Update on PFI debt refinancing and the PFI equity market

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1 Update o PFI debt refiacig ad the PFI equity market REPORT BY THE COMPTROLLER AND AUDITOR GENERAL HC 14 Sessio April 26

2 The Natioal Audit Office scrutiises public spedig o behalf of Parliamet. The Comptroller ad Auditor Geeral, Sir Joh Bour, is a Officer of the House of Commos. He is the head of the Natioal Audit Office, which employs some 8 staff. He, ad the Natioal Audit Office, are totally idepedet of Govermet. He certifies the accouts of all Govermet departmets ad a wide rage of other public sector bodies; ad he has statutory authority to report to Parliamet o the ecoomy, efficiecy ad effectiveess with which departmets ad other bodies have used their resources. Our work saves the taxpayer millios of pouds every year. At least 8 for every 1 spet ruig the Office.

3 Update o PFI debt refiacig ad the PFI equity market LONDON: The Statioery Office Ordered by the House of Commos to be prited o 18 April 26 REPORT BY THE COMPTROLLER AND AUDITOR GENERAL HC 14 Sessio April 26

4 cotets summary 1 This report has bee prepared uder Sectio 6 of the Natioal Audit Act 1983 for presetatio to the House of Commos i accordace with Sectio 9 of the Act. Joh Bour Comptroller ad Auditor Geeral Natioal Audit Office 3 April 26 The Natioal Audit Office study team cosisted of: Mark Simpso, Richard Wade, Roha Wijerate, Hele Thorpe, Roseaa Grudy ad Haah Paye, uder the directio of David Filay. Part 1 The Govermet has secured millio from PFI debt refiacig but there has bee little recet activity The Govermet has secured the right to millio from PFI debt refiacig The gais received by the public sector from the 11 volutary sharig arragemets uder the Code have so far bee less tha expected The agreed sharig arragemets have bee 17 applied i most debt refiacigs but there have bee exceptios Refiacigs have icreased ivestors returs by 2 varyig amouts This report ca be foud o the Natioal Audit Office web site at For further iformatio about the Natioal Audit Office please cotact: Natioal Audit Office Press Office Buckigham Palace Road Victoria Lodo SW1W 9SP Tel: equiries@ao.gsi.gov.uk Natioal Audit Office 26

5 Part 2 Debt refiacigs may brig risks as 22 well as beefits Icome from debt refiacig ivolves 23 some ucertaity There may be service related issues 25 Part 3 There have bee developmets i the 28 PFI equity market as the PFI market has matured ad fiacial markets have become more liquid There has bee a growth i ivestors sellig 29 shares i PFI projects which may brig beefits to the public sector Equity ivestors ad debt providers may derive 31 beefits from establishig portfolios of iterests i PFI projects There is scope to improve the compilatio of 32 iformatio o the fiacig of PFI projects ad the returs to ivestors Appedices 1 Reports ad Guidace o Refiacig by 34 the Natioal Audit Office, PAC ad Treasury 2 Study scope ad methodology 37 3 PFI Projects i the Survey 39 4 Secodary Market Fuds 42 5 Previous refiacig recommedatios from 44 NAO ad PAC reports ad the extet to which actio has bee udertake i order to meet those recommedatios 6 The Source ad Sharig of Refiacig Gais 52 7 Methodology for NAO estimates of the 54 public sector gai to be received uder the volutary code 8 Advatages ad disadvatages of the public 56 sector takig a refiacig gai as either a lump sum or over time i the form of a reduced uitary charge 9 Summary of refiacigs ad related data 57 Glossary 58 Photographs courtesy of ID8, Alex Beato, Justie Desmod Photography ad with kid permissio of GCHQ.

6 summary summary

7 summary 1 Most govermet projects by value uder the Private Fiace Iitiative (PFI) are fuded by the private sector through a mix of debt fiace (i the form of bak loas or bod fiace) ad risk capital (kow as equity capital 1 ) provided by the shareholders of the project compay. 2 Previous NAO reports 2 have show that there are opportuities for the ivestors of the equity capital to secure beefits by refiacig o more favourable terms the debt fiace of early PFI projects which have bee successfully delivered. The improved fiacig terms o these projects are available as: ledig i the PFI market is cosidered less risky ow that the PFI market is established; the delivery risks of the projects have bee dealt with; ad, i the debt markets, it is curretly possible to borrow for loger periods at fixed rates of iterest which are lower tha whe the early PFI cotracts were let. 3 Oly a small proportio of a PFI project s total costs are subject to refiacig. I most cases a refiacig will ot icrease the overall fiacig costs of a project i cash terms but, i improvig the terms of the debt fiace, will eable paymets to the ivestors of equity capital to be made earlier i the cotract period. The resultig beefit to the equity ivestors ca sigificatly improve the returs o their ivestmets as their iitial ivestmet is small (typically aroud 1 per cet of the project s fiace) relative to the debt beig refiaced (typically aroud 9 per cet of the project s fiace). I the illustratio of costs measured over the whole life of a typical project (Figure 1), 29 per cet are operatig costs ad a further 54 per cet represet the cost of fiacig the capital cost of the ifrastructure if the Govermet itself fuded the project through issuig gilts. The remaiig 17 per cet represets the additioal fiacig cost to govermet of the private sector takig the risks of costructig ad operatig the asset for the life of the cotract (the fiacial risk premium). 1 A illustratio of costs i a PFI project measured i omial whole life values It is the 17 per cet of costs which are subject to refiacig 1 Cost to the Govermet of the private sector takig the risks of costructig ad operatig the asset for the life of the cotract. 17% Operatig Costs 29% Capital Costs if the project had bee fuded by gilts 54% Source: This is based o a fiacial model developed by the Treasury, typical of a hospital project NOTE 1 I omial cash flows, refiacig redistributes the costs of fiace betwee debt ad equity but does ot icrease the total costs of the project. 1 Equity capital is usually a mix of ordiary shares ad subordiated debt (debt that raks behid the mai debt o repaymet). 2 Previous NAO ad PAC reports dealig with PFI refiacig are set out i Appedix 1. Update o PFI debt refiacig ad the PFI equity market 1

8 summary 4 Before July 22, it was ot madatory for PFI projects to have cotractual arragemets to share gais arisig from debt refiacig. Followig reports by the NAO ad Committee of Public Accouts (PAC) 3, which highlighted the particular opportuities for the private sector to secure gais from debt refiacig o early PFI projects, the Office of Govermet Commerce (OGC), who had resposibility at the time for PFI policy, cosulted with the private sector ad itroduced arragemets whereby: PFI cotracts siged from July 22 owards would provide for public authorities to receive 5 per cet of ay gais arisig from debt refiacig; As from September 22, a volutary code ( the Code ) would apply whereby authorities would geerally expect to receive 3 per cet of the gais from debt refiacig where their cotracts had ot icluded arragemets to share the gais. 5 The successful operatio of the volutary sharig arragemets of the Code is importat as it is the early PFI deals, etered ito before July 22, which are likely to have the greatest potetial for debt refiacig gais but most of these deals had o cotractual mechaism for sharig these gais. I later deals, the improved fiacig terms ow available should be priced ito the deal whe the cotract is let ad there are cotractual arragemets to share ay subsequet refiacig gais. I December 22, the OGC told the PAC that it expected the public sector to receive 175 to 2 millio from the itroductio of the Code. 4 Resposibility for PFI policy was trasferred from the OGC to the Treasury o 1 April The opportuities to refiace the debt fiace of PFI projects have arise as the PFI market has matured. A further developmet as a cosequece of the maturig PFI market ad a period of liquidity i the global capital markets has bee the emergece of a market, kow as the secodary equity market, i the buyig ad sellig of the equity capital i established PFI projects. 7 I this report we examied: how the level of debt refiacig gais which the Govermet has secured compares with the OGC s expectatios i 22; how well the ew arragemets to share debt refiacig gais have bee workig; whether there are ay risks for authorities from debt refiacigs; ad how the maturig PFI market is affectig the use of equity capital i PFI projects. 8 Our examiatio icluded a cross govermet survey of PFI projects. The study scope ad methodology is set out i Appedix 2 ad a list of the projects we surveyed is i Appedix 3. 9 I summary we have foud that: The Govermet has secured 137 millio from PFI debt refiacig but there has bee little recet activity; (Part 1 of this report) Debt refiacigs may brig risks as well as beefits; (Part 2) There have bee developmets i the PFI equity market as the PFI market has matured ad fiacial markets have become more liquid. (Part 3) I terms of the overall effect o the value for moey of PFI deals, the debt refiacigs that have bee completed relate to oly a small proportio of PFI cotracts. As we reported durig 25 5, the icreased risks to the public sector from certai refiacigs which geerated large refiacig gais through icreased private sector debt made the value for moey of those refiacigs questioable despite the sharig of the gais. The Treasury s emphasis o value for moey appears to be brigig greater disciplie but also a reductio i debt refiacig activity. 3 Appedix 1. 4 Report from the Committee of Public Accouts: PFI refiacig update (HC 23, Jue 23). 5 NAO reports o Daret Valley Hospital: the PFI Cotract i Actio (HC ) ad The Refiacig of the Norfolk ad Norwich PFI Hospital: how the deal ca be viewed i the light of the refiacig (HC ). 2 Update o PFI debt refiacig ad the PFI equity market

9 summary 1 Our mai fidigs have bee: a) Some large debt refiacigs have eabled the Govermet to secure gais of 137 millio The debt refiacig of PFI projects had eabled the Govermet to secure the right to gais of 137 millio up to February 26 (Figure 2). 12 millio arose from four refiacigs.three hospital deals (Norfolk ad Norwich, Bromley ad Daret Valley), where the lead ivestors were Barclays ad Iisfree, accouted for 6 millio of the Govermet s gais. The ivestors, who retaied large gais from these refiacigs, had shared 3 per cet of the gais with the public sector uder the volutary sharig arragemets of the Code. A further 42 millio of the Govermet s gais arose from the refiacig of the Lodo Udergroud Tube Lies project where the sharig was based o a cotractual provisio ad did ot, therefore, rely o the Code s volutary sharig arragemets. The remaiig debt refiacigs of early PFI deals sice the Code was itroduced have maily bee udertake o smaller projects. These have yielded small gais for both the public ad private sectors with the public sector securig o average less tha 1 millio from each refiacig. I additio, the fiacig of the Miistry of Defece s Skyet 5 project has bee improved as part of a much wider substatial restructurig of the project. b) Refiacig gais arisig from the Code have declied sice 24 The 137 millio of refiacig gais the Govermet has secured the right to icludes 72 millio from the volutary sharig arragemets of the Code, early all of which arose prior to 25. Oly three small debt refiacigs uder the volutary sharig arragemets have bee completed sice December 24 from which the public sector will gai.7 millio. The declie i gais from this aspect of debt refiacig has bee affected by ivestors takig stock of the additioal scrutiy of PFI refiacigs followig NAO reports i 25 o two of the large refiacigs of the Norfolk ad Norwich ad Daret Valley hospital projects. 2 The right to refiacig gais secured by the public sector up to February 26 umber of refiacigs Actual gais which the public 22 OGC estimate of sector has secured the right to gais to the public sector m m Volutary sharig uder the Code: Norfolk ad Norwich Hospital 1 34 Bromley Hospital 1 14 Daret Valley Hospital Other deals Other refiacig gais: Lodo Udergroud 1 42 Other deals o estimate o estimate Source: Natioal Audit Office Survey, PUK Database ad Report from the Committee of Public Accouts: PFI refiacig update (HC 23, Jue 23) Update o PFI debt refiacig ad the PFI equity market

