Battle over Midway

Deals fall apart for many reasons, and ultimately each gets its epitaph in the press. The Pennsylvania Turnpike deal failed for “political reasons”; the Port of Miami Tunnel stalled “because of a problem with the financial sponsor”. Now Midway Airport is said to have died because of “problems with the financial markets”.

Chicago: battlefield for investors

The first two are fairly uncontentious. For more than four months, the Pennsylvania legislature had $12.8 billion on the table for a 75-year lease of the turnpike but decided not to take a vote on the deal. In Miami, Babcock & Brown’s impending bankruptcy prompted the firm to pass its interest in the project onto another sponsor, which gave Florida second thoughts on inking the deal.

The Midway epitaph, though, is stirring stronger feelings. In the end, Citi Infrastructure Investors and its partners in MidCo, the concession company for Midway, simply could not get the equity they needed to close on the deal by their deadline. But there are two schools of thought among investors and industry observers as to what went wrong.

One camp argues that the timing of the transaction was just unfortunate and Citi was essentially a victim of circumstance. Markets deteriorated so precipitously between when the bid was awarded and when it needed to close that the economics of the deal simply didn’t make sense anymore, these people say.

Others take a more critical view. They argue the deal fell apart because of numerous decisions taken by Citi. These include over-bidding for the airport in the first place, submitting an unfinanced bid and presuming that its limited partners would let it over-allocate its fund to this one asset if other sources of equity weren’t available to fill up part of the $2.5 billion price tag.

Whichever camp they sit in, though, most observers agree the Midway transaction won’t be resurrected any time soon.  Chicago would need a bid that matches or tops the $2.5 billion Citi offered for the airport for the deal to be politically viable. In current market conditions, few see that as a possibility.

From bid to close

Few need reminding that the real work on any transaction starts the day after the bid is awarded. The euphoria of striking the deal wears off and the long, hard slog toward financial close begins.
After Chicago announced the winning bid for the 99-year lease of Midway on 30 September, 2008, Citi and its partners were given a six-month period to get the cash on the table for the $2.5 billion rent fee. They agreed on 6 April, 2009 as the deadline and placed 5 percent of the bid amount, approximately $126 million, in escrow as a break fee in case the deal would not reach financial close by that date.

Citi had managed to arrange about $1 billion of debt prior to the bid deadline according to sources familiar with the transaction. But Chicago’s final application for the Federal Aviation Administration’s permission to lease the airport, dated 9 October, was filed on an all-equity basis. It simply named Citi, Vancouver Airport Services and John Hancock Life Insurance Company as 89 percent, 3 percent and 8 percent equity sponsors, respectively, and explained that they would finalise their capital structure prior to lease signing.

Including transaction costs and other items, Citi needed to get to about $2.8 billion to reach financial close. Naturally, the first step was to raise senior debt. According to a pitch document seen by Infrastructure Investor, Citi obtained a term sheet for a five-year senior secured loan of $800 million with an initial interest spread of 3.5 percent over LIBOR, a common interest rate benchmark. Bankers also provided additional facilities for capital expenditures and a revolving credit facility.

That left Citi and its partners on the hook for $2 billion. About $1.5 billion was to come in the form of common equity from Citi, Vancouver and John Hancock. A person close to the transaction said their equity commitments were “firm and fair”. With those commitments written in, a gap of about $500 million remained.

Citi tried everything it could to fill it, sources say. It hired Barclays Capital’s private placement team to sell $500 million in convertible preferred equity with an eight-year maturity and a 14 percent lifetime internal rate of return. But buyers’ and sellers’ expectations on pricing didn’t match up, so it turned its attention to raising mezzanine debt. Neither approach was ideal for Citi since it would give its fund investors a more junior claim on the airport’s profits, and in the end neither approach succeeded in getting the deal over the finish line.

Citi also talked to the limited partners in its fund about the possibility of allocating more equity to Midway than they were contractually allowed to under the fund’s charter.

