Automatic Annually Renewing Contracts in the Solid Waste and Recycling Industries
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Although this article relates to structural issues in contracts, it is written from a finance perspective. That is, the term of a contract with a municipality has a direct relationship to the ability of a solid waste company to borrow money to purchase trucks, carts, build facilities and all the other expenses involved in providing solid waste, recycling and perhaps energy production using organic waste materials.
In any discussion of contracts between municipalities and private service providers, it is first important that all parties including potential lenders understand that solid waste companies are, in many ways, like small utilities, providing an essential service and, in California, they generally do so pursuant to exclusive or semi‐exclusive agreements with their municipalities. The agreements, of course, have elaborate rate making provisions which allow the municipalities to control costs imposed on their commercial and residential ratepayers, while still hopefully providing a fair return to the service provider.
But, like utilities, these companies must periodically make significant capital expenditures in order to provide that service and no matter what the size of the company, they must borrow at relatively high levels as do public and investor owned utilities. In deciding whether to loan money to a solid waste company, the lender will generally rely on two financial ratios and then set “covenants” in the credit agreement requiring a minimum level of compliance with those ratios.
The first covenant is based on “leverage” (a measure of a company’s debt level). The covenant is generally defined as “funded debt” (the total amount of borrower loans outstanding); divided by operating profit or Earnings Before Interest, Taxes and Depreciation (“EBITDA”). In effect, this shows how many years a company would take to pay back all its debt if all of its “cash flow” was used for that purpose. Federal regulators are most concerned with borrowers whose funded debt to EBITDA ratio is above 3:1 but borrowers in this industry (as well as large utilities) are often allowed to significantly exceed those levels. The banks justify their loans to more highly leveraged utilities and solid waste companies because of their exclusive right to operate for many years into the future.
The second covenant measures annual cash flow against the company’s obligations in that period to pay principal and interest on their loans. This is usually defined, at a minimum, as EBITDA less distributions to the owners for the purpose of paying income taxes; divided by principal and interest due for the measurement period. This known as the “Fixed Charge Coverage” or “FCC ratio."
To summarize, a successful borrower will have EBITDA sufficient to keep the leverage ratio relatively low while at the same time being sure that they have enough to pay annual debt service plus a reasonable margin above that to account for unforeseeable circumstances. So, a FCC covenant would typically be set at 1.20:1 but the borrower’s projected results for the future should indicate that the actual ratio would be more like 1.35:1 or higher or the loan will be problematic.
So, when one discusses solid waste and recycling agreements, assuring the ability of the service provider to finance its equipment is of paramount importance. The remainder of this article will discuss why an automatic annually renewing contract structure is generally going to be better from a financial perspective for both the service provider and the municipal ratepayers.
Why Some Banks are Willing to Finance These Companies...and Most Aren’t
As pointed out above, solid waste companies invariably must borrow a lot of money and banks are inherently conservative. Lenders get paid relatively little in making loans compared to their risk. For example, consider a $10 million loan for ten years on which they earn 1.5% per year. If the loan had no principal payments required until maturity—highly unlikely—they’d make a total of $1.5 million on that loan. But if out of five such loans, one defaulted, they could lose as much as $3‐4 million overall (4 times $1.5 million in profit on the performing loans equals $6 million—slightly higher depending on when the default on the one loan occurs—as compared to the loss of as much as $10 million in principal on the defaulted loan). While that is a grossly oversimplified example, it illustrates the point that since their return is relatively low, their risks also must be low.
How do these banks analyze the risk of a solid waste management company? The banks that understand the industry assign high value to the franchise system in California which is, of course, the predominant method of the arrangement by municipalities of the provision of solid waste and recycling services by private service providers. The banks have correctly determined that the continuing cash flow from those agreements is the single most valuable asset of any of the companies, much more valuable in most cases than the more traditional forms of “collateral” like buildings and equipment. So, they generally allow higher leverage and other concessions to the borrowers which they can justify to the regulators. But they also recognize that the length of the franchise term or terms held by a company is the most important consideration since that will determine how long the cash flow lasts. As a result, in cases of fixed term agreements, the loan term will be no longer than the franchise term to avoid “stranded assets” which are not fully amortized at contract’s end (more on stranded assets later).
While I believe it is a positive that these companies are much like utilities, no bankers for these “middle market” companies have any utilities as clients, nor do they generally know anything about them. As a result, there are only about five banks active in this industry who on the west coast that have officers who understand the companies with three of them banking the vast majority of solid waste companies in California. All that can be summed up quite simply—the banks that understand that these really are small utilities are willing to bank the industry, those that don’t, aren’t!
Flexibility Advantages of Automatically Renewing Agreements
Solid waste collection used to be simple. Buy a few used trucks and take the garbage to the local landfill. That is obviously no longer the case. The last couple of decades in the solid waste business recall a cliché, but very apt here—the only constant is change!
