Public- private-partnerships (PPPs) are at a crossroads in the UK. Deal flow is weaker than it has been for years with fewer new hospitals coming to market and the expected deluge from the Building Schools for the Future programme failing to materialise. Moreover, a switch in accountancy standards makes it likely that from 2008/09, after years of talking about it, the public sector's Private Finance Initiative (PFI) liabilities will have to be considered as debt in the public accounts.

If any of PFI's numerous critics are hoping this is the beginning of the end for the controversial scheme, they are likely to be disappointed. UK Chancellor Gordon Brown, set to become prime minister at the end of June, reiterated his commitment to the procurement method in a debate with two challengers for the Labour Party leadership on May 13. Given the instrumental role the Treasury has played, under his stewardship, in driving forward the initiative it seems inconceivable that the country will change direction on this issue under Brown's premiership.

PFI remains the procurement method of choice for infrastructure projects beyond a certain size, but it is not in new tenders but rather in secondary equity transactions that most of the action is happening. In the latest of these, Infrastructure Investors' (I2) bought PFI Infrastructure Company Plc for £157 million ($301 million) with the aid of an acquisition facility underwritten by Lloyds TSB and RBS. Some analysts have raised their eyebrows at the price of the acquisition – 30% higher than PFI Infrastructure Company's trading price on May 14 – and there is speculation that I2 will itself be up for sale at some point in the not too distant future.

This secondary market activity has raised some concerns among members of the parliamentary Public Accounts Committee (PAC), who have suggested they view these transactions as a form of backdoor "refinancing" where the gains made by PFI companies are not shared with the public sector as they are with real refinancings. A report issued by the PAC on May 15, just one day after I2's acquisition, stops short of adopting this position, but warns the Treasury to "keep the working of the PFI equity market under close scrutiny to make sure the public interest is not being compromised."

Any measures the Treasury might introduce – as a response to embarrassment when its officials are hauled in front of the PAC – for the public purse to take a share of the profits made in these transactions are likely to be met with opposition and resentment by contractors already annoyed that rules on refinancing gains on early PFI contracts were changed four years ago, after the event of their signing and the risks being costed. But the concerns highlighted in the actual PAC report have more to do with the effects on competition of equity being concentrated in the hands of just a few players. The liquidity that the secondary market provides, by allowing capital to be recycled for new projects, is acknowledged in the report.

New rules

The Treasury, for its part, seems likely to be hit by the switch in accounting standards from UK Generally Accepted Accounting Practice (GAAP) to International Financial Reporting Standards (IFRS), introduced by Brown in March in his last Budget as chancellor of the exchequer.

The announcement came a month after a report by the Financial Reporting Advisory Board criticised the way in which PFI deals are reported off balance sheet, underestimating the true amount of the public debt burden. The precise implications for PFI of the move to the international standard, which will come into effect in 2007/08, are yet to be determined. But it will require the Treasury to re-examine how it treats PFI, and so far the indications are that technical anomalies existing under the current standard will be removed, paving the way for the debt to come on balance sheet.

"What we have is the seeds of a change, which are rapidly growing," says Ken Wild, a partner at Deloitte. "We will have to hold up a mirror to PFI as rules unique to the UK change and are replaced by something new."

But Wild is one of many in the industry expressing confidence that the change will not herald a shift away from PFI, whose critics argue the primary reason it is used is for off balance sheet treatment. But for its advocates PFI is about value for money, and they claim such procurements are better at delivering projects on time and on budget. "Accounting is merely a way of telling people what happened, whereas a good deal is a good deal," says Wild. "You are not going to change a good deal because you change how you are telling people about it."

Others, in welcoming the change, argue it will be positive because the arguments over PFI will become more transparent.

"The government insists that refinancing gains are shared 50/50 because it finds it embarrassing that the private sector is making a profit out of these deals," says Gershon Cohen of Bank of Scotland. "But the real question is whether it is more efficient. There are already checks and balances in the process that prevent excessive profit being made. The returns are high on the early projects because they held greater risk, but there are no major gains to be made on the upside."

Much liquidity, little flow ...

Despite the diminished upside possibilities, appetite remains large among investors for PFI deals, as evidenced by the rise and rise of the secondary PFI market. However, this appetite is not matched by a corresponding flow of greenfield deals coming through the pipeline at present.

In particular, the health sector is providing nothing like the number of deals it used to. Last year saw several acute hospital financings hit the index-linked bond market between April and June, including the £1.28 billion St Bartholemew's and London Hospitals, the £327.7 million St Helens & Knowsley Hospitals and the £650 million Birmingham Hospitals PFI. The Birmingham project set a new pricing benchmark of 51.4bp over inflation-linked gilts as investors in the project were able to capitalise on the high liquidity in that market provided by asset-swappers, but since then there have been no more hospital bond issues and none seem imminent.

