The banks have been pulling out of the Private Finance Initiative and the contractors are struggling. As a scheme designed to transfer public sector risk becomes a growing liability, frantic efforts are being made to find new methods of funding
It is not just banks that will need to be bailed out to ensure that the economy stays on the road. With stinging irony, if the government’s plans to rebuild public infrastructure are to be sustained, the public finances will have to rescue the Private Finance Initiative. According to industry body the PPP Forum, an extra £4bn will be needed from government in the next 18 months to keep the PFI on track.
Far from transferring risk and responsibility to the private sector, the PFI increasingly looks to be a millstone round the neck of the public sector. Billions of pounds of investment in schools, hospitals, roads, armaments and waste management are dependent on the PFI – yet can be maintained only if public bodies put more capital up front, pay more in interest and bank charges and agree new methods of structuring the projects. The Treasury might be forced to announce a bail-out package soon.
Financing difficulties are jeopardising all the major PFI schemes moving to completion – the M25 widening scheme, a £3bn Greater Manchester waste disposal scheme and a £12bn Ministry of Defence training project. In each case, the solution is likely to involve a large capital injection from government. Other schemes – Scotland’s M80 upgrade, the Enniskillen hospital in Northern Ireland and the Building Schools for the Future programme – are being rescued by the European Union-backed European Investment Bank.
The crisis in funding has become so severe that a leaked NHS memo warned that the PFI flow was drying up and that there was no ‘Plan B’ for building new hospitals and Lord Darzi’s much-heralded polyclinics. There is also the rather important matter of the viability of PFI contractors. For example, Mapeley – Revenue & Customs’ landlords under a PFI contract – is in serious difficulty and trying to refinance debt.
Other contractors are likely to be in similar bother – the corporate bond market is pricing in a possible 40% default rate this year, suggesting many large companies will collapse. At the very least, companies will adopt a more cautious approach to tendering – so we can expect fewer bidders, less competition and higher prices.
But the biggest threat to the PFI is doubt over the solvency, liquidity and capitalisation of many of the world’s largest banks. Two of the biggest funders of infrastructure investments – Royal Bank of Scotland and Dexia – were rescued by their national governments and will not fund new PFI schemes. Another, HSBC, is restricting its funding to known and trusted clients, reducing its level of commitment to the sector and moving towards shorter-term funding.
Halifax Bank of Scotland has been another of the leading players in the PFI market, but its takeover by Lloyds TSB has further reduced capacity. ‘Bank of Scotland has a PFI team that will become part of the [Lloyds Group] wholesale team,’ says spokesman Ross Keany. ‘How these businesses will be brought together has not yet been decided. It is still very early days.’
Other banks will still lend to PFI projects, but at lower levels, for shorter periods and only if they can join ‘syndicates’ of lenders. The total capacity for PFI lending has been substantially reduced. Despite the positive noises from within government and from advisors, the question about whether PFI can survive is a legitimate one.
‘A lot of banks are saying they need to get back to their core business,’ says Nick Prior, a partner in Deloitte’s public sector practice. ‘For many, project finance is a pinprick on the arse of the elephant, and while it may be quite lucrative it is not what they consider core business.’ Prior adds that while banks remain unsure of the full extent of their losses from financial instruments and bad debts, this will only decrease their appetite to commit their balance sheet to non-core business.
‘The M25 and Greater Manchester Waste Project have both struggled to raise finance, because of the lack of senior debt liquidity out there,’ says Prior. He believes that increasingly the big PFI schemes will need the support of central government and the European Investment Bank to top up the funds available from the main banks and debt markets.
Prior also suggests that smaller PFI schemes are now encountering significant problems with the cost of financing. Until last year, higher margins and the higher cost of covenants imposed by banks on their lending had not increased the overall cost of borrowing because it was offset by the effect of lower inter-bank lending rates. Those rates have since risen sharply as the economic crisis intensified, making the actual cost of borrowing significantly higher, damaging both the affordability of schemes and their value for money. ‘So small schemes are also feeling the impact,’ says Prior.
