By Mark Hellowell
06 August 2009
The Private Finance Initiative was thought to be in trouble earlier on in the recession. But it has proved resilient to new accounting standards, and the banks’ credit margins on projects have soared
If nothing else, the Private Finance Initiative has proved itself to be a great survivor. Back in March, a combination of government accounting changes, the near-collapse of the banking sector and a general increase in mistrust and fear among financiers placed £13bn worth of projects in doubt and generated media speculation about the PFI’s demise. Yet, just a few months on, the outlook for this 17-year-old policy is bright.
As it turns out, the government’s move to International Financial Reporting Standards will have little impact on the PFI since, while assets will show up on departmental balance sheets, most of the related borrowing will remain invisible in measurements of capital spending.
Many accountants had expected that the switch to IFRS would remove the anomaly whereby direct public borrowing counts against measurements of expenditure and debt, but borrowing through
the private sector under PFI contracts does not.
Even the financial consultancies that make millions from the PFI programme had anticipated the change – and PricewaterhouseCoopers, the largest of them, said the move would ‘come as a relief’ since projects had often been ‘distorted’ to get them off the books.
But the Treasury’s Consolidated budgeting guidance, issued in June, makes clear that capital budgeting measurements will be determined by the European System of Accounts, which has specific rules dealing with the PFI and operates according to a very different framework to IFRS. The ESA system is based on an assessment of which party holds the majority of ‘risks and rewards’ associated with the ownership of the assets that underpin the transaction. This is quite different to that used under IFRS, which is based on the principle of ‘control’.
The effect of this is that, while almost all PFI projects will now be recorded in the public sector for accounting purposes, almost all the related investment will remain invisible to capital expenditure measurements – as has been the case since the PFI’s introduction in 1992. While 40% of the £65bn of PFI capital invested so far is on-balance sheet for the purposes of the national budgets, much of this relates to capital investment under the £17bn London Underground public-private partnership. For ‘mainstream’ PFIs, there is only £7.24bn on the books.
The Treasury’s move could result in the unusual situation whereby departments are forced to draw up two sets of accounts – one on the basis of the IFRS framework and one for national accounting, drawn up according to the ESA framework. While strange, the ‘fiscal advantage’ this brings the Treasury in shaving a few billion pounds a year off the public sector net debt figures is evidently one that ministers are keen to preserve. Chancellor Alistair Darling confirmed his ‘strong continued commitment’ to the PFI in his Budget.
The Treasury has established a new body, the Treasury Infrastructure Finance Unit, to lend to PFI projects directly, thereby allowing the signing of billions of pounds of contracts that had stalled due to the financial crisis, often at a very advanced stage of negotiations. But, so far, only the £640m Greater Manchester Waste Disposal Authority has taken up the Treasury’s offer, and even here the Tifu loan makes up less than 20% of the total capital raised. Other projects that were regarded as in need of government cash – such as the £1.4bn project to widen the M25 – have ended being funded entirely by commercial banks.
It would appear that the potential to charge high prices on PFI projects is now simply too large for many bank credit committees to resist. Credit margins – the premiums that banks charge over their own costs of raising capital – have been increasing sharply on PFI loans since September 2008. According to the commercial database ThomsonOneBanker, average margins are about three times greater than they were last summer (see graph on page 22). This increase has been greater still on accommodation schemes, such as schools and hospitals – illustrated by a comparison of funding terms on the last two hospital PFI projects to have signed in Scotland.
A few days before the Scottish National Party took power in Holyrood in May 2007, the Forth Valley NHS board hurriedly signed contracts on its £293m Larbert hospital PFI scheme. The credit margin on that scheme is less than 60 basis points (0.6%). In April this year, and despite the presence of a devolved SNP administration that is supposedly full square against what First Minister Alex Salmond calls the ‘folly of private finance’, NHS Fife signed contracts on a £189m PFI scheme for Kirkaldy Hospital. Here, the initial credit margin set by the banks was 300 basis points (or 3%) – more than five times greater than its predecessor – and the highest recorded for a social infrastructure PFI scheme in the UK.
Banks have characterised this increase in their profit margins as a welcome ‘correction’ in the project finance market, which they insist had become too aggressive in the midst of the pre-credit crunch boom. But the absence of competition in the debt markets suggests there is an element of monopoly pricing here. At the height of the market in 2006/07 there were more than 50 banks actively pursuing PFI/PPP deals in the UK and Europe. In the current market, which includes 116 schemes in negotiation with an estimated combined capital cost of some £12.4bn, there are probably fewer than 15 banks fully involved.
