The biggest public-private-partnership (PPP) project to date to close under the Partnerships Victoria programme, the A$425 million ($299 million) Spencer Street Station PPP in Melbourne, has become a public-private-partner-whipping session. The dispute is not about one deal going wrong with its own unique set of problems - it is a soapbox in an argument that has been brewing for some time between state governments, contractors, and banks over risk allocation across the whole Australian PPP market.

Australian PPP development has met with mixed success depending on the sector. The toll road market - begun in 1987 with the Sydney Harbour Tunnel - has spawned nine private roads and brought in total private sector investment of around A$10.5 billion.

Last year alone over 90% of the total A$4.5 billion Australian PPP volume was toll roads - Lane Cove and Western Sydney Orbital - and most recently Macquarie Infrastructure Group's Hills Motorway closed its third deal in the form of a A$470 million refinancing (for more details see www.projectfinancemagazine.com).

But beyond roads there have been a number of messy deals. The Brisbane and Sydney Airport rail link projects produced losses. The controversial A$700 million Oasis project between Macquarie Bank, the Bulldogs Rugby Club and Liverpool Council resulted in the council being sacked and Macquarie being labelled 'opportunistic and predatory' by the subsequent Daly Inquiry in June this year. And in the health sector both the Port Macquarie Base Hospital and LaTrobe Valley Hospital privatisations resulted in legal action - by the government on Port Macquarie, and by the operator, AHC, on LaTrobe - over spiralling costs and the level of state funding.

Conversely, there have also been a lot of successful deals - NSW Schools, Victorian County Court and Wodonga Water for example.

The majority of the duff deals started life in the late 1990s and are symptomatic of governments lacking PPP experience and realistic cost and risk benchmarks. Even the most advanced governments, Victoria and New South Wales (NSW), only developed explicit and detailed PPP policy guidelines in 2001-2.

Many state and territory governments are still weighing the benefits of PPP and where it can be applied. Queensland is hesitant on the issue and only one PPP in a purported A$3 billion pipeline - the A$300 million Southbank TAFE development - has gone to tender.

In real terms, and despite a lot of toll road deals, Australia is still very much an emerging PPP market.

Spencer Street a good procurement

Ironically, the problems at Spencer Street are an example of the Victoria government procuring the best deal it could. The government achieved much of what it wanted - cheap pricing, and the transfer of risk to the private sector.

The project has left Leighton Holdings crying into its balance sheet to the tune of A$110 million in provisions against its A$339 million construction contract. Leighton, 50% owned by Hochtief, is one of Australia's biggest PPP contractors and includes Leighton Contractors, Theiss and John Holland as divisions. The project sponsor is the Civic Nexus consortium - initially a 100% ABN Amro-financed vehicle - with Leighton sub-contracted to upgrade the station and build ancillary retail and commercial outlets before the Commonwealth Games in 2006.

The very public row between the contractor and the Victoria government stems from Leighton Contractors having limited access to the site, which continues to operate as a major commuter station, and changes to the design that have increased the value of the contract by around A$40 million.

But the real issue for Leighton lies in the terms of the turnkey contract, which places construction risk firmly with the contractor. Civic Nexus has a fixed price/fixed time contract with Leighton Contractors and can claim damages from Leighton Holdings, which guaranteed the deal, for late completion. Furthermore, under the concession agreement Leighton Contractors has track access from 12pm to 5am and has to compensate train operators for any disruption to services beyond those hours.

Fallout within the company has been widespread. In addition to the loss provisions, the head of the contracting division, Bob Merkenhof, resigned.

Leighton implies that it did not underestimate the construction risk but was unable to negotiate a better deal. According to a company spokesperson: "There needs to be a more realistic risk-sharing model from one where governments try and shift the maximum amount of risk to the private sector, and then the investment banks seek to shift that risk onto the construction contractor. Risks should be managed by the party or parties best equipped to do so, rather than those least able to resist."