The fund had held a first close on $1.325 billion in December 2007, and a final close on $3.41 billion in December 2008, according to data provider Preqin. To ensure diversification, funds typically set allocation limits that put a cap on how much equity they can commit to a deal. Citi’s equity cap for any one asset stood at 20 percent of the fund, according to a limited partner. Infrastructure Investor has learned that the limited partners in the fund have in the past let Citi over-allocate to certain assets, such as UK water utility Kelda. This time, however, there was no appetite among its limited partners to over-allocate, according to a person close to the transaction.

With all options exhausted, the consortium decided not to pursue a six-month extension on its original deadline for financial close and paid Chicago the $126 million break fee, ending the transaction.

Bad timing?

One view on Citi’s struggle to seal the deal is that it bid at the worst possible time. Investment bank Lehman Brothers had just collapsed and the government rescue of insurance giant AIG in September 2008 triggered unprecedented volatility in the markets.

On the debt side, US loan issuance fell by two-thirds between the third and fourth quarters of 2008 and was down 42 percent in the first quarter of 2009 versus a year earlier, according to data from Thomson Reuters. Credit spreads widened on nearly every type of debt instrument and club deals, where large numbers of banks come together to finance a tranche of debt, became the norm. So debt was more difficult to come by, more expensive and harder to negotiate among numerous counterparties. It was also likely to take much longer to raise anything: the credit markets essentially froze in the weeks after the AIG rescue.

On the equity side, a mere $3 billion of infrastructure capital was raised in the fourth quarter of 2008 and less than half that in the first quarter of 2009, according to data from placement agent Probitas Partners. Few investors were making new commitments to the asset class and those that had already made them were more than likely delighted not to get a capital call to commit money for a deal.

Another aggravating factor was the precipitous decline in the public markets. Between the end of September 2008 and the beginning of March 2009, US equities, as measured by the Standard & Poor’s 500 index, tumbled 35 percent. More to the point, investor appetite for airport assets also withered: the Dow Jones Brookfield Airports Infrastructure Index tumbled 44 percent over the same period.

Naturally, this made Midway’s $2.5 billion price tag look expensive vis-à-vis public market comparables. Industry observers took note. In late March, Swiss alternative asset manager Partners Group issued a report which argued that “Midway had the characteristics of a trophy asset for the acquirer, which resulted in the willingness to pay a considerable premium”. Listed comparables such as Zurich and Vienna airports were trading at 6x EBITDA, whereas Citi was willing to pay 28x for Midway, the report noted.

Not everyone takes this view. At a discussion panel on the Midway deal at the Dow Jones Infrastructure Summit in May, Mayer Brown partner John Schmidt, Chicago’s legal counsel on the transaction, vigorously defended Citi’s bid price. He said it was “ridiculous” to measure public-to-private transaction values on a historical basis, because “when the asset moves to the private sector, it changes in a fundamental way”. Based on the thesis that the private sector can run infrastructure assets more efficiently than the public sector, Citi would gain immediate savings that would deflate the supposedly too-high multiple of 28x.

According to the pitch document seen by Infrastructure Investor, Citi identified about $35 million of immediate operational expenditure reductions between 2008 and 2009, of which more than half would come from contractual savings provided by the City of Chicago. By 2010, its EBITDA multiple for the $2.5 billion price tag would have been more in the region of about 22x, assuming everything went according to its base case assumptions. But finding enough additional investors in MidCo proved impossible. 

With rising markets and cheap debt, perhaps things could have turned out differently, as they did for Macquarie and Cintra in their respective bids for the Chicago Skyway ($1.8 billion) and the Indiana Toll Road ($3.8 billion). The former valuation stood about $1.1 billion above the nearest bidder while the latter, excluding a bidder which dropped out at the last minute, offered a $1 billion premium. Citi’s Midway bid was only about $700 million above the nearest competitor, Macquarie. But by now the market had worsened.

“If we asked them what their confidence was in their bid, especially given where the market is today, I think they probably would retract from where they were six months ago,” says Sotiris Pagdadis, senior strategic advisor at international aviation consultancy SH&E.

The critics' view

Others put a different emphasis on what went wrong. Yes, the markets are tough, these people say, but Citi also made a number of decisions that compounded its difficulties in reaching financial close.
First, there’s the ever-present charge that Citi overbid. But there’s a wrinkle to it: unlike some other infrastructure assets, such as toll roads, airports have much scope for operational improvements due to their large retail component. Increasing shopping opportunities and adding new revenue streams over a 99-year period can add a ton to the upfront rent fee. It all depends on the assumptions.

