Pfist fight
For opponents of the concept of Public Private Partnership (PPP),
the row that has erupted in the UK press over recent refinancings
of PFI deals must have seemed like a godsend. The crux of the
dispute is the division of gains that have accrued when some of the
earlier PFI deals were refinanced, and how these gains have been
divided between the public and private sector. The fact that in
many cases the majority ? if not all ? of the refinancing gain has
been taken by the private sector has generated severe criticism
from not only the broadsheet press but public sector unions and
departments and backbenchers within the government itself.
Opponents of PPP have seized on this opportunity to demonstrate how
the scheme is yet again screwing the taxpayer and the private
sector sponsors of the projects have been caricatured as evil
bandits running away with all the loot. Not surprisingly, the
project finance community has reacted to these criticisms with a
weary resignation ? claiming that the issue is an easy target for
critics and that it is all a storm in a teacup, which will soon be
forgotten. But is it?
The row was mostly triggered by one case ? the refinancing of Fazakerly Prison in Liverpool in March 2000. The £92.5 million original loan ? which was arranged by ABN Amro and Halifax ? was refinanced post-construction. This deal was one of the first PFI projects and the prison was completed ? ahead of schedule ? in 1997. The refinancing saw the margin on the loan fall from 150bp over Libor to 70bp for the first five years and 90bp over Libor thereafter while its tenor was actually increased from 19 years to 22 years. The more favourable terms of the refinancing meant that the expected rate of return for the project's sponsors (Carillion and Group 4) has increased by a rumoured 75%. The net gain from this exercise has been put at anywhere between £11 million and £14 million. The deal closed smoothly but trouble began in June 2001 when the National Audit Office revealed that of these gains a mere £1 million had been taken by the Prison Service, with the remainder going to the sponsors.
Once this fact became public knowledge it was seized upon by PPP critics and other cases of huge windfall profits going to the private sector were brought to light. One of the most startling of these was the Norfolk and Norwich Hospital where it is estimated that refinancing will generate a full £70 million gain ? all of which would presumably go into the pockets of its sponsors. Other, smaller gains, are anticipated in the Dartford and Gravesham Hospital deal, where refinancing of an £108 million deal is expected to to produce a gain of around £20 million. Similarly, in the case of the Bridgend Prison project in South Wales, refinancing of a £77 million loan will generate a £5 million windfall gain.
It is not the size of the gains that is causing outrage ? that is simply a factor of market conditions and a change in risk perception for PFI deals. It is the fact that no-one seems to have thought to put a public sector clawback clause into the original documentation on the these deals. The National Audit Office has now revealed that of 107 PFI projects examined by its researchers only 25% contained any contractual rights for the public sector to share in refinancing gains. Is this a case of massive negligence on the part of the commissioning local authorities involved? Or would such clauses simply have been unworkable when PFI was in its infancy?
One London-based executive closely involved in PFI since its inception has no doubt that it is the latter. ?It would have been impossible to get people in to these early deals if they had contained profit sharing clauses,? he says. ?The contracts were brand new. If the public sector had pushed for profit sharing clauses the answer from the private sector would have been NO.?
Others disagree. Peter Robinson, senior economist at the Institute for Public Policy Research (IPPR), is co-author of its recent report examining PPP, ?Building Better Partnerships?. ?Responsibility for why this [profit sharing clauses in the original contracts] was not done lies squarely with the local authority,? he says. ?If the contracts were properly worded then it would not put the private sector off.?
Others are less keen to point the finger of blame. ?No-one is to blame for this,? says Mark Hake, construction sector analyst at Merrill Lynch in London. ?Blame is not the issue. When the schemes were taken out everyone was very wary of what was going on. The risk profile was relevant to what was going on.? It is a familiar refrain from the banks and the sponsors involved ? that people have forgotten the level of risk that the sponsors and banks were actually taking on with these first PFI deals, and that if they are now reaping rewards from refinancing then it is simply their just desserts for taking on the risk in the first place.
