Road to success

Anyone who knew little or nothing about the private finance initiative (PFI) and who tapped “PFI” into an internet search engine, then spent a few hours skimming the results, would come away convinced that PFI was ill conceived from the start, badly executed in practice and that it should be consigned to history as fast as possible.

However, the fact is that there are between 600 and 700 PFI projects worth around £55bn and the vast majority of them have come in on time and on budget. In most ordinary dialogues this would constitute success.

But while there have been few failures, they have been spectacular. London Underground maintenance group Metronet is the latest and most stellar instance in a list that includes the Mapeley STEPS property deal for the Inland Revenue (in which charges were bumped up to stave off bankruptcy) and the Skye Bridge project (which cost six times its original budget).

So what is it that continues to attract the private sector to bid for PFI contracts, given that the cost of simply preparing a tender for a PFI schools project could easily add up to £1m or more for a bidding contractor, with no certainty of success? Moreover, these contracts require the successful bidder to take on some large risks.

John Richards, group finance director at the Miller Group, and Mark Baxter, associate director, public-private partnership (PPP) finance at Miller Construction, have been involved in PFI contracts for around 60 schools totalling more than half a billion pounds. They point out that in the early days of PFI there simply was no option for any serious construction company. PFI might not have been the only game in town, but it was the biggest ticket game going anywhere in the country.

“We got involved in bidding because it looked like a great route into high-value government projects. PFI was clearly going to generate a flow of excellent construction projects for a very long time to come, and we wanted in,” he says. However, early on people realised that there were good PFI contracts and bad PFI contracts, and you strayed into the latter at your peril.

No room for manoeuvre
“The risks in a PFI contract are considerably higher at the outset for a contractor than in a traditional design and build contract,” says Baxter. These are lump-sum, fixed-price contracts and if you get any element wrong, there is little room for manoeuvre once you sign up to a deal. There is also little room for manoeuvre on the date of delivery, and there are good structural reasons why this is so.

“For all these projects, the private side borrows from the bank and we have a financial model that requires X amount of income to repay the bank from Y date. If you don’t deliver to that date, then not only do you still have to make that sum good to the bank, you also have penalties to pay to the client. So the penalties faced by the contractor are higher than in traditional contracts, because it is the builder, not the client, that services the debt,” explains Baxter.

The other unusual feature of PFI is the long life of the projects, which could stretch over 25 years or – as is the case with some recent NHS builds – 40 years. “In the early days the length of the contract was set by the funders and the length of time they were willing to lend over. They would go to a maximum of 25 or 30 years, so that was the length of the contract,” says Baxter.

The private sector side funds the project, and is reimbursed by the public sector month by month, or period by period, over the agreed term. As with any ‘mortgage’, the longer the life of the project, the cheaper it is for the private sector to fund and for the public sector to ‘lease’, so both sides had a vested interest in setting PFI over what was then deemed to be the useful life of the asset. It is important to realise, too, that the public sector side expects the asset to be returned in good condition at the end of the contract, or there will be penalties.

One of the first manoeuvres that a contractor would undertake in the early days of PFI was to increase its profits sharply by refinancing the deal. Once a PFI project was well underway and the initial success of the project had been put beyond question, it was straightforward to find a new funder who would extend the loan over a longer time span and at a lower interest rate, reflecting the fact that the completed (or nearly completed) project was by now visibly less risky than it had been at the outset.

But since the money that the private sector received from the public sector each period remained the same after the refinancing, the cost saving went to the bottom line as pure profit.

This kind of manoeuvre drove the unions wild when they first became aware of it, since it was seen as the private sector ripping off a dozy public sector client – a sort of money-for-old-rope scam. The cause célèbre was Fazakerley prison in Kilmarnock which was refinanced by the private sector, generating an 81% increase in profit, according to the National Audit Office, which examined the case in depth in 2000, five years after the refinancing. However, far from being a dastardly scam, when the Public Accounts Committee (PAC) and the NAO published its report on refinancing in PFI, they concluded that it was a good thing, but that government should ensure that it gets at least a 30% share of future refinancing gains. So that adds yet another incentive for private sector companies to get involved in PFI.

Changing rationale
However, the long life of PFI deals, along with the rigidity associated with them, leads to considerable difficulties when the government decides that the rationale for a particular project has changed, such as when it no longer wants as large a hospital, or a particular school. Much of the current brow-furrowing and head-scratching over PFI on both sides, public and private, is an attempt to find mechanisms to build more flexibility into PFI contracts so that they have a win-win for both sides.

However, there are big problems with achieving this. Darryl Murphy, London head of infrastructure and managing director, projects and export finance group at HSBC, handles the bank’s UK and European PFI and PPP deals. He points out that much as the government might like the notion of endless flexibility, the public sector has to grasp that this will inevitably build in very substantial additional costs to a PFI project.

“Take a 30 year project. I cannot allow the PFI company to take the interest rate risk for a term like that since they don’t have the resources. So when the deal is done, I swap out the interest rate risk for the term of the loan. That sets the deal in concrete. It can be bought out, but it can’t be changed,” he says. This is in the nature of project finance. If an authority wants to break a project in ten years, it is going to have to fund the cost of the break.

“The change mechanism in current PFI contracts is driven by the funders and it is inflexible because the funders have a vested interest in ensuring that you do not change the risk profile of the contract willy nilly,” says Murphy. This means that the funders won’t stand for the public sector side introducing more risk into the project, even if the private sector partner agrees to the change.

