Airport Sales Take Off with Lmm

PROJECT FINANCE INTERNATIONAL FEATURE

AIRPORT SALES TAKE OFF WITH LMM

BY RICHARD S LINCER , PARTNER, AND ADAM BRENNEMAN, ASSOCIATE, AT CLEARY GOTTLIEB STEEN & HAMILTON LLP . THEY LEAD THE CLEARY GOTTLIEB TEAM THAT REPRESENTED THE AEROSTAR CONSORTIUM IN CONNECTION WITH THE NEGOTIATION AND FINANCING FOR THE PRIVATISATION OF LMM IN PUERTO RICO.

On February 27 2013, the Puerto Rico Ports The willingness of airlines to accept an Authority (PRPA) transferred the operation of the aggregate fee structure showed their optimism Luis Muñoz Marin (LMM) Airport in San Juan, about air traffic at LMM after declines in recent Puerto Rico to Aerostar Airport Holdings in the first years – as the number of passengers rises, the successful privatisation of a hub airport under the rate per passenger effectively decreases. Some FAA’s Airport Pilot Privatization Program. airlines, however, were equally focused on the This landmark transaction, more than four crumbling infrastructure at LMM – a number of years in the making, was a significant success for airlines demanded specific fixes to facilities, all stakeholders – the PRPA was able to retire a ranging from large passenger-facing equipment significant amount of debt; airlines saw rates (antiquated jet bridges) to minor quality-of-life lowered versus the status quo; passengers can issues (faulty air-conditioning units in offices). look forward to improved facilities; and Aerostar Others were focused on space allocations and the was able to capture a significant opportunity to ability to maintain their existing locations at the bring value to its shareholders, infrastructure airport, particularly when faced with proposals to fund Highstar Capital IV and Mexican airport turn the airport into a common use terminal operator ASUR . equipment (CUTE) facility. In the broader context, especially in light of the Aerostar successfully managed this process by clear need for renewal of US transportation engaging with the airlines early on – it was able infrastructure, the transaction shows that there is to leverage ASUR’s positive relationships with appetite and demand for airport transactions in the airlines at its Cancun airport, as well as the United States among private operators, and that relationships that employees hired from the public airport authority sponsors have a lot to gain airline industry brought. However, an important from a public-private partnership (PPP). In light of lesson learned is that airport operators in the US the success of the transaction, here are a few have a long history of interacting with airport lessons that can be applied in future airport PPPs: customers in a manner that may be different from airports in other jurisdictions where private Early engagement with airline customers is key participation in the airport sector is more Under the FAA’s Airport Privatization Pilot prevalent. Successful engagement requires both Program, no privatisation transaction can occur public airport authority sponsors and private without the support of airlines representing 65% of operators alike to understand the complex the number of carriers serving the airport and 65% dynamics among airline customers and to ensure of the passenger traffic at the airport. While some that they understand the primary objectives of public authority sponsors or private operators each airline, which may differ within the group. might see this as the basis for a divide-and-conquer strategy, in practice the airlines at LMM tended to Not necessarily structured as a typical PF function as a fairly tight-knit group. The number of One of the key challenges for Aerostar in the LMM major commercial airlines in the US is small, and transaction was to obtain financing on terms that key airlines serving LMM recognised that the permitted it to operate the airport, meet its positives far outweighed any apprehension about a obligations under the Lease and Airport Use new operator coming in to manage the airport. agreements and respond to the dynamic air travel It is important to recognise the diversity of market, where customer preferences, technologies viewpoints among airlines. Most airlines at LMM and pricing structures are constantly changing. The were clearly focused on tariffs: the new rate initial response of Aerostar’s lenders was to look at structure at LMM caps aggregate fees at US$62m the transaction as a typical project financing, with per year (escalated by inflation after the fifth a strict cashflow waterfall, lockbox accounts and year). This represents a significant departure completion certificates for capital expenditures. from the tariff structure at many other public Viewed strictly through the prism of aeronautical airports around the world, which is based on a revenues, there is some support for this notion: per-passenger or aircraft unit rate. much like a power business or a ports business, the

