PFI in the UK healthcare sector is undergoing a period of uncertainty, with big hospital projects under government review, coupled with a fundamental rethink of how the National Health Service (NHS) should deliver healthcare.

Despite these twin uncertainties, the market for PFI senior debt has tightened considerably over the last few years.

"Depending on the transaction, margins have fallen from 1.2% to 0.8% over Libor for a typical 30-year tenor over the last four years," says Laughlin Waterstone, assistant general manager with Infrastructure PPP at SMBC.

The same has happened with equity. A few years ago returns of 12-15% were common, depending on the project. Bankers now talk about returns around the 9% level and lower.

Falling debt margins are symptomatic of an overall feeling of confidence in UK PFI and that the current uncertainties will be worked out in the end. That same confidence has also attracted a raft of new financiers to what they see as a relatively safe sector. "What's interesting is that the spread between triple-A and triple-B+ debt is eroding," says Richard Weston, managing director of Equion.

Despite greater confidence among lenders, the need for equity is unlikely to be reduced. "One of the ways of ensuring lenders remain comfortable with the situation is not to go for much higher gearing by putting in less equity," says Weston. Bankers agree that equity will still be needed to buffer transactions and to sustain lower lending margins.

Although bank project debt margins are at record lows, it is still generally cheaper for big healthcare PFI projects to tap the bond markets: £100 million-plus deals make bonds worthwhile once the costs of the rating agency and the monoline insurance wrap to get the triple-A rating are taken into account. The appetite for these bonds among pension funds has been considerable and spreads of 50-60 basis points over Gilts in the secondary market are the norm.

Hospital PFI review

However, the government's rethink on how healthcare should be provided is likely to substantially change the dynamics of this sector. In January, the Department of Health announced a review of the hospital building programme. According to various reports this means a reduction in the size of the programme from nearly £12 billion ($21 billion) to about £7-9 billion to get unitary charges down.

Even the long awaited flagship £1.1 billion St Barts hospital project, sponsored by Skanska and Innisfree, initially looked uncertain, but has now been given the go-ahead. The project has been cut by 250 beds to force down availability payments by £20 million per year. But these beds could be added again in the future. Financing for the project – a £1.2 index-linked bond wrapped by FSA and Ambac, with Deutsche and Morgan Stanley lead managing – is expected in the market in the coming weeks.

Other hospitals under review include the Birmingham, North Staffordshire, Leicester and St Helens projects. The £600 million Birmingham project, sponsored by Balfour Beatty and HSBC is now expected, like Barts, to go ahead with an FGIC-wrapped bond led by RBS and HSBC.

But some scaling down and restructuring is a certainty. The North Staffs project, sponsored by Equion, is expected to be cut back by 25% from £400 million; Equion's Leicester project will also likely be cut by around 30%; and the St Helens scheme is being tweaked to reduce the availability fee by 20% or more.

But cuts to new projects will not resolve the real issue – the financial health and management of the Trusts themselves.

Research carried out by the BBC in January showed that half the UK Trusts were £1.07 billion in debt compared with government forecasts for a deficit of £620 million for the year to March 2006. The government has made soothing noises to the effect that PFI obligations will be met – anything less would alter the entire risk profile of PPP and send financing costs soaring, which is not in the government's interest, especially when it remains fully committed to PFI.

Cost and management issues

But cost management at the Trusts is a source of worry for the Treasury. Overall UK healthcare spending is expected to hit £94.3 billion in 2007-8, compared to an anticipated £76.4 billion this year, which is double the 1997 figure. The Treasury is thought to be upset about the cost of various of the projects on hold, which have been substantially revised upwards.

Another factor is that the Department of Health is worried about whether these large flagship hospitals will meet future healthcare requirements. There is concern in the Department that the NHS will be locked into expensive unitary payments for large hospitals, which may not represent the best way to meet the UK's healthcare needs in the coming decades.

And the government is keen to reduce hospital waiting lists more quickly. That objective may be better met through lots of smaller community-focused projects, which can come online faster. The recent healthcare White Paper talks about primary care, community hospitals and polyclinics as part of the solution to evolving healthcare needs.

"The market is moving towards more smaller fragmented deals and I would say that favours senior debt financing," says Ceri Richards, head of infrastructure and housing finance with the Bank of Scotland. Increasingly, the NHS's preferred PPP vehicle appears to be the LIFT (Local Improvement Finance Trust). Around 60 LIFT projects should come online this year. Typically, a sponsor will have exclusivity to build and operate clinics in a particular area and deals come out at around the £20-35 million mark.