In recent years, CNG trucks have replaced older diesel models, new automated sorting equipment has been available for materials recovery facilities, new or improved technologies for processing organic waste have appeared, and in the summer of 2020, Republic Industries announced an agreement to ultimately purchase a large number of electric collection vehicles from one of the manufacturers working on that technology. These developments and the opportunities to take advantage of them don’t magically occur only at the beginning of new franchise agreements.
Why is this an issue with fixed term contracts? Because unless the municipality is comfortable with imposing a substantial rate increase on its residential and commercial ratepayers, as a practical matter, a service provider can borrow significant amounts for new trucks and equipment only once, at the start of the agreement or, the service provider has to be able to afford to purchase assets and amortize them over a shorter period with no rate adjustment—and virtually no company can do that.
The numbers are simple. Figure 1 above compares a $10 million loan made at the start of a 10‐year contract versus one made with only five years to go on the franchise term. As can easily be seen, the rate impact for the latter would be almost double the former.
Alternatively, if a municipality expected the service provider to absorb the annual principal and interest payments on the new equipment for that five‐year period, the bank would likely have something to say about it. That is because it would likely be in violation of at least the Fixed Charge Covenant. To carry on with our example of the $10 million loan, let’s say that company has $10 million of existing debt being amortized over ten years which, when added to the new loan, will total $20 million. In the first column of Figure 2, the company has a ten year annually renewing contract and can afford to incur the additional debt because its bank will let them amortize it over ten years. However, if they are five years into a ten year agreement, the total debt service would be the total of the payment amounts shown in Figure 1 because half their debt payments would be for equipment purchased at contract start based on a ten year amortization, while the new debt has to be amortized over the five years remaining in the contract. It doesn’t work for either the company or the bank. The owners don’t get any profit and the bank will call a default for violation of the fixed charge coverage ratio.
But, if you have a ten year (the “base term”) annually renewing contract, in effect you will always have ten years to amortize the debt, whenever the expenditure is made. In fact, a company that provides good service and has benefited from long service to the community may be allowed by the lender to amortize equipment over a slightly longer period then the stated base term for two reason. First, the long service gives the lender some comfort that the agreement will continue to be extended so in their view the borrower is highly likely to still be around eleven or twelve years from the date the equipment is purchased even though the base term is only ten years. Second, companies like Specialty maintain equipment well enough to, for example, can use trucks for 12+ years of service.
In the case of some companies and municipalities, amortizing and depreciating assets over more like the actual useful life can allow a significant benefit to the ratepayers. That is because depreciation plus the operating ratio on those amounts is a significant component of the rates so that every dollar by which depreciation is lowered will be applied to lower the overall rates. Happily, Specialty and the City of Sunnyvale have that type of agreement that could provide this benefit. On the next page, Figure 3 was prepared by Jason Reecy of the Company’s accounting firm VTA Accounting Associates which shows estimated savings due to possible lower annual depreciation on the trucks that the Company expects to purchase with the new agreement. As can be seen, the net present value of the savings comparing 10 and 12 year amortization over a ten‐year term is approximately $4 million. Coupled with the use of tax exempt debt to keep “all in” interest costs as low as possible, these are significant savings. While there is always some risk to any company (and its bank) agreeing to amortizations longer than the base term of its franchise, given the long relationship between this Company and this City, this may not be a problem.
Interest Rate Benefits of Auto Renewing Contracts
This is a simple analysis by a bank. Does the borrower have a long history with the municipality as shown by the granting of the automatically renewing contract in the first place as well as a period of years where neither party terminated the automatic renewal provision? If so, this type of borrower will be considered a lower risk and that can translate into lower interest costs as the bank will agree to a lower “spread” which is added to the LIBOR or Base Rate in effect from time to time and represents the bank’s profit.
Because of the franchise system and the fact that I represent a majority of industry participants with franchise agreements and automatically renewable ones, in negotiations with the few banks that understand the industry in California and the West, I have been able to drive pricing down so that spreads for Specialty’s and other of my clients’ banks average about half or less of what a similar borrower would be charged in other parts of the country.
COVID, “National Sword”, Plague of Locusts, Etc.
The industry has been hit by a series of crises starting in the early 2020’s as the largest market for recyclable materials, China, began to implement a series of measures which effectively made some products unsaleable without considerable additional and costly processing, and even then often there was no market. That got worse with the “National Sword” which further restricted sales to China as a practical matter and whose effects may, even now, not have been completely recognized.
With the current COVID crisis, every company has suffered financially to a greater or lesser extent. In addition to the obvious loss of commercial revenues, there are other effects. For example, COVID has only helped continue a trend of ever‐increasing contamination in recycling carts as people are spending more time at home. This has caused many programs designed to be source separated recycling efforts to be in fact mixed waste programs. With all these unforeseen circumstances, while no plague of locusts has yet hit, who knows? The point is that there will be positive and negative occurrences in the future that affect the parties to any solid waste agreement and any such agreement should be flexible enough to deal with anticipate that fact to the greatest extent possible.
