3.3.6.1 Public Enterprise Revenue Bonds

Public enterprise revenue bonds are issued directly by the public agency borrower. Revenue bonds are the preferred financing vehicle for enterprise revenue debt when revenue bonds can be issued without voter approval.

PRINCIPAL USES – Public agencies use public enterprise revenue bonds to finance facilities for revenue generating municipal utility systems, including power, water, waste water and solid waste systems, proprietary operations such as airports and parking, and other revenue generating enterprises. These bonds are also used for financing stand alone, revenue generating projects such as power generation facilities and toll roads and bridges. The use of public enterprise revenue bonds can be challenging for enterprises such as hospital systems that do not generate positive cash flow. These bonds are also often a vehicle for refunding revenue secured debt.

PRINCIPAL ISSUERS – The principal issuers of public enterprise revenue bonds are charter cities and special districts with the authority to issue revenue bonds without voter approval and public agencies refunding revenue secured debt.

LEGAL AUTHORITY – The issuance of revenue bonds requires city charter or statutory authority. The governing statutes of public agencies operating municipal enterprises generally authorize the issuance of revenue bonds, often expressed as an authorization to issue revenue bonds in accordance with the Revenue Bond Act of 1941. Local government agencies may issue revenue bonds under the local agency revenue bond refunding law (California Government Code Section 53570 et seq.) to refund indebtedness payable from enterprise revenues, including installment sale payments payable from enterprise revenues. California Government Code Sections 5450–5451 provide statutory authority for public agencies to pledge revenues to secure debt and to give a perfected security interest in pledged revenues.

APPROVAL PROCESS – The public agency’s governing board must approve the bonds and the financing documents by resolution or, if required, by ordinance. If voter approval is required, revenue bond statutes generally require a simple majority.

STRUCTURE AND DOCUMENTATION – Revenue bonds are issued using a bond structure. Because the amount of revenue can generally be controlled to a significant extent through the public agency issuer’s ability to set rates, revenue bonds can be either fixed rate debt or variable rate debt. Because decisions made in structuring a revenue bond issue will affect the public agency’s flexibility in managing the enterprise and will generally also apply to subsequent issues of parity bonds, careful consideration must be given to the key documentation decisions.

SCOPE OF THE “ENTERPRISE” – Although enterprise revenues are pledged and available to pay debt service, enterprise expenses are paid from the revenues, and debt service coverage is a function of net revenues of the enterprise and the debt service payable from the revenues, the public agency has flexibility in defining the enterprise. Agencies must decide whether the enterprise is an entire utility system, a portion of a utility system (a specific service area or customer class), or only the specific project financed. The following factors shape the decision:

Credit considerations. Should, for example, a stronger component and a weaker component be combined, so that they support each other, or be defined as separate enterprises? Combining the two could make revenue secured financing easier for the weaker enterprise but more difficult for the stronger enterprise.
Legal limitations on revenue generation. Enterprises may need to be defined by their unique revenue authority. For example, it may be difficult to combine a water utility and a power utility within on enterprise because water charges must be for water service and power charges must be for power.
Accounting considerations. What, for example, are the accounting challenges of maintaining separate revenue statements for separate services provided by a single utility? Revenue bond documents generally do allow for a public agency to exclude from the enterprise for revenue bond purposes financings for “special facilities”—a financing to construct particular facilities with revenues used to pay debt service derived solely from those facilities.

REVENUES, O&M, AND DEBT SERVICE – Three important terms associated with enterprises are revenues, operation and maintenance (O&M) expenses, and debt service. These terms are used to establish the source of repayment for revenue debt (revenues less O&M) and the rate covenants and additional debt tests such as debt service coverage (revenues less O&M divided by debt service). The definitions are based on generally accepted accounting principles (GAAP), but are consistent with the reality that debt service must be paid in cash when due, GAAP definitions are modified to exclude non cash items.

Revenues. Revenues of an enterprise consist principally of the income from rates and charges, connection fees and standby or availability charges and may include investment earnings (if not used for construction). Revenues do not generally include debt proceeds or amounts collected for dedicated purposes, such as property taxes for GO bonds, assessments for assessment bonds, grants, and contributions in aid of construction or refundable deposits. Further, although changes in the value of investments can create gains and losses under GAAP, distortion can occur if asset values change and are included in revenues before the value change is realized.