10 summary These NAO reports, together with a subsequet PAC hearig o the Norfolk ad Norwich deal, raised cocers about large refiacig gais where the private sector had icreased its debt to accelerate the beefits to ivestors. The cocers focussed o the fact that these refiacigs had bee based o the public sector acceptig both icreases to the liabilities it would icur to ed the cotracts early ad extesios to the miimum cotract periods. The authorities judged that, o the balace of curret probabilities, these arragemets would be value for moey i the log term. These coclusios could chage however if the authorities wish to ed the cotracts early because of chages i requiremets over the ext 35 years. The Treasury has re-emphasised to departmets the eed to rigorously evaluate the value for moey of all refiacig proposals. This is expected to take ito accout ay chages to public sector termiatio liabilities takig accout of the amouts that the providers of both debt ad equity fiace would be able to recover o termiatio. The amout beig received from debt refiacigs, where sharig of gais uder the Code would apply, has maily declied because the private sector is less assured that the public sector will ow agree to further refiacigs ivolvig sigificat icreased debt. The private sector has less iterest i takig forward other smaller value refiacigs because the time ad costs ivolved i arragig a refiacig of ay size are cosiderable. c) Gais from early PFI deals curretly look likely to fall short of the OGC estimate Up to February 26, the gais of 72 millio which the public sector had secured from the volutary sharig arragemets of the Code were well short of the OGC s 22 estimate of 175 to 2 millio. It is difficult to estimate how much more the Govermet may ow secure from these volutary sharig provisios particularly as it is curretly ucertai whether the recet declie i refiacig gais from early PFI deals will cotiue. I additio, the majority of the 7 PFI cotracts which have bee let may ot give the prospect for the public sector to beefit from refiacig; may are too small for refiacig to be viable, others do ot have project specific fiace or there would be costs ivolved i uwidig the existig fiacig arragemets which could make refiacig uattractive. If there is some recovery i refiacig activity, our curret best estimate is that the total gais to the Govermet from the Code are likely to icrease to betwee 11 ad 15 millio, still short of the OGC s 22 estimate. The OGC s estimate could, however, yet be achieved i due course if there are ay further large refiacigs. The Treasury accepts that the Govermet is receivig less from Code refiacigs tha iitially expected but its mai focus has bee o the achievemet of value for moey through a appropriate balace of risk ad reward rather tha maximisig the gais. The Treasury has carried out some iitial research to idetify which of the large PFI deals may be capable of refiacig. d) The ew gai sharig appears to be geerally workig well with some exceptios Where early deals have bee refiaced sice 22 the provisios of the Code for calculatig ad sharig the refiacig gais have, for the most part, bee followed. Overall, the public sector has secured the right to receive close to 3 per cet of the refiacig gais (Figure 3) which was the expectatio whe the Code was established. I lie with Treasury guidace, deals siged sice 22 are givig the public sector the right to 5 per cet of ay refiacig gais. We foud o evidece from the survey returs that the private sector had udertake refiacigs without iformig the relevat departmet. We did, however, fid three refiacigs sice the ew sharig arragemets came ito force, of roads cotracts let by the Highways Agecy, where the gais were ot shared i accordace with the Code. O two of these projects, the Highways Agecy ad Balfour Beatty said they had bee at a advaced stage of egotiatig these refiacigs i 22 before the sharig arragemets of the Code became effective. If the gais o these two refiacigs had bee shared i accordace with the Code, the public sector would have received 1.7 millio. The gais from a third refiacig, completed by the Roadlik cosortium i 24, have ot bee disclosed to the Natioal Audit Office but the Highways Agecy believes Roadlik s gais to have bee less tha 1 millio. 4 Update o PFI debt refiacig ad the PFI equity market

11 summary 3 Sharig of gais o refiacigs sice the Code came ito operatio Project Total refiacig Amout shared with % of gai shared with gais (NPV) public sector (NPV) public sector m m Norfolk & Norwich Hospital Bromley Hospital Daret Valley Hospital other projects where gais were shared i accordace with the Code 17 refiacigs where gais were shared i accordace with the Code 3 projects where o gais were shared completed refiacigs sice the Code came ito operatio Source: Natioal Audit Office Survey ad PUK database of PFI projects NOTES 1 Norfolk ad Norwich ad three other projects gave rise to gais to the public sector of less tha 3 per cet i accordace with the Code because returs to ivestors, prior to the refiacig, were less tha expected whe the cotracts had bee let. 2 Two refiacigs, ivolvig Balfour Beatty ad WS Atkis had refiacig gais of 4.8 millio. The gais from a third refiacig, completed by the Roadlik cosortium i 24, have ot bee disclosed to the Natioal Audit Office but the Highways Agecy believes Roadlik s gais to have bee less tha 1 millio. e) Refiacigs provide scope for sigificatly icreasig the ivestors iteral rate of retur I may refiacigs the cash which the ivestors will receive over the cotract period will decrease as ivestors exchage later beefits for the right to icreased early beefits from the project. The acceleratio of beefits ca, however, sigificatly icrease the iteral rate of retur 6 to ivestors i some cases. Most early PFI cotracts were let o the expectatio of a iteral rate of retur to ivestors of 15 to 17 per cet. Where projects disclosed to us the ivestors iteral rate of retur followig refiacig these raged from less tha 1 per cet to over 7 per cet. I a fifth of these projects, all early PFI deals, the ivestors iteral rate of retur followig refiacig had rise to over 5 per cet ad, i the case of Debde Park School ad Bromley Hospital, to as high as 71 per cet. As aroud half of the projects surveyed o this issue did ot disclose their ivestors iteral rate of retur there may be other projects where there have bee high iteral rates of retur after refiacig. f) The opportuity to beefit from refiacig ca also create ew risks Sharig i refiacig gais has the potetial to beefit the public sector but there are also risks. The risks relate to: Icome from refiacigs ivolves some ucertaity The public sector s gais from the Code depeds o cotiued adherece to what are volutary arragemets. The private sector has said that ay attempt to amed the code could jeopardise the volutary arragemets that have bee widely complied with sice the iceptio of the Code. I additio, the ability to refiace will deped o coditios i the fiacig market. Those authorities which have chose to take their refiacig gais over time could, depedig o the reasos for the termiatio ad the cotractual terms, also face ucertaity i collectig their gais if they were to effect a early termiatio of their cotracts. 7 The future flow of icome from the Code caot, therefore, be predicted with certaity. 6 See paragraphs 1.36 ad 1.4 for further explaatio of this measure of ivestor returs. The improved debt fiacig terms which cotributed to icreases i ivestors' iteral rates of retur should be available to the public sector i curret procuremets reducig the likelihood of later refiacig gais. 7 See paragraphs 2.4 to 2.5 ad Appedix 9 for further explaatio of the risks associated with takig the gai as a lump sum or over time. Update o PFI debt refiacig ad the PFI equity market 5

12 summary There ca be additioal liabilities followig a refiacig Some refiacig proposals have icreased public sector risk as they have required the public sector s agreemet to possible icreases i termiatio liabilities or a extesio of the cotract period. The Treasury expects departmets to carefully assess such proposals ad oly to accept them if the value for moey of such proposals is fully demostrated. There may be service related risks Although authorities reported they were geerally satisfied with service performace ad the icetives to perform followig refiacig, it is still too early to judge whether the acceleratio of beefits to shareholders followig a refiacig will have a impact o service delivery i the loger term. The theoretical risks are that, havig take beefits, the ivestors might become less cocered about the project s performace or the project may ot have retaied sufficiet fuds to meet future asset maiteace obligatios ad uforesee expediture. Ivestors argue, however, that, as they expect further reveues from the projects, they will be cocered to esure that cotractors cotiue to perform. The providers of debt fiace are also likely to be cocered that the repaymet of their debt, which i some cases has icreased o refiacig, is ot put at risk by poor service performace. The Treasury has also observed that the terms of fiacig of PFI project compaies followig a refiacig are ormally i lie with those of ew PFI deals. It therefore expects the risks to service delivery followig a refiacig to be o differet from those i ew deals. g) There are trasactios which Treasury guidace excludes from gai sharig The Treasury accepted, after market cosultatio ad takig accout of practicalities, that it would be uacceptable for the Govermet to iterfere i certai situatios which would, therefore, ot be subject to gai sharig arragemets. These exclusios, set out i Figure 1, page 18 ad para 3.6, iclude the sale of equity shares (although the profit o such sales will be subject to taxatio). Also, the Govermet s gai sharig does ot exted to the way that ivestors ad other fuders maage their portfolios of iterests i PFI projects uless this impacts o the uderlyig PFI cotracts which departmets have etered ito. These boudaries were iitially set out i Treasury guidace i July 22 ad were the also applied to the operatio of the Code. I egotiatig the Code with the private sector the Treasury ackowledged that the private sector was makig sigificat cocessios to volutarily share debt refiacig gais o early PFI deals where there had bee o cotractual requiremet to do so. h) There is ow a emergig secodary equity market i PFI shares The developmet of a secodary market for PFI equity has bee helpful to ivestors who fud PFI deals ad may also brig beefits to the public sector. Whereas previously there was ucertaity as to whether ivestors would be able to exit from their PFI ivestmets there is ow a reasoably assured market for ivestors to sell shares i successful PFI projects should they wish to do so. 4 per cet of projects told us there had bee a chage i the ivestors i their projects. I these situatios either the iitial or subsequet ivestors may wish to also refiace the project ad we foud that half of these projects had bee refiaced, a higher icidece of refiacig tha i projects where there had ot bee a chage i ivestors. The sale of equity ca also help future PFI projects where the proceeds are reivested i other PFI deals. As the supply of PFI equity icreases this should drive dow the cost of equity ad improve the pricig of PFI deals. The Treasury has said that it cosiders there is scope to reduce the returs of 13 to 15 per cet which ivestors curretly expect whe PFI projects are bid for. Further iformatio o the secodary market is set out i Appedix 4. 6 Update o PFI debt refiacig ad the PFI equity market

