It’s back! Return of the PFI

Just one of the remarkable things about the PFI is that it’s almost as controversial now as it was when it was conceived. To give an idea of how controversial, consider a recent National Audit Office (NAO) report into the effectiveness of PFI construction projects. Even though this was broadly neutral, the NAO commented in its preamble that “the PFI attracts an almost religious fervour … We debated the wisdom of releasing this paper because we feared that the results could be misused by proponents and opponents alike”.

The PFI was born in 1992. Its father was Norman Lamont, the then chancellor, and its mother was necessity. Its purpose was to persuade the private sector to put capital into public services at a time when the public sector borrowing requirement had hit the unheard of sum of £50bn. Many arguments were advanced against the initiative, both in practice and in principle, to which its defenders answered with a simple question: isn’t a PFI hospital better than none at all?

After a difficult childhood it was enthusiastically adopted by one of its sternest critics, the Labour party, after which it became a mainstay of public procurement: 750 deals with a combined capital cost of £55bn were signed by March 2007. Now that the borrowing requirement has risen to £1.2 trillion, the PFI is likely to become, once again, the only game in town. But whereas the financial sector remained relatively intact during the last recession, this time round it was the principal villain and victim of the piece. So, it follows that use of private finance is not going to be straightforward, and as a result there will be big changes in the volume and type of work available – and some uncomfortable choices for those companies that want to win it.

Here to stay

After bank lending fell 85% in the UK in 2008 some commentators naturally predicted the downfall of the PFI, particularly after the Treasury was forced to set up a special fund in March to bail out schemes such as the £3.5bn Manchester Waste PFI.

However, the signs are that the market is turning. To date, Manchester Waste is the only scheme to have called on the Treasury’s fund. Partnerships for Schools (PfS), the government’s delivery body for education,has about 20 lenders on its books, compared with a handful at the start of the year. Richard Threlfall, a corporate finance partner at KPMG, says: “My view is that the market is bouncing back quite strongly. For smaller projects, under about £200-250m, there is no issue over raising money for a 25-30 year contract.”

The return of investors’ appetite is welcome because, as stated, the government has no alternative. And if the Tories are returned to power, they will also be forced to use, despite their apparent distaste for their unruly offspring. Threlfall says: “The PFI has had its ups and downs, but the fundamental need for investment in public services will keep it going because it means the Treasury does not have to use its own cash. There is still a huge pent-up demand for investment, particularly in areas like waste, where EU regulatory pressures add to our own.”

The other fact helping to safeguard the future of the PFI is the change to government accounting processes that was made at the start of the year. Until then, the Treasury had spent the best part of two years panicking that it was going to have to bring the PFI onto its balance sheet to conform to an international accounting standard known as IFRS. This would have meant that the biggest benefit the PFI offers government – the ability to buy now and pay later – would be lost.

However, the Treasury finally realised that it could stay within international rules by applying another standard – the European System of Accounting 95. This is something that most of Europe has been doing for some time, because it rules that if the private sector is carrying both the construction and operational risk on a project, its cost does not have to count against national debt.

Small and safe

Although lenders are returning to the market, they are more niggardly than they were. For one thing, money is expensive: the typical margin on borrowing for PFI is 2.5% above the LIBOR (the interest rate that banks charge each other for loans), compared with 0.8% three years ago. This means that, even though the government is not paying for projects in advance, it will be scrutinising PFI schemes more closely because of the amount they may add to the national debt in the future.

This, in turn, means that the schemes that stand most chance of getting off the ground are those with the least perceived risk. Which usually means those where the risks are well understood, which means those in established markets such as prisons and schools. So, the Ministry of Justice has just shortlisted seven consortiums for a £1.8bn PFI framework deal, and PfS is considering setting one up. Another low-risk area is the burgeoning waste market, since European recycling legislation means councils have no alternative but to install waste plants.

The corollary is that less established schemes are likely to lose out: large windfarms or tidal barrages for example. Graham Kean, a partner in EC Harris, believes there is an appetite for these markets among investors but that the government may need to give them a gentle prod. “It’s going to be very challenging for government to choose between competing priorities, but if it wants to develop green technology it could use tax incentives to attract investment.”

