Peter Bach's independent film, Sell-off, highlights the pressures the NHS is under. Naturally PFI is heavily featured. You can watch the whole thing, below, or visit the Sell-off website.
Hexham Hospital is about to go through a voluntary termination. Reportedly, this involves Northumbria NHS Trust paying compensation to the private sector Special Purpose Company (SPC) of £114m. As a result, the Trust will regain ownership and management of the facility in all aspects and save £3.5m per year (£67m over the original life of the PFI contract).
What does this mean?
It means that, for this particular deal, the Trust was able to borrow sufficient funds (in this case from the Local Authority). It means that the cost to the Trust in re-procuring the services to run the hospital for the remaining years of the PFI, together with paying off the private sector for their contractual loss of profit, was £67m less than the cost of continuing to pay the PFI unitary charge.
To put all this in context, according to HM Treasury, the capital cost of the hospital was originally £54.1m.
The Trust Chief Executive called the hospital a “fantastic facility” that could never have been built without PFI. Nevertheless, the PFI was not seen as offering value for money in the current climate. Northumbria NHS Trust are to be congratulated for assessing their options and to have negotiated their way into a significant saving. It has taken them two years to do so.
Is this a model that other NHS Trusts and Local Authorities can follow? Unfortunately not all PFI contracts allow for voluntary termination. In addition, the compensation provisions vary, making termination more or less attractive.
And, crucially, not all PFI contracts are a bad deal for the public sector.
It is true that many PFI contracts have proved expensive, particularly the earlier deals. However, over time, the Treasury refined the standard form of PFI contracts. Mistakes were rectified, the imbalance between amount paid and the risks transferred was addressed.
The later PFI deals were a vast improvement on the earlier incarnations. If we look at later deals, in particular those done in Scotland, PFI was cut down to design, build and maintain. The provision of soft services (cleaning, equipment, catering, portering etc.) was generally outside the PFI. In our desire to rectify the wrongs of early deals we should not be blind to the fact that later deals provided a competitive procurement avenue. We should not throw out the baby with the bathwater.
What should a Trust (or Local Authority) do?
An Authority should be aware of the the difference between the costs of the PFI to the contract term, and the costs of running the facility under self-procurement. An Authority should also assess whether the contract can be terminated, and the amount of compensation payable. If the procurement saving is greater than the compensation payable, then the Authority should seriously consider its options.
Importantly, however, PFI contracts contain variation provisions. This means that the Authority has rights to change the contract. In many cases, significant savings can be made in this way. In assessing value for money, therefore, Authorities need to conduct a full review of their PFI contracts.
PFI contracts are complex and, to date, much of the experience and expertise has sat on the other side of the table. It’s different now. We would urge Authorities to seek expert advice and develop a plan for their PFIs. If value is already being achieved, that’s great. If not, then there is work to be done.
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Under a typical PFI contract, insurance is procured by the private sector. In the operational phase this generally includes cover for material damage, business interruption, public and third party liability.
At Financial Close, insurance has historically been priced on the basis of a stand-alone project to ensure that insurance can be re-provided in the event of Lender or Authority step-in.
Over time, insurance premia for PFI risks have reduced considerably for two main reasons:
Most PFI contracts since around 2003 have benefitted from Gain or Risk Sharing Mechanisms with respect to insurance premiums. These typically allow for the public sector to benefit from reductions (or contribute to increases) in actual insurance premiums when compared to the original contract price at Financial Close.
However, we are seeing many instances where the private sector has argued, when presenting risk share savings to the public sector, that the “portfolio effect” is an issue that should be carved out from the mechanism due to the fact that it is entirely down to their actions. Often, the public sector have accepted this argument. In addition, although most portfolio insurance placements include a low claims rebate, the private sector tend to omit this from their calculation of any gainshare. Together, this approach means that the private sector is top slicing the benefit that risk sharing was there to give.
It should be remembered that the private sector is partnering with the public sector for long periods. The terms of the agreement generally require the private sector to cooperate, pursue good industry practice, and mitigate costs. We would argue that actual means actual and shouldn’t be subject to manipulation. More importantly, the public sector can obtain insurances in line with those obtained by the private sector.
P2G, through its frameworks with a well known PFI insurance broker, is able to facilitate equivalent cover at market rates for the benefit of the public sector that at least match the premiums that the private sector can procure at, inclusive of their “portfolio effect”.
What does this mean for public sector bodies?
No longer should a public sector body allow the private sector to run any sort of argument about portfolio rates being excluded from a sharing mechanism. The result should be real returns to public sector budgets. There are over 900 PFIs and the benefit accrued from this one small measure is gained annually. The benefit to the exchequer is huge.
One of the most common questions we are asked is whether our involvement on a PFI project will have a detrimental effect on relationships with the private sector provider and ultimately will lower performance. The short answer is that it will not.
If you have a PFI contract, deciding to renegotiate elements of it is a complicated affair fraught with potential pitfalls. However the private sector expect it to happen and are often astounded that it doesn’t happen more frequently. PFI contracts are not as inflexible as many people choose to believe.
It is possible to cut costs in a successful PFI partnership. It certainly isn’t always easy, but with the correct approach and buy-in from key stakeholders, one can reach an agreement that benefits all parties in the long term.
Before you do anything you need to gain a better grasp of exactly what you hope to achieve through renegotiation. “Cutting costs” is all well and good, but you need to consider how costs will be cut. Renegotiating a contract under such circumstances is a delicate enough process as it is, so it is important that you equip yourself with an understanding of your intended outcomes before you approach your partner.
Most PFI providers have a large exposure to the public sector and many will have signed up to the new Treasury Code of Conduct, so it is important to use these levers to help bring pressure to bear on them to assist. However, far more important is your approach to them as an organisation.
All PFI contracts are “owned” by Special Purpose Companies (SPC’s). Their raison d'etre is to deliver long term sustainable returns for their shareholders. Given the length of PFI contracts, it is not in their interests to maintain their margins to a point where their public sector partner is put in serious financial jeopardy; but ultimately they are there to make a profit for their shareholders and weaving a path between these positions is a balancing act that requires finesse to deliver.
If you operate a traditional buyer/supplier relationship, this will make delivery harder as your private sector partner is likely to take a short-term and solely profit-driven approach to the contract. You may find that renegotiation or re-shaping is more adversarial in these circumstances.
If, on the other hand, you do have a true partnership/alliance operating model, your partner will understand your financial challenges and they are far more likely to work with you on potential solutions that can appeal to both their sense of partnership and moral obligation to work together for the public good.
Ultimately, a wise private sector partner will understand the long term benefits of working in true partnership with a public sector organisation, be it a local authority, NHS trust, police force or the like.
Partnership also extends to the way the contract fundamentals are handled. Knowing exactly what you should be getting and holding the private sector to account for failure to deliver are key components of successful contract management. Doing so will, in the long term, improve your ability to successfully renegotiate elements of the contract to deliver savings. However the way you conduct yourselves and your ability to think through the issues that your ‘partner’ will face, as a result of the changes, is vital.
There is nothing simple about the process of renegotiating a PFI contract. However, a healthy dose of common sense (including pro-actively helping the provider open new doors so it can address new opportunities) and a willingness to work in true partnership with your provider will take them and you a very long way towards achieving a positive outcome.
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.
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.
The authors have experience of more than 100 PFI projects in multiple sectors.