It is difficult to imagine a project delivery method that offers more excite-ment and causes more trepidation to contractors than public-private part-nerships (PPP). PPPs are rapidly growing in popularity because they enable the public sector to harness the expertise and efficiencies that the private sector can bring to a project and because PPPs are structured so that public sector bodies can make capital investments without borrowing. In the PPP model, the borrowing is incurred by the private sector partners implementing the project. Given the contract values and durations of most PPP projects being undertaken in North America, the rewards to the private sector Design-Build Contractor are obvious and long-lasting. With construction costs typically in the hundreds of millions of dollars and with lengthy operations and maintenance periods, PPPs offer great opportunities for contractors to generate substantial revenue and profit.
Why then are so few qualified Design-Build Contractors bidding and competing for PPP projects? Put simply, the risks that the PPP delivery model “drops down” on Design-Build Contractors are daunting and, if not properly controlled, can outweigh the rewards of being involved in a major project. In addition to the usual construction risks associated with any design-build project, the Design-Build Contractor bears risks that arise out of the unique nature of the PPP arrangement. For instance, the Design-Build Contractor involved in a PPP project will often be asked to take on risk related to site conditions, resource availability, equipment procurement and installation, permits and approvals, labor markets, changes in law, and force majeure events, among others. Under a more traditional project delivery method, all or a part of these risks would be allocated to the project Owner. Moreover, since the private sector’s participation in a PPP project often lasts much longer than in a more traditional construction project, due to its involvement in operations, maintenance and the concession period, the Design-Build Contractor’s risks relating to construction warranties and latent defects often extend beyond the normal one and six-year periods, respectively.
For those Design-Build Contractors prepared to confront these increased risks in order to compete for the rewards associated with successful PPP projects, this two-part article is intended to assist in developing a well-organized plan, with attention to detail, to understand, mitigate and manage the construction risks associated with the PPP project delivery method. This first part will address up front considerations regarding project participants and the basic contract agreements typically used in connection with PPP projects. The second part of the article will address risks associated with the performance of work on a PPP project and ways to mitigate those risks.
Pick The Right Project
Not all PPP projects are created equal, and not all projects are suited to the PPP model. Public owners usually undertake a thorough analysis that compares the outcomes for delivery under the PPP model to the outcomes under a standard design-build approach. As a general rule, public owners choose the PPP model only where the size and scope of the project justify the significant associated costs. From the Design-Build Contractor’s perspective, the viability of a PPP project often turns on whether there are clear performance criteria articulated up front at the time of the bid/proposal, as changes in performance criteria midstream create the potential for increased costs and raise the likelihood of disputes. Similarly, Design-Build Contractors should consider whether a prospective PPP project has clearly stated expectations regarding post-construction operation and management. The more autonomy the Design-Build Contractor has (i.e., control to devise the means and methods for the overall design and construction of the project to meet straightforward performance criteria), the higher the likelihood of a PPP project’s success.
In addition, new construction, as opposed to renovation or upgrade of existing facilities, is often best suited for the PPP model. New construction gives the private sector participants the greatest latitude to choose a design that meets the stated performance criteria while controlling risk. Projects involving the renovation or upgrading of existing facilities, on the other hand, often present fewer options for design and have a greater potential for open-ended or undefined costs, such as costs attributable to unforeseen conditions or design issues.
Choose Your Partners Wisely
The earnest pursuit of a PPP project typically begins with the negotiation of a teaming agreement among the primary participants, which includes the Proposal Sponsor, one or more contractors who will deliver the Design-Build Contract work elements, and one or more contractors who will be responsible for the operation and maintenance obligations during the term of the concession. Depending upon the nature of the project and the level of design development at the time of proposal submission, a significant burden is often placed on the Design-Build Contractor during the proposal phase. As the scope of PPP projects are often quite large, with construction costs typically in the hundreds of millions of dollars, there is an increased risk on the designer and contractor to accurately price the scope of work to be performed. Any mistake in pricing could prove disastrous and could have a serious impact on even the largest of contractors. Picking the right team members, who have substantial, relevant experience and expertise in the specific type of design and construction to be undertaken, is imperative.
