Are we mortgaging our future? Media coverage of the UK's Private Finance Initiative (PFI) has largely condemned the scheme as a government dodge designed to take the cost of financing expensive infrastructure projects off the Treasury's books. According to the press, PFI projects are variously too expensive, fail to deliver value for money and ultimately allow the private sector to benefit at the expense of taxpayers.

And as PFI matures, the role of secondary debt and equity markets in the process has renewed fears that private sector contractors, investors and banks are creaming off too much profit.

But private sector investment in such politically sensitive projects as schools, hospitals and prisons was always going to be controversial. And while PFI is not perfect, the reality is that much of the criticism is unfounded.

To date PFI deals worth about £43 billion have been signed, which according to the Treasury includes 670 closed projects. Much of this has been financed using debt and a mixture of private equity from investors such as Innisfree and project's sponsors – often contractors or operators such as Carillion, Mowlem, Balfour Beatty and Skanska.

But with more than 400, or 65% of UK PFI projects now operational according to Standard & Poor's, some primary equity investors are looking to recycle their investments.

Growing secondary market

Buy-side investors in the growing UK PFI secondary market include groups such as the Secondary Market Infrastructure Fund (SMIF), Innisfree, M&G PPP Fund, Henderson Investors and Infrastructure Investors (I2), a joint-venture between Barclays Private Equity and Societe Generale. Several of these secondary market players are also involved in PFI as primary investors.

Estimates vary over the size of capital available in the secondary market but there is thought to be over £1 billion available in the UK market, falling well short of a possible £2 billion required.

Barry Williams, director of SMIF, says his European infrastructure fund has interests in 35 infrastructure deals, most of which are in the accommodation sector and the majority are in the UK. The fund has about £275 million-worth of PFI assets in its portfolio and hopes to reach £500 million by the end of 2006. "We are currently on target to hit that. But it's an open ended fund, so we may not stop there," says Williams.

Williams adds that the emergence of the secondary private equity market over the past couple of years is a logical conclusion for the PFI process. This is because primary equity providers are either closed-end funds, which have a five-year life, or constructors and operators, who are often involved in the early construction phase of the project where they can use their skills to full effect.

These operators often want to play a role in the decision-making process and take advantage of the upside once construction is completed. But at the same time, construction groups have traditionally also needed to recycle their money once the initial building phase is over so that they can invest in the next project.

SMIF, for example, picked up 50% equity in the M40 motorway concession after Carillion's initial investment was first sold to John Laing for just under £20 million, realising a profit of £6 million. SMIF then bought it for £26.2 million.

"Constructors and operators are often capital constrained as their portfolio grows," says Williams. "Often they just want to build the project but in the longer term they are not interested in managing it."

Long term investment

In contrasts with its peers, SMIF will consider projects that are still in construction, the riskiest part of any infrastructure deal. "We can get involved in the latter stages of construction," says Williams, "because we can support non-yielding assets during that phase."

However as a secondary market player the incentives are different. Funds such as I2, SMIF and Henderson are really looking to the long-term. The attraction with PFI is that they can match their long-term asset management portfolio to the long-term nature of many PFI contracts, typically 25 years.

If an asset has gone through construction, then the initial equity investors have often made their money back on the short-term risk of reaching completion. Says Williams: "If we buy an asset at 10% return, we have to actively manage it to see it turn to 12%. It's a lower risk for a lower return...We are longer term investors who are not looking for one event [for example construction] to suddenly boost our return."

Such investors also argue that they have to be more "pro-active" in managing their portfolio to be able to achieve a reasonable return. This means maintaining a good relationship with the public sector.

Chris Elliott, managing director at Barclays Private Equity which co-manages the I2 fund, says that it was always clear that as the spate of deals signed in the late 1990s completed construction and began to have a proven operational performance, equity investors would be looking for a way to recycle their capital.

Nigel Middleton, managing director at Barclays Private Equity, says that what is critical for I2 is "size". The £450 million closed-end European infrastructure fund has so far invested £150 million and will organise assets to create portfolios of the similar types of assets, "to add value".
Says Elliott: "Our view is that the secondary market is not necessarily going to be long-term holders for 25 years." He says that by packaging the deals together, some of the risks are removed and PFI becomes more palatable for other long-term investors.

With the growth of PFI abroad, the likelihood is that secondary markets will emerge for deals in Europe, North America and Japan. To date many of the secondary market equity players have set up their funds to include European infrastructure deals but they admit that the market lags behind the UK and that there are domestic players in Europe who may be better able to mop up equity in places such as Spain, Italy, Portugal and Germany.

I2 and SMIF, for example, both have European funds but have primarily invested in UK PFI to date.