Profit-sharing clauses cannot be implemented retrospectively, so arguing about whether they should or should not have been part of the original deals does nothing to address public disquiet about how the windfall gains that are now materialising are distributed. ?All the headlines are giving the impression that the sponsors ?legged over' the client,? complains Hake at Merrill Lynch. ?This is simply not the case. The banks weren't willing to take the risk so the contractors took it on board.?
And the attitude to that risk has certainly changed beyond all recognition in the intervening period. ?When the first deals were closed the terms of the agreements between the contractor and the local authority were very different from how they are today,? says Fraser Greenfield at Royal Bank of Scotland, which arranged the recent refinancing of the deal which funded the Inland Revenue's headquarters in Newcastle upon Tyne. ?This is simply a process of catch-up, bringing the deals into today's marketplace.? The London-based PFI executive adds that these gains should not even be termed ?windfall? gains as they are simply the result of a radical drop in underlying interest rates. ?What is people's reaction going to be when rates start to go up?? he asks. ?If you start to push gain-sharing too hard, what happens when there is a loss??
Peter Robinson at the IPPR is, not surprisingly, critical of the private sector's attitude that sponsors are simply, and deservedly, benefiting from a fortuitous by-product of a rapid fall in interest rates. ?Everyone in Whitehall is extremely embarrassed about the headlines being generated by this,? he says. ?People don't like to see the taxpayer being ripped off. I am surprised by the lack of political acumen on the part of the private sector companies in this matter.? Robinson tells Project Finance that he thinks it is in the PFI sponsors' interests to share their refinancing gains with the public sector even if they are not contractually obliged to do so. ?[Not doing so] is a naïve way of approaching things,? he says. ?It would play better over the long term if they took a different approach as they would be more likely to get future contracts from the public sector.? In his report, Robinson argues that the sharing of any excess financial gain from PPP deals should be taken as one criterion for identifying a true ?partnership? arrangement.
The temperature of the row over profit-splitting has definitely been raised by the decision of the Office of Government Commerce (OGC) to recommend that all future PPP contracts must include a clause stipulating that any windfall gains from refinancing are split 50:50 between the public and private sector. This may go some way towards placating the many PPP critics on this issue, but it is the legislative equivalent of shutting the door once the horse has already bolted. ?It is all very well squabbling about this now but people have to realise that there are no longer going to be significant refinancing gains from these projects in the future,? says Fraser Greenfield at Royal Bank of Scotland. He explains that gains on the early deals have been so generous as the terms at which banks are prepared to lend have changed so drastically. ?Banks were not prepared to lend for longer than 18 years on 25-30 year contracts and they were looking for 120bp to 125bp. They are now looking for 85bp?95bp for 25 year money. How much better than that is it going to get?? Greenfield describes the moves to dictate profit-splitting ratios going forward as ?tiresome? for this reason. ?In future people will be splitting 50:50 the square root of nothing ? it is irrelevant going forward,? he says.
The London-based PFI executive is also particularly critical of moves to require profit-splitting clauses in future contracts ? and warns that it could even end up backfiring. ?There are ways of burying gains and the more you try to get prescriptive about this the more it makes the creative juices of the private sector flow,? he warns. He says that most defence and health sector deals do now include profit sharing clauses and that they will become standard practice. He reckons, however, that a 75:25 split between private and public sector is equitable, and says that 50:50 is ?a bit rich?. But he does agree that deals do need to include ?anti-embarrassment? clauses to avoid gains such as those rumoured for the Norfolk and Norwich refinancing happening again.
While critics are largely impotent in being able to do anything about this situation, there is evidence that the brouhaha has caused some sponsors to reflect on what the word ?partnership? actually means ? no matter how loathe they are to do so. One source close to the Norfolk and Norwich refinancing reveals that ?the heat has definitely been taken out of the deal. They are now looking at their options and if there are other ways for them to get some of the value out of it.? But he expresses frustration at the situation. ?If the refinancing does not happen then the business is less efficient than it should be.?
