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The PFI Secondary Market

13/5/2013

Traditionally companies, who invest in PFI/ PPP transactions, do so though a Special Purpose Company. This Company borrows using either traditional bank debt, or through bond issues, around 80-85% of the capital needed to construct the facility and pay back the winning consortium the costs associated with bidding and closing the transaction.

The remaining 15 – 20% of the required capital comes from the investors in the project, traditionally structured as a split between nominal equity and subordinated debt, in order to provide a tax shield for investors.

When PFI/PPP transactions complete construction and pass into their operational phases, the original equity (and subordinated-debt) investors often look to recycle their capital in order to re-invest in new primary transactions or to realise a return on their investment. Alongside this maturing market, new investors in PFI/PPP projects have emerged such as infrastructure investment funds and, indirectly, pension funds. These investors are attracted by the reduced risk profile of PFI/ PPP infrastructure assets and by the long term, stable profile of investment returns generated, which are often index linked. As a result there is now an active trading market for equity and investment products within the sector, whether by disposal, acquisition, or portfolio creation.

Private Finance Initiative equity is an attractive and growing asset class. PFI equity, post construction completion, historically offers income generation at low risk. Long duration, inflation adjusted, concession payments by the UK government provide index-linked bond-like characteristics, with clear attractions for matching against pension fund liabilities.

There are two main types of secondary deal in the market presently, a true arms length acquisition by 3rd parties, or disposal by a related entity to a fund or portfolio. Valuation methodologies are similar in each, although in the case of investment funds buying secondary assets from a related primary origination team, the actual return that investors in the fund may see can be diluted by fund management fees and highly overpriced subcontract arrangements, again with related entities, in order to suppress the headline IRR.

For the Public Sector a change in ownership is not necessarily a bad thing, although with bidding levels for secondary assets often delivering around a 6-7% yield; whilst many investors are seeking actual yields of 8-9%, many management teams are highly incentivised to enhance the cash flows of the project, a process often referred to as value enhancement.

Value enhancement is a process whereby private sector management, on behalf of the investors, will seek to analyse the base returns of the project, as evidenced within the Financial Model, and then look to increase these through the actions they take.

These can often take the form of just good management actions, such as better management of the supply chain, competitive tendering of things like insurance, or reduction of overhead. In these cases the private sector should be actively encouraged; as these will lead to better-run public assets with lower termination liabilities for the public sector. Unfortunately, all too often it can also engender a more commercial and claims orientated mind set amongst private sector managers that has, in many cases, created the bad publicity for this method of procurement as a whole.

For many commentators the term secondary market in PFI has been painted as intrinsically bad for both the public sector and us, as a tax paying public. Like most things in life, the truth is somewhat more complex.

On the plus side the secondary market has both sharpened costings within the industry, leading to better value primary deals and lower cost of infrastructure; and allowed the recycling of capital so that primary players can continue to support this method of procurement; where government feel it is still appropriate to pursue.

Unfortunately it has also effectively diluted many of the plus points of PFI in terms of having long term contracts supported by long term relationships; allowing some primary investors to do some very bad deals with the public sector and then exit these projects with massive windfall profits.

A January 2011 report by the European Services Strategy Unit found that there had been more than 240 secondary deals, with profits averaging over 50%. The report also found that government recording of these transactions is inadequate and grossly under-estimates the scale of the transactions.

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What is a PFI and how does it work?

4/5/2013

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Many people find PFIs hard to understand. Most reports in the press are riddled with poor assumptions and inaccuracies. People on the street certainly don't understand them. I regret to say that even many who work in the industry don't really have a firm grasp of how a PFI project is supposed to operate.

Simply put, PFI is a way for the public sector to build and subsequently operate an asset in an arrangement that requires the private sector to invest the upfront capital and results in the public sector paying a Unitary Charge. As its name suggests a Unitary Charge is one payment (made monthly) that encompasses the costs of building the asset, financing it, and operating it for the whole length of the contract. Think of it as a mortgage for your house, maintenance costs, insurance and housekeeping all rolled into one payment. If the lighting doesn’t work in your kitchen or your dining room is unavailable because of lack of maintenance then you don’t need to pay for that portion of your house.

Often in the press you see references to a £100m hospital which will costs many times more than £100m over the life of the contract. Embarrassingly often, the press neglects to tell their readers that the fee also includes the maintenance, cleaning, catering, portering and other services for more than 20 years.

We believe that PFIs should be better understood. In the first instance let's begin by looking at the various players and their relationships to one another:

The Authority - this is the NHS trust, local authority, or government department that is the initiator of the PFI deal. They want a hospital / school / road built and maintained, and certain services delivered.

The Constructor - the company that builds the asset.

The Service Provider - One or more companies that provide hard (maintenance) and soft (cleaning, catering, portering) services through the life of the contract.

The SPC / SPV - Special Purpose Company / Vehicle (both terms are widely used) that is a limited company set up to run and operate the project. The shareholders are normally made up of the private sector parties that are successful in the PFI bidding process. These can include the Constructor, the Service Provider, and a financier or specialist PFI organisation. Often these parties' shares are subsequently sold in the secondary market to other parties. The secondary market, how it works, and its implications will form another article soon.