Many bankers concede that although they make less profit on LIFT, they favour the scheme because construction risk is lower and projects are up and running much more quickly. There is also the possibility of LIFT projects being bundled and refinanced with bonds sometime in the future when there are enough of them in a portfolio.

In addition to more local healthcare, the government is also keen to introduce more free-market dynamics into the NHS. For example, this means that patients can shop around different hospitals for their operations. For individual Trusts, that translates into payment by results and having to think more like a private company. "Money will follow the patient and this is linked to patient choice, letting them decide where they want to be treated," says Jason Radford, a partner at Lovells.

The government is smoothing the transition away from block budget funding towards the market-orientated approach to give Trusts time to adapt. But bringing in market dynamics implies more unpredictable income streams and hence a greater degree of financing risk.

"Commercial risk is a concern, however competition concerns reside more with the Trusts than the contractors," says SMBC's Waterstone. "They still have to pay the unitary charge even if they don't get the patients." Consequently Trusts could become more hesitant about PFI procurement, fearing they cannot meet their obligations over the long-term.

Clinical risk

Martin McCann, head of PPP at Norton Rose, sees healthcare evolving away from the traditional large PFI bricks and mortar-type deals towards deals that contain clinical risk. These projects involve a material change in risk profile for most banks, and have proved a disaster in Portugal, where none have reached financial close after four years of lurking around the market: ironically Portugal is now considering copying the UK template and dropping clinical services from its concessions.

But as McCann points out, any bank lending to the government's ISTC (Independent Sector Treatment Centre) initiative is already taking clinical risk – albeit low volume. And "it is difficult to explain why healthcare PPP should just revolve around buildings and servicing them and not the end deliverable – care", he adds. "There are property plays that have enabled some banks to finance these deals. However the long-term solution is for the banks to become comfortable with clinical risk".

There are medical insurance and Crown indemnity solutions which the lending community will be asked to rely upon. "In terms of opportunity, having worked on a series of these projects, there are about 20 active banks in PPP, of which only two have credible solutions to deal with clinical projects" says McCann. "This is a highly fluid market, which is already seeing government looking to pass an element of volume risk to the private sector" adding that: "this will prove another challenge or opportunity depending how lenders look at it".

The credit guarantee finance (CGF) approach to funding projects is also gradually taking off. This involves the government raising the finance and banks guaranteeing the debt. PFI critics contend that private sector financing costs are often more than the public sector equivalent and CGF is therefore designed to bring the best of both of worlds – the lower cost of government borrowing and the discipline of the private sector.

To date there have been two healthcare CGF deals: the £170 million Oncology wing of the Leeds Teaching Hospital and the £250 million Queen Alexandra Hospital in Portsmouth. The CGF approach is still in prototype stage and many doubt that it will become the norm. Banks are not so keen on it because it entails lower margins, as they are only furnishing guarantees. And CGF adds a lot of complexity, so much so that associated costs can outweigh going down a straightforward PFI route.

The REIT way

A more intriguing possibility is the evolvement of REITs (Real Estate Investment Trusts) in the PFI sector. These are stock market-listed property investment vehicles, very common in the US, which pay out a substantial part of their revenue in dividends and enjoy special tax treatment. So far it is unclear how UK REITs will be structured and the regulatory framework that will govern them. Some bankers see the possibility of them being a means of recycling equity or even injecting equity into various PPP schemes. "REITs are on our radar. They may well be applicable for PFI, but it's very early days and while we're waiting for them to be rolled out there is no shortage of capital for PFI," says Waterstone.

Whatever the outcome of the UK healthcare review, the general trend is towards smaller deals. So far the market is comfortable with PFI, and this is borne out by falling borrowing costs. The next stage in the market's development is less certain. The broad introduction of clinical risk will likely be as disastrous as in Portugal and is a step the government will probably not be able to take, because the banks will not buy into it at politically acceptable margin levels – if at all. It is also a step the UK electorate is unlikely to stomach.

Nevertheless, PPP looks set to play an even bigger role in UK healthcare, and in an effort not to upset this evolution the government needs to carefully consider the outcome of its current review. High profile cancellations would be a serious set back for the PFI market and make it more difficult for the government to achieve value for money for future projects.