Who is investing?

Steven Proctor of Henderson says that groups interested in investing in PFI deals include both public and private sector pension funds who are looking to get a better-than-average rate of return on their investment, given the risk profile of the asset, but who are in for the longer term. The investor is locked in to the investment because it is illiquid – the additional return being compensation for the lack of liquidity.

Local authority pension funds such as the London Pensions Fund Authority, the South Yorkshire Pensions Authority and the London Borough of Newham have all invested, as have private pension groups such as Norwich Union, Hermes and Prudential.

"In the face of the unprecedented pension fund deficits, emerging alternative investment opportunities such as PFI should be considered as a welcome and valuable opportunity. But as with any investment it is a question of understanding the market, issues at stake and knowing the right questions to ask," according to an article by David Toplas, chief executive of the Mills Group, which operates long-term investment funds in PPP under its 'Investors in the Community' (IIC) programme.

Vinci plc, the UK arm of the French group, took a novel approach to the disposal of its equity after construction of its Bute Avenue PFI deal, a £40 million road boulevard project that linked the city centre to the Cardiff Bay regeneration area. In 2003, with the project up and running and a refinancing in progress, Vinci decided it wanted to sell its 50% of the equity.

Though the deal was offered to the market, Vinci's own pension scheme decided buying the equity stake would provide a return of 15%, much higher than alternative investments. In fact the fund eventually bought the remaining 50% from MEPC, the property group. The total investment by Vinci's pension fund represents less than 2% of the total £140 million in the fund.

Alec Comba, Vinci plc's finance director, says the deal could be repeated but concedes that it would be difficult to find a project that the fund knew as well or was as comfortable with.

Interestingly some contractors are opting to hold on to their equity investment once construction is complete. Balfour Beatty and Skanska BOT have a strategy of holding their equity stakes in the long-term, seeing it as a key part of their business.

And others have now followed suit. Last year Carillion paid 1.7p a share as a special distribution to shareholders from the £11.2 million profit it made from the sale of its equity stake in the Darent Valley Hospital in 2003. Since then the group has also sold its stake in the M40 motorway project and reduced its stake in the A249 road scheme to 50%.

Carillion said that the dividend payout was designed to make sure investors shared the benefits from company's PFI deals.

John Denning, director of group corporate affairs at Carillion, says the move helped the market recognise the true value of PFI equity investments. "The first PFI deal was done back in the mid 1990s, but it has taken a long time for the market to get to grips with this method of procuring public services and the true value of PFI equity investments."

Since then Carillion's policy has shifted. With the market now having a firmer understanding of the value of deals, the group says it is now only willing to sell if it is sure it can get more than it would by keeping the asset on its books.

Such contractors are prepared to hold out for the longer-term gains that may emerge through the life of the asset.

Value for money?

Critics of PFI argue that the scheme fails to deliver value for money and that contractors are skimming off too much profit. In fact a recent survey showed that 88% of public-private-partnership deals were delivered on time and to budget, compared to only 30% of comparable projects delivered in the traditional way.

Much was also made of the recent problems at Jarvis. The support services company struggling to avoid financial collapse has seen its share price battered and its reputation tarnished. Would its problems mean public authorities would be left without unfulfilled contracts for schools, hospitals and university accommodation?

Jarvis' woes are still unravelling but the sector is remarkably unruffled. Observers argue that the beauty of PFI is that the demise of one player should make no difference to services promised to the public sector.

Richard Abadie, head of PFI at the Treasury, says that while Jarvis' problems were "unfortunate" for the company, the structure of the PFI deals takes into account such risks and helps minimize the disruption to services. It would, he says, be unrealistic to expect that, across a PFI portfolio, no corporates would experience distress.

"Ultimately, our question is simply 'Will the deals continue to deliver services and value through difficult times?' Our experience with Jarvis, Ballast UK and the National Physical Laboratory is that they have, thanks to the robust nature of their PFI contracts," says Abadie.

In fact even, the forced sale of equity investments have earned Jarvis a sizeable profit. The support services group sold its stake in the London Underground PPP Tubelines consortium to Amey for £146 million.

Says one contractor: "What you have to allow is that the private sector takes risks and for those risks there needs to be a fair reward. It seems unreasonable that if you make a profit the government would seek to take it out, while at the same time expecting the private sector to bear any loss."

But the belief that investors are making excessive profits continues to fuel public concern. The fear is that while debt refinancing contracts signed since 2002 are now shared with the public sector, private equity stakes have been trading over the past couple of years providing a significant profit for private contractors and investors.

Reports at the tail end of 2004 suggested that The National Audit Office would be looking into the gains made from equity investments as part of a wider ranging review into PFI. The Office said in November that while it was not opposed to the buying and selling of PFI assets there could be grounds for some sharing of the windfalls.

