Take It to the Bank: Covering the Cost of Capital Equipment with Hybrid Financing Structures
While most municipal water districts in the past have turned to bond financing as a way to cover the cost of upgrading equipment, a more cost-effective option of traditional bank financing, commonly known as installment purchase financing or lease purchase financing, is proving to be an easier way for some.
|Installment/lease purchase structures can be used to cover the full scope of equipment and technology needed by water utilities|
By Brian DePonte
According to the American Water Works Association's (AWWA) 2014 State of the Water Industry Report, the condition of water and wastewater infrastructure is the top issue facing today's water professionals and those they serve. Financing capital projects is close behind as the third most pressing issue, and it's no surprise why: a 2012 AWWA study found that replacing and expanding drinking water infrastructure alone will come with a price tag of more than $1 trillion, and wastewater costs are thought to be similar.
While the cost of upgrading and maintaining an outdated water infrastructure continues to climb, utilities are facing complex budget issues, and many lack the funds needed to invest in capital equipment.
While most municipal water districts in the past have turned to bond financing as a way to cover the cost of upgrading equipment, a more cost-effective but lesser-known option of traditional bank financing, commonly known as installment purchase financing or lease purchase financing, is proving to be an easier way forward for some.
The Benefits Add Up
While bond financing has historically been the most common way for water utilities to fund new or upgraded equipment, it also comes with some heavy lifting. Bond financing can be time consuming and intimidating, especially for smaller municipalities.
To help meet the need for easier, more flexible financing for water infrastructure expenditures, banks are starting to integrate some of the key components of bond financing into more traditional equipment financing structures to meet the specific needs of water utilities. These agile hybrid finance arrangements provide aggressive tax-exempt rates for municipal water districts; can be customized to meet the specific budgetary requirements of a particular utility; and can accomplish this without the reams of paperwork that accompany a typical bond issue. These structures may entail funding provided directly from an equipment manufacturer/vendor or the bank. This also offers the added value of working one-on-one with a lender who can offer guidance and advice throughout the process.
Water Industry Issues
Issues Facing the Water Industry as Ranked by all SOTWI Respondents
|From AWWA's State of the Water Industry Report.|
Installment/lease purchase structures can be used to cover the full scope of equipment and technology needed by water utilities, including everything from water meters and pumps to supervisory control and data acquisition (SCADA) solutions and billing systems. In addition to the cost of equipment, traditional financing can also cover the "soft costs" of an equipment acquisition, which means utilities can plan for one predictable monthly payment that covers the cost of the equipment and the subsequent installation, service, training, and support fees.
Other benefits of installment/lease purchase financing for municipal water districts include:
- Less Paperwork: While typical bond issues can be 200 to 300 pages long, an installment/lease purchase agreement is typically between 20 and 30 pages. This means less time spent reading and approving documentation and more time serving customers.
- Eliminate Cost of Issuance: Installment/lease purchase agreements help save water utilities money by eliminating all fees associated with the COI. This means no fees for insurance companies, trustees, borrower's and lender's council, and Escrow agents.
- Speed: Putting together a bond and getting all necessary approvals - and in some cases voter approval - can take anywhere from 90 days to six months. With installment/lease purchase financing, applications are typically approved within two weeks.
- Flexibility: With installment/lease purchase financing, it's easy for water utilities to add or upgrade equipment to meet the demands of population growth. Typically, the bank will add a "schedule" to an existing finance agreement, which means approximately 90 percent of the required paperwork is already complete from the initial transaction. Once again, this provides a faster, cheaper and easier alternative to bond financing, which would require starting from scratch to obtain the funds to cover the additional equipment needs.
- Debt Coverage Ratio: Like bond financing, installment/lease purchase financing can include a rate maintenance covenant. By building into the agreement a reasonable debt coverage ratio (or "additional debt test") - which is less onerous than that contained in typical bonds - both the investor and borrower benefit. The investor gains comfort with regard to future borrowings, and the borrower receives a better rate reflective of that comfort.
- Debt Service Reserve: In certain instances, a debt service reserve (DSR) fund of 10 percent or less of the total acquisition may be established. Escrowed and held for the borrower, this reserve can help a challenged credit gain approval by providing a means with which to help cover the cost of the lease payment in case of emergency. The DSR is then replenished by the borrower prior to the next payment due date unless other arrangements are made. In addition, this credit "cushion" can also help a utility weather an extraordinary or unforeseen financial event and provide an adequate window for adjustment and recovery.
End of Term Options
Water utilities have several options at the end of the financing arrangement. While traditional tax-exempt qualifying structures will typically be used, other options can offer important alternatives in certain situations. Depending on the specific details of the finance agreement, at the end of a lease purchase agreement the municipality can: purchase the equipment at the fair market value; renew the finance agreement at a fixed price; or choose a $1 purchase option. This flexibility offers more alternatives for asset management in terms of acquisition, replacement and renewal.
Selecting a Partner
Installment/lease purchase financing, while used on a daily basis in other government sectors, is an option that not all banks offer when discussing options for water utilities. When searching for a finance partner, look for a company that is experienced working with water utilities. You should also look for a finance partner that:
- Is flexible and willing to work with you to develop a program that will meet your financial objectives.
- Considers the relationship a partnership and is readily available to answer questions and provide support throughout the life of the agreement.
- Offers fast credit approvals and quick, easy processing.
- Is a financially-stable, long-term business partner.
Questions to Ask
Like any business decision, it's important to ask the right questions before entering into a finance agreement, particularly for municipalities that are more familiar with bond financing or for those that have not secured financing for capital expenditures in the recent past. The following list of questions will help guide you through the process from beginning to end:
1. How am I planning to use this technology in my utility?
2. Does the finance representative understand my industry and how this transaction helps us do business?
3. What types of "soft costs" will I encounter, and can they be financed?
4. What is the total of the monthly lease payments, and are there any other costs that I could incur before the financing period ends?
5. What happens if I want to change this financing agreement or end it early?
6. How am I responsible financially if the equipment is damaged or destroyed?
7. What are my other financial obligations for the equipment (such as insurance, taxes and maintenance) during the financing period?
8. Can I upgrade the technology or add equipment under this agreement?
9. What are my options at the end of the financing term?
10. Are there any extra costs at the end of the financing period?
Just as innovations in technology are making water utilities more efficient, so too are innovations in finance. By entering into a traditional finance partnership that combines the most important benefits of bond financing with a faster, easier and less costly finance option, many utilities are finding an easier way to fund equipment upgrades. And by helping overcome two of the industry's biggest challenges, it just might help water utility supervisors sleep a little easier at night.
About the Author: Brian DePonte is senior vice president of innovation markets at Key Equipment Finance. He has nearly 20 years of experience in water infrastructure financing and leads a team dedicated to meeting the equipment finance needs of this market. He can be reached at firstname.lastname@example.org.