The basis on which these banks lend to PFI projects has completely changed over the last 12 months. There is a trend away from the traditional ‘lead arranger’ model, whereby one bank manages a transaction, underwrites the whole debt and syndicates part of the debt to other banks to reduce their exposure to project risk.
Many banks are now refusing to accept syndicated debt from other banks because, frankly, they don’t trust one another. Instead, lending is coming from banking ‘clubs’, which spread the debt among participants in packages of £25m to £50m each. On the Kirkaldy project, for example, a club of four was established – Helaba, National Australia Bank, the Sumitomo Mitsui Banking Corporation and the part-public Lloyds – in which each bank contributed £42m.
The larger number of institutions involved in projects has, of course, increased transaction costs, all of which are ultimately borne by the public sector. In addition, a review of post-September 2008 transactions, recorded in the database of the specialist journal Project Finance International, shows a significant hardening of the conditions on which most banks are lending to PFI projects.
First, most banks now require an increase in the amount of cash that is available per year from the project to meet debt interest and principal repayments.
Second, they are asking for a longer ‘tail period’ – a phase at the end of a contract during which no debt payments are scheduled to be made, such that all cash flow in the project is available for its sponsors. The purpose of both these requirements is to increase the amount of cash flow to the project, and therefore de-risk the investment the banks are making. But the effect is to increase the flow of money to the private equity investors – and thereby reduce value for money for the public authority.
Third, a majority of UK bank credit committees are no longer willing to sanction long-term lending, such as the 27-year loans that were the norm before the financial crisis. This has resulted in forms of financial innovation that are undesirable for the public sector.
Often, loans are being provided on a ‘soft mini-perm’ basis, in which a long-term loan tenor is retained but there is an increase in the credit margin after a certain date, providing a higher overall interest rate after that date. On the Greater Manchester waste scheme, for example, the initial credit margin is 325 basis points (3.25%) during construction (the highest margin ever on a waste PFI scheme), but this rises successively in the operational period, becoming 450 basis points (4.5%) after 16 years. It is this higher margin that is used to set the fee that the public sector must pay.
In theory, the long-term impact of this structure will be reduced when private equity investors refinance their debt. Since they must share any ‘windfall’ gains they make on a 70% – 30% basis in favour of the public sector, this will in effect lower the fee paid by the public authority. However, the risk that a refinancing cannot take place (perhaps due to continued difficulties in the financial markets) is now fully on the public sector. In that eventuality, the public authority will continue to pay what is, in effect, a penalty rate.
In this context, the Treasury’s intervention in the financing market provides it with an opportunity to reduce the long-term cost of schemes. But the Treasury has said it won’t do this. Officials confirmed in an e-mail that ‘Treasury loans will rank pari-passu to commercial lenders. Tifu’s all-in margin in lending to PFI deals will reflect that of the other commercial lenders in the banking group’. What this means is that, where the Treasury lends to PFI schemes along with other banks, it will set its prices and conditions according to theirs.
This reflects the fact that the Treasury hopes that its intervention in the project finance market will be short term, and that Tifu will be able to sell its PFI assets when conditions return to normal and project sponsors are able to refinance their loans. By charging such a high cost of debt, the Treasury maximises its chances of getting out of deals as quickly as possible, and this will likely yield a sizeable return for it when it does so – in addition to making any fiscal impact of this lending strictly short term.
But it will also leave public authorities with a long-term cost of capital that is determined by liquidity constraints to which Tifu is not subject. This is a fact that is likely to be a source of considerable friction between some public authorities and Whitehall. Public sector net debt is due to reach 76.2% of gross domestic product in 2013/14, and capital funding is set to halve in cash terms from £43.8bn in 2009/10 to £22bn in 2013/14. In this context, it is no surprise that the government remains committed to the PFI.
With most private finance remaining invisible in the public debt figure, substituting private for public capital investment is very attractive politically, since it allows for a higher level of spending than would be possible using public funds and borrowing alone. The PFI is already a significant call on resources – with the future bill for existing schemes reaching £217bn in April. But the public sector is facing a tight expenditure squeeze from 2011 and matters will not be improved by the need to pay the inflated ongoing costs of new PFI schemes.
