 1967 and 1971)

– Operate 6,700 km of motorways in Europe, and several international airports

– Public company traded on the Bolsa de Madrid (BMAD: ABE)

– Earned 3.9 billion Euros of revenue (2009); over 12,000 employees

Valuation not as high as previously contemplated

– Final bids were around $12 billion, the low end of valuation range originally indicated

– Governor Rendell indicated later that the $18 billion range contemplated tolls being increased 5.5% annually (not possible since tolls would be capped to the greater of 2.5% or CPI)

State Assembly vote would face opposition from public

– Bid expiration was extended twice by the consortium to facilitate discussion

22 Source: InfraNews, Abertis

Decision

23

What Would You Do?

If you were a State Congressman...

Outcome

State Assembly ultimately did not hold vote

– Some members of Congress were offended by “low” valuation, although some confessed that the vote would not have been favorable in any case

Unforeseen issues:

– Credit crisis eroded debt markets for financing

– Equity sponsors less willing to make investments due to uncertainty

– State finances eroded as tax revenues were lower due to high unemployment

– Municipalities unable to refinance debt (and break out-of-the-money interest rate swaps) or issue lower cost debt due to credit risk

Citi Infrastructure Investors moved on soon after to bid on Midway Airport (large hub airport in Chicago area)

– Bid also failed since acquisition was contingent on securing financing

– Closed credit markets provided challenge

24

6: Thesis Application in the Real World

Goldman Sachs

Investment Banking

– Mergers and Acquisitions

– Industry coverage groups (Technology, Media and Telecom (TMT), Natural Resources, Financial Institutions, Industrials, Consumer/Retail, Real Estate)

– Product group (Leveraged Finance, Equity Capital Markets, Derivatives)

Asset Management

– Asset Management (GSAM) and Private Wealth Management (PWM)

Trading and Principal Investments

– Equities

– Fixed Income, Currency, Commodities (includes Special Situations Group)

– Merchant Banking/Private Equity Division Principal Investment Area (Corporate Equity, Corporate Debt, Mezzanine,

Real Estate, Infrastructure)

25

What is Private Equity?

Acquisition through leveraged buyout (LBO) of mature, stable cash flow businesses with free cash flow generation used to support debt service

– Reasonable growth, defensive business model, strong management team, low capital expenditures, over-equitized capital structure

Leverage used to increase purchase price in auctions

– 2004-2007: 75% debt / 25% equity, low cost of debt (low credit spreads)

– 2008 and after: at most 50% debt / 50% equity

Private Equity Firm (General Partner) Investors (Limited Partners)

Private Equity Fund(Limited Partnership)

Investment A Investment B Investment C

26

Characteristics of Infrastructure Investments

Stability

– Provision of essential services to communities

– Insulated from business cycles, high barriers to entry

Duration

– Nature of services supports asset longevity

– Long-term cash flows support long-term investment horizon

Inflation

– Regulation or concession determines pricing (inflation-linked cash flows)

Yield

– Current yield through free cash flow

Diversification

– Low correlation with other asset classes

– Alternative to other investments (including traditional private equity)

27

Competitive Landscape

Competitors

– Private equity firms KKR, TPG, Carlyle, Blackstone, Bain Capital, Apollo

– Boutique infrastructure investment firms Global Infrastructure Partners, Alinda, Macquarie, Babcock & Brown

– Investment Banks Morgan Stanley

– Insurance companies / pension funds

– Sovereign wealth funds

28

Selected Transactions

Sea Ports

– Restructuring of $5 billion North American terminal operator

– Distressed LBO of $5 billion international port and rail company

Toll Roads

– LBO of Florida toll road through P3 auction; approx. $1 billion transaction

– Proprietary recapitalization strategy for select North American toll roads

Airports

– LBO of regional airport through P3 auction

Natural Resources, Energy and Power

– Equity investment in one of the largest natural gas pipelines in the U.S.

– Investment in natural gas storage facility in Wyoming (development)

– Investment in water storage facility in southern California (development)

– Carve-out of regional electric utility

Fundraising

– Raised $3.1 billion of equity capital for new infrastructure fund29

Then and Now

30

Mega funds

– Diversification of investor base

Auctions accepted

Use of leverage

Cheap cost of debt (low spreads)

Long tenor (7-10 years)

Steep growth profile underwritten

Stable, solvent companies

Pre-Credit Crisis

Smaller funds

– Limited Partners want to exit

Negotiated transactions

More equity required

High cost of debt (debtor risk)

Short tenor (3-5 years)

Low base, moderate growth

Restructuring strategies through debt or equity investments

Post-Credit Crisis

7: Q&A