Given the size of most PPP projects, the costs that will be incurred during just the proposal stage can be substantial. As such, the teaming agreement should unambiguously spell out the responsibilities of the various team members for the preparation of the proposal, as well as address how the costs associated with the proposal will be reimbursed at financial close or split among the team members if the bid is not accepted. It is imperative that the teaming agreement reflect a firm commitment by the Project Sponsor to award a design-build contract to the Design-Build Contractor if the team bid is accepted. The teaming agreement should also address whether members of the team may participate in another team or have the intent to form an exclusive venture. Further, it is highly recommended that the Design-Build Contractor seek to include language in the teaming agreement that provides the Design-Build Contractor the greatest possible involvement in all aspects of the project, including an opportunity to participate in all meetings between the Concessionaire and the project Owner. As discussed below, the risks the Design-Build Contractor will face on the project are driven, in large part, by the terms of the concession agreement, and ensuring that the Design-Build Contractor has the right to participate in the negotiation of that agreement is critical to the Design-Build Contractor’s success.
Often, the Proposal Sponsor is a large international construction firm, a financial institution, or an infrastructure investment fund that operates toll roads or other revenue-generating infrastructure facilities, or may be a combination of any of these. The teaming agreement and any proposal that is submitted to the project Owner customarily provide that the Project Sponsor, upon acceptance of the proposal, will form a Special Purpose Entity (“SPE”) to manage the project. An SPE is organized to shield the Project Sponsor and equity investors from liability and to provide “clean” collateral for Lenders to the project. The SPE typically will be responsible for obtaining limited recourse financing for the project’s design and construction and for managing the project’s performance as the Concessionaire. In connection with securing financing, the SPE Concessionaire is typically required to pledge all of its assets to the Lenders on the project, supported by a pledge of the Project Sponsors’ respective equity interests in the SPE. The SPE Concessionaire also must negotiate a contract with the Design-Build Contractor and with any specialty contractors on the project. Although not always the case, in most instances the concession agreement and the Design-Build Contract are negotiated concurrently, and the Design-Build Contractor has an opportunity to (and should if at all possible) participate in the negotiations between the Owner and the SPE Concessionaire related to the allocation of risk under the concession agreement.
Finally, one of the most overlooked aspects of a successful teaming relationship is an open discussion of how disputes will be resolved. It is highly recommended that any PPP teaming agreement include a robust dispute provision that defines the procedures to be followed in the event of a dispute (e.g., use of a dispute review board, binding or non-binding arbitration, or court proceeding), identifies potential causes of action, and sets forth the available remedies (e.g., indemnity, specific performance, injunctions, liquidated damages, or limitations on damages). Provisions that provide clear guidance and prompt resolution of disputes should be a priority for all other PPP agreements as well.
Understand The Inherent Risk In The Concession Agreement
Risk allocation in the PPP project delivery model follows a natural, flow-down progression. In short, most of the risk inherent on a PPP project is shifted from the Owner to the SPE Concessionaire and flows down contractually to the Design-Build Contractor. The Design-Build Contractor may be able to mitigate its exposure under this flow-down paradigm by similarly pushing some of the risk down to lower level subcontractors and suppliers. Mitigation of the Design-Build Contractor’s risk can also be accomplished through insurance, bonds and other contractual agreements.
As a starting point, Design-Build Contractors must first appreciate that, although an SPE Concessionaire will usually accept responsibility for its own acts or omissions, the SPE Concessionaire will generally only grant relief to the Design-Build Contractor for risks that the public sector Owner accepts under the concession agreement. For this reason alone, it is critical that the Design-Build Contractor negotiate the contractual right to a seat at the table when the Concession Agreement is being negotiated between the Owner and Concessionaire.
Absent contractual rights against the Owner or public sector authority, the SPE Concessionaire will be reluctant to agree to any adjustment of the Design-Build Contract price or schedule, for fear of a potential “mismatch” with its Concession Agreement. In this regard, the Concessionaire’s own cash flow constraints would likely encumber its ability to make a payment to the Design-Build Contractor in advance of receiving funds from the Owner. For this reason, Design-Build Contracts in the PPP project delivery model typically include “Equivalent Project Relief” provisions, which are structured to provide the Design-Build Contractor a right to require the Concessionaire to pursue a claim against the Owner. Because any such claim must be brought in the name of the Concessionaire, the Equivalent Project Relief provision typically allows the Design-Build Contractor to control the management of the claim in a pass-through manner. Notably, the enforceability of “Equivalent Project Relief” provisions needs to be considered on a jurisdiction-by-jurisdiction basis, as certain jurisdictions do not permit the assertion of pass-through claims.
With the Owner’s acceptance of a team’s proposal and after the Concession Agreement and the Design-Build Contract have been negotiated, the Design-Build Contractor’s risk is anything but set in stone. The second part of this article will address additional ways in which the Design-Build Contractor can mitigate its risk during performance and through other vehicles, such as insurance.