The UK’s private finance initiative (PFI), which was set up by a Conservative government in 1992, has become the primary means of public capital investment under New Labour.
Under PFI, a private sector consortium finances a public building project through a mixture of its own members’ equity and money raised from banks or the capital markets. This allows a transfer of construction risk to the private sector, in theory ensuring a better building outcome and, in return, high returns to the consortium over the 25-year concession period in which it manages the building.
And with Prime Minister Tony Blair’s explicit support, there is now little of the public sector that has not been touched by PFI. As of 1 April, a total of 660 PFI projects had been signed, representing private financing of £29.6bn (e43.5bn), in the main sectors of health, education, prisons and defence. And if the three London Underground public-private partnership concessions, which are PFI deals in all but name, are included, that figure rises to £57.98bn.
Because of the risk taken by the private sector, and the role they play in managing buildings, the amount of money consortia stand to make through these deals is more than double that.
Looking ahead, the pipeline of deals is also strong. In September, health secretary John Reid announced 15 new hospital schemes worth a total of over £4bn. In education, PFI investment will reach £1.2bn a year by 2005-06 as the government’s ambitious Building Schools for the Future programme gets under way. And in smaller sectors such as local government, social housing and local transport, Chancellor of the Exchequer Gordon Brown has outlined three years of significant growth.
Increased demand is posing serious questions about the capacity of the existing PFI market to meet it. There is a need for leading construction players to offload primary equity tied up in completed building projects and use these resources to bid for new schemes. After all, while construction companies, as the principal risk takers, have majority ownership of most PFI consortiums, equity provision is not their core business. Construction firms’ original financial input is necessary to complete projects but they have a much more limited role when tbuilding work is complete, and it is natural for them to seek a profitable exit in this phase.
A secondary market for PFI equity was always expected to emerge as the industry matured. And with hundreds of contracts now moving from construction to operation it seems its time has come.
Last year there was a notable increase in activity, with new funds established and competition for equity heating up. A more innovative marketplace has also emerged. Secondary market players are now bringing new models to the contractors in an attempt to avoid restrictions on share transfers and pre-emption schemes.
But what do these equities look like from an investor’s point of view? Most existing industry players believe the risk profile rapidly improves at the operational stage. Once the risky construction phase is over, the government-backed revenue stream depends for most accommodation projects on the provision of relatively straightforward and low-risk services such as maintenance and cleaning. But because construction risk is factored into the project model, primary equity players on most projects stand to make about 15% on their equity for the full 25-year concession period.
So PFI offers a low-risk investment opportunity with high returns. It is no surprise then that investors such as pension funds are now looking to build up PFI portfolios.
But there are factors that would-be investors need to consider carefully. For example, while the risk of a reduction in revenue is low in the operational phase, there are political risks associated with working with the public sector that are not found elsewhere. Working in PFI in particular draws a level of political scrutiny that many private sector businesses will find uncomfortable. It can also have material effects on the health of some businesses.
The classic case is engineering group Jarvis. The company’s public image was initially hit after the 2002 Potters Bar rail crash. Following this, though, its PFI work attracted sustained media criticism.
This contributed to a massive downturn in the company’s fortunes. Over 12 months, Jarvis lost its good reputation and its unassailable market position. Its success rate in winning bids fell markedly. Some councils, such as Fife in Scotland, which selected Jarvis as its ‘preferred bidder’ on the basis of its designs and prices, has recently ditched the company and reopened talks with rival bidders.
Figures from the Jarvis annual report, issued in July, paint a vivid picture. They reveal a pre-tax loss of £246.7m this year compared with last year’s £62.7m profit.
Operational PFI schemes have other uncertainties apart from political risk. One of the challenges from the initial three waves of projects is the lack of consistency in contractual terms and the lack of knowledge about delivery problems, which can make the matter of due diligence on such projects more complicated.
Although this is balanced against the fact that most of these equity acquisitions are post-completion and hence at a point when the reality of service delivery is known, some residual risk remains.
It is possible that the risk associated with the long-term maintenance exposure has been understated in the original business model. Building experts believe the true cost of maintenance cannot be fully understood until about 10 years after the completion of a building, since at the design stage the rate of deterioration can only be an educated guess.
Changes in the financial environment have also hit profits. A good example is vandalism in PFI school projects. The private sector was unaware on closing the initial wave of projects of the crippling scale of the problem. Insurance advisers did not believe that insurance costs would increase over the course of the project and hence considered that the private sector could take any risk that did result.
Over the past few years, school projects have incurred massive claims for vandalism and insurance cost increases of more than 100%. Although in new projects authorities have retained more vandalism risk and are sharing the cost of insurance, this example shows that seemingly guaranteed returns can be hit by lack of foresight.
One recent development for secondary market players to consider has been government’s increasing desire to take equity interests in project companies through joint ventures with the private sector.
This is a particular feature of the education and primary healthcare sectors, where reformed PFI programmes are being developed. There has been concern on the part of secondary market players that this might affect liquidity in the market. Investors concerned about this should monitor the small number of cases where the government has already taken equity interests to see how it behaves.
Perhaps the greatest risk inherent in the secondary PFI market is competition. Possible changes in the political or financial environment notwithstanding, PFI seems to offer the market a class of equities that offer super-normal profits for relatively low risk.
Such a market could end up overpopulated, in stark contrast to the primary industry. In this context, the danger is that secondary market players will price their bids too competitively and that by the time pension funds get involved, the risk-to-reward calculation might look very different.
Mark Hellowell is editor of Public Private Finance, published in London