Barry Sheerman, chair of the Commons children, schools and families select committee, has raised his concerns about the financing of the Building Schools for the Future programme with the prime minister. ‘He tried to put my mind at rest,’ Sheerman says. ‘But I hear serious problems about the PFI from councils across the country. If we don’t have a lifeline on the finance – and a lot of that has been and still is coming from overseas – will the government step in with the money that we need to invest? It’s a lot of money. It’s not just BSF, it’s also the further education colleges programme, which is now on hold, and some big projects for new energy from waste that are not being funded. It is difficult to get money for more than seven to ten years. So there are big problems.’
But despite all these pressures on finance, the government insists that the PFI remains viable and will still be used. A spokesman for the Department of Health says: ‘In the November Pre-Budget Report, the Treasury made it clear that government policy continues to be that the PFI and other public-private partnerships should be used to deliver public services when this offers value for money, and that this is assessed on a case-by-case basis.’
Similarly, Partnerships for Schools, the body responsible for Building Schools for the Future, is determined to press ahead with the PFI. A spokeswoman says: ‘We are also exploring options for accessing shorter-term debt – seven or ten years – to fund schemes with a PFI component.’ She adds that innovative approaches to adapting the PFI to new economic realities ‘are helping ensure that deals continue to close’.
Nor are banks completely walking away from the PFI, says Mike Harlow, a partner in KPMG’s corporate finance practice. KPMG has just surveyed banks that have invested in PFI and found eight that still want to be involved. Harlow warns, though, that banks will typically lend only up to £30m per deal, creating serious challenges for large PFI schemes and a reliance on syndication for lending.
However, Harlow is confident that the PFI will continue, despite its problems. ‘We are seeing no fall in PFI projects being completed,’ he says. ‘We closed four deals in January.’ Quite simply, he points out, the demand remains for projects, especially for BSF, waste and social housing schemes. But he believes a new structure is needed to provide financing for PFI schemes, one that takes into account lenders’ reluctance to provide long-term financing. Consequently, KPMG is promoting the ‘mini-perm’ approach, converting long-term debts into short-term funding (see box).
Mark Burke, a partner in Grant Thornton’s government and infrastructure advisory practice, is another who expects the PFI to stay on the road. In particular, local authorities remain committed to it to enable them to meet EU-set waste management obligations, while NHS primary care Lift (Local Improvement Finance Trust) schemes are ‘still progressing’, he says.
In other areas, he concedes, there are hold-ups. ‘In the health sector, acute trusts have been quiet for a while.’ Progress is restricted because the Department of Health wants to be sure there is flexibility to move patients out of the acute sector as different approaches to treatment emerge, he says. ‘The PFI doesn’t seem to offer them this flexibility. This is not about financing. But, having said that, financing is going to be difficult.’
In local government, a mutual savings fund is being planned partly to address the issue of financing PFI schemes. The New Local Government Network, the Local Government Association and Kent County Council are behind the plan. They believe that if they could persuade councils to place 25% of their £15bn–£20bn of reserves in a common fund, some of this could be used to substantially increase the flow of funding to PFI schemes.
NLGN director Chris Leslie says that while potential investment losses drove much of local authorities’ interest in a common fund, the drying-up of infrastructure funding was also a factor. ‘This is what prompted a lot of the discussions – as much as the Iceland issue,’ says Leslie. ‘Two problems were cropping up and one solution might ameliorate both.’ The mutual fund could, he suggests, split its money between holding cash, government bonds and investing in public infrastructure. This could potentially both reduce councils’ exposure to risk and improve their returns.
He says a new and systematic method of putting public funds into infrastructure projects is needed for the fund to be able to invest in the PFI. He believes that the government shares his view – and as a former minister, he understands the politics. ‘I think both the prime minister and chancellor are going to have to look at infrastructure planning in the Budget,’ he says.
