In 2004 the nascent UK PFI secondary equity market was dominated by four players – Secondary Market Infrastructure Fund (SMIF), Laing, Infrastructure Investors (I2) and Henderson. A wave of consolidation in the intervening time has seen Henderson acquire Laing and Land Securities Trillium (LST) acquire SMIF. Only I2 has remained broadly the same, the most significant change being the acceptance of 3i as a new partner.

Now, as the UK PPP deal pipeline wanes, significant changes are occurring once again. The investors in I2 are seeking an exit and are in the midst of an auction as Project Finance Magazine goes to press, and Land Securities Trillium is looking to split its businesses and has launched an infrastructure fund containing SMIF's assets. Both I2 and SMIF had aggressively bid UK PPP assets to become the two dominant funds, now these portfolios are hoping to attract more conservative investors.

The demerger of LST

Land Securities Group became a real estate investment trust (REIT) in January, and has now decided to demerge into three separate businesses – Trillium, London and Retail. This will take place next year when market conditions are right. Part of the reason has been cited as the preference of global property investors for specialised property plays, another has been that many of Land Securities Trilliums' businesses have been undervalued by analysts specialising in REITs who have been unable to fully understand and value the Trillium investment model. Land Securities Trillium is currently trading at a substantial 33% discount to its net asset value (NAV), a situation – albeit in a depressed property market – the demerger should address.

The Land Securities Trillium business is valued at around £1 billion, and is active in three key markets:
• property outsourcing
• primary PFI/PPP business
• secondary market activity

LST's secondary market offering has recently been bolstered with the launch of a £1.14 billion ($2.34 billion) infrastructure fund. The fund is leveraged by a £570 million senior debt facility provided by Lloyds TSB and HBoS, which accounts for 50% of the total. The fund is called, Trillium PPP Investment Partnership, and its intention is to invest in PFI equity, with 81 projects predominately from the SMIF portfolio comprising the initial pool of assets.

The launch of the fund follows Land Securities Trillium's acquisition of Secondary Market Infrastructure Fund from STAR Capital Partners, Halifax Bank of Scotland and AMP Capital Investors in 2006 for £927 million. The one-year acquisition facility for that deal was also arranged by Lloyds.

Trillium is currently run as a standalone business and has made a few structural changes in readiness of a listing. Newly appointed managing director of New Business at Land Securities Trillium Janet Chamberlain says: "When the time is right in the equity markets we will list. We plan this to be within the next 12 months."

Secondary to primary

As well as the spread of UK investors to continental Europe, another trend has seen secondary equity move into the primary market, obtaining bidding, operational and contracting expertise. Henderson obtained this capability with the acquisition of Laing, and seems to operate at the riskier end of the spectrum compared to its peers by being much more active in continental Europe.

Likewise LST has this capability via the acquisition of Investors in the Community and AMEC's project investments business. "We have a number of deals in bid and others coming through," says Chamberlain. "Once these assets are constructed they will be transferred into the fund, so our primary activities provide a pipeline of deals – we have very complimentary business lines."

LST's model will therefore share similarities with the models pioneered by Australian exporters of the genre, Babcock & Brown and Macquarie, with a development arm providing a pipeline to a fund predominately managing third-party money, from which they can extract a management fee.

A challenge to the big three?

The hegemony of the three main protagonists in the UK secondary market will be difficult to challenge in the near future because of the high barriers to entry. Larger portfolios benefit from a lower cost of capital, with a diversified pool of revenue streams lowering volatility so that they should be able to leverage their assets to a greater degree and more cheaply in the bank market. This enables established players to apply more aggressive models lowering their rates of return when bidding for assets compared with smaller, newer players.

Despite the dominance of LST, Henderson and I2, their monopoly as winners of any auction of PPP assets was broken recently by HSBC's listed fund, HSBC Infrastructure Company (HICL). While Henderson has been busy with the integration with Laing, the former-SMIF and I2 teams were regarded as the most aggressive bidders but have been preoccupied with their exits.

HICL won the auction for 50% of Kajima Partnerships' interest in six UK PFI projects. From eight initial bidders, price bids were made by six, with phase one of selection delivering three pre-qualified bidders, from which HICL emerged as winner. A joint venture company was set up, to which Kajima will continue to provide management services as well as tendering for further projects.

The portfolio of projects has a combined value of £30.2 million and comprises five school projects (Ealing Schools, North Tyneside Schools, Wooldale Centre for Learning, Haverstock School and Darlington Schools) and the Health and Safety Executive's headquarters in Merseyside.

