Finance, Ferraris and following the money

13 Mar 13

The cost of funding public sector construction projects can be high, but don’t forget to refinance when the risk profile changes. It’s like leasing a Ferrari to attract girlfriends then ditching it for a Mondeo when the dog and kids turn up

One of my close friends has unfortunately divorced his wife and started dating much younger women. And by much younger, I mean people born in the 1980s. I am sure this seemed like a spiffing idea at the time but the reality of hanging around with the twenty-something generation has not proved all it’s cracked up to be.

The cultural chasm is wider than he anticipated and, given that my favourite second bottle of wine conversation is reminiscing about 1970s confectionery, it was hard to bridge the gap when they came over for dinner. I have come to realise that there is a synchronicity to life. Your choices in cars, relationships, clothes and recreational stimulants must evolve as you mature or your life feels weirdly out of kilter. My friend has painfully learnt this lesson so we don’t have to.

Now the inevitable segue into the more prosaic world of public finance is that there is a similar synchronism between the cost of money and the maturity of your project. We have been over this much ploughed ground many times but once more, for the benefit of the tape, the price of money is a function of the risk associated with the borrower. Payday loans are more expensive than mortgages because the people who need to borrow £200 in a pressing hurry are unlikely to be a good credit risk. Markets are very good arbitrators of this sort of stuff so, in the long run, the cost of your capital is a good barometer of how likely you are to repay it.

This is relevant for the public sector in a number of ways. Firstly the ongoing debate about the best way to fund infrastructure keeps getting stuck on the scratch in the vinyl that says ‘the public sector can borrow more cheaply’. Yes, of course you can, but only because the banks are looking straight through you to the wallets of your captive tax base safe in the knowledge that whatever happens they will be backstopping their loan. Get real here, it’s not because they like you. Try telling the banks that you want the money on a non-recourse basis and watch that interest rate soar by 2% to 3% at least.

This is because construction projects are very risky propositions and the history of infrastructure development in the UK in the last 20 years is peppered with horror stories of projects that have gone spectacularly wrong. The Scottish Parliament, the Millennium Dome, the Edinburgh Tram and Wembley Stadium are all examples of big gleaming projects that have come in millions of pounds over budget and sometimes years late.

Quite a few of these have been propped up by the unsuspecting largesse of Mr and Mrs Taxpayer, but I suspect their appetite to keep doing this is waning so you may need to bite the bullet of project-specific funding. Debt is going for about 7% to 8%, and if you want to borrow 100% of the cost you are looking at a blend of mezzanine and debt that will cost you a blended rate of something in the very early teens.

Construction should only last for a couple of years at best, however, so the key is to grit your teeth, borrow expensive money for a short period then refinance it once the risk profile has changed. Lending against operational assets that make money is always cheaper then lending against architectural drawings. This sounds blindingly obvious but you would be amazed at how many projects in both the public and private sector waste years trying to get cheap money too early in the arc of the project lifespan. We know at least two projects that have withered and died on the drawing board because the developers would only ever contemplate cheap debt funding for unproven technology. Repeat after me: the most expensive money you will ever borrow is the cheap money you never get.

The converse of this is to make sure you can refinance out the expensive money once you have got to the point of no longer needing it. This is like leasing a Ferrari to attract potential girlfriends, then chopping it in for a Mondeo once the dog and kids turn up. A word of caution here. Buying a tatty ten-year old Ferrari to impress somebody in the office whom you have romantic feelings for is a very bad idea. Over a six-month period, it would have been cheaper for my friend to have spent precisely £739.65 per week buying flowers and chocolates, with the added bonus of not spending hours in the rain waiting for the man from the AA to once again rescue him from the side of the M25.

Again this all sounds pretty obvious but I know a couple of people who are locked into pretty punitive interest rates for projects that are well past the construction stage. The thing is to look carefully at the small print for phrases like ‘early redemption penalty’ or ‘pre-payment clauses’ or some other fancy working that says ‘we don’t want our money back so if you send us a cheque it will be a lot bigger than you thought it would be’.

Finally, you should make sure that you fit the nuts and bolts of your project together in a way that enables you to finally sell it on to a pension fund after two to three years of operation. Pension funds offer the cheapest money but are predictably the most risk averse. They want long-term cash generative assets ideally backed by a public sector covenant. They don’t want risky or lumpy stuff, but get it right and there is a huge upside to be had from the difference between the cash flows you needed to pay for the expensive finance at the start and the cash flows you now need to satisfy the pension fund.

This arbitrage is a big source of untapped opportunity for the public sector as they are the owners of exactly the sort of long-term low-risk cash generative projects that the pension funds want to buy. The secondary market in PFI assets has had lots of MPs snorting at the profits being made by the private sector in this way but there is a more imaginative response that says ‘hang on, what other assets has the public sector got that it could sell to a pension fund?’ Car parks, toll roads and landfill sites all fit the bill perfectly so why the public sector are hanging on to them whilst laying off front-line staff is a mystery to the rest of us.

So, in conclusion, all infrastructure projects follow a predictable arc of risk and the key is to match this with the cost of your capital. Build things with expensive money then refinance them with debt and finally sell them to a pension fund. Don’t go for the cheap money too early and, in the same vein, don’t stick with the expensive funder longer than you have to.

Oh and two other things; try to make sure that your partner is at least born in the same decade as you because otherwise you won’t have anything to talk about and stay away from secondhand ‘cheap’ Ferraris because they are unforgiving bottomless money pits.

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