As this article was updated in 2020 in the midst of COVID, service providers and municipalities are working together to work out ways and means for the companies to continue to survive despite significant drops in formerly profitable commercial collection while not burdening residential and commercial ratepayers during the worst financial crisis since the Great Depression. We are working with a number of companies in addition to Specialty to use innovative ways to structure loans that are quite a bit different than standard loan structures offered by the banks.
Each company has a different financial situation and each contract is different to a greater or lesser extent so each loan structure will also be unique. But one thing is shared by all the new structures and that is the necessity of time. That is, we can lower principal payments or even propose some interest only periods, but only if the bank is assured that the principal can be recovered in later years when things will be better. The automatic annually renewable franchises provide that time and therefore the ability to propose different loan structures to the banks with a good chance of having them accepted.
Procurements Can be Expensive
The facts speak for themselves as everyone has seen instances of communities in Northern California and elsewhere where rates have risen as much as 25‐40% upon the completion of a procurement for a new service provider where all new equipment and new services were required. Experience also teaches us that if a potential contractor bids rates that are substantially less than its competitors, service will suffer, and soon thereafter the management will be in the municipal offices asking for a rate increase. It is a lot easier to have strong ratemaking procedures as in the Sunnyvale‐‐Specialty contract, get good service, and solve any issue related to unforeseen circumstances in a collaborative way.
The current franchise agreement between the City of Sunnyvale and the Company contains provisions which deal with the issue of stranded assets in order to eliminate the negative rate impact of equipment bought mid‐term as discussed above. That is, were the contract to end or be terminated, amounts of principal on any assets purchased with City knowledge during the term that remain unpaid at the end of the term would have to be repaid to the borrower’s bank.
At present, the Company estimates that the total amount of stranded assets were the contract allowed to expire next year would be around $11 million. For the sake of argument, let’s use $10 million and say the City borrows that amount to make that payment to the bank and amortizes the loan over 10 years. That would yield a payment of about $1.2 per year million as shown in Figure 1 above. Presumably that would have to be added to the rates that would otherwise be required by the new contract.
If there were a procurement, let’s assume that a new bidder bids the same as the Company would receive in year one of its new contract based on the HFH forms. Adding the annual payment on the $1.2 million borrowing outlined above to amortize the stranded assets, if added to the contractor’s payment, would result in the latter being around 4.5% higher than it otherwise would. Not a good result. (Of course, the City could use cash to pay off the stranded assets, but it would then lose the “opportunity costs” of using those funds in some other way.)
No Fault Termination
An important feature of these contracts is the ability of either party to terminate the automatic extensions, leaving the agreement with a term of whatever the stated period is, ten years for example. This rarely happens because of the advantages of the renewal provisions described in this article and the fact that my clients are excellent service providers with long histories of working successfully with their municipalities. And, keep in mind that municipalities aren’t “stuck” forever with a service provider who at some point can’t keep up with its service responsibilities. The modern municipal franchise agreement is very detailed in describing those obligations and penalizing the service provider for failure to meet them. And, of course, for continued defaults of a contractor’s obligation, the ultimate penalty is termination of the contract for cause. Happily, this has never been necessary in the case of the clients with whom I work.
When the original version of this article was written, some 85+ California municipalities have chosen to use the auto annual renewing type of contract and at least for the great many clients who have one or more, no notice of termination has ever been given. Solid waste and recycling companies in California are among the most innovative in the industry and these contracts allow them to continue to be so. When a new technology comes along, the companies can react quickly, undoubtedly one reason that the industry’s conversion to CNG vehicles occurred well before the California Air Resources Board required them to do so, for example.
Annually renewing contracts are an important tool in the effort by municipalities and service providers to continue to provide good service, adapt to changing circumstances, and adopt new technologies, all while keeping the cost of service as low as possible for the ratepayers.
About the Author
Mr. Rose has served as special counsel to approximately 85+ clients in the solid waste, renewable energy and recycling industries (including the vast majority of all of the independent medium to large such companies in California). In that role, he has assisted clients in the arrangement of financings totaling over $8 billion over the past 25+ years including periodic renewals and increases in credit facilities.
These financings have included everything from compressed natural gas collection vehicles and new waste carts and containers, to facility financings including material recovery facilities and—in the last few years— organics processing facilities such as anaerobic digestion projects.
While his traditional legal work is generally limited to review and negotiation of credit documents between his clients and lenders, he also has been active in politics and government since the early 1980’s. He is often called upon by clients to assist them in negotiation of franchise agreements using his finance perspective including appearing at local government meetings. Mr. Rose has considerable experience working with clients and local governments on the issue discussed in this article over the years, but he has also been called upon periodically for help with state government. For example, he was one of three people that testified on behalf of the industry in opposition to a bill some years ago which would have limited or extinguished the ability of municipalities to contract in this way. The bill failed to even get a vote in its first State Senate committee for reasons summarized in this material described at the hearing expressed by Mr. Rose and the others testifying.