This whole dispute is a prime example of the clash of ideologies that PPP espouses. Calling such deals ?partnerships? is a piece of typical New Labour spin-doctoring: both public and private sector partners are in these projects for what they can get out of them and are primarily concerned with protecting their own interests. Despite protestations that the first PFI deals would not have been able to get done with profit-sharing clauses, this latest row again raises questions over the advice that the public sector has received in negotiating its PPP contracts. ?The public sector has not been particularly clever in selecting advice,? says one market participant. ?It has often bought advice on the basis of price and locality. A local law firm might get the deal because they did the conveyancing on the chief executive's house: the result is sloppy deals with a lot of slack left in them.?
Profit sharing clauses are ? for better or worse ? now likely to be a permanent feature of PPP contracts. But they will not be the deal-breaking horrors that supposedly would have sent potential sponsors running for the hills in the early days. Indeed, they will be largely irrelevant as the likelihood of any substantial refinancing gains going forward is so remote. ?This is all a storm in a teacup,? says Tim Stone, at KPMG in London. ?It is a natural consequence of a mature market and the injection of a bit of common sense into these deals.? But in the highly-charged political atmosphere following the bitter tussle between the government and Mayor Ken Livingstone over the merits of PPP as a financing mechanism for London Underground it is not surprising that the issue has been capitalised on by the anti-PPP lobby. ?This has been ?Son of Fat Cat'. There have been a lot of cheap shots scored by broadsheet journalists who should know better,? fumes one PFI participant. But while nothing can now be done to rewrite history, refinancing gains are a graphic illustration of the true nature of the ?partnership? that exists between the public and private sector in these contracts.
The row was mostly triggered by one case ? the refinancing of Fazakerly Prison in Liverpool in March 2000. The £92.5 million original loan ? which was arranged by ABN Amro and Halifax ? was refinanced post-construction. This deal was one of the first PFI projects and the prison was completed ? ahead of schedule ? in 1997. The refinancing saw the margin on the loan fall from 150bp over Libor to 70bp for the first five years and 90bp over Libor thereafter while its tenor was actually increased from 19 years to 22 years. The more favourable terms of the refinancing meant that the expected rate of return for the project's sponsors (Carillion and Group 4) has increased by a rumoured 75%. The net gain from this exercise has been put at anywhere between £11 million and £14 million. The deal closed smoothly but trouble began in June 2001 when the National Audit Office revealed that of these gains a mere £1 million had been taken by the Prison Service, with the remainder going to the sponsors.
Once this fact became public knowledge it was seized upon by PPP critics and other cases of huge windfall profits going to the private sector were brought to light. One of the most startling of these was the Norfolk and Norwich Hospital where it is estimated that refinancing will generate a full £70 million gain ? all of which would presumably go into the pockets of its sponsors. Other, smaller gains, are anticipated in the Dartford and Gravesham Hospital deal, where refinancing of an £108 million deal is expected to to produce a gain of around £20 million. Similarly, in the case of the Bridgend Prison project in South Wales, refinancing of a £77 million loan will generate a £5 million windfall gain.
It is not the size of the gains that is causing outrage ? that is simply a factor of market conditions and a change in risk perception for PFI deals. It is the fact that no-one seems to have thought to put a public sector clawback clause into the original documentation on the these deals. The National Audit Office has now revealed that of 107 PFI projects examined by its researchers only 25% contained any contractual rights for the public sector to share in refinancing gains. Is this a case of massive negligence on the part of the commissioning local authorities involved? Or would such clauses simply have been unworkable when PFI was in its infancy?
One London-based executive closely involved in PFI since its inception has no doubt that it is the latter. ?It would have been impossible to get people in to these early deals if they had contained profit sharing clauses,? he says. ?The contracts were brand new. If the public sector had pushed for profit sharing clauses the answer from the private sector would have been NO.?