13 summary i) Fuders may derive beefits from establishig portfolios of iterests i PFI projects As the umber of PFI cotracts has icreased there has bee a tred towards ivestors ad debt providers buildig a portfolio of iterests i PFI projects. This may eable ivestors to achieve operatig efficiecies across the portfolio or to improve fiacig terms either for the existig portfolio or for subsequet trasactios. It is possible i theory that ivestors or debt providers may seek to improve the fiacig of the portfolio rather tha refiacig idividual projects, but there is little evidece to date of this type of activity. j) There is limited iformatio at preset o the operatio of the PFI equity market All authorities receive iformatio about a PFI project compay s fiacial structure ad the expected returs to ivestors whe the compay bids for the cotract or if it refiaces the project. I additio, Treasury guidace sice 1999 has provided that authorities should have the right to further iformatio available to the leders. Nevertheless, may authorities had difficulties providig fiacial iformatio about their PFI projects to assist this examiatio. Parterships UK (PUK) records refiacigs which have bee otified to it ad also lauched i 25 a database of PFI projects which icludes fiacig iformatio. However, cosiderable further work is eeded to make aspects of this data accurate ad comprehesive ad this will require the support of the authorities. The profits or losses which ivestors may derive from sellig shares i PFI project compaies are ot disclosed to authorities because the cotract is betwee two private sector parties. Update o PFI debt refiacig ad the PFI equity market 7

14 recommedatios Recommedatios arisig from previous NAO ad PAC refiacig reports are set out i Appedix 5 together with a commetary from the Treasury o progress i implemetig these recommedatios. Recommedatios arisig from this curret examiatio are set out below. Criteria for acceptig refiacig proposals 1 The Treasury should cotiue to support authorities i esurig that value for moey is achieved i refiacig. It should cotiue the steps it has take to articulate to the PFI market the public sector s criteria for acceptig refiacig proposals, particularly those ivolvig chages to termiatio liabilities. The Treasury should also cotiue its efforts to idetify ad dissemiate examples of good practice i the treatmet of termiatio liabilities ad other refiacig issues. 2 Before acceptig a refiacig proposal, a authority must give careful cosideratio to the impact of the proposals o the future of the project, i particular: a whether, after ivestors have withdraw beefits from the project, there will still be sufficiet icetives to perform the required services ad sufficiet reserves withi the project to fud the life cycle maiteace of the project ad cotigecies; b c the cosequeces of acceptig ay proposal to icrease termiatio liabilities, or exted the cotract period, particularly give that uforesee evets may arise i the future, such as chages i public service requiremets or cotractor performace, which could icrease the likelihood of early termiatio of the cotract eedig to be cosidered; ad that, depedig o cotract terms, receivig the gai over time may create a possible risk that part of the gai might ot be received if the cotract is termiated early. Decisios o the best basis for receivig the gai should take ito accout this risk ad other aspects of value for moey such as the impact o termiatio liabilities. Trasactios excluded from gai sharig 3 As Treasury guidace permits a umber of fiacig trasactios which would ot lead to gai sharig, the Treasury should moitor these trasactios to esure that the primary motivatio of the private sector eterig ito such trasactios is ot to avoid sharig refiacig gais. Update o PFI debt refiacig ad the PFI equity market

15 summary Moitorig of the extet to which projects may be capable of refiacig 4 As there are ow 7 PFI cotracts i existece, the Treasury should exted the work it has bee doig o cosiderig the capability of large projects to refiace, to form a view o the proportio of the 7 cotracts which might be suitable for refiacig. Cosideratio of whether cotracts are suitable for refiacig should take ito accout whether they have fixed iterest arragemets which are comig to a ed which might preset refiacig opportuities. Moitorig the cost of PFI fiace 5 Curret expectatios are that the icrease i sources of equity arisig from the emergig PFI secodary market should drive dow returs which equity providers seek from PFI projects. Debt fiace should cotiue to be provided at competitive rates reflectig the lower risks ow the PFI market is established. I order to demostrate whether these expectatios are achieved, the Treasury should make use of the ew PUK project database to produce a aual summary of the treds i PFI fiacig costs. Improved trasparecy i the returs to ivestors from PFI projects 6 To provide trasparecy ad a better uderstadig of the dyamics of PFI equity ivestmet, further iformatio is required o the full rage of costs ad beefits which ivestors experiece from participatig i the PFI market. Part of this iformatio should be provided by authorities makig more extesive use of their cotractual rights to iformatio. To provide the full picture of the ivestors experiece from their ivolvemet i the PFI market, the Treasury should discuss with ivestors what further iformatio they could provide which would illumiate this issue. Update o PFI debt refiacig ad the PFI equity market

16 part oe Part oe The Govermet has secured 137 millio from PFI debt refiacig but there has bee little recet activity 1 Update o PFI debt refiacig ad the PFI equity market

17 part oe 1.1 Most early PFI deals had o provisio for sharig refiacig gais as the Govermet cosidered the fiacig risk lay with the private sector. Followig reports by the NAO 8 ad PAC 9 which highlighted the potetial for refiacig gais i early PFI deals, the OGC lauched, i 22, with the support of the Cofederatio of British Idustry (CBI), the Code which expects the private sector to volutarily share 3 per cet of refiacig gais with the public sector. PFI deals siged after July 22 icorporate a 5:5 sharig arragemet. The Govermet has secured the right to 137 millio from PFI debt refiacig 1.2 The amout of refiacig gais to the Govermet up to February 26 is set out i (Figure 4 overleaf). Further details are listed i Appedix 9. I additio, the fiacig of the Miistry of Defece s Skyet 5 project has bee improved as part of a much wider substatial restructurig of the project. The gais received by the public sector from the volutary sharig arragemets uder the Code have so far bee less tha expected 1.3 The operatio of the Code is very importat to eable the Govermet to secure a volutary share of refiacig gais from early PFI cotracts, most of which do ot have a sharig mechaism but have the greatest potetial for refiacig gais. The Govermet gais uder the volutary sharig arragemets of the Code have so far bee 72 millio of the aticipated millio 1.4 At the PAC 1 hearig i December 22 o the NAO s PFI refiacig update report 11, the OGC stated that the expected gai to the public sector from the volutary sharig arragemets uder the Code would be i the regio of 175 to 2 millio, although the period over which this gai would accrue was ot idicated. 8 Refiacig of the Fazakerley PFI priso cotract HC Thirteeth Report from the Committee of Public Accouts, The Refiacig of the Fazakerley PFI Priso Cotract (372 (HC 995-i ). 1 22d Report from the committee of Public Accouts, PFI refiacig update (HC 23 Jue 23). 11 PFI refiacig update (HC 1288 November 22). Update o PFI debt refiacig ad the PFI equity market 11

18 part oe 1.5 The 2 refiacigs which have occurred uder the Code have resulted i a total refiacig gai of millio. Of this, the public sector has secured the right to receive 71.5 millio (Figure 5), 28.9 per cet of the total gais. The amout receivable by the public sector falls well short of the 175 to 2 millio estimated by the OGC i However, the 22 estimate was oly a approximatio usig a simple methodology based o a small amout of data o completed refiacigs available at the time. I additio, the OGC did ot set ay time limit withi which the 175 to 2 millio estimate would be achieved. The amout received has also bee iflueced by a umber of other factors (paras 1.8 to 1.24). There remais a utapped pool of projects which may be viable for refiacig uder the Code 1.7 I total over 7 PFI cotracts have bee let. The 2 Code refiacigs are from a populatio of approximately 5 early PFI cotracts let before the Code came ito operatio (Figure 6). However, the characteristics of the majority of these projects may ot give the public sector the prospect of beefitig from refiacig. For example, almost half are small projects (less tha 1 millio i capital value). For these small projects, the cost of edig their curret fiacig arragemets i terms of the exteral legal ad fiacial advisor costs alog with the iteral resources eeded to arrage ew fiace, may exceed the potetial refiacig gai ad thereby make the refiacig uattractive. There are also some PFI projects that are excluded from havig to share ay refiacig gai with the public sector as the fiace is ot specific to the PFI project (Figure 1, page 18). This leaves aroud 15 early PFI projects which could potetially be suitable for refiacig. There may, however, be costs ivolved i uwidig the existig fiacig arragemets of some of these projects which could make refiacig uecoomic. 12 The balace of whether the opportuities for gais, for example by beig able to borrow for loger periods at lower rates of iterest, outweigh the pealty costs of edig existig arragemets will vary from case to case. 4 5 Project Summary of the public sector s refiacig gais from the Code s volutary sharig arragemets Norfolk & Norwich Hospital Bromley Hospital Daret Valley Hospital Scotlad ad Wales (oe project each) 8 other projects (excludig schools) 7 schools Sources of refiacig gais to the Govermet up to February 26 Refiacigs takig place before the Code Refiacigs as part of the volutary sharig arragemet uder the Code Refiacigs sice the Code with a cotractual sharig mechaism Total Total Refiacig Gai to public sector 23 millio 72 millio 42 millio 137 millio Source: Natioal Audit Office Survey ad PUK database of PFI projects Refiacig Gai to the public sector ( m) Source: Natioal Audit Office Survey ad PUK database of PFI projects Full details of all refiacigs ca be foud i Appedix 9. Sice the volutary code was itroduced the value of refiacigs has bee less tha expected due to a umber of factors 1.8 Excludig rescue refiacigs 13 where the public sector would ot expect to receive gais 13 Code refiacigs had yielded 7.8 millio up util the ed of By compariso, there were oly three Code refiacigs i 25, of which oly oe, Lagaside Courts yielded a share (.7 millio) to the Govermet. There are a umber of factors which may accout for this subdued ature of refiacig activity despite there beig projects which could be suitable for refiacig. 12 These costs could be for breakig fixed iterest arragemets o bak loas or pealty paymets for the early repaymet of bod fiace. 13 A refiacig where the cotractor has bee i fiacial difficulties. 14 Details of all Code refiacigs are i Appedix Update o PFI debt refiacig ad the PFI equity market

