M3 Capital Partners looking to put the ‘F’ in ‘DBOF’

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One Chicago investment firm is looking to turn routine water and wastewater projects into long-term revenue streams. Can a new twist on the design-build-operate-finance procurement model do the trick?

 The U.S. market for public-private partnerships (PPPs) has long proven to be elusive quarry for operations firms and financiers hoping to get a piece of the alternative procurement pie, but one investment firm is working on a plan to bring the reclusive beast into the open using a novel approach to project financing. If all goes according to plan, a PPP financing structure being developed by M3 Capital Partners could encourage more cashstrapped cities to consider the design-build-operate-finance (DBOF) model and turn individual, routine water projects into long-term revenue streams for investors.

M3 is a Chicago-based private investment and advisory firm that manages $2.9 billion in equity commitments on behalf of a U.S. public pension plan. Looking for stable investments with reliable returns, M3 has turned to the water infrastructure market, and the firm has been fine-tuning its “Water Infrastructure Initiative” for several months. At its most basic, the initiative will be a fund devoted exclusively to investing in water and wastewater projects. M3 anticipates the fund will be initially capitalized by a U.S. public pension plan as the “cornerstone” sponsor, and it will be managed by M3 and invest in projects through its wholly-owned subsidiary Evergreen Investment Advisors.
M3’s proposed model puts several spins on traditional DBOF procurement. While DBOFs in the past have traditionally been carried out by firms that design, build, operate and finance a project, M3’s approach would have a separate investment firm contribute to project financing. M3 would form strategic partnerships with established DBO firms or with consortia of operations and design-build companies. When the partnership locates a potential PPP opportunity, it would offer the municipal client private funding to complete the project outright in exchange for being paid back over a predetermined concession period. The municipality would retain control of the utility and set water rates at a level required to pay the partnership for annual operating services and allow the partnership to recover its investment and make a modest, long-term return.
“We intend to be the finance – the ‘F’ in ‘DBOF,’” M3 vice president Thad Wilson told AWI. “We envision an up-front investment for either a major upgrade or a replacement facility where we could provide all the capital required. Over the course of the concession period, that up-front investment is repaid by the service fees that are supported by the [...] broad base of ratepayers.”
The M3 model would have financial partners working with DBO firms before RFPs are released and would put an emphasis on small to medium-sized cities instead of major municipalities. The firm would primarily target projects with a capital cost in the range of $50 million to $200 million. The returns would be modest but very stable, potentially making them appealing to institutional investors – especially public pension funds looking for long-term assets that are insulated from inflation and the swings of the wider market.
“Pension funds have experienced more volatility over the last few years than they had anticipated in some of their other core or stable investment programs,” Wilson said. “Many of them are thinking about an allocation to what they may call ‘tangible assets’ or ‘real assets’ that would be long-term investments structured on a project-level basis as opposed to a publicly traded security.”
Project performance would be guaranteed in the contract, and the municipal customer would have rate-setting power. While the water or wastewater asset could be transferred or leased to the operator-financier partnership for the duration of the concession period, ownership would ultimately be retained by the client. The private partners would be at risk for performance, meaning they would bear the financial burden of a project if things did not go as planned. Wilson anticipates the transfer of risk would appeal to cities looking to avoid financially risky but mandated work. He believes the immediate availability of capital could also help accelerate slow-moving projects.
At first glance, the model bears some resemblance to the deal closed in May for the operations and maintenance (O&M) contract in Nassau County, N.Y., in which the county released separate RFPs for an operator and a financier.
Wilson said the initiative will also have much in common with the recent successful DBOF in Santa Paula, Calif., where PERC Water partnered with Alinda Capital Partners to create a projectspecific LLC that leveraged private funds to build a 4.2MGD plant, completed well ahead of the city’s compliance deadline.
Unlike Alinda’s more general infrastructure mandate, however, M3’s initiative is solely focused on water, and Wilson believes that the success of Santa Paula can be replicated elsewhere, with M3 leading the way. There is still widespread resistance to the DBOF model amongst municipalities, however, partly because of the relatively high cost of capital, noted Doug Herbst, Southwest Region Chairman for the Design-Build Institute of America and board member for the Water Design-Build Council. Tax-exempt municipal bonds often seem more appealing in the short term, but cities need to look closely at the lifecycle costs of each project, Herbst said. Cities that conduct a thorough review often find DBOFs attractive once the project risk is monetized.
“The one thing that probably comes out in favor of the traditional [DBB model] is that the pure cost of capital would probably be lower than under the DBOF. But that’s only one component. There’s a lot of the other components on the DBOF side where the cost advantage would be in [the client’s] favor,” said Herbst.
He added that DBOFs will likely be less appealing to cities that are generous with water and sewer funding. For utilities that must make do with shoestring budgets, however, a DBOF can be a very efficient option.
Any attempt to roll out DBOFs to new cities would undoubtedly be met by political opposition from ratepayers and public employees who are concerned about working for a private operator. Fears of lost jobs and unethical practices are real, whether they are justified or not, Herbst said, adding that many public workers who initially oppose PPPs come around when they see how well private operators work.
In March, officials in Placer County in California voted down a private proposal to design, build and operate a new 2.7MGD wastewater treatment plant using either SRF funds or private finance, while it looks as though a similar proposal to build a new 4MGD water reuse plant for the City of Pinole, Calif., on a DBOF basis is likely to be edged out in favor of an optically cheaper upgrade to an existing facility.
“I think the evidence has shown from the O&M business that the initial reaction of the public employees is to fight it,” Herbst said. “The initial knee-jerk reaction is real to them. That’s a real challenge that owners have to face when they look at a DBOF.” Wilson said a few initial, successful projects should allay some of those fears, and that DBOFs that benefit the client will speak for themselves. He added that success will largely depend on helping cities to see the efficiencies that a PPP – and specifically a DBOF – can bring to the table.
“The key to increasing the number of public-private-partnerships is that the municipalities see value in the full project delivery. It’s not just that the capital is available – it’s about packaging the entire project delivery in a more efficient manner.”