On that front, according to the aforementioned sales document, Citi assumed that it could grow commercial revenues at the airport from about $60 million in 2009 to nearly $300 million in 2019 in a base case scenario. This would be done through an expansion of current shopping, car parking and advertising revenue streams at the airport. It would also add a brand new earnings stream by leasing land and office space at the airport and deliver $8.5 million a year in revenues by 2013. The airport’s EBITDA, according to these assumptions, would more than quadruple in the first ten years of operation.

Potential investors in the preferred equity saw this anticipated uplift in earnings – and, consequently, the bid price – as too optimistic. And, of course, the higher the bid, the less room there is for error in one’s business plan (as private equity group KKR’s legendary RJR Nabisco deal, which ultimately accomplished an internal rate of return of less than 1 percent, demonstrated).

Secondly, there’s the suggestion that submitting a bid without a firm capital structure in place was a mistake. Chicago’s bidding rules didn’t preclude it, but essentially it amounted to a risky bet that credit markets would recover and allow Citi to raise debt on favourable terms. Markets did not improve, and critics insist Citi should not have made the bet in the first place.

However, a person close to the transaction makes the point that at the time, given the mood of the market, no so-called committed financing was ever as firm as it seemed. Prior to the bid due date, banks were demanding material adverse change (MAC) clauses – terms that allow a transaction participant to back out of their financial obligations – which made any debt commitments far from certain.

Thirdly, detractors argue Citi should not have assumed its limited partners would free it from its allocation cap in order to put more equity into the deal. Although it had successfully flexed its allocation cap before, Citi was either naive or rash to think it could do so again and top up with more equity in the depressed environment of late 2008, these people say.

“They were presumptuous about what they could and couldn’t do in terms of how to finance this,” says one person familiar with the deal.

Using more equity in order to complete a transaction is of course not unique to Citi. In fact, some see the need for dispensation from allocation caps as a necessity in today’s market. “Where we would have seen much more senior debt on a deal, now we’re seeing less senior debt and more equity. Until this essentially reverses itself, you’re going to have a lot of funds reaching their [allocation] cap. You’re going to see this happening over and over and over,” predicts SH&E’s Pagdadis.

“It’s something that we’re going to see on Gatwick as well,” he adds, referring to the London airport that is currently being auctioned off by the British Airport Authority. Notably, the Citi consortium was ejected from the Gatwick bidding in mid-May not only on account of being outbid, but reportedly also over concerns about the deliverability of the bid [see page 10 for the latest on Gatwick]. 

Done deal

Whichever camp you sit in, few are optimistic that the Midway deal will resurface any time soon even though, on the day it announced the deal’s failure, Chicago reiterated Mayor Richard Daley’s commitment to do a deal on Midway. With a $96 million budget deficit that is expected to reach $300 million by December, according to a recent press conference by Daley, there seems ample reason to give it another try.

But buying or leasing a public asset is not like doing a corporate takeover, where submitting a lower bid after markets deteriorate can still result in success. Above all else, public-private partnerships must be politically viable, and that means meeting politicians’ – and their voters’ – expectations. In the case of Midway, Citi’s bid set a very high floor price that will be very difficult, if not impossible, to meet or beat anytime soon.

Pagdadis believes the US’s infrastructure stimulus bill may also dampen enthusiasm for rebidding the airport. Part of the reason for doing the deal in the first place was to try to shore-up the city’s infrastructure spending. But with the stimulus package boosting infrastructure spending on cities and states all over the nation, that may be less of a priority.

“Everyone has to go back to the original premise of ‘why do we want to do this?’” Pagdadis says. “I’m not sure that this project will get rebid – I just don’t see it.”

For some though, the fact that Midway almost happened is cause enough for optimism. “The basic Midway lesson is that it is in fact possible to privatise a major airport in the US. We were denied the climax, but it is possible,” Schmidt said at the Dow Jones conference. For a chastened Citi, this may provide small comfort.