19 part oe 6 PFI Projects (aggregate Capital Value at cotract sigature) Capital Value ( millio) 14 Approx 5 Projects which are eligible for sharig refiacig gais uder the Code Approx 15 Projects with a cotractual 5:5 sharig mechaisim 12 1 Not Refiaced Refiaced 2 Q 3-4 Q 1-2 Q 3-4 Q 1-2 Q 3-4 Q 1-2 Q 3-4 Q 1-2 Q 3-4 Q 1-2 Q Q 1-2 Q 3-4 Q 1-2 Q 3-4 Q 1-2 Q 3-4 Q 1-2 Q 3-4 Q 1-2 Q 3-4 Q 1-2 Source: PUK database of PFI projects Bi-aual NOTES 1 The peaks durig 22-3 relate to three Lodo Udergroud Projects with a combied value of 16.2 billio of which oe, with a value of 5.5 billio, has bee refiaced. The other two are bod fiaced ad Europea Ivestmet Bak fiaced ad this limits their ability to refiace. 2 I additio to the above there were 11 PFI deals reachig fiacial close previous to 1994 of which oe (Secod Seve Crossig) has udergoe a refiacig. 3 There is usually a time lag (usually 2 to 3 years) from cotract sigature to whe a project ca be refiaced based o the time it takes for a PFI project to become operatioal. The sharig of gais ad public sector ivolvemet has caused the private sector to cosider whether to go ahead with certai refiacigs 1.9 The NAO s PFI refiacig update report (November 22) idetified that oly 26 per cet of cotracts let before Jue 2 had a arragemet to share refiacig gais, ad oly half of these required the authority s approval for a refiacig. Hece prior to the itroductio of the Code there was, i most cases, o obligatio o the private sector to share refiacig gais or to cosult with the public sector over the refiacig. 1.1 The itroductio of the Code has meat that the private sector ow has to cosider: whether the refiacig is worthwhile after sharig 3 per cet of their total refiacig gai with the public sector; ad whether it wishes to udertake the time ad expese of complex egotiatios with the public sector before the refiacig ca be effected. Puttig the Code ito practice has brought greater appropriate scrutiy of the value for moey of refiacig proposals 1.11 The fact that there were oly two Code refiacigs i 25 which yielded gais of.7 millio to the public sector was maily attributable to the market takig stock of the scrutiy of two large refiacigs of early PFI deals uder the Code. The NAO s reports o Daret Valley Hospital ad Norfolk ad Norwich Hospital highlighted large refiacig gais by the project compaies icreasig their debt at the more favourable terms the available ad thereby acceleratig the distributio of beefits from the project to the shareholders. The iteral rate of retur to ivestors followig the refiacigs of these early PFI deals able to take advatage of the improvemet i fudig terms were 56 per cet at Daret Valley ad 6 per cet at Norfolk ad Norwich. 15 The public authorities agreed to higher termiatio liabilities ad exteded miimum cotract periods as part of the icreased debt arragemets. The authorities judged that, o the balace of curret probabilities, these 15 O a similar refiacig, of the Bromley Hospital project, the iteral rate of retur to ivestors icreased to 71 per cet followig the refiacig. Update o PFI debt refiacig ad the PFI equity market 13

20 part oe arragemets would be value for moey i the log term. These coclusios could chage however if the authorities wish to ed the cotracts early because of chages i requiremets over the ext 35 years There was cosiderable iterest show by the media i these NAO refiacig reports, particularly focussig o the high returs to private sector ivestors. Some seior public sector officials expressed to us reservatios that a refiacig i the curret climate would lead to a critical press eve if the refiacig is prove to be value for moey. This is especially the case with regards to the earlier PFI projects where the market had bee immature ad therefore the refiacig gais could be large I February 25, followig the NAO report o Daret Valley Hospital, the Treasury issued a Applicatio Note to help authorities ad their cotractors to apply existig Treasury guidace more rigorously ad cosistetly to refiacig proposals. The ote emphasises the eed for a prove value for moey case for refiacig proposals, particularly where the public sector teams are asked to accept icreased termiatio liabilities i cojuctio with the refiacig. This focus of attetio is desiged to prevet refiacigs occurrig which geerate large returs to the private sector while at the same time icreasig the risk to the public sector without due regard to value for moey. The private sector s eed to cosider the impact of this Applicatio Note, ad the existece of other ivestmet opportuities i a active market durig 25, cotributed to the declie i PFI refiacig activity. The Treasury has set out its positio o the value for moey aspects of refiacig but there has bee some ucertaity i the market 1.14 Although the Treasury s Applicatio Note emphasised the eed for a prove value for moey case for refiacig proposals, iterviews we coducted with baks, advisors, moolie isurers ad secodary market fuds (SMFs) idetified that, evertheless, the market became ucertai i 25 about what future refiacigs would be acceptable. Their ucertaity arose i part because the Applicatio Note was ot prescriptive i the methodology to be applied i carryig out the value for moey evaluatio. Some fuders ad advisors geerally assumed that icreases i termiatio liabilities were o loger goig to be accepted by departmets. The Applicatio Note had said that: Give the complex issues which Refiacigs raise, it would ot be surprisig for a Authority to coclude that the simplest Refiacig proposal particularly oe that does ot ivolve ay chage to Cotract termiatio liabilities was also the best. The Treasury has clarified i discussios with the market o specific deals that cosideratio of whether there has bee ay chage to termiatio liabilities should take ito accout the total amouts that the providers of both debt ad equity fiace would be able to recover o termiatio. Sice refiacigs that did ot ivolve a icrease i public sector termiatio liabilities were relatively uattractive to the private sector, this cotributed to the reduced activity The Treasury has take opportuities to articulate that there could still be cases where departmets would be justified i acceptig some icrease to their termiatio liabilities but oly where the cosequeces of agreeig to these icreased liabilities has bee fully assessed as value for moey. The Treasury, together with the Departmet of Health, is plaig to establish good practice i dealig with these issues o a curret refiacig beig take forward o the Swido PFI hospital project. The public sector relies upo the private sector to istigate a refiacig 1.16 Evidece from our survey showed that public sector project teams were: aware of the potetial for refiacigs withi their projects but, had o kowledge of the reasos why the private sector were ot pursuig a refiacig ad, were ot proactive i fidig out the reasos why the private sector were ot pursuig a refiacig Although there are beefits to both sides i sharig i a refiacig gai which offers value for moey for the public sector, the iitiative for settig a refiacig i motio lies with the private sector sice it is their debt which is to be refiaced. There is a risk that public sector drive refiacigs could be motivated by affordability rather tha value for moey reasos. Also, the Treasury cosiders that there are risks to a public authority i pressig for a refiacig sice the private sector might try to take a egotiatig advatage from the authority s eageress for a refiacig. For example, pressure might be brought to bear o the authority to agree to icreased termiatio liabilities ad cotract extesios. Or, the authority might be asked to share i the iitial costs of the refiacig proposal or fid its bargaiig power weaker i resolvig ay separate cotract disputes. 14 Update o PFI debt refiacig ad the PFI equity market

21 part oe 1.18 However, there could be beefits from the public sector project teams beig more aware of the refiacig itetios of their private sector couterparts sice they could for example prepare i advace for dealig with the techical fiacial issues which arise from a refiacig. Creatig a receptive atmosphere may also facilitate the refiacig process where the gai is deemed to be margial by the private sector. The refiacig gai which ca be realised from a project ca vary 1.19 May factors ca play a part i determiig the size of the refiacig gai such as whether the size of the debt withi the project has icreased, the legth of time remaiig i the PFI project ad the coditios i the fiacig markets (Appedix 6). Refiacig without icreased termiatio liabilities is likely to reduce the refiacig gai to the public sector 1.2 Treasury guidace expects that if the private sector proposes icreases to the authority s termiatio liabilities, the the authority should also obtai a alterative refiacig proposal ivolvig o icrease to termiatio liabilities. This is expected to be part of the value for moey assessmet process. However, there is o requiremet for the private sector to proceed with this alterative proposal. If the private sector is uwillig to refiace o terms which the public sector assesses as value for moey, the this may reduce the extet of refiacig activity ad this appears to have cotributed to the low refiacig activity i 25. The size of gais will be affected by the timig of a refiacig ad coditios i the fiacig markets 1.21 A PFI cotract is of fiite legth usually betwee 25 to 35 years with the debt remaiig withi the project reducig over time. Hece, the potetial gais to be made from refiacig the debt will dimiish (other thigs beig equal) the loger the delay i udertakig a refiacig. If ledig rates o future ew deals should become higher tha they ow are, there might, however, be a case to defer refiacig util ledig rates reduce Although fiacig terms for PFI projects have geerally bee improvig as the market matures, there could be fluctuatios which either icrease or decrease the scope for refiacig gais depedig o fiacig coditios at the time of the refiacig. For example, i recet times there has bee a high degree of liquidity i the bak ad bod credit markets. This has created a competitive market with historically low risk margis the part of the iterest cost reflectig credit default risk (Figure 7 overleaf). It is ucertai though whether these favourable coditios will cotiue. The Treasury ote that ivestmet decisios are log term decisios, ot drive by potetially short term market pheomea Whilst may ew deals are ow bod fiaced where, as with all bod fiace, sigificat pealties for early repaymet of the bods mea that refiacigs may ot be a feasible optio, there may still be opportuities to reduce the risk margi o some other bak fiaced PFI deals. 16 The potetial for refiacig gais eeds to be weighed agaist the costs of edig ay fixed iterest arragemets Furthermore, the cost of fiace could icrease if ew opportuities emerge which attract fuds which would otherwise have bee ivested i PFI projects. For example, the curret growth of ew overseas markets i PFI ad PPP projects, or the 212 Lodo Olympics projects, may create attractive opportuities for ivestors as a alterative to ivestig i what is ow a relatively mature UK PFI market where returs are expected to declie or remai tight. The Treasury does ot expect these factors to have a sigificat effect o the PFI sector. It also otes that the cost of fiace will be drive primarily by matters beyod leders choice of whether to ivest i the Uited Kigdom credit margis beig curretly very low due to global liquidity i fiacial markets, the iterest of pesio fuds i makig log term ivestmets as a hedge agaist log term pesio liabilities ad bakig regulatio chages. Nevertheless, whether a ivestor will remai motivated to udertake a PFI refiacig give the time ad costs ivolved will always be iflueced by the opportuity costs of other possible trasactios. Curret estimates suggest it is ulikely that the OGC s previous estimate for Code refiacig gais will be achieved i the foreseeable future 1.25 I order to reach the OGC estimate of 175 to 2 millio, there eed to be further gais of aroud 15 to 13 millio shared with the Govermet from future refiacigs uder the Code. To cosider the likelihood of this outcome we cosidered four potetial refiacig scearios ad their likelihood of outcome (Figure 8 overleaf). Further details o the four scearios are preseted i Appedix Bods ca be a attractive source of fiace for a refiacig sice they have a loger term to maturity which suits a 3 year PFI project, ad they ted to be cheaper tha bak debt. There may be costs ivolved i switchig from oe form of bak fiace to aother. Update o PFI debt refiacig ad the PFI equity market 15