The reality is that Leighton was probably too ambitious in its bidding and a measure of how much Leighton wanted this deal is that another of its divisions, John Holland, was in a competing consortium for Spencer Street.

Mispricing construction risk

Nevertheless, the general thrust of the Leighton argument is valid. The market is in danger of mispricing risk again - partly because of keen competition for deals, partly because Australian governments equate low cost with value for money, and partly because some bank-led deals have been structured solely to reduce debt pricing to the minimum by insulating debt investors from as much risk as possible and with a view to selling the equity side of the deal on.

The irony is that all parties in Spencer Street are performing to the max in the current environment. Spencer Street was promoted at the time as being the new PPP model with the majority of risk transferred to the private sector - and in that respect it works.

In addition to cost certainty and even with the delays, the Government of Victoria's independent auditor of PPPs - Peter Fitzgerald at Growth Solutions Group - has conceded that Spencer Street could not have been delivered as quickly by the public sector alone.

The project debt was also keenly priced and low risk - attracting a preliminary rating of Aa2 from Moody's. ABN Amro financed the deal with a A$135 million ($82 million) 30-year inflation linked bond; a A$200 million 12-year bullet; and A$90 million in equity. Pricing on the 30-year tranche was 45bp over commonwealth government capital indexed bonds with the fixed rate yield coming in at 67bp over swap. Coupon was 6.5%, accruing quarterly from 31 October 2002.

In terms of risk mitigation for debt investors, the 30-year tenor on the deal matches the concession period and the payment cascade ensures timely debt servicing. The structure also allows for withholding dividends from equity in the unlikely event of a debt service crisis.

ABN Amro also provided bondholders with a letter of credit, thus guaranteeing debt service until completion or the sunset date and a top up/first loss of up to A$70 million if there is a shortfall under the termination agreement.

Will contractors pull back from PPP?

Spencer Street was a good model - for everyone but the contractor. Leighton's threat to take Victoria to court, since withdrawn, was both unrealistic and misplaced. Leighton has entered into a process for variations/claims to be first determined by an independent reviewer and then an independent expert (form of arbitration) - all part of the various contracts in the original deal.

But as a Leighton spokesperson says, there is a very real possibility that "unless there is a better sharing of the risk equation, you will find construction contractors not bidding for PPP's or factoring the risk into the bids thereby increasing the project cost. In terms of value for money, governments need to be grounded. There are indications that governments have unrealistic ideas of what a PPP will cost and have declined to proceed with a project after the bids are received."

The argument is somewhat overstated. Spencer Street has not stopped Leighton Holdings taking a piece in both bidding consortia for the flagship 30-year A$2 billion Mitcham-Frankston Freeway concession in Melbourne which has just gone to BAFO: Leighton Contractors in Mitcham Frankston Motorway Consortium along with Transurban, Abigroup, Deutsche Ontario Teachers pension Plan and Westpac/Hastings Fund Management; and Thiess and John Holland in ConnectEast Consortium along with Macquarie, Alstom Australia and Hyder Consulting.

However, the risk fault lines in Spencer Street need resolving if the Australian PPP market is to continue to grow. ABN Amro's 100% debt and equity model dominated the PPP market in 2003 because it gave governments exactly what they wanted - tight pricing and full risk transfer to the private sector.

ABN's willingness to initially underwrite all the debt and equity was a deal clincher. In addition to Spencer Street the bank arranged and closed Berwick Hospital in Victoria, Victoria County Court, NSW Government Schools and the Lane Cove Tunnel.

And the majority of the deals have been successful - the A$131 million NSW Government Schools project has already delivered four schools ahead of schedule and the remaining five will open on time in early 2005.

However, contractors were normally the junior partners with the best bid, and the deals were heavily structured to attract cheap debt and secondary equity investors.

Implications of bank-driven consortia

Bank-driven consortia are not new and not always controversial. Macquarie Infrastructure Group (MIG) has grown into the biggest private toll road operator in the world. But the difference between the MIG model and the ABN Amro structure is that MIG is in for the life of the project. Conversely, ABN Amro has sold both its equity stakes in Spencer Street and NSW Schools to Development Australia Fund Management.