Since Birmingham, the only notable hospital deal to close at all has been the £180 million Glasgow Hospitals, though the £300 million Kent Hospital PFI and the £300 million Larbert Hospital in Forth Valley are both meant to be closing soon. Apart from these, the kinds of deals being closed instead are mostly smaller schemes, like the £30 million Lincolnshire Hospital that closed earlier this month, and a few of the NHS Local Improvement Finance Trust (LIFT) schemes, which tend to be in the £10-20 million range.

As far as finding an outlet for liquidity goes, the lack of health sector activity would matter less but for the slow rate at which the Building Schools for the Future (BSF) programme has progressed. An ambitious scheme intended to provide for the refurbishment of every secondary school in England and Wales over three years, it was hoped that by now BSF would have replaced hospitals as the mainstay of PFI.

Instead the process has taken far longer than expected to take off as contractors and councils have struggled to get to grips with BSF's structure, which involves bunching together many schools in each deal and the creation of Local Education Partnerships (LEPs) where the project company and the local authorities both have a stake. Although some deals have been closing, most recently the £83 million Solihull programme which closed early in May, hopes that under BSF the schools sector in England and Wales will start providing some projects for the capital markets, as has been the case in Scotland, have so far been dashed.

"On the lending side BSF follows very much a standard [PFI] model," says Laughlan Waterston of SMBC. "But on the equity side the structure has changed. Introducing change introduces delays; the point of change is that it adds cost and time."

... but some though

Yet even if PFI has passed its peak in the UK, there are reasons to believe that the slowdown in deal flow is just a temporary drop and that the UK market will pick up again. In education in particular, the problem with BSF as far as the project finance market is concerned has been its slow start, but the pace is now quickening. The programme was worth £2.2 billion in 2005-2006, its first year, with the government committed to allocating further funds over the coming years. Moreover, according to the Standard & Poor's 2007 PPP Credit Survey, over the long term the LEPs should help projects achieve better credit ratings as they lead facilitate better relations and shared interests between the local education authorities and the PFI contractors.

Even in healthcare, where the rollout of acute hospitals has been delayed by budgetary turmoil, constant reviews and a shift towards smaller LIFT projects, there exists a pipeline of sizeable projects still to come, eventually. The Department of Health in February approved a tranche of seven new projects worth a total of £1.5 billion, the largest of which is the £343 million Mid Yorkshire Hospitals.

And one sector where things are finally moving is the waste sector, where things had stalled for what seemed like an eternity. Five projects – Northumberland, Berkshire, Cornwall, Nottingham and Lancashire – have closed since the latter half of 2006 after two years of nothing signing as authorities tried to hammer out a way of fitting complex waste projects into standardised PFI contracts. Given the backlog that built up during this period, the deals are now coming in thick and fast, with the Greater Manchester scheme, worth up to £3 billion over the life of the concession, likely to close next. However, people working in this sector say that stability is what is now needs most, and some have complained about the new EU-wide "competitive dialogue" procedures, which will bring yet more change to how contracts are tendered.

Secondary the sweet spot

But while primary market activity remains relatively low, most eyes are fixed on the secondary market. If rumours are correct and I2's acquisition of PFI Infrastructure Company does turn out to be a play for sufficient critical mass to generate an attractive offer, it will be following hot on the heels of two of its major rivals in the secondary equity market – SMIF and Laing, which were both bought in December 2006.

The kinds of returns necessary to make such acquisitions vary from case to case, where buyers are acting under different motivations. For instance, whereas I2 might have been looking to make themselves more attractive to potential buyers, for Lands Securities Trillium, which purchased SMIF for almost £1 billion in December, PFI assets would seem a logical diversification of their property portfolio. A major driver of all this secondary market activity is the fact that pension funds need somewhere to put their cash.

This consolidation is beginning to have an effect on the whole of the PFI market as some PFI companies begin contacting secondary funds about deals before contracts for them have even been signed. Other companies are choosing to hang on to equity for longer than they normally might, such as one construction company that generated extra value by building up a portfolio of six schools before selling a 50% stake in them.

The effect on competition was one of several concerns about PFI highlighted by PAC in their report. But what is clear is that the maturing of the secondary market could bring new changes and developments to the whole UK PFI market. Another concern highlighted by the report was that the public sector gains under the voluntary code whereby refinancings of early PFI deals are less than half the £200 million that had been anticipated. People in the private sector say this code makes it harder to do refinancings, but the economies of scale brought by the secondary market brings about new possibilities. That could bring benefits to the public purse if the result via the innovation of portfolio refinancings in the UK.