Doing more with dollars

Since 1968, private companies have been able to finance qualifying projects by issuing tax-exempt private activity bonds (PABs) as an alternative to traditional corporate debt. The benefits of PABs include potentially significant interest rate saving in light of the tax-exempt status of the bonds, potentially longer term debt than otherwise available, access to an additional pool of investor capital and flexible financing structures.

However, to receive PAB benefits, the issuer needs to comply with various federal and state regulatory requirements that may result in smaller bond issuances and a more involved bond issuance process (with pre- and postissuance compliance requirements) than traditional corporate debt. Nevertheless, the use of PABs is widespread across multiple industries by publicly traded and privately held companies.

OVERVIEW

PABs are municipal bonds issued by or on behalf of local or state governments for the purpose of providing special financing benefits for qualified private projects that serve a public purpose. Companies with qualifying activities, which include solid waste disposal facilities, are eligible to issue tax-exempt PABs through a conduit issuer, or a third-party organization, under the Internal Revenue Code.

Solid waste PABs are commonly referred to as industrial revenue bonds (IRBs). Other qualifying private activities include airports; docks and wharves; sewage treatment facilities; local district heating; hydro-electric, green building and sustainable design projects; and facilities for furnishing water. (See Exhibit 1).

The issuance of PABs is most prevalent with electric utilities ($26.2 billion outstanding); oil and gas ($11.1 billion); airlines ($5.9 billion); and environmental control companies ($4.6 billion). PABs also have been issued by companies outside of these industries, including Intel, Toyota and Office Depot.

In the context of IRBs, the Internal Revenue Code defines solid waste disposal facilities as “any property or a portion thereof used for the collection, storage, treatment, utilization, processing or final disposal of solid waste.” Recycling facilities also qualify.

Further, solid waste is defined as “property which is useless, unused, unwanted or discarded solid material, which has no market or other value at the place where it is located.”

In practical terms, this definition may encompass a wide variety of solid waste capital expenditures, including carts, trucks, transfer stations, material recovery facilities (MRFs) and landfills.

Solid waste IRBs may be used to finance the qualifying solid waste capital expenditures for projects at a single location (e.g., a new MRF), projects at multiple locations within a single state, and/or the qualifying portions of much larger projects (e.g., the capital expenditures to handle solid waste in a factory). In addition, a variety of assets may be bundled within a single IRB.

Federal tax law imposes a number of restrictions and requirements on PAB issuance, including the requirement that the project be allocated “volume cap” at the state level for certain qualifying activities (including private solid waste IRBs). Each year, the states receive a volume cap allocation from the federal government based on the state’s population.

Also, unused volume cap may be carried forward for future use for up to three years. For 2017, the volume cap allocation for each state is based on the greater of (a) $305.32 million or (b) $100 multiplied by the state’s population for 2016. Ample volume capacity is available in most states, though an allocation is not guaranteed.

SIGNIFICANT INTEREST SAVINGS

Municipal bonds are considered “tax-exempt” securities when the interest payments to bond investors are not subject to federal income taxes and may not be subject to state and local income taxes. Therefore, investors in tax-exempt municipal bonds will accept lower interest rates than a comparable taxable bond.

The formula that expresses this relationship is taxable equivalent yield equals tax-exempt yield divided by (one minus the investor’s marginal tax rate).

For example, in January 2017, Casella Waste Systems, a Rutland, Vermont-based regional integrated solid waste services company, remarketed a senior unsecured $25 million Maine tax-exempt IRB at a yield of 5.25 percent for eight years.

An investor in Maine in the top income tax bracket would be subject to marginal income taxes of 46.75 percent (federal income taxes of 39.6 percent plus Maine income taxes of 7.15 percent). Therefore, the taxable equivalent of this bond would be 9.86 percent (5.25 percent divided by [one minus 46.75 percent]) for a theoretical interest rate savings of 4.6 percent, or $1.15 million, annually for eight years.

In practice, interest rates on municipal bonds are driven by supply and demand for these secured funds, and the yield difference between PABs and taxable bonds often is less than implied by tax rates alone because of various additional factors.

For example, while most governmental bonds are fully tax-exempt, PABs are generally subject to the federal alternative minimum tax (AMT).

Many investors who might otherwise purchase municipal bonds are subject to the AMT and are required to pay federal taxes on the PAB interest, which thereby reduces the demand for PABs.

EXTENDED BENEFITS

The potential for meaningful interest savings is often the primary motivation to issue IRBs. Ancillary benefits also include potentially longer-term financing than would otherwise be available, access to the municipal bond investor base and flexible debt structures.

The maximum bond maturity for a solid waste IRB is determined by the type of qualifying assets that are being financed, with maturities of up to the lesser of (a) 120 percent of the weighted average asset life or (b) 30 years. For example, financing capital expenditures with a 10-year asset life would support an IRB maturity of up to 12 years.

PABs are municipal securities that are issued by a government agency as a conduit on behalf of a private company (or other nongovernmental organization). As a result, municipal bond investors, that would otherwise not be eligible to purchase corporate securities are able to purchase the PABs, thereby opening up this pool of investor capital to the company. However, it is important to note that the required interest and principal payments remain the obligation of the company. The government agency issuing the debt on the company’s behalf generally does not provide credit enhancement or otherwise assume any of the payment risk associated with the project.

Companies securing PAB financing often have quite a bit of flexibility in structuring the transaction to balance the needs of the company and investor preferences. Structuring considerations include whether to use project finance debt, obtain a letter of credit and/or rely on the company’s balance sheet to support the offering; whether to issue floating-rate debt or fixed-rate debt; the contemplated issuance’s seniority relative to the company’s other debt; and which assets, if any, will secure the bonds. The company may also seek to mitigate investor concerns through undertaking feasibility studies, securing supply and off-take agreements, obtaining a credit rating and/or obtaining bond insurance.

SOLID WASTE IRBS

Tax-exempt IRBs have been widely used to finance facilities for five of the six publicly traded solid waste management companies. (See Exhibit 3)

IRBs represent a significant portion of the capital structure for Waste Management (25 percent); Covanta (24 percent); Casella (21 percent); and Republic Services (13 percent). Collectively, the peer group of companies has more than 150 outstanding IRBs representing $4.1 billion (or 16 percent) of the companies’ total debt. (See Exhibit 2) These companies have outstanding IRBs in 32 different states with a median outstanding issuance size of $19 million and a weighted average maturity at issuance of over 21 years.

In recent years, Waste Management and Casella have been the most frequent issuers of IRBs.

John Ruth is the founder and managing partner of CTBH Partners LLC, Hanover, New Hampshire. He can be reached at jruth@ctbhpartners.com.