Councils have an added incentive, Leslie adds. They fear that when the current crisis is over, restrictions could be imposed on their borrowing powers. The mutual fund could be one of the few routes available for them to invest in local infrastructure.
But for the mutual fund to work, there needs to be a more effective way to spread PFI risk and dilute exposure to individual schemes. This is also true if the public and private sector pension funds are to increase their holdings in the PFI. Some large insurance companies – particularly Norwich Union/Aviva – are discussing significant investments, effectively replacing the role of banks. Local government pension funds are also keen to increase their involvement in the PFI, which at present is below that of the average for private sector pension funds.
To enable small and medium-sized funds to invest in the PFI, it will be necessary to ‘unitise’ PFI holdings. ‘Unitisation’ involves the ‘securitisation’ of PFI investments – essentially this means grouping a large number of PFI bonds together into a fund and selling stakes in this fund as ‘units’. In theory, this should provide more effective risk-sharing, enable smaller investments than is currently the case and create a more liquid market for disposing of PFI investments. The downside is that this is uncomfortably similar to the type of investment securitisation that brought the financial system crumbling to a halt.
Richard Abadie, head of infrastructure finance at PricewaterhouseCoopers, agrees that unitisation is important in creating a new flow of funding for PFI. ‘Institutions now want to find ways of putting money into PFI schemes,’ he says. ‘They are trying to find securitisation solutions.’
Abadie explains that this will involve issuing corporate bonds by PFI investment vehicles. But it will need to be backed by a new form of bond insurance. As Public Finance explained last year (‘Don’t bank on it’, February 22, 2008), the collapse of specialist bond insurers had a damaging effect on the financing of PFI schemes. PFI bonds had been backed by ‘monoline’ insurers – such as Ambac and MBIA – which provided guarantees that raised bonds’ investment grade from triple B to A grade or higher. But the monolines almost collapsed because of their guarantees on sub-prime mortgages. Without the monolines, PFI projects increasingly relied on bank loans instead of bonds.
The question is who can take over the role of bond guarantor – and the answer, says Abadie, is most likely to be the government, either directly or through a government-owned bank.
It looks as though any solution to the PFI funding crisis will have to involve the government taking a more hands-on – and money-down – role. Any idea that the PFI removes risk and finance-raising responsibility from the public sector has disappeared just as surely as bankers’ reputations.
Getting the public sector’s house in order
Funding is not the only problem with the Private Finance Initiative. The public sector remains a poor client. A recent National Audit Office report found that waste management PFI projects needed to be speeded up to avoid councils being fined hundreds of millions of pounds for breaching European Union rules on landfill waste disposal. Projects were held up by the Department for Environment, Food and Rural Affairs’ slowness in initiating the programme and in issuing PFI credits to councils. There were also delays in obtaining planning permission for local schemes.
The NAO found similar problems in the Building Schools for the Future programme, where the Department for Children, Schools and Families underestimated the time it would take to get it off the ground. A report last month from the Northern Ireland Assembly’s Public Accounts Committee complained that the Department of Finance and Personnel had mishandled its now-suspended Workplace 2010 PFI programme, delaying it and requiring compensation to be paid to a failed bidder.
Late last year, the NAO criticised the Ministry of Defence for taking 37 months on average to close PFI deals — and 45 months for large contracts.
The new PFI funding options
Securitising and unitising PFI investments into bonds, which can be issued to life insurers, pension funds and other institutional funds.
Contractors accepting debt on their own balance sheets – but only practical where contractors have access to large pools of capital and probably in a limited number of cases for smaller PFI schemes.
The ‘mini-perm’. This is akin to buying a home on a 25 year mortgage, but with a short-term fixed interest deal. The client would commit to refinancing after 7 years or so. Failure to refinance would trigger financial penalties. Banks could be attracted back into the market because they have a guarantee of either having the money back after 7 years, or else earning much higher returns.