Funding Options: In-line Systems: Consultant explores alternative financing mechanisms available to airports

Security

FUNDING OPTIONS: IN-LINE SYSTEMS

Consultant explores alternative financing mechanisms available to airports

By Dan Dean

May 2004

Many U.S. airports are currently embarking upon in-line baggagescreening system projects — that is, the "in-line" installation ofexplosive detection systems in baggage handling systems. While somelarger airports have been able to fund the systems up front witha promise of future funding from the Transportation Security Administration (TSA) via letters of intent, most commercial aiports continue to grapple with how to finance the systems. Here, an industry consultant offers insights into some of the funding mechanisms which airport sponsors should consider when looking to fund the in-line systems.

TSA has mandated that all U.S. airports electronically screen 100 percent of all baggage. To assist airports in meeting this requirement, TSA devised the Letter of Intent (LOI) program to reimburse airports for the capital and engineering costs associated with the installation of in-line baggage screening systems.

Baggage System Baggage System

To date, TSA has issued only eight LOIs (LAX, Denver, Dallas/Ft. Worth, Boston Logan, Las Vegas McCarran, Seattle-Tacoma, Atlanta Hartsfield-Jackson, Phoenix SkyHarbor). The earlier LOIs were to be funded with a 75 percent federal contribution. The recent FAA reauthorization bill requires TSA to adjust all LOIs to a higher 90 percent federal contribution level. Acting TSA director David Stone revealed in March that the administration’s request for $250 million for FY2005 EDS funds will only allow the administration to fund the eight LOIs at the lower 75 percent level. Stone also says that TSA has no plans to issue additional LOIs in the current fiscal year or in FY2005.

The Challenges
In-line projects at many airports have been placed on hold indefinitely due to:

a) financing challenges;
b) airline resistance to paying for in-line projects; and,
c) the real or perceived risk that pursuing in-line projects without prior TSA commitment may result in the airport becoming a lower priority when the TSA makes decisions to dole out future grant reimbursements.

Traditional Methods
Given TSA’s limitations in extending additional LOIs, the continuation of in-line project development will likely depend on innovative financing solutions and negotiations with TSA for non-LOI funding sources (e.g. reimbursement of security personnel cost savings). The following are the traditional finance methods used by airports:

  • General Airport Revenue Bonds (GARBs).
  • Passenger Facility Charge (PFC) Revenue Bonds.
  • Commercial Paper (CP).
  • Equipment Loans & Leases.

For many airports, traditional financing methods are unacceptable due to:

  • Revenue covenants may require increases in airlines’ rates and charges (a “tough sell”).
  • Limited capacity and high cost of traditional credit enhancement.
  • PFCs may be previously committed to other projects or are needed for planned projects.
  • High interest cost associated with non-enhanced bonds and equipment loans and leases.

Airports seeking to pursue in-line projects without prior TSA commitment will be best served by using innovative financing methods that eliminate (or at least minimize) the impact on airlines’ rates and charges. Deeply subordinated (lowest lien position) and “off-balance sheet” (Special Facilities) borrowings are financing methods that usually eliminate the requirement for airports to increase airlines’ rates and charges to pay interest and amortization costs on bonds used to finance the in-line project.

Innovative financing methods allow third-party private risk participation in the in-line project financing. Private companies will be willing to share in project finance risk in exchange for the prospect of a reasonable rate of return.

Diagram A - Click for larger image Diagram A

Deeply Subordinated Financings
As stated previously, deeply subordinated financing is one method of financing in-line projects without increasing rates and charges to airline tenants.

Diagram A depicts a typical airport lien structure and exemplary revenue covenants (required revenue “coverage” of debt service) and the relatively weak credit structure of the deeply subordinated lien position (3rd lien position in this example).

With few exceptions, in today’s bond market deeply subordinated in-line project financings cannot be marketed efficiently using traditional forms of credit enhancement (bond insurance and bank letters/lines of credit based on the subordinated net airport revenue pledge alone). Given the challenges of subordinated airport financing structures and associated high costs of traditional credit enhancement, airports should explore methods of bringing in alternative forms of credit enhancement to support the subordinated bonds.

