The announcement last month of a UK Treasury PFI debt fund has given the UK PFI market the prospect of an effective liquidity injection. The Treasury believes it can provide up to £2 billion, across schemes totalling £8 billion, to the end of March 2010 – a combination of drawdown and committed debt.

The fund will be managed by Partnerships UK director Andy Rose and will be set up as a new unit in the Treasury – much like UKFI, which holds the government's stakes in the quasi-nationalised UK banks. The fund will provide fixed interest loans to top up projects that cannot raise full bank debt and will act as a commercial bank – there will be no provision of soft loans or undermining of commercial bank debt pricing. The fund loans will match the terms and provisions of the commercial bank loans on any given deal and be transacted under the same loan agreement.

Many details on the scheme have yet to be finalised and the team of project financiers that will run it, yet to be hired. What has been made clear is that the fund will not be participating in mini-perms – the structure favoured by commercial banks – on the grounds that its existence means mini-perms will no longer be necessary.

The fund is a significant move to freeing up liquidity for PFI, which saw volume drop 30% in 2008 to around £10 billion, and is predicted to fall further in 2009. In part that volume drop is attributable to the fall in deal size, with much of the major infrastructure having been financed in previous years. But with the UK hosting the next Olympics, and deals like the M25 a caveat for winning that bid, there are still some major PFI financings in the pipeline.

With mini-perms a non-starter and the fund only matching commercial terms, it remains to be seen whether long-term liquidity is the only issue holding back PFI schemes or whether higher debt pricing and fees makes some projects economically unviable.

Bankers say that the UK government strategy is to get the high profile M25 and Manchester Waste deals closed as soon as possible, and then get to work on other waste recycling PFIs as well as projects under the Building Schools for the Future (BSF) programme.

They add that the Treasury is cajoling well established PFI lenders to support the PFI pipeline at a critical time for the UK economy, and that banks that now have the government as a major shareholder (RBS and Lloyds Banking Group, which includes PFI lender HBOS) are under pressure to keep up PFI lending – RBS announced its new UK PFI lending unit last month despite having previously announced it was pulling out of long-term project finance.

Bank appetite

In fact many banks do still have an appetite for new deals, but the problem is that this limited appetite is at the shorter end of the yield curve – mini-perms – and many lenders have serious difficulties with the kind of 23-27 year tenors that were typical in the PFI sector.

In addition, though the government is having some success in bringing in high-profile lenders at the arranger and bookrunner level, many foreign banks that used to come in on PFI syndicates have pulled back, and are either not lending at all or are concentrating on PPP deals in their own home markets. During 2009 loan syndicates in the European PPP/PFI sector are likely to have a much more domestic flavour than was the case at the time of great liquidity such as 2006-7.

Bankers point to Manchester Waste, where NIB Capital, Natixis, BayernLB, Unicredit and NAB were all initially expected to be involved as syndicate members but have pulled back. Nonetheless, in addition to Lloyds TSB and Bank or Ireland, SMBC and BBVA are still in on that deal.

"Tenor is a critical issue for us," comments one banker at an institution that has temporarily pulled back from UK PFI lending. "Banks are going into deals knowing that there is no long-term refinancing market at present, so we are staying away from both the M25 and Manchester Waste deals."

He notes that lenders may be doing deals with long term relationships with sponsors and governments in mind, hoping that they will be in a strong position when the inevitable market upturn comes.

Mini-perms

Upcoming deals are likely to see medium term financing in the form of mini-perms, with an assumption that refinancing at year seven will be done in a better environment. Punative interest rate steps ups will play a role, as will cash sweeps and other mechanisms.

"Where the project revenue consists of an availability based unitary charge, the cost of debt service is one of the components which makes up this charge, so the value which is agreed for the unitary charge for the life of the project assumes a certain cost of debt and amortisation profile," comments Robert Franklin, partner in the Project Finance group at Denton Wilde Sapte.

"At the moment, debt may only be available for up to about seven years, or if longer term debt is available it may be prohibitively expensive," he adds. "Therefore there is a potential mismatch between the long term nature of PFI projects on the one hand, and the relatively short term maturity of affordable debt which may be available on the other. This mismatch gives rise to the issue of refinancing risk, because the unitary charge will continue to assume the existence of funding which amortises over 25 years, but the project company sis financed using a partially amortising seven year mini perm facility with a bullet repayment, which it will have to refinance."