That the ABN model skews the spread of risk too heavily in favour of the banks is arguable given that the contractors have full access to the design and documentation process - if they don't like the deal they don't sign up. And the outcome of the Spencer Street arbitration should make for interesting reading for all parties.

However, the combination of full construction risk to the contractor and the developing secondary market in equity sales mean that hopes of a quick resolution to construction disputes on an ABN style deal are slim - governments are no longer dealing with a long-term equity player with a long-term interest in the project.

The ABN model is growing in popularity with other banks looking to copy the model. If that happens contractor fixed price bids could rise as they become more aware that the long-term equity player that contracted them to the deal is in fact a short term equity player and is not going to be around to assist in resolving any disputes. Alternatively fixed price will become fixed price with a lot more 'what if clauses' - in effect not fixed price.

And governments or banks will have to adjust expectations accordingly. According to Tony Poulter, partner at PricewaterhouseCoopers, "that creates the potential for a big fall-out of deals because governments will no longer view PPP as value for money."

But it is only potential fall-out. There is enough competition for market share in the Australian PPP construction sector - primarily between major players Leighton Holdings, Bilfinger Berger (which owns Baulderstone Hornibrook and Abigroup), Barclay Mowlem and Multiplex - to keep the bidding market competitive and buoyant.

More likely is that pricing overall will become more competitive and as the secondary equity market develops, banks look to profit more from their post-construction equity sales rather than debt margins and arranging fees.

New solutions, new markets

To some extent the arranging market is already adjusting to concerns over short-term equity. A new boutique, Plenary Group, is promoting a hybrid PPP model, a joint venture with contractors with equity underwritten 50-50. Formed by staff from the exodus from ABN Amro earlier in theyear - ex-ABN Amro staff include managing director Paul Oppenheim, Ray Wilson, John O'Rourke, David Lemming and Paul Bell - the boutique is 20% backed by Deutsche Bank.

According to Oppenheim, 'the cornerstone of our approach is equity ownership so that we are ultimately exposed for the long term. Whilst we might sell down a portion, we will always keep at least 10% for the life of the project. The whole purpose of banks and arrangers in PPP is to bring capital and active equity to the table and to manage the PPP process long term.'

Plenary has already joined up with Multiplex to bid on the A$250 million Chatswood Interchange and is on the shortlist along with Barclay Mowlem with CRI, Bovis LendLease, Leighton Contractors and Macquarie Bank. Plenary and Multiplex are also set to bid on the A$370 million Melbourne Convention Centre for which Victoria has just appointed KPMG Corporate Finance as government adviser.

Despite its problems the Australian PPP market already has around another A$5 billion in the pipeline, including Mitcham-Frankston Freeway, the A$1.5 billion Rail Infrastructure Corp deal in NSW (the EOI on which is out September 2), the A$600 million Darwin City Waterfront, the A$300 million Joint Operations Command national defence project and a whole swathe of hospitals in NSW.

And the emerging local councils PPP sector - primarily in NSW and Victoria - could see contractors playing a more empowered role given that most deals look set to have a strong property development flavour. The Oasis controversy (Liverpool Council signed away the land at the heart of the development, Woodward Park, with little or no public scrutiny), has not dampened the appetite of councils to try PPP, and Paramatta Council is tendering a A$1billion new civic centre: preferred bidders are Bovis Lend Lease, Leighton Properties, Grocon and Multiplex.

Spencer Street may be a blip - and there are a lot of quality deals based on the same model to suggest that it is. Nevertheless the Australian PPP sector has some risk/ reward issues to resolve - if only because it is a very big blip and could happen again.

The market has contradictions at its heart - on the one hand governments appear too short term cost obsessed, and on the other there is no national market, no contract standardisation and high bidding costs. In addition, banks and contractors practise public-private-brinkmanship over risk allocation and long-term management of projects, and until that changes the robustness and future deal flow of the Australian PPP market will remain suspect.