22 part oe 7 Movemet i risk margis o bod fiace Bod Idices Spread to Gilts (percetage) BBB spread 2. A spread AA spread.5 AAA spread. Jul Oct Ja Apr Jul Oct Ja Apr Jul Oct Ja Apr Jul Oct Ja Apr Jul Oct Ja Apr Jul Oct Ja Apr Jul Oct Ja Apr Jul Oct Source: Royal Bak of Caada (from Bloomberg iformatio) NOTE AAA, AA, A ad BBB are grades of ivestmet. AAA has the least risk ad therefore the lowest risk margi. 8 Four possible scearios for the future of refiacig uder the Code Sceario Likely public sector gai Explaatio of Sceario Likelihood of sceario comig to pass 1 millio The curret subdued state of the refiacig market will cotiue idefiitely ad there will be o further refiacig of PFI deals uder the Code. Possible, but the Treasury has bee facilitatig egotiatios i a umber of Code refiacigs ad so it appears probable that there will be more refiacigs i the future. 2 8 millio All early PFI projects with the potetial to refiace will be refiaced but the refiacigs will ot ivolve cotract extesios or the icreasig of debt, ad gais will oly be derived from lowerig the cost of the existig fiace. Possible, but there may be some reluctace from the private sector to udertake refiacigs with lower beefits tha previously. 3 3 millio Future refiacigs uder the Code will cotiue with the average gai, i relatio to capital value, that has bee see thus far. Ulikely. Public sector gais of the magitude of Norfolk ad Norwich ( 34m) ad Daret Valley ( 12m) are ulikely to be repeated ad so average refiacig gais i the future will be lower tha those see i the past millio Future refiacigs uder the Code will geerate the same high level of returs, i relatio to capital value, which was see i the Norfolk ad Norwich deal. Highly ulikely give the curret guidace ad scrutiy of PFI refiacig deals, ad the limited umber of deals offerig similar levels of retur. Source: Natioal Audit Office 16 Update o PFI debt refiacig ad the PFI equity market

23 part oe 1.26 It is difficult to estimate how much more the Govermet may secure from Code refiacigs as it is curretly ucertai whether the recet declie i refiacig activity will cotiue. I additio, the majority of PFI projects may ot have the characteristics to give the public sector the prospect of beefitig from refiacig (para 1.7). If there is some recovery i refiacig activity, our curret best estimate is that the future gais uder the volutary sharig arragemets of the Code will probably be somewhere betwee Sceario 1 ad 2, with the future gai to the Govermet i the 4 to 8 millio rage. Addig this to the sum already raised ( 71.5 millio), total refiacig gais from the Code would the be somewhere betwee 11 to 15 millio; still short of the OGC 22 estimate of 175 to 2 millio. To geerate more from refiacig i lie with OGC s origial estimate, the umber of refiacigs, or the gais arisig from each refiacig, would eed to icrease compared to our assumptios. The OGC s estimate could, however, yet be achieved i due course if there are ay further large refiacigs. The Treasury accepts that the Govermet is receivig less from Code refiacigs tha iitially expected but its mai focus has bee o the achievemet of value for moey through a appropriate balace of risk ad reward rather tha maximisig the gais. The agreed sharig arragemets have bee applied i most debt refiacigs but there have bee exceptios Authorities have bee kept iformed of ay debt refiacigs udertake by the private sector but some trasactios do ot require gai sharig 1.27 We foud o evidece i the survey returs that the private sector had withheld iformatio about a debt refiacig from a authority. We did fid six projects where the authority had ot reported a refiacig but there had bee some form of fiacial restructurig of the debt. However, these did ot costitute refiacigs where the gais should have bee shared with the public sector (Figure 9). Treasury guidace permits gais o certai trasactios which improve the terms of a project s debt fiace to be retaied by the private sector (Figure 1 overleaf). 9 PFI projects withi our survey which had experieced some form of fiacial restructurig of the project debt Form of Fiacial Restructurig Access to a fudig allowace which could be draw upo to meet the demads for variatios. [Coect ad Power Supply PFI projects] To resolve the distressed fiacial positio of the cotractor. [Croydo Tramlik] Additioal borrowig to ru the project. [MoD s Sigal Service project] Corporately refiaced (fiaced usig its ow resources) [Global Wide Area Network Likig Operatio] New owers sought exteral fiacig origial deal was corporately fiaced (Lodo Fire) Source: Natioal Audit Office Survey Numbers of Projects Why the fiacial restructurig does ot require ay sharig with the govermet There was o refiacig of the origial debt ad there was o gai realised to be shared with the public sector. There was o gai to be shared. Rescue refiacigs are specifically provided uder Treasury guidace as situatios where the public sector will ot share i refiacig gais. The Authority explaied that the debt icreased whe, after the cotract award, the Cotractor foud a error i the fiacial model used to support the bid for the project ad therefore had to borrow more moey, with o deterioratio to the Authority s positio. Corporate refiacigs are defied by guidace as o-qualifyig i.e. the private sector is ot obliged to share the gai. 1 Cosultats to the project team cocluded i a review of the restructurig that there was o gai to be shared. NOTE 1 Treasury guidace o stadard PFI cotract terms (SoPC3 sectio ) requires the authority ad its advisors to coduct due diligece over corporately fiaced projects i order to satisfy themselves that the fiacial structure is ot simply desiged to bypass the refiacig provisios. Update o PFI debt refiacig ad the PFI equity market 17

24 part oe I additio, i the MOD s Skyet satellite commuicatio project, the private sector cosortium Paradigm has raised ew fiace i coectio with a revised isurace strategy for the project, the additioal costs of which will be bore by the MOD. 1 Debt trasactios where Treasury guidace provides that gais do ot have to be shared The followig is a summary ad the full details of exemptios from gai sharig are as stated i the stadard cotract terms issued by the Treasury. Corporately Fiaced projects. These projects are fiaced through the corporate fuds of the service provider rather tha through fiace obtaied specially for the project so that the cotractor is both service provider ad fiacier. The Treasury view is that i the circumstaces which meet the criteria set out i its guidace it is ot feasible to idetify ay fiacig beefit that the cotractor may secure. There is o gai sharig util the iteral rate of retur (IRR) assumed i the bid has bee achieved. Ivestors whose IRR at the time of the refiacig is below their base case model IRR, are etitled to retai refiacig gais without sharig, util the project s IRR rises above its base case IRR. This cocessio was maily iteded to help projects i fiacial difficulties. However, i our opiio, it ca also produce outcomes which appear overly geerous to ivestors whose returs i projects out perform iitial expectatios as a result of large refiacig gais. For example, i the Norfolk ad Norwich hospital refiacig, i lie with the volutary code, the cotractor Octago was exempt from sharig 5.8 millio of the refiacig gai as its pre-refiacig IRR (16 per cet) was below its base case IRR (19 per cet). Immediately after the refiacig, Octago s IRR icreased to 6 per cet. I our view it would seem more appropriate i such cases where the post refiacig IRR is sigificatly above the base case IRR for the full amout of the gai to be shared. The Treasury view is that chagig the volutary code would jeopardise the volutary sharig arragemet which to date has bee adhered to. Improvemets i geeral iterest rates if the private sector was exposed to iterest rate risk. The cotractor bears the risk of icreased iterest rates followig fiacial close. Where the cotractor has ot hedged this risk ad is therefore exposed to both upward ad dowwards movemets i iterest rates, the cotractor is etitled to keep gais arisig from favourable movemets i iterest rates. Source: Stadard cotract terms issued by Treasury (SoPC3). Iformatio o the Norfolk ad Norwich Hospital Refiacig from the NAO report o that trasactio It would be risky for a private sector compay ad associated leder to udertake a refiacig without iformig the public sector. Ay refiacig that icreases termiatio liabilities or requires coveat chages, requires agreemet by the cliet. Also, guidace o PFI cotract terms provides for termiatio of the PFI cotract for a breach of the refiacig provisios. I this evet the authority s termiatio liabilities would iclude othig i respect of compesatio to the equity shareholders. Furthermore, it would be difficult for the private sector to secure the agreemet of all of the equity holders i a project to such actio give the reputatioal damage that would result from subsequet discovery. The sharig of refiacig gais has bee, i geeral, i accordace with guidace but with some exceptios I most cases refiacig gais have bee shared accordig to the Code 1.29 The Code required the private sector to geerally share 3 per cet of the total refiacig gai with the public sector. Figure 11 shows the amout shared with the public sector of those projects that were refiaced uder the Code. Five projects resulted i the public sector receivig less tha 3 per cet of the refiacig gais for reasos permitted by the Code but three projects did ot share gais which the Code expected to be shared. The three exceptios were road projects where there was o sharig of the gais 1.3 I three PFI road projects maaged by the Highways Agecy there was o sharig of the gais o refiacigs after the Code came ito operatio. Two refiacigs (A3/A35 (Exeter to Bere Regis) ad A5/A564 (Stoke Derby Lik)) were siged o November 7th 22, a short period, 5 weeks, after the Code had bee published. If these had proceeded uchaged but shared i accordace with the Code, the public sector would have received a gai of 1.7 millio. 17 At the time of the refiacig, the shareholders i both of these roads projects, which had bee awarded by the Highways Agecy, was Balfour Beatty (68 per cet of the equity) ad WS Atkis (32 per cet). 17 O these deals there is o compesatio payable by the Highways Agecy to the leders o cotractor default, therefore the termiatio liabilities of the Highways Agecy are ulikely to have icreased beyod the origial cotract. 18 Update o PFI debt refiacig ad the PFI equity market

