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Over the past ten
years, various governments have espoused the use of PFI/PPP projects for the
delivery of improved services in the Public Sector. PFI/PPP projects are
designed to tie the provision of an asset, such as a school, to its operation in
order to provide the lowest total expenditure over the life of the asset. In
part this policy was designed to prevent the selection of the lowest cost
investment in the fixed asset or building which resulted in expensive
maintenance over the life of the asset - ultimately a more expensive solution.
The major characteristic of PFI/PPP is thus the requirement to take into account
the full cost of the asset over its normal economic life. PFI/PPP projects
therefore lead to long term contracts covering periods of 25 years and above,
involving both the creation and the operation of assets.
In theory, there is
nothing to prevent the government from financing such projects itself through
taxes or direct borrowing from the market. It has, however, been an inherent
part of the government's PFI/PPP strategy that the financing of such assets
should not be considered as government borrowing, and therefore does not count
as part of the Public Sector Borrowing Requirement. This rationale has, in many
instances, resulted in the perception that investment projects in the Public
Sector, such as hospitals, will only receive approval from the government if
they are to be provided by PFI/PPP.
The basis for
considering such investments as falling outside the Public Sector is the
transfer of risk to the consortium that is responsible for realising the PFI/PPP
project. The consortium is responsible both for most, if not all, of the
construction risks and also for most of the risks associated with its operation.
The financial evidence of this risk transfer is provided by the payment
mechanism that sets how the amount to be paid in the unitary charge may be
varied if there are failures in the performance standards.
PFI/PPP projects are
the subject of long term contracts. So far, by the very nature of the projects,
there is very little experience of what happens over the life of a project - we
only have a maximum of five years' operating experience. Operating in such a
long term environment is new. It requires sufficient rigidity to punish poor
performance but also sufficient flexibility to meet the unexpected. In spite of
the transfer of risk to the private sector, the government will always
ultimately be concerned in the delivery of services in the public sector.
From the point of
view of the government, matching the economic life of the asset with long term
financing means that the annual repayments may be kept down, thus reducing the
annual outgoings of the Treasury. The higher the percentage of the financing of
the project is provided by long term finance the lower the amount of profit is
required to remunerate the equity providers (thus reducing overall costs to the
government). Nonetheless, the equity contribution of the shareholders is
important in demonstrating their commitment to the project.
In the last
analysis, the availability of long term loan finance will depend upon the
investors' perception that the risks attached to interest payments and loan
repayments are adequately reflected in the interest rate they are offered.
Growing experience of PFI/PPP projects and the comfort provided by the presence
of the Public Sector client have reduced the margins attached to the interest
rates for such projects.
The revenue to meet
interest payments and repayment schedules comes from the unitary charge which is
paid by the Public Sector client. Long term investors wish to be assured that
the unitary charge provides a sufficient safety margin to ensure that the
project can meet its financial obligations. For this reason the negotiation of
cover ratios is important in providing a measure of security to loan providers.
The unitary charge
is itself affected by the payment mechanism which provides protection to the
client to ensure that pre-set performance standards are met. Failure to meet
target levels of service are penalised through reduced monetary payments and a
corresponding decrease in the unitary charge. The importance of employing
experienced companies with a proven track record as a means of reducing such
risks is self-evident.
The financial
structure of PFI/PPP projects is characterised by high ratios of debt to equity
in the Special Purpose Vehicles, SPVs, which undertake them. In part such levels
of gearing - 10 or 12 times equity (including subordinated debt) - are the
reflection of the government's desire to reduce overall payments. The
willingness of investors to provide loans, however, is also a function of their
perception of the risks attached to the projects and their assessment of the
level of government involvement.
To date, experience
of PFI/PPP projects has been fairly positive. Although there have been problems
with IT projects (which normally do not involve long term contracts and long
term finance) and there have been delays with some (usually politically
sensitive) projects, the general experience has not revealed major hidden risks.
The companies involved in winning consortia have started to establish a track
record. The Public Sector has improved its commissioning skills. The projects
are becoming more standardised. On the surface the risks appear to be
diminishing.
There are other risks that are emerging. The level of concentration in the
construction, services and financial industries means that the number of major
participants is reducing with the attendant risk of over-extension (in terms of
bidding costs and resources) and lack of diversification. In some sectors,
notably health, there are possible difficulties arising from political
differences.
Overall, however,
investors appear to derive consolation from the presence of the government as
the ultimate client. This perception of risk is likely to hold until the
government walks away from a major project; if it does, the perception of the
risks attached to PFI/PPP projects will rise substantially - as will the cost of
financing them.