aeronautical revenue side of the LMM transaction Aerostar whose shareholders comprise existing has predictable revenue streams, long-term public airport operators and investors. In addition, contracts and, at least initially, well-defined capital newly-minted airport operators must receive expenditure programmes that are reviewed and security clearances to be able to view TSA security approved by the FAA. plans, and if an airport operator’s shareholders are However, after further engagement with the located outside of the US, it may be prudent to file project, Aerostar was able to show its lenders that an application with the Commission on Foreign the traditional project finance model had serious Investment in the United States (CFIUS). In total, limitations at commercial airports whose the closing of the LMM transaction took over operations are far more dynamic than other seven months from the date that the lease infrastructure facilities such as, for example, toll agreement with the PRPA was signed. roads. Airline and airport technology is Adding to the challenge of the long periods to constantly changing – whereas self check-in negotiate and close an airport PPP transaction, terminals were barely on the radar screen just 15 maintaining stakeholder support for airport PPP years ago, today they are the norm and in some transactions during these periods is crucial. Unlike cases are the only options for passenger check-in. ports or energy sector PPP transactions, large Ten years ago, charging passengers for baggage portions of the population have some amount of would have been nothing short of heresy, regular contact with an airport, whether they are whereas today all but a select group of elite air travellers or merely picking up visiting friends passengers will pay beginning with the first piece and relatives. Airports are also frequently of luggage at most airlines. Aerostar needed a significant generators of public employment in a financing structure that permitted it the community. Finally, airports are considered by flexibility to respond quickly to the needs of its many politicians to be a gateway to a community. airline and passenger customers. As a result, even small changes in airport More importantly, one of the most attractive operations are often put under a microscope. This revenue streams for private operators in airport PPPs was certainly true in the PPP transaction at LMM is not passenger charges or other forms of airport, where support or opposition to the aeronautical revenue but, rather, the revenues that transaction was voiced early and often by are generated by leasing space to commercial politicians, labour unions and community groups. tenants seeking to serve passenger needs, such as In this regard, a few lessons can be learned food and beverage concessionaires, parking from Aerostar’s experience with LMM Airport. operators or fixed-base operations (FBO) tenants. To First, it is important to build in contractual take an example, ASUR’s commercial revenues grew incentives – both positive and negative – for from 8.1% of its total non-construction revenues in community support. The Lease Agreement for 1999, when the Mexican airports were privatised, to LMM Airport provides not only for a large initial 31.7% in 2012. Given that aeronautical revenues at up-front payment, but also a fixed annual LMM are capped at US$62m per year (adjusted for payment of US$2.5m in the first five years of the inflation), commercial revenues were even more transaction, followed by payments of 5% of gross crucial to Aerostar – and it was even more critical for revenues for each of the next 25 years and 10% of Aerostar to have a financing structure that afforded gross revenues in each of the final 10 years. it the flexibility needed to attract and retain tenants. From the PRPA’s perspective, the large up-front Aerostar’s financing structure successfully payment allowed it to retire all of its airport- balanced the protection of lenders’ interests with related debt and still have enough left over for the flexibility necessary for a dynamic operating other ongoing obligations. Further, the ongoing business. While Aerostar’s revenues do go into a payments ensured a revenue stream that would pledged account, Aerostar has broad flexibility to be able to continue to pay for the PRPA’s use funds to operate its business. Aerostar’s oversight of Aerostar as well as help fund the capital expenditures are limited by a budget (plus regional airports for which the PRPA remained a cushion for contingencies), but the budget is responsible, which were a key issue in not subject to lender approval. In light of the community discussions on the transaction. commercial opportunities that exist at most Ongoing payments also helped the PRPA to major public airports in the US, future private build political consensus for the transaction by operators would be well-advised to seek similar allowing it to highlight that it would share in the flexibility in their financing structures. project’s success down the road. On the other hand, the contract provided for reimbursement by Maintain stakeholder support the PRPA of up to US$8m in bidder expenses if the Nearly all PPP infrastructure transactions take a PRPA walked away without justification. Both the long time to develop – taking many months or ongoing revenue-sharing and the costs for even years – because of the nature of abandoning the privatisation were invoked in a infrastructure assets and public bidding processes. speech given by Governor Garcia Padilla the night Airport PPPs in the US, however, have the added before the closing of the transaction took place. complexity of regulatory requirements that are Second, it is important that the bidding process be not applicable to the operator of a toll road or as efficient and transparent as possible, consistent even a power plant. Any private operator of an with achieving the public airport sponsor’s objectives airport must apply for and receive a Part 139 for the transaction. Bidding processes that drag on Operating Certificate from the FAA, a process that for substantial periods of time can often weaken can take many months, even for operators such as public support by making it seem as if there are