Mark Hellowell is a research fellow at Edinburgh University
06 August 2009
The Private Finance Initiative was thought to be in trouble earlier on in the recession. But it has proved resilient to new accounting standards, and the banks’ credit margins on projects have soared
If nothing else, the Private Finance Initiative has proved itself to be a great survivor. Back in March, a combination of government accounting changes, the near-collapse of the banking sector and a general increase in mistrust and fear among financiers placed £13bn worth of projects in doubt and generated media speculation about the PFI’s demise. Yet, just a few months on, the outlook for this 17-year-old policy is bright.
As it turns out, the government’s move to International Financial Reporting Standards will have little impact on the PFI since, while assets will show up on departmental balance sheets, most of the related borrowing will remain invisible in measurements of capital spending.
Many accountants had expected that the switch to IFRS would remove the anomaly whereby direct public borrowing counts against measurements of expenditure and debt, but borrowing through
the private sector under PFI contracts does not.
Even the financial consultancies that make millions from the PFI programme had anticipated the change – and PricewaterhouseCoopers, the largest of them, said the move would ‘come as a relief’ since projects had often been ‘distorted’ to get them off the books.
But the Treasury’s Consolidated budgeting guidance, issued in June, makes clear that capital budgeting measurements will be determined by the European System of Accounts, which has specific rules dealing with the PFI and operates according to a very different framework to IFRS. The ESA system is based on an assessment of which party holds the majority of ‘risks and rewards’ associated with the ownership of the assets that underpin the transaction. This is quite different to that used under IFRS, which is based on the principle of ‘control’.
The effect of this is that, while almost all PFI projects will now be recorded in the public sector for accounting purposes, almost all the related investment will remain invisible to capital expenditure measurements – as has been the case since the PFI’s introduction in 1992. While 40% of the £65bn of PFI capital invested so far is on-balance sheet for the purposes of the national budgets, much of this relates to capital investment under the £17bn London Underground public-private partnership. For ‘mainstream’ PFIs, there is only £7.24bn on the books.
The Treasury’s move could result in the unusual situation whereby departments are forced to draw up two sets of accounts – one on the basis of the IFRS framework and one for national accounting, drawn up according to the ESA framework. While strange, the ‘fiscal advantage’ this brings the Treasury in shaving a few billion pounds a year off the public sector net debt figures is evidently one that ministers are keen to preserve. Chancellor Alistair Darling confirmed his ‘strong continued commitment’ to the PFI in his Budget.
The Treasury has established a new body, the Treasury Infrastructure Finance Unit, to lend to PFI projects directly, thereby allowing the signing of billions of pounds of contracts that had stalled due to the financial crisis, often at a very advanced stage of negotiations. But, so far, only the £640m Greater Manchester Waste Disposal Authority has taken up the Treasury’s offer, and even here the Tifu loan makes up less than 20% of the total capital raised. Other projects that were regarded as in need of government cash – such as the £1.4bn project to widen the M25 – have ended being funded entirely by commercial banks.
It would appear that the potential to charge high prices on PFI projects is now simply too large for many bank credit committees to resist. Credit margins – the premiums that banks charge over their own costs of raising capital – have been increasing sharply on PFI loans since September 2008. According to the commercial database ThomsonOneBanker, average margins are about three times greater than they were last summer (see graph on page 22). This increase has been greater still on accommodation schemes, such as schools and hospitals – illustrated by a comparison of funding terms on the last two hospital PFI projects to have signed in Scotland.
A few days before the Scottish National Party took power in Holyrood in May 2007, the Forth Valley NHS board hurriedly signed contracts on its £293m Larbert hospital PFI scheme. The credit margin on that scheme is less than 60 basis points (0.6%). In April this year, and despite the presence of a devolved SNP administration that is supposedly full square against what First Minister Alex Salmond calls the ‘folly of private finance’, NHS Fife signed contracts on a £189m PFI scheme for Kirkaldy Hospital. Here, the initial credit margin set by the banks was 300 basis points (or 3%) – more than five times greater than its predecessor – and the highest recorded for a social infrastructure PFI scheme in the UK.
Banks have characterised this increase in their profit margins as a welcome ‘correction’ in the project finance market, which they insist had become too aggressive in the midst of the pre-credit crunch boom. But the absence of competition in the debt markets suggests there is an element of monopoly pricing here. At the height of the market in 2006/07 there were more than 50 banks actively pursuing PFI/PPP deals in the UK and Europe. In the current market, which includes 116 schemes in negotiation with an estimated combined capital cost of some £12.4bn, there are probably fewer than 15 banks fully involved.