In fact the NAO has since appeared to backtrack, saying that as a matter of course the gains made from equity investment will be addressed in the report, due to be published by August. But the market is confident that, in fact, there will be no change to government policy in this respect.

Meanwhile, in May 2005 the Office of National Statistics indicated that it would change its treatment of PFI schemes in the public financings, potentially threatening the accounting advantage for public sector managers to procure big projects through PFI.

The Office of National Statistics, however, says it "has taken no decision to change the treatment of PFI schemes in the public finances", though it added that if any decisions were made advance notice of changes would be "given in the usual way".

Abadie claims the emergence of secondary market players is likely to have a knock-on effect on initial equity investments. Writing in a recent report for S&P, he says that the increase in funds buying second-hand equity will "provide more liquidity in the market and add more certainty to the exit strategy of primary market investors". He says that the prices paid in secondary market trades are expected to "enable primary investors to reduce their initial yield expectations".

So far the evidence does not support that.

Barclays' Middleton says that to date he has not seen an obvious drop in price in the primary market but that with more competition for projects prices could eventually drop. "What you have to remember is that primary investors are still taking on different, greater risks," says Middleton.

Bob Shekleton, managing director of the project development division at Mowlem, says that it is "wrong" to suggest that the secondary market is driving down the price of primary private equity investments. "What drives price is risk and not the ability to sell."

Meanwhile Vinci says that contractors would always aim to go into a project knowing that the returns were acceptable. Comba says that while Vinci is "inclined" to sell its equity stake once a PFI deal is completed, "we always go in knowing that we will get a good enough return so that if were forced to keep the asset in the long-term, it would still be attractive".

Freeing up capital

Meanwhile as the secondary investors are contributing to liquidity in the wider PFI market, those same secondary players are also working on ways to free up their own capital.

Earlier this year SMIF raised £250 million in debt, secured against its secondary PFI equity. WestLB and BES underwrote the transactions, which is structured as a six-year bullet. Because banks lent against equity cash flow – whereby the debt is junior to the project debt against each asset – pricing is higher than a vanilla PFI deal.

The transaction represented the first time debt had been raised against secondary PFI equity and could provide a template for others.
Institutional investors have also shown an appetite for secondary debt markets.

Last year, Depfa, the Irish bank, pulled off a remarkable deal, with the first synthetic securitisation backed by loans to PFI projects.

The £391.7 million deal, which 'warehouses' 24 UK PFI loans, allows Depfa to release capital and enhance its return on equity without selling the underlying loans.

The key to the transaction, lead managed by Merrill Lynch, is the involvement of KfW, the German state-owned bank. KfW sets up a credit default swap with the Depfa. KfW then purchases credit protection by entering in credit default swaps with institutional investors. KfW is AAA rated so can get the best credit default swap prices.

KfW is one of the few institutions to provide a 0% risk weighting as a swap counterparty, which means that Depfa does not need to set aside capital to cover counterparty risk.

Paul Leatherdale, head of infrastructure finance at Depfa in Dublin says that as a specialist lender to the private sector the bank was used to its assets enjoying a 0% or 20% BIS risk weighting. As private sector lending, which typically carries a 100% risk allocation, carries a lower equity return the bank needed to manage its exposure.

The bank had always aimed to package up its portfolio with the aim of placing it into the secondary market or through a securitisation. "For us having a PPP portfolio isn't an end itself," says Leatherdale.

The deal attracted insurers and pension funds that are used to investing in asset-backed securities and were keen to get involved in a new asset class. Leatherdale says that banks, like equity players, have the same need to recycle funds and free up capital.

This particular collateralised loan obligation (CLO) is a synthetic transaction, so it stays on balance sheet and transfers the credit risk. Because it is not a 'true sale', where the assets are sold to a special purpose vehicle, Depfa avoided many of the problematic security transfer issues.

"By side-stepping these problems, we saved a lot of work and cost," says Leatherdale. "It also gave comfort to the investors as we were still the lender of record and still managing the assets."

Leatherdale says that Depfa hopes to repeat the transaction when it has accumulated sufficient volume. Meanwhile other banks are known to be looking to copy the template. As KfW was motivated by the desire to add liquidity to the market and not by any German connection, it could well look to follow up with other banks.

Such moves to develop both the secondary markets for PFI debt and equity can only add to the liquidity in the market. As the UK government aims to spend a further £12 billion on increasing public infrastructure over the next three year and as much as £60 billion over the next 15, the need for further sources of financing become ever more pressing. The increasing involvement of institutional investors in PFI deals is the logical next step.