Alternative credit enhancement may take the form of corporate guaranties delivered by contractors and corporate sponsored bank letters of credit secured by a “negative pledge” of future TSA grant reimbursements and corporate financial and/or performance guaranties. A “negative pledge” differs from a revenue pledge in that instead of pledging future grant revenues to the repayment of debt service (which is not an option as TSA grants cannot be encumbered), it requires the airport to use future TSA grant reimbursements for no other purpose than to pay debt service on the in-line project bonds.

Diagram B - Click for larger image Diagram B

Diagram B illustrates a financing structure that provides a costs-effective means of marketing a deeply subordinated variable rate bond offering.

Meanwhile, the competitive situation that exists in the marketplace with manufacturers of baggage handling systems (competing over in-line system contracts) lends itself well to airports seeking to attract private contractor financial participation. To the extent that the airport wishes to utilize corporate financial participation, it may be necessary to use “best value” procurement rather than the traditional “low bid” methodology. In order to provide an incentive for contractors to provide marketable financial participation in the project, the airport will have to establish a clear methodology for evaluating both technical and financial value offered by competing contractors.

Baggage System Baggage System

Best value procurement also allows for the additional opportunity for contractors to provide: long-term maintenance contracts; product warranties and guarantees; and, operational and technical efficiencies.

Under the subordinated financing model with contractor risk participation, private contractors will bear certain risks that they are routinely in the business of accepting anyway. These risks include Federal (TSA) appropriation risk and project delivery and timing risk.

Special Facilities Financing
Special Facilities bonds are tax-exempt revenue bonds secured by rental payments (from the corporate lessee) and a corporate guaranty. The Special Facilities are owned by the airport and leased to the corporation(s). To date, Special Facilities financings have been utilized by airports for corporate sponsored projects such as: terminal, cargo, fuel, hangar, aircraft maintenance, training, food and hospitality services, and rental car facilities.

The Special Facilities financing model is an “off-balance sheet” financing alternative available to airports seeking to move forward on their in-line system projects. With this financing model, the in-line facilities are owned by the airport and leased to the corporate in-line special facilities manager.

Diagram C - Click for larger image Diagram C

Diagram C is an illustration of a Special Facilities financing that could be implemented for an In-Line System project.

Under the Special Facilities model, the airport issues the In-Line Special Facilities Bonds. The bonds are guaranteed by the corporation(s) providing the in-line facilities (or through a bank or other guarantor provided or arranged by the corporation(s)). Debt service on the In-Line Special Facilities Bonds is repaid with rental payments made to the airport by the corporate lessee(s).

The airport pays for the In-Line Special Facilities through a per-unit fee (per bag or other unit measure) pursuant to a Per-Unit Service Contract with the in-line special facilities manager. The Per-Unit Service Contract also provides the potential for a reasonable return on investment for the private contractors at risk.

The airport should have the ability to terminate the lease at anytime, in the event that TSA grant reimbursements are received or for any other reason, including unsatisfactory performance of the lessee.

Special Facilities lease and service contract agreements are highly-customizable and should be created to meet the specific needs of individual airports. Termination options of these agreements should be structured with consideration of the likelihood of receiving TSA funding in the near term.

The primary advantage of the Special Facilities financing method is that the debt is not an obligation of the airport, and therefore does not affect the balance sheet or the credit quality of the airport. Instead, the debt is an obligation of the corporate In-Line Special Facilities Manager (one or more corporate lessee(s)), who is at-risk if passenger traffic declines substantially, or if TSA does not appropriate future grants, among other risks.

* * *

Many airports are experiencing difficulty in pursuing in-line system projects due to funding challenges for these projects. The difficulty lies in the lack of available TSA funding and airline resistance to paying for these projects in their rates and charges.

Daniel Dean Daniel Dean

Innovative financing provides alternative methods for airports to move forward with their in-line projects without TSA commitment and with minimal impact to the airlines.

Daniel Dean is an Assistant Vice President in the Transportation Finance Group within George K. Baum & Co’s. Tax-Exempt Investment Banking Division. Mr. Dean specializes in Public-Private Joint Ventures in aviation, surface and maritime transportation. Mr. Dean can be reached for comments or questions at (303) 391-5461 or dean@gkbaum.com.

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