There is also, as Threlfall commented, likely to be a bias towards smaller projects, worth up to about £250m, simply because they are smaller bets. On the other hand, the schemes do have to be big enough to register on investors’ radar screens.

If they are not, they could be bundled together into larger deals. This trend is one that, according to David Long, partner in Davis Langdon, could be particularly applicable to the schools market, where smaller refurbishment projects are likely to dominate over more expensive new build.

One hope for schemes worth more than £250m is the rise in “mini-perms” – that is, projects that are still let over a 25-30 year period, but on which the cost of the loan goes up considerably if the project is not refinanced after seven. This effectively forces an early refinancing, and so offers the lender a de facto break clause. It could be in the interests of the public sector as well, as it may be able to shop around for a better deal after the lending market has picked up.

Larger PFIs may also be helped by recent guidance sent out by the Treasury which says that bidders need not have finance in place before putting in their tender. Traditionally, PFI bidders had to have all the money for a project lined up before a bid, which meant that if there were four bidders for a £400m scheme, banks would need to make £1.6bn available. Now, bidders only need statements from one or two lenders that the deal is in, in theory, bankable. “It’s a pragmatic reflection of the market,” says Threlfall.

Another new pressure on the public sector is to get a better long-term return from its deals. This means it needs to get a share of the profit made when a project is refinanced. This will reduce the amount that private sector partners make from selling on their equity stakes in PFIs, which for contractors has always constituted much of the charm of PFI work. Late last year, the Treasury rewrote the rules to make it standard for the government to get a 70% share of profit from refinancing, after the first £2m, compared with the traditional 50-50 split. “Whether that will be enough to avert howls of protest, I don’t know,” says Threlfall.

So what’s in it for construction?

With gains for private sector equity partners reduced and greater scrutiny of costs, the PFI might well be more voter-friendly than it has been. But how attractive will it be to bidders?

Julian Rudd-Jones, managing director of Kajima Partnerships, which is focused on the UK PFI and PPP markets, says: “I think the scarce resource is not bank lending. Getting bidders to spend a large amount of money bidding at risk is going to be the tricky one.” Another senior source says he has noticed only a slight drop in the number of bidders for recent projects, but says that is not an accurate indicator of the “willingness to spend the money needed to see a bid through to the end. We have seen a number of parties pulling out of bids”.

Rudd-Jones says that bid periods have grown over the past two to three years, and says if the government wants to ensure private sector players continue to chase deals then it needs to “shorten the bid periods and be clear about what it wants”.

This problem is already being looked at by PfS, whose chief executive Tim Byles is involved in discussions about how EU procurement rules might be applied less rigidly, which would help to shorten the bidding process. There is anecdotal evidence of a reduction in bidders on some schools projects, although PfS says it is satisfied with the interest in the project as a whole.

KPMG’s Threlfall believes that the public sector needs to do more to ensure that the efficiency of bidding is not hampered by an “overly bureaucratic process”. However, he adds that bid costs are unlikely to come down significantly. “I think the arguments around this can be slightly overdone. What people have to bear in mind is that the rewards are considerable, with up to 30 years of guaranteed revenue – and that the PFIs that fall over do so because of error.”

And with public spending likely to be constrained for many years to come, for those that can stretch to the initial outlay, 30 years’ guaranteed income has to be an attractive prospect …

The £180m schools programme

An established sector and a project under £250m looks the safest bet for investors. Chances 4/5

The £650m waste project

Waste is a burgeoning sector thanks to the impact of EU and UK legislation, and investors and contractors alike are looking to establish themselves in the market. This should be enough to attract money in the amount required. 4/5

The £500m roads scheme

This is an established sector, which works in its favour – but the scale of the scheme means that it may have to be broken down into smaller packages and split between consortiums. 3/5

The £1bn windfarm

The combination of a large project and a relatively untested sector means that the government may have to offer extra incentives to attract lenders. 2/5

£20m on streetlighting

Projects of this size will not be worth the risk to investors – so this one would most likely need to be packaged up with other schemes. 1/5