25 part oe 11 Whether the PFI projects refiaced uder the Code have shared 3 per cet of the gai with the Departmets Shared 3 per cet (or greater) with the Departmet Did ot share 3 per cet with the Departmet for reasos permitted by the Code (Medium Support Helicopters 1, Hairmyres Hospital 2 ad Tower Hamlets Schools 3 Heart of the City Offices 4, Nottigham Express Trasit 5 ) Did ot share with the Departmet where there was a gai which the Code expected to be shared (A3/A35 ad A5/A564 ad A69) Total Source: Natioal Audit Office Survey NoteS 1 At the time of the refiacig, the retur to the project was below that projected i the base case whe biddig for the cotract. 2 A project based i Scotlad ot icluded i our study. 3 This was a rescue refiacig where the post refiacig project IRR was below that of the IRR stated i the busiess case, hece there was o gai sharig accordig to the Code (Figure 1). 4 No gai to be shared. No. of Projects 5 At the time of the refiacig, the retur to the project was below that projected i the base case whe biddig for the cotract Balfour Beatty ad WS Atkis had begu the process of a refiacig i the previous year prior to the itroductio of the Code. They siged commercial terms with their baks i February 22 ad received credit approval from their fuders betwee April ad May 22. Durig late 21 ad the first half of 22 it was widely kow that the Treasury was egotiatig with the private sector a code which would expect the private sector to make 3 per cet of the refiacig gais o early PFI deals available to the public sector. The refiacigs of these two projects were plaed by Balfour Beatty ad WS Atkis o the basis of o gai share with the public sector. Balfour Beatty ad WS Atkis were ready to sig the fial refiacig agreemets with the Highways Agecy i September 22, but due to various delays, the fial sigig of the refiacig deals took place whe the Code had come ito practice. The ature of the refiacigs did ot require ay coset or documet chage ivolvig the Highways Agecy ad were structured so as ot to icrease the potetial termiatio liability of the public sector Balfour Beatty ad WS Atkis told us that had they bee required to share ay gai with the public sector the they would probably ot have proceeded with the refiacig because the resultig value to shareholders would have bee reduced to a level that it would ot have bee worth pursuig give the additioal maagemet time required to re-egotiate the trasactio applyig to the Code ad the ucertaity of outcome that would have bee created. However, both Balfour Beatty ad WS Atkis cofirm that they support the priciples of the code ad subsequetly each has bee ivolved i several refiacig discussios with various public sector bodies where the sharig of refiacig gais was a accepted base assumptio eve though the cocessio cotracts do ot require them to do so O a third roads cotract, the A69 Carlisle to Newcastle, which the Highways Agecy had let to the Roadlik cosortium the project was refiaced i 24 but with o sharig of the gais. The amout of the refiacig gais has ot bee disclosed to the Natioal Audit Office but the Highways Agecy believes that the gais to Roadlik were less tha 1 millio The Highways Agecy has succeeded i obtaiig gais of 4 millio o two other road projects where the refiacig gais were shared. The authorities have take steps to check refiacig gai calculatios but there has bee oe variatio from Treasury guidace i the use of the discout rate 1.35 I projects where a refiacig had occurred, the public sector teams had geerally ivolved advisors i checkig that the refiacig gai had bee calculated correctly. Update o PFI debt refiacig ad the PFI equity market 19

26 part oe 1.36 Guidace recommeds to departmets that refiacig gais should be discouted usig the ivestor s IRR as set out i the PFI cotractor s base case submitted whe biddig for the cotract. This discout rate is used as it is a measure of the private sector s expected cost of usig equity capital i the project. I most cases, the higher the discout rate used, the greater the refiacig gais. 18 However, i the refiacig at Daret Valley Hospital, the cotractor, THC Dartford, successfully argued that usig their busiess case IRR would have give the Trust a ureasoably high amout from the refiacig i relatio to the risks that THC Dartford had bore i udertakig such a early PFI deal. After extesive egotiatios ivolvig the Departmet of Health ad the Treasury, a compromise discout rate (15 per cet) was agreed betwee the parties. The 15 per cet used was a approximate equity retur prevailig i the market at the time of the refiacig. If the origial busiess case discout rate of 21 per cet had bee used, the Trust would have secured a extra 1.4 millio. The refiacig gais o other early PFI deals did use higher discout rates equivalet to the base case IRR: Norfolk ad Norwich Hospital (19 per cet) ad Bromley Hospital (22 per cet). There are cotractual arragemets to share refiacig gais i curret deals 1.37 The survey resposes to deals siged sice October 22 which are expected to share refiacig gais 5:5 cofirmed that these cotracts icorporated the prescribed 5:5 sharig mechaism Of the eleve large projects siged after October 22 which we surveyed, oly oe had so far udertake a refiacig (Jubilee, Norther ad Piccadilly Tube Lies). The reaso why there have ot bee more is that oly oe of the remaiig te that have ot bee refiaced is purely bak fiaced, where the prospects for refiacig are most likely, ad, i ay evet, the projects are ulikely to have reached the stage whe a refiacig would take place. I the Tube Lies project the public sector share of the refiacig gai was a cotractually egotiated 6 per cet. This higher sharig arragemet with the Govermet reflected the fact that the authority was required to give approval to a deal which was predomiatly bak fiaced but was plaig to be refiaced usig a bod at a early opportuity. Refiacigs have icreased ivestors returs by varyig amouts 1.39 I most cases the refiacig will ot icrease the overall fiacig costs of a project i cash terms. The total cash which the ivestors will receive over the cotract period will geerally decrease as ivestors exchage later beefits for the right to icreased early beefits from the project. Further iformatio o the effect o ivestors cash receipts from PFI projects which have bee refiaced is set out i Appedix 9. If icreased debt is used to improve the beefits to the ivestors, the project cash flows will iclude the repaymet of the icreased debt ad related iterest charges over the cotract period. 1.4 The acceleratio of beefits ca however, sigificatly icrease the rate of returs to ivestors. The iteral rate of retur (IRR) is a stadard busiess measure used to compare the returs to ivestors i differet projects. 19 At the request of the PAC, we have aalysed the IRRs of PFI projects after refiacig ad the rate of chage i the IRR as a result of the refiacig. These aalyses requested by PAC are set out i Appedix 9 together with other data o the projects which have bee refiaced. Although there are other measures of ivestor returs, the characteristics of the IRR calculatio make it very sesitive to icreases to ivestor beefits i the early years of a project which is a feature of may refiacigs Treasury guidace otes that: the IRR calculatio is relevat for the purposes of calculatig the refiacig gai; however the authority should be aware that IRRs are geerally ot a reliable alterative to Net Preset Value measuremet for the value of a ivestmet O early PFI deals, the expected IRRs were geerally 15 to 17 per cet. Figure 12 shows that, where projects disclosed their IRR after refiacig, the IRRs have varied from below 1 per cet to over 7 per cet. At the top ed of this rage, i four out of 2 projects (all refiacigs uder the Code), the IRR had rise to over 5 per cet. As aroud half of the projects surveyed did ot disclose to us the rate of ivestor returs there may be other projects with high ivestor returs after refiacig. 18 I the case of a refiacig comprisig oly a reductio i bak debt margi this effect is reversed. 19 The IRR is the discout rate at which the preset value of the ivestors receipts from a project equals that of their paymets, icludig their iitial ivestmet. The IRR percetage does ot mea the ivestors will receive this as a costat retur each year; the receipts from the project may vary from year to year. 2 Update o PFI debt refiacig ad the PFI equity market

27 part oe 12 The IRR of PFI projects post refiacig Post refiacig Iteral Rate of Retur (%) Number of Code refiacigs Number of other refiacigs Total Total No respose/retured icomplete iformatio Total PFI projects surveyed A full aalysis by project is set out i Appedix 9. We set out below the three projects with the highest ivestor IRR ad the three with the lowest ivestor IRR followig refiacig based o the iformatio which project teams provided to us. The three projects with the highest ivestor IRRs followig refiacig were: Project Total refiacig gai Pre refiacig iteral rate of retur to ivestors Post refiacig iteral rate of retur to ivestors Mai iitial ivestors Debde Park School 1 millio 16% 71% Jarvis PLC, Barclays Capital Bromley Hospital 45 millio 27% 71% Iisfree, Barclays, Taylor Woodrow Costructio Norfolk & Norwich Hospital 116 millio 16% 6% Iisfree, Barclays Private Equity, 3i PLC & Serco Group The three projects with the lowest ivestor IRRs followig refiacig were: Project Total refiacig gai Pre refiacig iteral rate of retur to ivestors Post refiacig iteral rate of retur to ivestors Mai iitial Ivestors Tye ad Wear Fire % % Jarvis PLC, Barclays Private Equity Calderdale Hospital 12 millio 7% 2 8% Bovis Led Lease, RCO Holdigs, HBOS Brooklads Aveue, Cambridge.8 millio 9% 9% Kajima Parterships Limited, Japa Eglad Isurace Co Ltd, WestWid Capital Parters Ltd Source: Natioal Audit Office Survey NOTES 1 Iformatio was requested from the 36 Eglish PFI projects which have bee refiaced. 2 The cotract award IRR was used i this table as the pre refiacig IRR was ot provided by the project team. Update o PFI debt refiacig ad the PFI equity market 21

28 part two Part two Debt refiacigs may brig risks as well as beefits 22 Update o PFI debt refiacig ad the PFI equity market

29 part two 2.1 The complex ature of refiacig trasactios meas that they may create risks for the public sector as well as offerig beefits. Icome from debt refiacig ivolves some ucertaity The Code is volutary ad the private sector has stated that ay chages could damage their commitmet to it 2.2 I most early PFI deals there was o cotractual requiremet to share refiacig gais. It was, therefore, a major chage whe the private sector accepted i 22 the itroductio of the Code which provided for sharig refiacig gais o these deals. The Code is ot legally bidig ad its ogoig operatio depeds, therefore, o the support of the private sector. Some private sector parties have told us that they would withdraw their commitmet to the Code if ay future chages are made which could adversely affect their ability to beefit from refiacigs or if it were exteded, for example to iclude equity trasactios which are curretly defied as fallig outside the Code. The Treasury have emphasised to us that the Code has ot ad will ot be chaged. They have repeated this view i recet Treasury guidace. The future flow of icome from refiacig caot be predicted with certaity 2.3 As the recet refiacig experiece described i Part 1 of this report demostrates, the rate of refiacig takig place, ad the gais from them, may be subject to fluctuatios. They will be affected by various factors icludig coditios i the fiacial markets ad the types of refiacigs which are etered ito. It is ot possible for the public sector to pla with ay certaity for particular levels of future refiacig icome. There are risks from the public sector takig its share of refiacig gais over time through a reduced charge 2.4 The public sector ca take its share of the refiacig gai as either: a lump sum; or over time i the form of a reduced aual uitary charge; or by receivig services to the value of the authority s share of the refiacig gais. Update o PFI debt refiacig ad the PFI equity market 23