A further signal of intent by HICL that it will not just be a conduit for the primary equity stakes made by HSBC but an aggressive bidder of third-party stakes, is its planned £200 million leveraging that will be solely arranged by HBoS and is due to reach financial close at the end of 2007 or early 2008.

HICL also has a mandate to move up the risk reward curve and invest up to 35% of its assets in pre-constructed projects, including investments in bidding consortia or demand-based projects, such as toll roads.

Nevertheless, the fact that HICL will play the role of investor in the Kajima portfolio rather than operator or head contractor highlights a limit to where funds with a strict mandate can go: unless investors come on board with strategic operating partners, they must acquire an operational skill set to extract the maximum value from their stakes.

PPP assets are not straightforward financial assets and require hands-on management to ensure success both at the operational and client facing levels. Chamberlain says: "When managing investments in SPCs (special purpose companies) the delivery of the services to the required standard and maintaining a good relationship with the public sector client is important."

Bachmann adds: "Where concessions contain shorter FM agreements or are subject to periodic review, we are able to leverage the relationships with our service partners to obtain best value for money to install new FM providers or keep the incumbent FM provider honest."

Banks as vendors

Though most financial investors have the skills of asset, treasury and portfolio management, few, if any, are likely to be as adept at negotiating FM service contracts and maintaining dialogue over the fineries of service contracts as LST or Laing-Henderson which have an operations/sub-contracting background. It is for this reason that the next wave of portfolio sales, or series of individual asset sales could come from project finance banks that have built a portfolio of UK PPP assets, such as RBS and HBoS.

"Despite the large number of acquisitions, there is still a large amount of untraded equity," says Bachmann. "There are many opportunities still remaining where contractors need to recycle equity to continue the bidding process for new projects. Also, perhaps banks are sitting on assets which would be natural candidates for selling given the level of asset stewardship required in PFI/PPP assets."

RBS's PFI equity vehicle is called Royal Bank Project Limited and has no cash constraints, which gives it a great deal of flexibility. RBS has sold individual assets and is currently "constantly looking at different ideas and options."

The bank always has an exit strategy in mind when it makes its investments, and usually has 50% stakes in projects in which it participates such as the City Airport and Woolwich extension Docklands Light Rail projects. RBS is also a shareholder in the North Durham and Portsmouth hospital schemes among others.

Halifax Bank of Scotland (HBoS) also has a fairly sizeable portfolio and is believed to hold investments in around 60 PFI project companies with committed risk capital in excess of £300 million, but like RBS it is unlikely to divest itself of all its PPP equity in the short term.

There is not much sense in divesting assets where banks such as RBS and HBoS have a dedicated resource to value enhance the investments through refinancing and negotiating service contracts. Bank investors tend to manage exit gains over a longer period helping to smooth profit, so they are unlikely to sell off all their assets in one go. Rather banks will look to gain value by de-risking projects through to operation then refinancing where capital gains can be made, then offloading the assets to a tertiary fund or starting their own fund. Third-party capital will come in at this stage from pension funds which enjoy low risk and stable returns over the long run.

Refinancing malaise

Although banks seem the natural sellers of the next wave of equity, all holders of UK PFI equity in a deal that has yet to be refinanced may be less inclined to do so given the sizeable refinancing gains that can be made. In the short term the taps have loosened the moratorium on UK refinancings to a dribble, which would appear to harm the liquidity of the secondary market.

"We are keen to do refinancings at code [the voluntary refinancing code] but sometimes lack of clarity in the system means that this may not be possible," says Bachmann. "Sometimes it is not economically viable to do a refinancing with a 50% share in the upside. There is often the situation where all parties, including the public sector client, wish to proceed with a refinancing and stick to the code, only for it to be rejected because of political pressure."

Recently LST refinanced its debt on four schools on a portfolio basis. The four schools in Liverpool, Wirral, Kirklees and Salford were originally part of the Jarvis portfolio. Nationwide Commercial arranged the £110 million facility.
The scarcity of refinancings over the past 18 months highlights the political sensitivity surrounding PPP transactions.

The uncertainty about the Treasury and Public Accounts Committee's stance over refinancings has held back development of the secondary market because it has prevented the natural maturation of assets, blurring the distinction between the capital gain phase and stable, less-volatile returns. This is why there is such a mix of investors involved, with private equity houses, such as 3i, rubbing shoulders with pension funds.