The Internal Rate of
Return, IRR, attached to the equity element in early PFI/PPP projects was
relatively high, 15 - 18%, reflecting the unknown nature of many of the risks
involved. With experience, and competition, the IRR has been reduced and is now
in the neighbourhood of 10 - 12%. This reduction in IRR decreases the attraction
of equity investment and encourages consortium members to minimise their equity
contributions when they have the possibility of gaining higher returns
elsewhere.
The government's
desire to improve the amount and quality of Public Sector Services is on-going.
As a result, it has come to rely more and more on PFI/PPP as a means of meeting
its targets, in spite of opposition from some sectors of the Labour Party. The
range of programmes is wide, from major transport projects to small IT projects.
Although attention tends to be focused on the large projects, the desire to
include small projects in PFI/PPP type solutions has led to the bundling of
similar small projects in an attempt to make them more economic to administer
and execute.
Future demand for
PFI/PPP projects is likely to continue to rise over the next decade. There is
substantial demand for PFI/PPP projects in the health sector with further waves
of new hospital developments due to be launched over the next few years.
Transport requires major investment and new programmes have recently been
announced for the roads; rail investment is also set to rise substantially (even
if not enough to provide a rapid transformation of the system). Education is
another sector where demand is set to increase in the government's spending
review. Prisons and other areas of the Home Office's activities also require
substantial spending to improve facilities.
In fact, the problem
is likely to be one of a plethora of projects competing for resources. The
amount of management skills, both on the commissioning and the tendering sides,
is limited and is likely to prove a bottleneck. In addition, the costs of
bidding remain high, which tends to limit the number of companies capable of
mounting a PFI/PPP activity.
Whilst the demand
for projects is there, constraints will remain on their ability to effectively
come to market.
Given the length of
PFI/PPP contracts, matching financing for periods longer than those habitually
seen in the financial markets are required. Currently, PFI/PPP financing comes
chiefly from the sterling bond markets, the UK commercial banks and private
placements. In both the bond markets and private placements financial
institutions such as funds and insurance companies are of major importance. In
principle the sterling bond market for maturities typical of PFI/PPP projects is
somewhat limited.
The supply of
finance to the sterling bond market will depend upon a number of factors.
Government regulation will determine how the various financial institutions,
pension funds, insurance companies and investment funds, allocate their
investments: any change in regulations will alter the relative importance of
their holdings of long term sterling bonds or private placements. In addition,
if the government manages to alter the saving habits of the UK consumers, then
the total amount available for allocation will increase. More specialist funds
may emerge.
In international
terms, the relative attractiveness, or otherwise, of sterling and UK interest
rates may influence the amount that foreign financial institutions are willing
to place in sterling bonds or loans to maintain a diversified portfolio.
So far the European
Investment Bank, EIB, has started to figure as a major provider of funds for
some areas of investment in social infrastructure. In the future, however, the
expansion of the European Union, EU, means that these funds are unlikely to
increase their allocations to the UK.
Looking towards the
future, the financing of PFI/PPP projects is unlikely to remain static.
Currently, the financing depends upon the availability of long term finance and
the use of high levels of debt to equity; in addition, returns have been
declining. This situation is unlikely to continue indefinitely.
There is an enormous
potential demand for PFI/PPP financing. It is by no means clear that such an
amount of long term financing will be available without some government action
(as for example regarding pensions). Interest rates may also have to rise to
attract the additional amounts of financing required.
Currently there is a
perception that the level of risk attached to PFI/PPP is very low. Over time it
is inevitable that some PFI/PPP projects will run into difficulties and that the
perception of risks will change. In addition, if the number of PFI/PPP projects
is to increase substantially then the number of participants will also have to
increase - particularly for smaller projects. At the present time, PFI/PPP
projects tend to be confined to the larger, more credit-worthy, companies, but
as the range of companies increases so will the risks. The variation in risk
among different projects will therefore increase.
Eventually then, as
a reflection of changes affecting both demand and supply, it is likely that the
structure of PFI/PPP project financing will alter with margins rising and the
equity element becoming more important than it is at the present time.
Companies mentioned
in this report include:
Innisfree Ltd, HSBC
Plc, Bank of Scotland Corporate Banking, Norton Rose, Barclays Private Equity
Ltd, Mizuho Bank, Royal Bank of Scotland, Abbey National Plc, European
Investment Bank, Societe Generale, Deutsche Bank AG London, Canadian Imperial
Bank of Commerce, HypoVereinsbank, Barclays Plc |
