The close of Barclays Capital and SG's secondary fund in September is further evidence that the secondary market in UK PFI is taking off. The two institutions have established a secondary market fund to be called Infrastructure Investors into which each institution will invest £150 million, with a further £150 million to come from third-party investors. This comes after Innisfree set up the first official secondary fund in the market in September last year with £100 million from Prudential Assurance Company and £50 million from John Hancock Life Insurance Company. Innisfree will look to expand this fund next year once it has invested in enough core revenue producing projects. Other secondary funds have emerged since, including the Secondary Market and Infrastructure and Facilities Fund of Abbey National and the STAR fund.

What the secondary market provides is a means for traditional equity investors - contractors and operators - to recycle capital in order to concentrate on their core business activities and fund new projects, It also provides them with an opportunity to offset losses from unsuccessfully bidding on other PFI projects. Divestment becomes an option once construction is complete and the project moves into the operational stage because the risk profile of the project decreases, thus allowing original investors to realise potential gains from taking that risk and allowing the more risk adverse investor to enter the market.

"The emergence of a secondary market is a natural progression with most securities markets having followed a similar route. This market could not have developed four years ago, as there were only a handful of deals in the operational stage, but now there are a few hundred," comments Tim Kashem, investment director at Innisfree. A primary equity investor can sell before or after refinancing as it is possible to price refinancing benefit. "However, when carrying out refinancing existing equity investors should take care not to be too aggressive such that following refinancing they are left with an equity structure that is unattractive to an incoming purchaser," notes Kashem. This secondary market provides the opportunity for investors looking for stable, high-yielding government-backed cash flows to enter the PFI market, by being given the opportunity to invest in existing operational projects free of construction risk.

Market participants are positive about the emergence of a secondary market, as it is a means for contractors, operators and other primary equity investors to demonstrate to shareholders and analysts that PFI is a liquid market that contains value. "The secondary market should develop some new concepts in financing. The ability to generate long-term financial products with secure yield characteristics can be useful in a number of sectors, including the pension markets," remarks Chris Elliott, MD at Barclays Private Equity, responsible for infrastructure investing. "If one can establish a significant operating PFI portfolio and enough diversity in the fund to minimise individual project risk, it will be possible to get revenue streams that can be used in various sectors." A splurge of activity is expected in this sector over the next six months with fund managers reporting a number of potential purchases on the cards.

"The emergence of secondary market should also be welcomed by the public sector," indicates Mathew Vickerstaff, MD and regional head of project finance EMEA and head of infrastructure at SG. "While contractors are interested in building the infrastructure, it is arguably not their core business activity to hold onto the underlying infrastructure asset thereafter. A secondary fund provides the public sector with a sensible long term partner, that will look to improve the management in order to operate the asset more efficiently and make certain that performance levels are met in order to ensure equity dividends flow," explains Vickerstaff.

Although most secondary funds have not been leveraged to date, it is expected that all funds will anticipate some degree of leverage along the way. "The Innsifree fund is unleveraged at the moment but leveraging a fund to some extent is a logical approach, especially if one takes the view that these funds will evolve into long term businesses," indicates Kashem. Bank of Scotland Corporate Banking head of infrastructure finance Philip Grant says that the bank, which has a substantial equity investment portfolio, is as of yet undecided as to whether it will look to be a buyer or seller in this secondary market. "Funds will need to divest from the primary markets as they have a mandate to give their investors returns within a given time period - bank equity investors do not have this kind of constraint and therefore have more freedom of decision in this regard," remarks Grant.

On or off balance sheet?

The emergence of the secondary market is not the first notable shift in equity ownership in the UK PFI market. Although initially mainly operators and contractors put equity into projects, since the mid- to late-90s a number of infrastructure funds have been established as a means for investors to operate in the PFI market and some of the banks that have been active in the market on the advising and arranging side have also put in equity - a service that is traditionally not the domain of banks.

Scottish banks, Bank of Scotland Corporate Banking and Royal Bank of Scotland have both been active providers of risk capital over the last five or so years. Both these institutions generally arrange the finance and offer advisory services on the projects that they put equity into. Philip Grant at Bank of Scotland (now merged with Halifax) says that the bank intends to optimise value from an integrated sustainable business model. If investing in risk capital serves the sustainable business model approach, Bank of Scotland will invest as much value in risk capital as is necessary for market optimisation.

Banks adopting this approach believe that the Chinese walls set up in these transactions have proved successful although many outsiders have expressed concern as to whether it is really possible to eliminate conflicts of interest, especially when the Chinese walls are erected within a single project finance team. Some have also criticised banks adopting this approach as investing in equity as a means to obtain arranging and advisory mandates, as the banks do not put in equity on projects they are not arranging and/or advising on. To date Bank of Scotland has invested in some 40 projects and Royal Bank of Scotland in about 18. HSBC has also invested in PFI projects and since 2001 it has had access to a £125 million fund managed by HSBC Infrastructure Fund Management - run by the team responsible for PFI investments at Charterhouse before it was bought out by HSBC. HSBC Infrastructure Fund Management has the ability to offer the integrated approach or each service can be offered independently. SG has also made a number of on-balance sheet investments in projects that it has arranged and/or advised on - mostly hospital and court projects.

The hammering of debt margins over the last few years has undoubtedly had some bearing on banks choosing to invest in equity on balance sheet in order to maximise their market interest. "At the moment there is insufficient value in primarily concentrating on the senior debt market with returns being too low to generate required returns on capital. Having equity investment enhances the company's profit loss account as most PFI equity is high yielding loan stock," remarks Grant. "However, the integrated approach does require separate governance of equity and management of debt - hence the need for a team approach."