30 part two 2.5 Most public sector departmets have chose to take the gai as a lump sum with the exceptio of the Departmet of Health which has advised NHS Trusts to take their refiacig gais over time. There are possible advatages ad disadvatages of either takig the refiacig gais as a lump sum or over time (Appedix 8). But, if the gais are ot take as a lump sum, a authority could be exposed to ucertaity over recoverig the outstadig balace of the gais it is due if the cotract is eded early. Whether this becomes a issue will deped, amogst other thigs, o the cotractual arragemets for early termiatio (which differ betwee curret cotracts ad early PFI cotracts) ad the reasos for termiatig the cotract (which ca effect the terms of the termiatio). The Departmet of Health accepted, whe examied o this poit by the PAC, that a authority had less protectio if a PFI cotractor failed ad the authority had ot take the gais as a lump sum. The Departmet poited out, however, that by takig the gai as a lump sum, the eed to fud this amout would add to the cotractor s debt which could icrease the authority s termiatio liabilities. The Treasury emphasises the flexibility of curret arragemets whereby authorities are able to select the optio for receivig their share of the refiacig gais that best suits their circumstaces. It also otes that, i curret cotracts, if the cotract is termiated due to cotractor default, the authority will ormally pay its termiatio liabilities over time by cotiuig to pay a aual charge which will have bee reduced to take accout of the authority s share of the refiacig gais. There ca be additioal liabilities followig a refiacig 2.6 Where the private sector has icreased debt o refiacig i order to accelerate shareholder divideds, it is possible that the public sector will face the prospect of icreased termiatio liabilities as, i certai circumstaces, the termiatio liabilities may be liked to the amout of private sector debt. 2 It will the be for the authority to assess whether the refiacig proposals represet value for moey takig accout of the likelihood that it might wish to termiate the cotract at some stage durig the cotract period. However, assessig such a likelihood is difficult because the chagig ature of public service delivery over time meas that a authority could chage its view o the desirability of cotiuig a existig cotract i future years. A authority should, therefore, be very cautious about acceptig icreased termiatio liabilities because high levels of termiatio liabilities could act as a disicetive to ed a cotract where other factors would suggest this is the correct strategy. Half of the refiacigs i our survey ivolved icreased debt with most resultig i icreased termiatio liabilities 2.7 From our surveys, 17 projects retured iformatio o their debt structure followig a refiacig (Figure 13). I eight of these projects the authorities reported icreased termiatio liabilities followig the refiacig The icreases i the projects mai borrowigs (kow as seior debt), where sigificat, were from 6 millio to 16 millio (Norfolk ad Norwich Hospital). The average icrease was 31 millio. O average, the icreases represeted about a 2 per cet icrease i the seior debt i the project. I oe project the private sector had accepted that the authority s termiatio liabilities would ot icrease 2.9 I oe case, o the Highways Agecy s A19 PFI road deal, the cotractor arraged for their leder to bear the additioal risk arisig from a 9 millio icrease i the seior debt. This illustrates that the public sector does ot ecessarily have to accept icreased termiatio liabilities where the private sector icreases its debt. I other projects, however, the authorities had ot appreciated the impact o their termiatio liabilities 2.1 I some situatios, however, it was ot always clear whether authorities had bee fully aware of the possible impacts o their termiatio liabilities as a result of a refiacig. For example, oe cotractor had released cash reserves as part of its refiacig but the authority did ot recogise that this would have icreased its termiatio liabilities Uder curret guidace, i termiatios due to cotractor default, the termiatio liabilities are calculated by referece to the market value of the project, ot by the outstadig debt. 21 Further details are set out i Appedix Followig the refiacig, the authority s termiatio liabilities would have had to cover that part of the cotractor s borrowigs which could previously have bee repaid out of the cash reserves. 24 Update o PFI debt refiacig ad the PFI equity market

31 part two 13 Effect of refiacig o private sector debt structure ad public sector termiatio liabilities % Chage i amout of debt umber of Projects > 5 icrease 2 No aswer provided 3 Total 47 Source: Natioal Audit Office Survey 14 Cotract Extesios o refiacig PFI Project cotract Legth of Extesio 1 extesio Daret Valley Hospital 28 to 35 years 7 years Bromley Hospital 3 to 35 years 5 years Norfolk ad Norwich Hospital 34 to 39 years 5 years Source: Natioal Audit Office Survey NOTES 1 I each case the miimum period of the cotract was exteded. The authorities had the optio to cotiue the cotracts for loger periods. 2 Barclays ad Iisfree were the lead ivestors o all three projects. Some authorities have take o icreased termiatio liabilities without a full appraisal ad explorig alteratives 2.11 I two projects, the authorities termiatio liabilities were icreased although the projects teams reported i the survey that there had ot bee a clear value for moey case justifyig the icrease. I four projects, termiatio liabilities were icreased without ay exploratio betwee the cotractor ad the project team of alterative refiacig terms which could have resulted i o icrease i termiatio liabilities The effect o termiatio liabilities where the private sector has icreased its debt o refiacig ca be dramatic. As we oted i our report o the refiacig of the Norfolk & Norwich PFI hospital the NHS Trust s termiatio liabilities could be as much as 257 millio higher followig the refiacig which icreased the PFI cosortium Octago s debt from 2 millio to 36 millio. Some cotracts have bee exteded o refiacig, but it is difficult to be certai that existig services will be eeded for loger periods 2.13 We were iformed of three hospital projects where cotract extesios had bee agreed by the public sector at the time of the refiacig. The cotract extesios had bee proposed by the private sector to eable their debt to be repaid over loger periods, thus icreasig the refiacig gais (Figure 14) There are various issues which could affect the value for moey of a cotract extesio. I our report o Daret Valley Hospital we oted that the fiacial case for extedig the cotract was ot as clear cut as the Trust had believed. 23 I each of the above projects where the cotract had bee exteded, the authorities were committig themselves ow to payig for further services i over 3 years time. The chagig ature of public service delivery makes it difficult to be certai ow that such services will be eeded so far ito the future. Authorities must therefore carefully assess both the beefits ad risks relatig to ay suggestio that the cotract period should be exteded as part of a refiacig with the decisio beig take o operatioal ad value for moey factors. The Applicatio Note advises authorities over the eed to justify o soud value for moey terms a cotract extesio. There may be service related issues 2.15 There is a potetial risk that, where, followig a refiacig, ivestors receive large accumulated beefits from a PFI project they may become less cocered about whether the service performace is satisfactory i the remaiig period of the cotract. 23 See NAO Report Daret Valley Hospital: The PFI Cotract i Actio HC 29 February 25 paragraph Update o PFI debt refiacig ad the PFI equity market 25

32 part two O other projects surveyed there has bee o evidece so far of major chages to operatioal risk 2.16 I other projects surveyed we were iformed that the authority did ot cosider that there was ay major chage to the operatioal risk, or the quality of performace, withi the project followig the refiacig. I most cases these are still early days followig the refiacigs ad the service performace will eed to be closely moitored i the comig years, icludig issues relatig to life cycle maiteace (para 2.2). Where the private sector brigs forward gais, there are still icetives for them to perform 2.17 As part of our survey, authorities were asked if they cosidered that their private sector cotractors still had suitable log term icetives to deliver the cotract satisfactorily after they had beefited from a refiacig. All of the project teams who respoded o this issue felt that there were still sufficiet icetives to perform. The mai reasos give to support this view were that: the cotract specified pealties for uder performace; there were cotractual icetives for good performace; ad there was the possibility of reputatioal damage to the cotractor if they uder-performed The risk that ivestors may be less cocered about performace after takig early beefits is balaced by the fact that their ability to realise the further beefits they expect to ear over the remaider of the project will cotiue to be depedet o the performace of the cotractors. Oe would expect the ivestors, therefore, to be cocered about ay declie i service performace ad to seek to address delivery problems. I additio, there is a added comfort for the public sector i a refiacig from the fuders checkig process kow as due diligece. The leder will be cocered that the repaymet of their debt, which may have icreased o refiacig, is ot put at risk. It will take care to assess the future profitability of the project ad the likelihood of termiatio before agreeig to the proposals. A itegral part of this assessmet is a evaluatio of how icetivised to perform the cotractor would be followig the refiacig. The Treasury has also observed that the fiacig structures of PFI project compaies followig a refiacig are ormally i lie with the structures of ew PFI deals. It therefore expects the risks to service delivery followig a refiacig to be o differet tha i ew deals. It further cosiders that the PFI cotract is what drives the PFI cotractors icetives ad that the mix of fiace is ot a direct cotributor to performace The eed for good performace icetives followig a refiacig reiforces the importace of a strog performace maagemet system withi PFI projects. A public sector authority cosiderig a refiacig should review their performace maagemet system ad re-evaluate its effectiveess i a post-refiacig eviromet. Where ecessary they should seek to stregthe the PMS although the private sector may demad a pricig adjustmet if there is a sigificat chage i the risks they are beig asked to bear. It is too early to judge, however, whether large early distributios to ivestors will affect future performace 2.2 Whilst the projects surveyed were geerally satisfied with performace so far sice refiacig, it is too early to judge how well the icetives to perform followig a refiacig are likely to work i the loger term. I particular, followig a refiacig, if the project compay distributes to the shareholders a very high level of accelerated beefits to the detrimet of retaiig cotiget fuds there could be a risk that the project compay would fid it difficult i future years to fud oe-off items of expediture such as large value items of buildig maiteace or cotigecies (uforesee items of expediture). Ivestors have ackowledged to us that service expediture eeded o maiteace ca vary sigificatly from earlier estimates. The private sector s ability to fud whole life asset maiteace is a issue which the public sector eeds to moitor. The Treasury agrees this is a importat issue which it expects authorities to give proper attetio to, but oted that the icetives to perform outlied i paragraphs 2.17 to 2.19 will require the PFI cotractor to give appropriate cosideratio to asset maiteace. 26 Update o PFI debt refiacig ad the PFI equity market

33 part two A refiacig may preset a opportuity to develop other aspects of the project relatioships 2.21 I our survey: o authority reported that the relatioship with their cotractor had deteriorated followig a refiacig; most authorities idicated that their relatioship had remaied the same; ad a small umber of authorities commeted that their relatioship had improved Those authorities which oted that there had bee a improvemet i the relatioship with their cotractor commeted that there was a greater degree of mutual trust ad a icreased sese of partership followig the refiacig. The process of refiacig, which teds to ecessitate a great deal of iteractio betwee project teams, ca therefore re-establish ad develop relatioships Some authorities reported that refiacig had provided a opportuity to resolve cotractual issues which had bee i dispute. For example, a characteristic of some early performace maagemet systems has bee the iappropriate use of subjectivity i defiig performace idicators. 24 This has caused problems i assessig the performace of facilities maagemet services ad imposig, where ecessary, fiacial deductios for poor performace. A refiacig ca eable such cotractual problems to be resolved but they should be egotiated separately from the refiacig ad should ot be viewed as reasos for eterig ito refiacig egotiatios. 24 See NAO Report Daret Valley Hospital: The PFI Cotract i Actio HC 29 February 25 paragraph Update o PFI debt refiacig ad the PFI equity market 27

34 part three Part three There have bee developmets i the PFI equity market as the PFI market has matured ad fiacial markets have become more liquid 28 Update o PFI debt refiacig ad the PFI equity market

