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UBS real estate focus January 2011 23

Public-private partnership ndash more than a buzzword

Governments and companies have a long

history of collaboration However public-

private partners have to do more than just

work together They also need to defi ne

processes to structure their relationship

allocate risk award contracts and lay

down ground rules for the partnership

Operating maintaining and repairing a build-

ing over a 25- to 30-year period costs about as

much as constructing it in the fi rst place (ex-

cluding fi nance costs) Even a er accounting

for the time value of money only two thirds of

the total budget go toward the initial construc-

tion with one third consumed by operating

costs over 25 to 30 years Planning for any

construction project should thus consider the

subsequent operational phase This is one of

the strengths of public-private partnerships

(PPPs)

Originally conceived abroad by governments

seeking a way out of fi nancial predicaments

today one of the PPP modelrsquos major virtues is

the fact that bidders already have to consider

the operational phase when they make their

bids PPP does not do half-measures either

Besides addressing operating costs directly the

bidders are also free to design a building and

or infrastructure that minimizes operating

costs PPP thus integrates the buildingrsquos future

operator in the bidding consortium from the

start thereby improving long-term planning

design and construction

The tendering procedure is the key

The core of every PPP project is a contract be-

tween a public-sector entity and a project com-

pany with a clearly defi ned scope of services

The long contract terms (generally 20 to 30

years) show that PPPs cover the propertyrsquos en-

tire lifecycle not just construction and fi nance

Successful PPP projects utilize well-designed

tendering procedures that integrate planning

design construction fi nance and operation

into the bids and encourage competition for

each stage of the project

Some government clients hold architecture

competitions and then solicit bids from com-

panies to build and operate the property This

is not true PPP The problem Since the archi-

tecture has already been determined the

private service provider has little leeway to

optimize construction andor operation in its

proposal And so while planning and opera-

tion may be more effi cient these gains are

swallowed up by the companyrsquos higher fi nanc-

ing costs compared to its government client

The typical PPP tendering procedure can de-

liver signifi cant savings ndash for both the project

company and the public-sector client Numer-

ous analyses of PPP projects in neighboring

countries have documented effi ciency gains of

15 to 20 percent not to mention shorter build-

ing periods in many cases In Switzerland the

effi ciency gains for above-ground projects

should range from 5 to 10 percent

Higher fi nancing costs

a hollow counterargument

Critics of prefi nancing and outsourcing ser-

vices to private providers o en argue that

companies have higher fi nancing costs than

governments Unfortunately they ignore the

fundamental diff erences between the public

sectorrsquos risks in a PPP project as versus projects

where the building is constructed by govern-

Typical structure of a PPP project

Source UBS Real Estate Advisory

Contract

Construction Operationmaintenance

User fee

Public sectorClient

(ordering party)

Project companies(contractorsconcession holders)

User

Typical shareholdersndash Investors (funds etc)ndash Generaltotal contractors (GCTC)ndash Operators

Supervisory authority

Investorsbanks

PermitProject

financing

Generaltotal contractor(designbuild)

Operator(public private)

Project company as the contractor

Christian Unternaumlhrer

Wealth Management amp

Swiss Bank UBS AG

Niklaus Scheerer

In focus Commercial real estate and special uses

UBS real estate focus January 201124

ment entities In a PPP project the private

contractor assumes construction and opera-

tion risks while government construction

places some or all of these risks on the public

sectorrsquos shoulders

Low public-sector fi nancing costs ultimately

stem from taxpayersrsquo implicit guarantee Re-

course to debt guarantees from taxpayers is

hard to justify though especially when the

risks and services could easily be offl oaded to

the private sector Risk allocation becomes dis-

torted by a kind of circular logic The taxpayers

are essentially guaranteeing their own debts as

the indirect project initiators Since this struc-

ture ignores the eff ective project risk in all fi -

nancing deliberations capital allocation is fre-

quently suboptimal

PPP projects by contrast clearly identify and

quantify all visible project risks and allocate

them to whomever can best judge and bear

them The private sector provides the project

fi nance although the government client is still

able or required to furnish greater or lesser

guarantees If guarantees are furnished how-

ever they are tied to a risk event so that the

client can manage the risks properly

Many potential areas of application

PPP projects are ideal for building transporta-

tion infrastructure They have also proven

their value over the last ten years in health-

care education criminal justice and national

defense particularly outside of Switzerland

Within Switzerland PPP models will probably

play the largest role in hospital fi nancing in

the near future Indeed the hospital fi nancing

reform slated for early 2012 (see ldquoHospital

property market in upheavalrdquo on page 25)

