Capital Project Solutions – October 2010
Integrated Project Delivery – The Pre-Cursor to Alternative Financing & Procurement? Patrick E. Duke – Senior Vice President Throughout 2010, Capital Project Solutions will run a series of articles dedicated to Integrated Project Delivery (IPD). We will explore all issues related to IPD, from project identification to team selection to contract and incentive development. With four (4) IPD projects currently underway, we will share case studies and lessons learned throughout the series. Last month, we featured lessons learned from an IPD project at Owensboro Medical Health System. This month, we will discuss opportunities for alternative financing and IPD. If you have missed any of the previous articles or to learn more about other strategies to ensure your project’s success, visit KLMK Group at www.klmkgroup.com.
In the August 2010 issue of Capital Project Solutions, we discussed the collaborative development of an incentive plan by the Integrated Project Delivery (IPD) Team to balance the risk and reward equation among project participants. While IPD provides a better framework to allocate risks in a capital project, it still falls short in providing the Owner with means for effectively mitigating or sharing their financial and completed operations risks. In the midst of an anemic economic recovery where hospitals face pressure from declining volumes, they also are learning to navigate the waters of recent financial and healthcare reform. While this indeed is a turbulent time for hospitals and “belt tightening” is the phrase of the day, the need for facility improvements and expansions still exists. During the past nine months, Moody’s has reported declining credit ratings for the majority of hospitals, which has significantly affected owner’s ability to secure capital. The need for capital is one of many variables that is fueling consolidation at all levels in the healthcare industry. Hospitals are merging with one another as well as with physician practices in an effort to increase their bargaining and buying power in a given market. All of these activities are beginning to blur what historically have been clear definitions of core and non-core real estate assets and service lines for a hospital. During this time of uncertainty, IPD has gained momentum as an alternative approach for the delivery of capital projects. Thus, it would only make sense to 1
Capital Project Solutions – October 2010
explore whether the adoption of IPD could be a pre-cursor to Alternative Financing and Procurement as has been the case in Canada. A Lesson from the North? Throughout the healthcare reform debate in the United States, we were exposed, more than ever, to the public Canadian Healthcare System. The focus of most healthcare stories was on the actual access and availability, or lack thereof, for patients in the Canadian public system. The one topic that never seemed to make the nightly news was the actual facilities where patients are receiving care. Canada is currently experiencing a tremendous building boom in order to ensure that each Province has safe, accessible and efficient hospitals and medical centers to meet patient demand. So, how are the Provinces delivering the new facilities that are included in this hospital building boom? Alternative Financing and Procurement. Provinces such as Ontario have established execution agencies within the Provincial government such as Infrastructure Ontario to correct their infrastructure deficits. This agency drives the development of critical infrastructure and public use projects such as schools, hospitals, and roads. They do this through public-private partnerships known to many as P3 Projects. However, to the Province of Ontario they are known as Alternative Financing and Procurement (AFP) projects. AFP integrates the finance, design, build and completed operations phases of a facility project. Backed by the Province’s credit, the projects are financed by private syndication and the delivery team shares the risk and reward over the useful life of the facility improvement. The Province pays nothing until construction is complete and the facility is available for its intended use. The delivery team maintains the facility and provides a lifetime warranty to the Province. The warranty ensures that the facility will be operational and functioning as intended. The Province pays an availability payment (similar to a lease payment) for the agreed upon term of the policy. Understanding the AFP concept and comparing it to traditional delivery models, yields the following distinct differences: The Owner (in this case the Province) transfers financing and completed operations risk more effectively to the project delivery team. 2
Capital Project Solutions – October 2010
The Owner preserves cash during the construction period as no payment is made until after the building is available for its intended use. The private lender, not the Owner, provides necessary due diligence to ensure the project delivery team delivers on time and within budget. The project delivery team provides a “Warranty” to the Owner that the facility will be available over the term agreed upon. True integration of design and construction with building maintenance and lifecycle costs is achieved and not just discussed. While IPD in its current state provides for better risk transfer between all project participants than the traditional project delivery model, it falls short of providing the Owner with any relief from the financing and completed operations risks as AFP does. In the defense of project delivery teams, there has never been incentive for them to take on financing and completed operations risks on a given healthcare facility project. Is the time right for that paradigm to shift?
Barriers to Healthcare Project AFP in the United States In the midst of a perfect storm, AFP may indeed be an answer to the healthcare Owner with facility expansion and modernization plans. It would allow for cash preservation while maintaining a focus on scarce resources to drive efficiency in care models to meet Accountable Care Organization standards being implemented by CMS. However, AFP has the following barriers to overcome prior to its introduction: Credit Worthiness Still Rules – The majority of hospitals in the United States are still privately owned and this does not seem likely to change anytime soon. Therefore, any expansion plans would require credit worthiness in order to finance the deal. Even in single tenant Medical Office Building deals where the hospital becomes a tenant and seeks a third party to develop and own the building, the hospital must be credit worthy to make the deal happen. To close an AFP deal in the United States, a private not-for-profit hospital system would first be required to be credit worthy.
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Capital Project Solutions – October 2010
The Controlling Mindset – The mindset that a healthcare owner must control and maintain its core real estate assets, such as acute care centers, still rules the day. In recent years, there has been a shift regarding outpatient service facilities and certain support functions within a healthcare organization. To allow AFP in any form to be implemented, healthcare owners and their boards must be willing to relinquish control over their traditional core real estate assets. Policy of the Day – Hospitals are highly regulated and those that enjoy a tax-exempt status have many requirements that they must meet to maintain this status. In addition, states have various regulations for reimbursement of services that are deemed to be in regulated or non-regulated space. To facilitate a delivery model like AFP, policy makers will need to enact regulations that provide incentive for this type of deal. These barriers can be overcome, but this will not happen overnight. As more municipalities look at ways to fund critical infrastructure through public-private partnerships, policy makers are beginning to come around to delivery models such as AFP. Conclusion As we contemplate the changes in the healthcare industry over the past two years and then look toward the future, it seems inevitable that traditional models of project delivery will continue to be challenged. Even IPD in its current practice may not be aligned with the true risk equation for a healthcare owner in the 21st century. The question is whether healthcare owners are willing to relinquish the control of core real estate assets and whether United States policy makers will create an environment conducive to some hybrid form of AFP.
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