Sting in the tail
It all comes back to ‘let the buyer beware’: don’t PFI a project unless you really want what that project has been scripted to deliver. Changing your mind is going to sting.

However, it remains the case that the government is keen on introducing break points into long-term PFI contracts and the mechanism being proposed by the National Audit Office is that the bidder should tell the public sector side at the outset what the price would be at the break point. The problem with this, says Miller Group’s Mark Baxter, is that “government hates the idea of flexible figures. A solution which says, ‘If the interest rate at the break point is X then the break price will be Y, and if it is Z, then the price will be W,’ is anathema.”

Rhona Harper, a partner in the projects division at law firm Shepherd & Wedderburn, argues that what people need to realise is that some projects are great candidates for PFI and others are not. She says that Metronet – the business that had a 30-year PPP contract to maintain and upgrade much of the London Underground network – was a classic example of a project that should never have gone down the PFI route since there was too much about the project that could not be quantified at the outset. Metronet – jointly owned by Atkins, Balfour Beatty, Bombardier, EDF Energy and Thames Water – went into administration in July.

Harper argues that government and the public sector need to realise that you can only PFI clean projects, where everyone can see all round the project and evaluate all the risks.

“The problem with Metronet was that by the nature of the thing, no one could tell at the outset what kind of state the various bits of the London underground were in. We’re talking about deep tunnels that are in continual use,” she says. So the parties ended up trying to write a suck-it-and-see contract that was flexible enough to cater for all eventualities but which ended up being unworkably complicated.

Much the same problem has hit big IT procurement contracts that have been put to PFI. The departments concerned weren’t able to write a clear specification at the outset because they didn’t understand quite what system they wanted to build. From a muddled beginning comes a failed contract. The lessons for private sector companies are clear. Know your project and know the risks. If you can’t see all the risks you can get badly burned.

Former Deloitte partner Eric Tracey was called in to act as a turnaround finance director at Amey which had a stake in the Tubelines PFI deal – the London Underground PFI project that works. Tracey points out that private sector companies are under tremendous pressure when evaluating potential PFI bids. “You really need to understand and model all the things that can happen and it can be a huge exercise. If you don’t, or can’t, do this, then you will find surprises – and some of them can be nasty,” he says.

Success and failure
For Tracey, the reason why the Tubelines contract works and Metronet imploded spectacularly is that, with Tubelines, the consortium (Amey and Bechtel) quickly decided that it needed to be run as a strongly managed entity with good disciplines. All contracts are up for tender and if outside parties are cheaper they get the work rather than the consortium members. This creates tight project disciplines and a clean, defensible track record. With Metronet, on the other hand, the partners all tried to keep a good chunk of the work for themselves, arguing that they were best placed to do the work at the best value.

“Metronet got itself into a position where it had a huge amount of additional work to do and was totally dependent on the regulator to approve a change in the regulation order on price,” says Tracey. “However, it did not have the paper trail to demonstrate that the reason why its costs were high had nothing to do with inefficiency or a failure to deliver value for money. This turned out to be a disaster for it.”

However, this does not prove that PFI has a huge flaw in it. “There can be no doubt that it has allowed projects to get done that would not otherwise have been done and that has been a great benefit to the country. It is hard to quantify that benefit, but it is huge,” Tracey argues.

At Miller, Richards and Baxter believe that if people want to find a real weakness in PFI, the place to look for it is not in private sector greed, but in the failure of government to ensure that someone on the public sector side is in a position to take decisions. “One of the most frustrating things for us in many PFI deals is that you will find that 95% or so of the contract is straightforward and is covered by more or less standard documentation. Schools are now fairly standard and this is where the bulk of our PFI work has been. The main risks between the parties are already settled – demand risk, which sits with the client, and price risk on the assets, which sits with the contractor,” says Baxter.

But trying to get agreement on the remaining 5% can be very time consuming, since the “best value” provisions of PFI make it difficult for councillors to compromise. “It always assists deals where there is someone on the public sector side authorised to push a sensible compromise through,” says Baxter.

More talk, less action
There are a few clouds on the PFI horizon, despite the fact that there are huge policy commitments to push tens of billions of pounds worth of further projects through PFI. First, there is what government calls “competitive dialogue”.

The idea is that public sector clients will keep more private sector bidders talking for longer before getting into a preferred bidder phase. This is ramping up costs for the private sector massively and is discouraging bidders. “The plus side of competitive dialogue is that the public sector client knows that the deal ticks all the boxes for their chosen contractor. The downside is the length of time and the cost that the process takes,” says Richards.

A new feature of PFI, which is good for the private sector and not bad for the public sector – though it has exercised some unions – is post-deal equity buyouts of the private sector partners. Because these deals can generate profits of, say, 13% for 25 years, it is open to a new investor to buy a project off an existing consortium, which takes, say, a consolidated 7% profit in cash now, leaving the new investor with a guaranteed income of 6% on its investment for 25 years. In the money markets that is a very attractive proposition. It gives the PFI consortium a quicker win, and frees it up and funds it to tackle new projects. There are issues here with termination clauses, but nothing the lawyers can’t solve.

Developments such as this, which seek to build low-cost options and flexibility into inherently risky long-term contracts, seem certain to increase both the attraction and the success rate of PFI.