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.