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.