35 part three 3.1 As the PFI market has matured there have bee developmets i the PFI equity market. I particular, there is a emergig secodary market for sellig shares i PFI project compaies. The developmets i the PFI equity market may brig beefits to the public sector but at preset the public sector has oly limited iformatio about the operatio of the PFI equity market. There is scope to improve the compilatio of this, ad other, iformatio o the fiacig of PFI projects. There has bee a growth i ivestors sellig shares i PFI projects which may brig beefits to the public sector The developmet of a secodary market has cotributed to the growth i trasactios ivolvig the sale of shares i PFI projects 3.2 There is ow a emergig secodary market for the sale of shares i PFI project compaies. This has developed because ivestors are seekig opportuities to ivest i established PFI projects ow that the PFI market has matured ad there is curret liquidity i the fiacial markets. As a result, whereas previously there was ucertaity as to whether ivestors would be able to exit from their PFI ivestmets, there is ow a reasoably assured market for ivestors to sell shares i successful PFI projects, should they wish to do so. While sellers may reivest their proceeds i other PFI projects there is o obligatio to do so. The shares are beig bought by existig ivestors ad specialist fuds (secodary market equity fuds (SMFs)) established to build portfolios of shareholdigs i PFI projects. Further details about SMFs are i Appedix projects reported that there had bee a chage i the shareholdigs of their PFI project compay which represeted 4 per cet of those projects which provided iformatio o their curret ivestors. The timig of these share sales is set out i Figure Timig of whe share sales have take place Withi oe year of cotract lettig 1 Oe to two years after cotract lettig 2 Two to three years after cotract lettig 4 More tha three years after cotract lettig 25 Share sales have ot occurred 48 Number of % projects 32 4 Total 8 1 Source: Natioal Audit Office Survey NoteS 1 45 out of 123 projects did ot respod to this questio. 2 Of the 32 projects reportig a share sale 16 (5 per cet) had bee subject to a refiacig. Of the 48 projects reportig that a share sale had ot occurred 12 (25 per cet) had bee subject to a refiacig. Update o PFI debt refiacig ad the PFI equity market 29

36 part three 3.4 Where a share sale takes place either the iitial or the ew ivestors may still wish to refiace a project s debt fiace i which case authorities would expect to share i the gais. Depedig o their ivestmet strategy, there may be less icetive for iitial ivestors to carry out a early refiacig if they ca receive part of the project s potetial refiacig gais i the value they receive for sellig their shares. The value at which the shares are sold may iclude a amout which the purchaser is willig to pay for the potetial of the project to yield future gais o refiacig the debt fiace after allowig for the ucertaities of whether a refiacig will actually take place. Nevertheless, we foud that half of the projects where there had bee a share sale had bee refiaced by either the iitial or subsequet ivestors which was a higher icidece of refiacig tha i projects where there had ot bee a share sale. 3.5 I additio, it ca be possible for ivestors to sell their ecoomic iterests i a project without sellig shares. Jarvis had built up iterests i a portfolio of aroud 3, maily schools PFI projects, whe it bega to experiece fiacial difficulties i 24. Jarvis respoded by iitially sellig the rights to the distributios from their shares i most of their PFI projects to the Secodary Market Ifrastructure Fud (SMIF) ad subsequetly sold the shares i certai of the compaies to SMIF (Appedix 4). 25 I priciple, the icetives applicable to Jarvis as sub-cotractor are ot affected by the sale of its shares or ecoomic iterest i shares. However, there is a risk that Jarvis may ot have a suitable icetive for satisfactory performace, ad ideed may ot have the fiacial resources to fulfil its service obligatios. SMIF is likely, however, to be cocered to protect the iterests it has acquired i these projects ad may be able to brig i specialist asset maagemet capabilities which could improve the way these projects perform. Treasury guidace excludes equity sales from gai sharig although profits o sellig shares would potetially be subject to taxatio 3.6 The Treasury ackowledged i its July 22 guidace that the profits o sellig equity shares i PFI project compaies would ot be subject to gai sharig. 26 The factors the Treasury s decisio took ito accout icluded: these trasactios should ot affect the fiacial robustess of the project compay which is i a cotractual relatioship with a authority; the value for which the shares are sold may reflect factors other tha the performace of the project; profits o the sale of shares i PFI project compaies will, like other chargeable gais, be potetially subject to taxatio; ad if gai sharig were to be applied it is possible that primary equity returs may rise to compesate. The expasio of the PFI equity market may brig beefits to the public sector 3.7 The emergece of the secodary market may brig beefits to the public sector by attractig more ivestors ito the PFI market. As the supply of equity i PFI projects icreases this should, assumig efficiet markets, drive dow the relative cost of equity ad brig beefits to the public sector i the pricig of PFI projects. The Treasury has said that it cosiders there is scope to reduce the returs of aroud per cet which ivestors expect whe PFI projects are bid for. 3.8 I additio, the public sector ca lear from the maagemet techiques employed by SMFs to reduce the operatig costs of a portfolio of PFI projects. The Treasury has a ogoig iitiative to also seek to idetify ways i which operatig costs ca be reduced. It otes that it always ecourages ad welcomes efficiecy i its supply chais ad would expect ay efficiecies which the SMFs itroduce to be reflected i the prices which they bid i future PFI procuremet competitios. 25 I December 25 Treasury guidace o chage of owership restrictios was exteded to iclude the sale of the ecoomic iterest i PFI projects. 26 The detail of this exemptio is set out i the stadard cotract terms issued by the Treasury. 3 Update o PFI debt refiacig ad the PFI equity market

37 part three Equity ivestors ad debt providers may derive beefits from establishig portfolios of iterests i PFI projects 3.9 As the umber of PFI cotracts has icreased there has bee a tred towards equity ivestors ad debt providers buildig a portfolio of iterests i PFI projects. The SMFs are a example of this tred. Where a equity ivestor or debt provider is ivolved with a portfolio of projects there may be opportuities for further beefits from: greater operatig efficiecies arisig from ecoomies of scale ad commo workig practices across the portfolio; ad makig chages to the fiacig arragemets of the whole portfolio rather tha refiacig idividual projects. Ivestors may be able to reduce operatig costs through efficiet maagemet of a portfolio of projects 3.1 Ivestors with a portfolio of PFI projects may also be able to improve their returs by efficiet maagemet of the operatioal activities of the projects withi their portfolio. Oe secodary market fud told us: their busiess had bee ratioalised by the creatio of regioal directors; 7 per cet of the fud s employees are ivolved i asset maagemet; these employees had specialist kowledge i operatioal ad costructio matters; ad they were charged with the task of ehacig the value of the PFI projects. Ay gais which arise from a efficiet asset maagemet approach are operatioal profits outside of the code ad would ot have to be shared with the public sector although, as oted above, the Treasury would expect operatig efficiecies to feed through ito better pricig of ew competitively bid PFI cotracts. There may be other opportuities for equity ivestors ad debt providers to geerate fiacig beefits from a portfolio of PFI projects 3.11 It is a ormal busiess strategy for equity ivestors ad debt providers with a portfolio of iterests to seek ways of improvig the fiacig of the portfolio. A example of this which has take place i the PFI sector is that the Dubli based fiacial istitutio, DEPFA, created a special purpose vehicle i order to structure what is kow as a sythetic securitisatio of 24 of its portfolio of PFI loas. This ivolved trasferrig the risks iheret i the loas to other fiacial istitutios. DEPFA was the able to reduce the capital it had to set aside uder bakig regulatios. As a result, DEPFA was able to ehace its retur o capital o its PFI debt portfolio by icreasig its ledig base. The Treasury has accepted that sice such securitisatios are exteral to the PFI cotracts ad at a leder s corporate level, they are ot to be icluded i the gai sharig arragemets. It is possible that other fiacial ivestors or debt providers may have securitised some or all of their PFI exposure as this is a commo ad accepted meas of portfolio maagemet I additio to possibly layig off the risk of fiacig a PFI portfolio, it is also theoretically possible that equity ivestors with a portfolio of PFI projects, such as the SMFs, could seek to improve the fiacig terms for their portfolio as a whole rather tha refiacig idividual projects o a project by project basis. I order to do so, they would have to be the primary equity holder i all of the projects withi the portfolio or have the agreemet of the other equity holders. If it were possible to refiace the portfolio without requirig authority permissio (which would, for example, be eeded for icreases to termiatio liabilities) the ay gais may ot have to be shared with the govermet. The Treasury otes that its guidace limits the opportuities for portfolio refiacigs where there would be o gai sharig with the public sector. Although we were iformed by some SMFs that portfolio refiacig without gai sharig was a optio ope to them, either we or the Treasury are aware of ay such trasactios havig bee completed. Oe SMF told us that it would rather ot go agaist the spirit of the Code which geerally expects the sharig of refiacig gais. Update o PFI debt refiacig ad the PFI equity market 31

38 part three There is scope to improve the compilatio of iformatio o the fiacig of PFI projects ad the returs to ivestors 3.13 All authorities receive iformatio about the fiacig arragemets of their PFI project compaies whe the compaies bid for the cotract ad whe the compaies seek the authorities approval for a refiacig. I additio, stadard cotract guidace o rights to iformatio, which has bee preset i cotract guidace sice the first versio i 1999 ad has bee expaded i December 25 guidace, gives authorities the right to further iformatio available to the leders. I total, this iformatio helps departmets ad the Treasury to keep track of fiacig terms available o PFI deals ad should help them to moitor the ogoig fiacial positio of the PFI project compaies. Curret expectatios are that the icrease i sources of equity arisig from the emergig PFI secodary market should drive dow returs which equity providers seek from PFI projects ad that debt fiace should cotiue to be provided at competitive rates reflectig the lower risks ow that the PFI market is established. However, the Treasury has ot published a summary of the curret treds i PFI fiacig terms across the PFI sector Parterships UK lauched i 25 a database of PFI projects which icludes available iformatio o the fiacig of PFI projects ad the extet of refiacig activity, although cosiderable further work is eeded to make aspects of this iformatio accurate ad comprehesive. I order to complete this work, Parterships UK will require the support of the authorities. The results of our survey are beig made available to Parterships UK to eable them to improve the accuracy of data they had bee compilig o completed refiacigs The authorities we surveyed would ot ormally receive updated iformatio o the profits or losses which ivestors may derive from sellig shares i PFI project compaies; this iformatio is ot disclosed to authorities because it is a cotract betwee two private sector parties. Such iformatio, together with further iformatio o the full rage of costs ad beefits which ivestors experiece from participatig i the PFI market, would provide greater trasparecy, a isight ito the balace of risks ad rewards which the private sector experiece from eterig ito PFI projects, ad a better uderstadig of the dyamics of PFI equity ivestmet Although authorities should, therefore, have iformatio o the curret fiacig structure of their PFI project compaies, may of the project teams that we surveyed had difficulties i providig this iformatio. 2 PFI project teams, out of 123 surveyed, did ot retur our questioaire despite repeated remiders. I a follow up survey to obtai further iformatio o refiaced projects requested by the PAC, icludig the curret ivestor iteral rate of retur, 16 out of 36 projects provided o iformatio or icomplete iformatio. 32 Update o PFI debt refiacig ad the PFI equity market

39 part three Update o PFI debt refiacig ad the PFI equity market 33

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