The Lenders - the banks or bond holders that provide the majority of the financing to construct the asset.

The Manager - Sometimes the SPC is staffed by direct employees, or those seconded from shareholder companies. Often, however, the SPC is managed by one of the private sector parties, or a specialist PFI management organisation.

Below is a simplified diagram that seeks to show the contractual arrangements between the parties in a typical PFI. In practice there are also a number of direct agreements in place between the parties.

Let's look at each of those agreements:

Project Agreement (PA) - this is the fundamental agreement underpinning the PFI. It states what will be built, how it will be operated, and what risks are retained by the Authority or transferred to the SPC. It also governs relations between these two parties, including what happens when things go wrong, or when the parties cannot agree, or when one or other party wants to change the contract. The PA will typically run for a term of 20 - 30 years.

Construction Agreement - This is a contract between the SPC and the Constructor to determine what will be built, by when, and for what sum.

Facilities Management Agreement (FMA) - This is the agreement between the SPC and the organisation that will do the work of maintaining and operating the asset. Hard services will typically run for the entire length of the contract (PA term), whereas for Soft services there may be provisions to benchmark or market test the cost of those services, typically every five years.

Credit Agreement (CA) - This is the loan agreement and is also sometimes referred to as the Facilities Agreement. The SPC will be borrowing a lot of money (typically 90% of the costs) to build the asset and fund the other up front costs required prior to income being received from the public sector. This agreement details the period over which the money must be paid back and what happens if things go wrong. Some PFI assets are financed by private or public placement bond issues. We won't go into the differences here for the moment.

So that’s who’s involved in a PFI deal and what the relationships are between the parties. In future posts we want to tackle:

- the secondary market and how this works
- benchmarking and market testing
- RPI and its implications
- what happens when there are disagreements
- lifecycle

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Honesty and PFI contracts

4/5/2013

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PFI has had its fair share of bad press over the last few years with some notable headlines on poor value for money. For the most part, though, the private sector has only played by the rules of the contract. These contracts, we should not forget, were initiated and largely drafted by the public sector.

However, there is one principle of PFI that seems to have escaped the spotlight in the furore over high debt costs, poor management or refinancing benefits: the principle of honesty.

What constitutes honesty?

Few would argue that the private sector shouldn’t make a profit out of what they do as long as they do it well. Private sector profit does not equal public sector loss.

Equally, wherever we sit on the ideological spectrum, we can all agree that fraud or misrepresentation is dishonest and should be punishable under the contract, which of course it is.

But there is a gulf in between these two ends of the spectrum in respect of how we expect people to behave, an area we have seen highlighted by recent notable issues such as what MPs should properly claim as expenses, what constitutes improper tax avoidance, or even whether tradesmen should be paid in cash.

So how is this relevant to PFI? Well, one of the underlying principles of PFI contracts is that of self-monitoring by the private sector.

The private sector, under most existing PFI contracts, have an obligation to report where they have not done something correctly; whether this be a performance failure or a breach of contract.

Does this happen? No one will be surprised to hear that the answer is an emphatic “no”. If anyone were to suggest the abolition of breathalyser tests by the police on the basis of self-regulation by alcohol consumers, they would be held up to ridicule. So why should PFI be any different?

Because this is what the private sector has agreed to do. Indeed, it is one of the things that the public sector is paying for under their PFI unitary payments. In many cases the private sector have overlaid high management fees on top of service delivery costs against their obligations to monitor performance.

The only answer in the long run, of course, is for the public sector itself to monitor performance of the contract. The NAO recently suggested that the public sector should be spending, on average, one per cent of the costs of PFI on monitoring. Unfortunately, in many instances, either the public sector will find this unaffordable, or it may not have the in-house resources to monitor areas of the contract that are not purely service performance related.

However, if the public sector is already paying for something that isn’t being done, increased monitoring is not the complete answer. So what is?

There are two options for the public sector:

The first is to vary the existing contracts to omit this obligation, thus clawing back the costs of this obligation from the private sector. Unfortunately, this is unlikely to work as the private sector will argue that they still need to monitor performance as a separate duty to the project lenders, or for their own purposes, and thus will offer back negligible savings against the omission. This will be both difficult to counter and, arguably, self-defeating in the sense that we should expect the private sector to monitor performance. In many cases it is not the monitoring that isn’t being done; rather it is the failure to honestly impart the results of the monitoring that is at fault.

The second option is to leave the obligations alone, but to properly enforce the contracts where the private sector does not self-monitor or report properly. Too often, when fault is found, the public sector’s expectation is to either just be grateful that the issue is fixed, or for small performance penalties to be levied.

We are not advocating a raft of litigation for breach of contract but, rather, a radical shift in behaviours, both from the private sector in terms of their honesty and integrity, but also from the public sector contract monitoring teams who must be given the support and advice to properly use the contract terms for the betterment of long term delivery.

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The PFI Secondary Market

What is a PFI and how does it work?

Honesty and PFI contracts

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