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A potential conflict of interest

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The proposals put forward by the Local Government Association are certainly radical, but the problems they are designed to tackle are correspondingly serious.

Since the collapse of Lehman Brothers a year ago, the cost of capital for private finance initiative firms has increased, and this has driven up the rates of return required by project sponsors.

Meanwhile, the interest rates on senior debt have soared, as competition in the PFI market dried up, and the banks that remain in the market hiked their margins.

Perhaps the most obvious solution to the problem would be to substitute traditional public borrowing for PFI borrowing – at least until prices return to something like normal.

But Alistair Darling effectively closed down that option in April when he outlined his “strong continued commitment” to the PFI, and a halving of projected capital budgets by 2013-14.

The LGA’s response is to explore two separate, but not mutually exclusive, options: to consider the use of their collective pension funds for investment in PFI equity and/or for debt.

For equity, this would have the advantage of providing useful competition in a financing market that is heavily concentrated – one that has an average excess rate of return of 6-8%.

In terms of debt, this is a market that badly needs new liquidity and new market entrants.

While underlying fixed interest rates have been edging up this year, the ‘spread’ banks are charging on top of this for PFIs has increased by a factor of about three in the last year. Anything local authorities can do to cut some of the fat from the cost of finance is therefore attractive. But there are complexities.

The first is the potential for conflicting interests.

To put the matter crudely, as purchasers, local authorities want to keep rates of return as low as possible, but as investors they must, of course, seek to maximise their return.

Second, there is the issue of risk. Experience shows that, on the debt side, the level of credit default risk (the chance of at least one missed re-payment of capital) is extremely low.

But equity providers do bear a level of risk, mostly related to the long-term maintenance of facilities.

These risks are potentially magnified for so-called ‘secondary market investors’ – those who buy into projects after construction. And on current plans the funds would act in that role.

Mark Hellowell, research fellow, University of Edinburgh

 

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