"If the cost of debt in the market is higher in year seven, the sponsors projected equity returns will be eroded or potentially eliminated," Franklin explains. "Soft mini-perms are one possible solution where the debt retains a long maturity, but the margin ratchets up after seven years. Because the unitary charge is modelled on the basis of this uplift, the effect is that the public sector assumes the first slice of refinancing risk. Under the pricing and gearing which has been typical in PFI projects, equitys' ability to absorb refinancing risk is very limited."

"Where structures are used which assume refinancing after seven years, there have been calls from the private sector that the public sector should take some or all of the risk, perhaps covering the cost of debt pricing above a certain level at the time the refinancing takes place," adds Dominic Spacie, partner in the Project Finance group at Denton Wilde Sapte.

"The UK government is committed to keeping the PFI pipeline moving, in order to help the UK economy move out of recession, and the Treasury has indicated that it will take a pragmatic approach and ensure that upcoming PFI deals are able to be financed," says Spacie. "This could even involve the Treasury acting as sole lender, with this debt being sold off in the secondary market at a later date."

Manchester Waste and M25

The two highest profile transactions that the government is currently discussing with debt arrangers are the widening of the M25 London ring road, and the Manchester Waste facility. Both may feature EIB involvement and direct UK government lending, and both are very near to financial close.

It was in January 2007 that Greater Manchester Waste Disposal Authority signed a deal with a consortium made up of Viridor Waste Management and John Laing Infrastructure.

The European Investment bank was expected to be involved all along, and early in 2007 approved financing that could go up to 50% of senior debt. At that time, with lots of bank liquidity, the amount would have expected to be less, but in the current environment the EIB contribution has become more significant – it is anticipated that the EIB will lend over £200 million. Lloyds TSB, BBVA, SMBC and Bank of Ireland are committed to providing the remaining £400 million. The deal is in its final stages with negotiations focused lowering bank fees – rumoured to be above 300bp.

The M25 road widening and maintenance PFI scheme is more problematic, since with approximately £1.3 billion of debt needing to be raised to get phase one underway, the deal cannot be financed with a handful of banks, but needs a much bigger syndicate which inevitably complicates negotiations.

Four commercial banks are co-ordinating the financing, and these are Lloyds, SMBC, WestLB, and BBVA. The project developers are the Connect Plus consortium, made up of Skanska (40%), Balfour Beatty (40%), WS Atkins (10%) and Egis Projects (10%). The Highways Agency being advised by PwC and HSBC. Work is scheduled to start in April.

The EIB is planning to provide a Eu170 million direct loan and a Eu330 million loan that is counter guaranteed. That will leave another £840 million in 24-year debt to be provided by a bank syndicate, which could include both a group of Japanese banks brought in by SMBC as well as a £100 million ticket from RBS.

The suggestion is that the commercial bank tranche may be priced at a hefty 250bp, which is more than double what might have been seen in 2006. The step-ups after year seven will be punative, with two separate 50bp increases meant to ensure that the sponsor does indeed refinance at year seven. There are also cash sweeps to incentivise the sponsor to refinance, the first – a 50% cash sweep – happens at year 9.

UK PFI model

In the UK the government remains firmly committed to the PFI model featuring a private sector sponsor and commercial bank debt, though one banker notes that in continental Europe there are moves to push the commercial banks out of the way and simply provide government debt funding. "They are missing the point somewhat, since the banks do not just provide liquidity but also monitor transactions and during the negotiating process between the debt and the equity ensure that the deal is properly structured," he says.

Elsewhere in Europe, governments have stepped in with guarantees about what will happen if debt cannot be refinanced at year seven. Though realistically few people expect the market to still be in bad shape seven years from now, the possibility of future market disruptions are clearly a concern.

Although the initiatives in UK PFI – the government fund and the benchmarks the M25 and Manchester Waste are expected to make – there may still be a fresh set of problems to be confronted, problems that are affecting many non-PFI project deals.

In a typical PFI the government wants to see sponsors with committed funding when they are shortlisted, which in the buoyant market of 2005 or 2006 meant a small group of banks committing to provide the debt knowing that it would subsequently be easy to sell down.

In today's market deals are being done on a club basis, which means negotiating simultaneously with ten or twenty banks. It will be all but impossible for sponsors to get funding commitments, since the same group of banks would be needed by each consortium at the initial bidding stage.

Another problem that will need to be addressed is a potential shortage of sponsor equity, since sponsors are being hit from two directions. First, their own debt at corporate level is either more expensive or lenders are demanding that the overall level of debt on the balance sheet be reduced. And second, the uncertainty over PFI debt refinancing could potentially hit sponsors a few years into the life of a PFI project.

So although the M25 and Manchester Waste deals may soon reach financial close, newer deals at the early stages of the bidding process potentially face more difficult challenges.