© Reproduced by Thomson Reuters 2013 doubts about whether the transaction will move upcoming debt maturities. The commercial tenants forward and allowing opponents additional time to at the airport had a poor history of paying rent and mobilise support. In the LMM Airport PPP, Aerostar many of them had abandoned their spaces. was selected from an initial pool of six bidders. This For many of the bidders, this situation pool was wisely reduced to two by the PRPA before a represented a daunting challenge: how could you final bid, which gave both sponsors a greater unlock the value at an airport that, by all accounts, incentive to spend the diligence dollars necessary to was substantially under-utilised? complete the transaction. Adding to the difficulties faced by bidders at LMM Unlike many public procurement processes, in Airport was the fact that, under the tariff structure, which bids are based on a final form of agreement, aeronautical revenues were fixed independently of the PRPA submitted draft Lease and Use passenger traffic – so a private operator couldn’t Agreements to all bidders and asked for comments generate additional aeronautical revenues by in three separate rounds. This process produced promoting additional flights to the airport. One of some benefits – it resulted in bidders obtaining a the key strategic decisions that Aerostar made early number of value-enhancing changes to the in the bidding process was to make a relatively agreement, which, insofar as they translated into a radical suggestion: rather than propose to build out higher upfront payment, was a key objective of the and increase the size of the airport, which is the PRPA in light of its stated goal of using the basis for many PPP transactions, Aerostar actually proceeds to deleverage. Although each airport PPP proposed to consolidate the airport into a smaller will obviously be somewhat different, now that footprint that was more consistent with its current there is a form of agreement that has been usage, and then reserve two entire concourses to be accepted by market participants, future airports for future growth. may be able to use that form as a base for their Although Aerostar’s proposal was initially met negotiations with prospective private operators. with scepticism by the PRPA and resistance by Finally, having a deep bench of industry experts airlines concerned about its operational impact, and advisers, both during contract negotiations and both constituencies grew to see the plan – which the closing process, is essential to success. Aerostar was called the Capacity Enhancement Plan, or CEP – engaged experienced transaction counsel as well as as beneficial. special FAA counsel, who were essential to ensuring The PRPA recognised that, by allowing a bidder to that there was a constant line of communication eliminate the fixed costs of operating terminals that open between Aerostar and its regulators. Aerostar’s were barely used, that could translate into a higher shareholder ASUR seconded a number of key up-front payment. In addition, in order to personnel for a transitional period, all of whom implement the CEP, Aerostar would have to make brought years of experience from the operation of significant capital improvements to two of the other ASUR’s airports in Mexico to discussions with airlines three remaining concourses, which would result in and commercial tenants, while shareholder Highstar an improved travel experience for passengers and Capital IV fielded a team of financial experts who better functionality for airlines. had extensive experience with public infrastructure After a significant period of engagement between projects, including Highstar’s investment in London Aerostar and the airlines, the airlines and the PRPA City Airport and the Seagirt Marine Terminal in grew to recognise that the CEP would provide for a Baltimore. Finally, Aerostar hired a US airport better passenger experience and would result in a industry expert to both advise on US airport practices number of long-overdue construction projects being during contract negotiations and to facilitate a accelerated. For Aerostar, the CEP was key to smooth transition with key airport stakeholders, obtaining financing and meeting the financial goals such as airlines, technical staff and cargo carriers. set by its shareholders. Having this team in place meant that Aerostar could The lesson for future bidders in airport PPPs is quickly respond to changes in agreements during that it isn’t necessarily the case that the airport negotiations and assure that they were correctly has to be taken as it stands. Although there are implemented during the closing process. certainly restrictions imposed by regulators as well as the inherent limitations that arise from Look at an airport as a blank canvas operating a space where planes take off and land Because of the very limited history of private at all hours, airports are, in many ways, an ideal participation in airport operation in the US, most commercial opportunity waiting in the wings – major public airports have historically been with captive consumers, existing infrastructure operated as akin to utilities or public works – and it and limited competition. shows. Compared with many of their peer airports in Latin America, Asia and Europe, US airports have Conclusion far more limited commercial offerings, less The LMM Airport PPP transaction was the first advertising and fewer sources of revenue. LMM successful PPP transaction in the US airport sector Airport was no different: LMM Airport had declining since the fizzled out Stewart Airport privatisation traffic for many years – from 2007 to 2011 attempt in the 1990s. It shouldn’t be the last. enplanements had declined by approximately 20%, There are many opportunities to be gained by and one of the Airport’s key airline customers – public airport authorities and private operators American Airlines – was about to file for Chapter 11 alike – improved operations, enhanced passenger bankruptcy and begin reducing capacity. LMM experiences, and at a time of state and municipal Airport was in severe need of remedial maintenance fiscal austerity, an opportunity to participate in and the PRPA was running low on cash and faced the success of a PPP transaction.