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End of the line for PFI?

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Could the credit crunch bring the controversial private finance initiative to a standstill?

Left-wing ideologues and critics of privatisation are poised to find joy in the credit crunch beyond the sackings of a few thousand bankers: the hated private finance initiative might finally be dying a slow death.

Some say it is ‘privatisation by stealth’, but the PFI has been a key plank of the government’s public sector reform programme.

Explained: How PFI works

More than 600 projects with a capital value of nearly£60bn have been signed, meaning the PFI has accounted for 10%-14% of annual public sector investment since 1997.

The PFI has been particularly important for local government. About half the£5.2bn-a-year secondary schools rebuilding programme and£1.8bn of planned house building and refurbishment will use PFI.

The credit crunch has started to undermine these plans. The£4.4bn recycling plant planned by the Greater Manchester Waste Disposal Authority PFI should have been signed in June; 13 of the 17 projects in the first phase of the school rebuilding progamme are delayed; and the value-for-money argument championed by PFI supporters is under close scrutiny.

Kevin Lavery, Cornwall CC’s new chief executive, previously held the same position at Serco Solutions . The company worked on partnership-type IT contracts - similar to PFI - with local government, such as a£26m deal to provide modernised servers and software applications at Southwark LBC.

As a result, he understands the PFI better than many. He believes that the procurement method could be destroyed by the economic crisis: “The cost of money could go up and competition could go down.”

Mr Lavery says banks are becoming “more risk-averse”, meaning they are unwilling to lend at reasonable rates as the economy falls. This increases the cost of borrowing.

“Banking institutions will look at PFI deals in light of the credit crunch, even though local authorities are very good [secure] payers that will be around [for the entire repayment period],” says Mr Lavery, who also suggests that construction companies, vital in the PFI, are likely to go bust - resulting in less competition in the bidding process.

Bob Griggs, head of social infrastructure at KPMG , says there is firm evidence that Mr Lavery’s fears are becoming reality. He says banks are quoting about 1.5% interest on PFI loans, up from around 60 or 70 basis points a year ago. This means repayments on a£100m PFI would go up by£800,000-a-year to£1.5m. That cost is passed on from the private to public sectors.

“That puts pressure on affordability - the project costs more per annum - and on the public sector comparator, which shows whether or not PFI is better value for money than another form of procurement,” explains Mr Griggs.

He argues that the second problem is not as great as the first: “There’s normally enough headroom to show that PFI is better value for money.”

A way of getting around the affordability issue is for councils to claw back greater so-called ‘refinancing gains’ in the later years of the contract. When the cost of a PFI loan is first calculated, it includes the risk in constructing the house or school. Actually building an asset is risky as variables such as highly polluted land can unexpectedly crop up, suddenly making the project more expensive.

However, once the asset is built, that school or house is essentially secure - there are fewer problems likely to emerge. At this point the private sector consortium refinances its loan, potentially making millions from the cheaper debt. This is shared with central or local government 50:50.

However, the£600m Kent CC schools contract, won by a team led by outsourcing specialist Land Securities Trillium last month, has structured this future refinancing differently. When a cheaper loan is secured, Kent will take 100% of the profit until it has recovered the amount it lost through paying expensive initial debt in the time of a credit crunch.

Mr Griggs, who advised the council on the deal’s structure, smiles as he says this means Kent is “first in line” for any profit.

The deal was signed at a time when central government came up with similar thinking. The Treasury has decided that though the 50:50 split will remain on refinancing gains of up to£1m, between£1m to£3m the taxpayer will get a 60% share. Any more than£3m and the council would get 70%. Local authorities will also have the right to demand a refinancing at the time they see fit, a right only the private sector consortium had previously.

David Metter is chairman at the PPP Forum , which represents 106 PFI companies, and chief executive at Innisfree, the biggest private sector investor in education PFIs. He counters suggestions that the loss of refinancing gains might deter companies from bidding for PFI contracts: “I’m not that concerned about it. The sharing arrangements the Treasury has proposed are fair enough.”

However, he points out that there is no knowing when traditional, cheaper lending rates on long-term finance will return. As a result, the project might be less risky when the asset is built, but there is no guarantee that there will be a major refinancing gain until the country pulls out of recession.

“We’re right in the middle of a difficult market,” he says. He suggests that the government needs to provide repayment guarantees to banks when consortia raise funding if the PFI lending market is to be re-established.

Others are less pessimistic. Phil Harrison is finance director at VT Group , which counts a£210m contract to rebuild and refurbish Lewisham LBC’s 17 secondary and special schools among its PFI wins.

He says: “The cost of funds for PFI and the speed of closure of contracts have certainly been impacted by the credit crisis, but there has been no noticeable reduction in the appetite for this type of contracting.

“PFI remains attractive to the private sector because of the long-term nature of projects and the security offered by central government and local authorities.”

Chris Wilson, executive director at local government project adviser 4ps , is also adamant that PFI will survive. He points out that the government has committed to an£11bn PFI programme in the three years to 2011, and insists that most project delays are only “short term”. Indeed, there is talk that the Manchester waste PFI could be signed by the end of the year.

Mr Wilson adds that banks are simply coming up with less risky ways of loaning cash. Pre-credit crunch, a lead arranging bank would loan out, say,£100m to a PFI consortium and then syndicate that debt to other banks after the deal was signed. The syndication market has since closed as banks grew unwilling to lend to each other.

Now, banks are forming ‘clubs’ upfront, meaning that rather than there being one arranger, maybe four offer£25m each.

Mr Wilson says this does not mean PFI projects risk being canned. Instead, dealing with several banks, rather than one, typically “sees weeks’ delays” in arranging the finance. He believes there is a slight slowing down of PFI, but nothing more fundamental.

Indeed, Mr Wilson is even advising local authorities to insist on introducing ‘funding competitions’. This was an idea floated in the Treasury’s PFI reform paper, Strengthening Long-term Partnerships in 2006 .

These have rarely been run since the document’s publication, but the idea is that a preferred bidder on a PFI holds a competition among banks so there is pressure on them to provide the best loan rates. Currently all bidders usually tender for PFI projects with finance already in place, though some companies are known to run their own funding competitions.

One advocate of PFI is Dr Tim Stone, a partner at KPMG. He admits to “a strangulation of the [PFI] market”, which should sound alarm bells among the optimists.

However, the great question for him is what happens post-PFI?

Many of the procurement models developed in recent years, such as the NHS Lift programme , which builds smaller health projects, are not technically PFIs. They are successors to that market, with differing equity and funding structures. “The PFI was a pilot project for a small subset of public service problems government had to deal with. What happens after the pilot?” Dr Stone asks.

The answer will almost certainly be decided by how much more pressure the credit crunch places on the project finance lending market. Ultimately, that will show whether PFI and post-PFI programmes are really affordable for both local and central government.

See also

How PFI works

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