was motivated by a desire to create a level

playing fi eld for public- and private-sector

operators of acute care hospitals Having gov-

ernments build and operate hospitals would

not have been conducive to achieving this

goal This does not mean however that the

public sector has pulled out of the hospital

sector Instead it should assume a new role

as envisioned by the PPP paradigm Public and

private partners have unlimited scope for cre-

ativity in determining how they will share the

work It is important though for work alloca-

tion arrangements to be clearly structured

and consistently implemented by both part-

ners from the beginning PPP is not a game of

ldquohot potatordquo between the public and private

sectors

Intelligent risk allocation with PPP

PPP models are a viable form of fi nancing projects in Switzerland as

illustrated by the canton of Bernersquos new Neumatt Administrative

Center in Burgdorf The government is receiving a new piece of infra-

structure that it probably could not have built and fi nanced itself ndash

and the project is on schedule and on budget Debt-to-equity ratios

vary in PPP projects depending on the area of application and risk

structure Ten to 20 percent of project costs is the standard equity

ratio for above-ground projects where the private partner bears little

to no market risk This low ratio ndash which is only possible thanks to

the clear risk allocation of PPP projects ndash can deliver an attractive

return on equity and also optimizes overall fi nancing costs And that

protects government coff ers Large real estate investors would do

well to familiarize themselves with PPP since Switzerland is expected

to see many PPP projects in the future It makes sense to learn as

much as possible early on

In focus Commercial real estate and special uses

UBS real estate focus January 2011 25

Hospital real estate in upheaval

Switzerlandrsquos hospital system is complex

Its structure buildings and fi nancing are

on the cusp of a radical transformation

This change opens up attractive opportu-

nities for investors

The Swiss hospital real estate market is in up-

heaval Not only do the properties (largely

built in the 1970s and 1980s) need signifi cant

renovations but the hospital structure in many

cantons is outdated and balkanized Plus the

widespread shi from inpatient to outpatient

treatment is creating new demands on space

that the current hospital infrastructure is un-

able to meet adequately or cost-eff ectively

New hospital fi nancing as of

January 1 2012

The biggest change facing hospitals is probably

the 2007 amendment to the Federal Health

Insurance Act (Krankenversicherungsgesetz

KVG) which will roll out an overhaul of hospi-

tal fi nancing on January 1 2012 The purpose

is to improve effi ciency and transparency The

reform applies a system of ldquodiagnosis-related

groupsrdquo (DRGs) for the treatment of patients

Patients are assigned to DRGs based on criteria

such as the main diagnosis additional diag-

noses treatment and severity The DRG assign-

ment determines the fl at fee paid to the hospi-

tal for treating the patient This contrasts with

the existing system where hospitals receive

payment retrospectively with defi cit guaran-

tees or global budgets DRG rates are set using

the least expensive hospitals as a baseline and

are regularly updated They are defi ned on a

national level by SwissDRG AG an organiza-

tion set up specifi cally for this purpose Part of

the DRG fee goes toward capital expenses that

used to be fi nanced by the cantons Special

provisions have been instituted during the tran-

sition from the old to the new system of hospi-

tal fi nancing The new system however does

not cover outpatient services which continue

to be paid using the Tarmed tariff system

Unpredictable regulator

If the new system takes the form envisioned by

the legislature hospitals will fail if they cannot

provide services at or below the DRG rates

Only time will tell if policymakers will stand by

and watch this happen as the cantons are re-

quired to ensure an adequate supply of inpa-

tient hospital services Thus the market will

probably not be given a free hand to reform

Switzerlandrsquos hospital system quite as radically

as envisaged in the amended KVG

Cantons will have to decide whether to prop

up hospitals as long as they continue to wear

several confl icting hats Not only do they stipu-

late what services hospitals have to provide as

part of the hospital planning process (this

ldquoservice mandaterdquo is necessary for hospitals to

appear on the Hospital List) but they also di-

rectly or indirectly own and operate many hos-

pitals themselves

Financial assessment

Under the new system fi nancing risk is as-

sessed based on the hospital operatorrsquos cred-

itworthiness not the cantonrsquos That means

hospital fi nancing will increasingly use the

standard assessment criteria for corporate

fi nance The reason The competition-distort-

ing eff ects of public guarantees would run

counter to the new systemrsquos goals As a re-

sult investors will have to carefully review

each hospitalrsquos prospects and viability before

providing equity or debt capital

Hospitals with a strong costquality profi le

and attractive catchment areas ought to be

able to easily raise capital for future operations

despite the various hurdles such as ensuring

adequate capitalization Poorly positioned

Structure and income sources of hospitals as of 2012

Source UBS Corporate Finance Switzerland Project amp Product Development

Illustrated by an example

Func

tion

s

inte

rfac

esSe

rvic

es

floor

spa

ce

Sour

ces

of fu

ndin

g

Investor

Doctors Providers of radiology etc Hospital operator

Canton

Real Estate Ltd(hospital owner)

Hospital Ltd or other legal structure

Hospital

SwissDRGCantonsInsurance

Private households

Ground subleaseService mandate ground lease

Management contract

Lease

Outpatient treatment

Inpatient treatmentCommon areas

Subleases

TARMED

In focus Commercial real estate and special uses

Markus Wagemann

Wealth Management amp

Swiss Bank UBS AG

Christian Unternaumlhrer

Niklaus Scheerer