One of the most serious consequences of an encumbered secondary market is the reluctance of constructors to recycle their equity until the political stance over refinancing has softened. However this consequence may have been overplayed, as a number of secondary assets are known to have changed hands with a condition entitling the vendor to a share in a later refinancing.

The political brouhaha of refinancing gains has been avoided by large portfolio players who are able to raise debt against their portfolios and effectively lend into their own projects.

A refinancing gain was thought to only be payable if there is a distribution increase from the project company, however according to a senior placed official the Treasury is in dialogue with funds that have leveraged their portfolios. "If a leveraging is accruing a benefit to the shareholders, then this is caught in the spirit of the terms of the voluntary code. We would hope that there is self-policing going on – I know a dialogue has occurred."

Given the lack of public disclosure and lack of media appetite for releveragings as opposed to single asset refinancings which carry a headline refinancing gain, it seems unlikely that the public sector will benefit from these transactions.

Debt and asset pricing

In the aftermath of the credit crunch the market has moved away from the most borrower-friendly terms. "Debt pricing had reached an all-time low and banks had begun to meet new deals with some trepidation and wary of making large underwriting commitments," says Bachmann. "Pricing was probably a bit too low at sub-40bp but now it has moderated slightly and has plateaued to perhaps better reflect the underlying project risk."

Also, the credit crunch is likely to moderate asset pricing. "Asset pricing exhibits a great deal of seasonality, with certain players looking for an exit before the end of the year and with some fund managers becoming very aggressive to avoid a carry position," says Bachmann. "In general, our experience is that asset pricing has settled down."
Given that I2 is leaving the market and that the other most aggressive bidder LST is seeking a partial divestment through the establishment of its fund, it is likely that the immediate knock-on consequence is a fall in the price of UK PPP equity assets. Now is not the best time to divest UK PPP equity stakes.

Although there is an increasing acceptance of PFI/PPP assets as an asset class within the investment community and there is likely to be greater participation from pension funds either directly or through asset managers, in the current market environment it could be a testing time for LST and I2 to attract a conservative staple of pension funds to aggressively bid portfolios. A good fit for both would be Macquarie itself, or cornerstone investors in Macquarie funds such as hedge funds which operate higher up the risk/reward spectrum.

Although HSBC Infrastructure Company's successful bid at the Kajima Partnerships' portfolio could signal a sea-change in the secondary market, it would be churlish to discount LST, or the standalone business Trillium. "We could look at something like the I2 portfolio and consider it – that is the beauty of the LST model," says Bachmann. "At present we are particularly interested in diversifying into other areas such as waste where there are several operators that have a small portfolio of two or three projects under their belts."

Side note: Changes at Land Securities Trillium
Land Securities Trillium (LST) has appointed Janet Chamberlain as managing director of New Business; she spent the previous 15 years employed with Amec. Supporting Chamberlain is the senior management team. Peter Bachmann is director, Investment Acquisitions, Rick Lawrence, Director, Property Partnerships, Neil Rae, Director, Transaction Services and Ian Wolstenholme, Director, Primary PPP Business. Chamberlain will now join the Land Securities Trillium Board. Bill Doughty ex SMIF joined the board earlier in the year.

Side note: Competition troubles in UK PFI?
The Public Accounts Committee issued a damning report of aspects of PFI on 27 November. High on the agenda was the paucity of bidders on some PFI tenders, and the lack of competition for facilities management contracts.

The report suggests that the provisions in PFI contracts which allow for benchmarking and market testing of service elements are not driving down cost, but on the contrary are causing price increases at the periodic points along the contract.

However, the report's conclusions should not be over emphasised, according to Michael Mousdale partner at Eversheds comments: "The examples given are all health based and should not necessarily be seen as a true indicator of what the effect would be on a local authority contract. Most local government schemes cover simple accommodation, largely schools, compared to the more complex structures of hospitals, which are 24 hour buildings and where the risk profile is greater for the contractor."

The secondary equity market may also raise fears of anti-competitiveness given that the market is dominated by three main players. When the Treasury was asked about the relatively few number of secondary players, a spokesperson responded in a typically phlegmatic manner:

"It is in the Government's interest is to ensure that new shareholders in PFI projects have the resources and capabilities to meet performance requirements under the terms of the contract. The situation is monitored to make sure there is a competitive market for PFI contracts."