Chris Elliott at Barclays embraces a different approach, believing that the purpose of debt and equity in PFI products is different and each product should be priced and managed to reflect this - "products should be self-standing in their own right, the role of equity is different to the role of debt and they are best separated. When everything is going well and is in the bidding period where there can be a high degree of commonality between different financial products, the cross subsidised blended approach can appear attractive, but if things go wrong the commonality interest soon disappears," states Elliott.

Barclays Private Equity has reached first close on its latest primary market fund this month at £66 million (target size is £100 million). Known as the Alma Mater Fund, it is a joint venture with 3i and is targeted at university accommodation projects.

Innisfree prefers to invest in the larger projects, as it believes that the due diligence undertaken for these projects has to be thorough, as it is open to the scrutiny of a number of parties. Innisfree has three primary market funds and is in the process of increasing the capacity of its third fund from £60 million to between £250 and £300 million. To date, Innisfree has made commitments amounting to some £264 million to 36 projects. Other investors in the equity portion of PFI projects include the Noble PFI Fund and Babcock & Brown.

Participants note that there is a healthy demand for equity in the market but do not necessarily see more participants entering the primary market as a result of the time it takes to build up a sizeable portfolio. In a report released in July by the UK Treasury entitled 'PFI: Meeting the Investment Challenge' on the evolving role of PFI in delivering cost effective investment in public services, it states that some £12 billion is to be invested in new projects between now and 2005/2006, with investment increasing from £35 billion in 563 deals at the time of the report to £47 billion by 2005/2006. This means that the market will have to come up with about £1.2 billion of equity.

Rate of return

In the last five or so years there has been much downward pressure on returns in the UK PFI market, mainly as a result of growing experience and confidence and increased competition. According to a recently released PricewaterhouseCoopers study for the Office of Government Commerce into rates of return bid on PFI projects in the UK between 1995 and 2001, average bank lending margins declined by about 30 to 40 basis points to around 100 basis points over the swap rate and debt service ratio cover ratios declined from 1.4 to 1.25. The general consensus is that debt margins, which have reached unsustainable levels, have reached their lower limit and that decreased liquidity in the debt market, caused in part by the likes of Abbey National and Bank of America relinquishing their interests in PFI, will in fact cause debt margins to increase again. The average final maturity on debt, which is sitting at around 30 years, is also expected to contract. Equity margins have also come down over the years ? margins were as high as the low twenties but have settled in the mid-teens - 12% to 16%. It is believed that returns will remain at this level. "Banks are definitely not as aggressive as they have been, which is good for equity as returns will be less downward pressure on returns," indicates Kashem.

The PWC report compared projected internal rate of returns (IRRs) of PFI projects at financial close with a weighted average cost of capital (WACC) for each project - WACC being the return that should be expected from a project by a diversified investor according to the project's risk. The 64 projects in the sample show expected Project IRRs that are 2.4% above the appropriate WACC before various adjustments, which suggests some element of excess project return. However, the report makes a number of points as to why this may be the case, including the nature of the standard Capital Asset Pricing Model from which WACCs are derived, bid and swap costs and structural issues that in the past have limited competition in the PFI market. Bidders' target equity returns average 14.5% over the period before adjustment for bid costs, whereas the cost of equity implied by a traditional WACC calculation is in the range 8.3% to 9.4% depending on the assumptions used.

"I believe that the UK PFI market has been healthy, both on the debt side and as far as third party equity is concerned. As with any market, there are going to be fluctuations on returns, some of which overshoot and become unsustainable," remarks Tony Poulter, head of Project Finance at PwC. "If government is to take something from this report, it should be that if transaction costs are brought down and if factors that limit competition, such as high bid costs, can be addressed, then returns could come down. We are not saying that returns have been too high, but it might be possible to attract investors at lower returns if the costs of closing a project are not too high for the risk taken," he continues.

However, others in the market do not believe that it will be possible to find investors for projects that have equity margins any lower than what they are at the moment. Jeff Thornton, head of the infrastructure finance group at Royal Bank of Scotland, points out that equity returns for the most part depend on senior debt coverage ratios and are generally not under the control of sponsors. James Hall-Smith at HSBC Infrastructure Fund Management reiterates this point, "Banks require a certain amount of comfort reflected through the need for coverage ratios. If equity returns come down any further then this lenders' comfort zone will be eroded." Kashem at Innisfree describes the report as an "interesting and challenging academic analysis" but feels that it is difficult for any such report to provide a true reflection of the market.

Widespread opportunity

The general outlook for the UK PFI equity market is positive. "I think that the market is active and growing and believe the introduction of the secondary market will go some way in helping liquidity, however, deals still need to be closed quicker and become less complex. Our strategy is to remain active in both the primary and secondary markets," comments Elliott.

"The project pipeline is looking healthy at the moment with a number of defence, batched health, and education schemes coming to market," points out Hall-Smith.

All participants surveyed say that they are looking to the rest of Europe with some enthusiasm and most have already made some investments in projects in these countries and set up offices in major centres. Those attracting the most interest are France, Netherlands, Germany, Italy, Spain and Portugal. Some of the smaller countries entering the PPP market, such as Norway, Hungary and Poland, will probably not see much equity investment until there is more deal flow to justify the costs of setting up offices in these countries. Beyond Europe, some banks and fund managers are looking at opportunities in Australia, Japan and Canada. The realisation that PFI will need to be adapted to fit the needs of the various countries is there, and some local participants have plans to set up joint ventures with local institutions. It is also not certain whether all countries will be looking to attract UK equity investments or will prefer to take the UK model and find equity investors locally.