The basis on which these banks lend to PFI projects has completely changed over the last 12 months. There is a trend away from the traditional ‘lead arranger’ model, whereby one bank manages a transaction, underwrites the whole debt and syndicates part of the debt to other banks to reduce their exposure to project risk.
Many banks are now refusing to accept syndicated debt from other banks because, frankly, they don’t trust one another. Instead, lending is coming from banking ‘clubs’, which spread the debt among participants in packages of £25m to £50m each. On the Kirkaldy project, for example, a club of four was established – Helaba, National Australia Bank, the Sumitomo Mitsui Banking Corporation and the part-public Lloyds – in which each bank contributed £42m.
The larger number of institutions involved in projects has, of course, increased transaction costs, all of which are ultimately borne by the public sector. In addition, a review of post-September 2008 transactions, recorded in the database of the specialist journal Project Finance International, shows a significant hardening of the conditions on which most banks are lending to PFI projects.
First, most banks now require an increase in the amount of cash that is available per year from the project to meet debt interest and principal repayments.
Second, they are asking for a longer ‘tail period’ – a phase at the end of a contract during which no debt payments are scheduled to be made, such that all cash flow in the project is available for its sponsors. The purpose of both these requirements is to increase the amount of cash flow to the project, and therefore de-risk the investment the banks are making. But the effect is to increase the flow of money to the private equity investors – and thereby reduce value for money for the public authority.
Third, a majority of UK bank credit committees are no longer willing to sanction long-term lending, such as the 27-year loans that were the norm before the financial crisis. This has resulted in forms of financial innovation that are undesirable for the public sector.
Often, loans are being provided on a ‘soft mini-perm’ basis, in which a long-term loan tenor is retained but there is an increase in the credit margin after a certain date, providing a higher overall interest rate after that date. On the Greater Manchester waste scheme, for example, the initial credit margin is 325 basis points (3.25%) during construction (the highest margin ever on a waste PFI scheme), but this rises successively in the operational period, becoming 450 basis points (4.5%) after 16 years. It is this higher margin that is used to set the fee that the public sector must pay.
In theory, the long-term impact of this structure will be reduced when private equity investors refinance their debt. Since they must share any ‘windfall’ gains they make on a 70% – 30% basis in favour of the public sector, this will in effect lower the fee paid by the public authority. However, the risk that a refinancing cannot take place (perhaps due to continued difficulties in the financial markets) is now fully on the public sector. In that eventuality, the public authority will continue to pay what is, in effect, a penalty rate.
In this context, the Treasury’s intervention in the financing market provides it with an opportunity to reduce the long-term cost of schemes. But the Treasury has said it won’t do this. Officials confirmed in an e-mail that ‘Treasury loans will rank pari-passu to commercial lenders. Tifu’s all-in margin in lending to PFI deals will reflect that of the other commercial lenders in the banking group’. What this means is that, where the Treasury lends to PFI schemes along with other banks, it will set its prices and conditions according to theirs.
This reflects the fact that the Treasury hopes that its intervention in the project finance market will be short term, and that Tifu will be able to sell its PFI assets when conditions return to normal and project sponsors are able to refinance their loans. By charging such a high cost of debt, the Treasury maximises its chances of getting out of deals as quickly as possible, and this will likely yield a sizeable return for it when it does so – in addition to making any fiscal impact of this lending strictly short term.
But it will also leave public authorities with a long-term cost of capital that is determined by liquidity constraints to which Tifu is not subject. This is a fact that is likely to be a source of considerable friction between some public authorities and Whitehall. Public sector net debt is due to reach 76.2% of gross domestic product in 2013/14, and capital funding is set to halve in cash terms from £43.8bn in 2009/10 to £22bn in 2013/14. In this context, it is no surprise that the government remains committed to the PFI.
With most private finance remaining invisible in the public debt figure, substituting private for public capital investment is very attractive politically, since it allows for a higher level of spending than would be possible using public funds and borrowing alone. The PFI is already a significant call on resources – with the future bill for existing schemes reaching £217bn in April. But the public sector is facing a tight expenditure squeeze from 2011 and matters will not be improved by the need to pay the inflated ongoing costs of new PFI schemes.
Mark Hellowell is a research fellow at Edinburgh University