Operation and Maintenance Expenses. Generally, O&M expenses comprise the ongoing costs of running an enterprise (other than non cash items). These include purchased power or water; repair costs; salaries and independent contractor costs; administrative expenses allocable to the enterprise; insurance premiums and debt carrying costs such as trustee, legal, and accounting fees. O&M expenses exclude depreciation, replacement or obsolescence charges and amortization of intangibles, premiums, and discounts. O&M expenses can also exclude expenses paid from sources other than revenues (e.g., taxes).Certain obligations may be O&M expenses under GAAP, but the obligations require large payments over time like debt (e.g., “take or pay” contracts). Because these types of obligations are paid before debt service, there may in some cases be a perceived risk to debt security. An approach to this concern is to require, before these obligations can be treated as O&M, a determination by the public agency that entering into the obligation will be beneficial to the enterprise and will not adversely affect the public agency’s ability to comply with its rate covenant (the contractual agreement to establish rates and charges at levels that will generate revenues sufficient to achieve a stated minimum ratio of net revenues to debt service).Debt Service. Debt service consists primarily of principal and interest payable on debt, broadly defined to include revenue bonds, installment sale agreements, and similar obligations (without regard to whether the obligations are publicly offered or privately held or whether the obligations are “debt” within the meaning of constitutional or statutory restrictions). Debt service, however, generally excludes interest that has been capitalized and debt not payable from revenues, such as GO bonds, assessments, and conduit debt obligations paid by private borrowers. Debt service may have multiple levels of payment priority (e.g., senior lien debt and subordinate lien debt).Because projecting debt service is necessary to set rates at levels sufficient to meet a rate covenant and satisfy additional debt tests, it is critical to establish appropriate assumptions about variable rate debt and principal expected to be refinanced. Variable-rate debt is generally assumed to bear interest at either current or recent variable-rates, at the current index rate, or at an assumed fixed-rate. Bullet maturities can often be assumed to be refinanced over a longer term. Some public agencies will also find it important to specify the treatment of interest rate swap revenues, obligations, and termination payments.

FLOW OF FUNDS, PLEDGE – The flow of funds for revenue bonds, and the timing and priority of application of revenues to expenditures and deposits, follows a basic pattern, although some flexibility is possible. Generally, enterprise revenue is deposited in a “revenue fund.” Revenues are used first to pay O&M when due and second to pay debt service and related costs. Revenues are then applied to make required reserve fund deposits and to pay subordinate obligations. Any remaining amounts are deposited in a fund separate from the revenue fund and may be either expended for other purposes or retained. In the ordinary course, revenues should be sufficient to fund all requirements. When an issuer’s source of payment is limited to revenues, however, the flow of funds becomes critical if revenues are insufficient to pay all obligations.

Revenue bonds may be secured by a pledge of gross revenues, with the public agency nevertheless allowed to apply revenues to pay O&M, or by a pledge of net revenues (revenues remaining after the payment of O&M). A pledge of gross revenues provides greater clarity in the event of the public agency’s bankruptcy and is therefore preferable. But because payment of O&M is essential to the continued generation of revenues, the practical difference between a pledge of gross revenues and a pledge of net revenues is minimal.

RATE COVENANT – Because successful enterprise operation is essential to generate revenue, revenue bond issuers must make a variety of system covenants. See Section 2.4.5, Covenants. The most central of these is a rate covenant in which the issuer agrees to set rates and charges at levels that will produce enough revenue to pay all amounts payable from revenues and result in net revenues each year at least equal to a specified percentage of the debt service for that year (e.g., net revenues at least equal to 120% of debt service). A rate stabilization fund, which allows the public agency to use deposits from excess debt service coverage to supplement coverage in later years, can allow a public agency the flexibility to address debt service coverage requirements over a multi year period while maintaining a smooth rate increase trajectory. The rate covenant reflects, of course, only the contractual minimum amount of debt service coverage. Public agencies seeking strong credit ratings may select higher levels of savings.

ADDITIONAL BONDS TEST – The ability to incur future debt payable from revenues at the same priority level as existing debt is important to revenue bond issuers. Additional debt tests generally require projected satisfaction of the issuer’s rate covenant in future years. See Section 2.4.6, Additional Debt.

OTHER CONSIDERATIONS – A particular enterprise may be the operations of a single facility or a utility serving a large area and a variety of customer classes. Enterprises also vary in the degree to which revenues can be controlled by the public agency borrower through its status as a monopoly service provider versus revenues that are dictated by competitive market forces. An understanding of the credit is essential to the development of a successful approach to a revenue bond financing. Investors must take into account how revenues, O&M, debt service, and the rate covenant are defined as well as the assumptions used to project future revenues, O&M, and debt service.

POST CLOSING ADMINISTRATION AND OVERSIGHT – Public agencies that operate enterprises tend to be regular borrowers. The issuer should have a long term financial plan that is used to anticipate and structure rate increases and meet debt service coverage targets.