Others disagree. Peter Robinson, senior economist at the Institute for Public Policy Research (IPPR), is co-author of its recent report examining PPP, ?Building Better Partnerships?. ?Responsibility for why this [profit sharing clauses in the original contracts] was not done lies squarely with the local authority,? he says. ?If the contracts were properly worded then it would not put the private sector off.?
Others are less keen to point the finger of blame. ?No-one is to blame for this,? says Mark Hake, construction sector analyst at Merrill Lynch in London. ?Blame is not the issue. When the schemes were taken out everyone was very wary of what was going on. The risk profile was relevant to what was going on.? It is a familiar refrain from the banks and the sponsors involved ? that people have forgotten the level of risk that the sponsors and banks were actually taking on with these first PFI deals, and that if they are now reaping rewards from refinancing then it is simply their just desserts for taking on the risk in the first place.
Profit-sharing clauses cannot be implemented retrospectively, so arguing about whether they should or should not have been part of the original deals does nothing to address public disquiet about how the windfall gains that are now materialising are distributed. ?All the headlines are giving the impression that the sponsors ?legged over' the client,? complains Hake at Merrill Lynch. ?This is simply not the case. The banks weren't willing to take the risk so the contractors took it on board.?
And the attitude to that risk has certainly changed beyond all recognition in the intervening period. ?When the first deals were closed the terms of the agreements between the contractor and the local authority were very different from how they are today,? says Fraser Greenfield at Royal Bank of Scotland, which arranged the recent refinancing of the deal which funded the Inland Revenue's headquarters in Newcastle upon Tyne. ?This is simply a process of catch-up, bringing the deals into today's marketplace.? The London-based PFI executive adds that these gains should not even be termed ?windfall? gains as they are simply the result of a radical drop in underlying interest rates. ?What is people's reaction going to be when rates start to go up?? he asks. ?If you start to push gain-sharing too hard, what happens when there is a loss??
Peter Robinson at the IPPR is, not surprisingly, critical of the private sector's attitude that sponsors are simply, and deservedly, benefiting from a fortuitous by-product of a rapid fall in interest rates. ?Everyone in Whitehall is extremely embarrassed about the headlines being generated by this,? he says. ?People don't like to see the taxpayer being ripped off. I am surprised by the lack of political acumen on the part of the private sector companies in this matter.? Robinson tells Project Finance that he thinks it is in the PFI sponsors' interests to share their refinancing gains with the public sector even if they are not contractually obliged to do so. ?[Not doing so] is a naïve way of approaching things,? he says. ?It would play better over the long term if they took a different approach as they would be more likely to get future contracts from the public sector.? In his report, Robinson argues that the sharing of any excess financial gain from PPP deals should be taken as one criterion for identifying a true ?partnership? arrangement.
The temperature of the row over profit-splitting has definitely been raised by the decision of the Office of Government Commerce (OGC) to recommend that all future PPP contracts must include a clause stipulating that any windfall gains from refinancing are split 50:50 between the public and private sector. This may go some way towards placating the many PPP critics on this issue, but it is the legislative equivalent of shutting the door once the horse has already bolted. ?It is all very well squabbling about this now but people have to realise that there are no longer going to be significant refinancing gains from these projects in the future,? says Fraser Greenfield at Royal Bank of Scotland. He explains that gains on the early deals have been so generous as the terms at which banks are prepared to lend have changed so drastically. ?Banks were not prepared to lend for longer than 18 years on 25-30 year contracts and they were looking for 120bp to 125bp. They are now looking for 85bp?95bp for 25 year money. How much better than that is it going to get?? Greenfield describes the moves to dictate profit-splitting ratios going forward as ?tiresome? for this reason. ?In future people will be splitting 50:50 the square root of nothing ? it is irrelevant going forward,? he says.
The London-based PFI executive is also particularly critical of moves to require profit-splitting clauses in future contracts ? and warns that it could even end up backfiring. ?There are ways of burying gains and the more you try to get prescriptive about this the more it makes the creative juices of the private sector flow,? he warns. He says that most defence and health sector deals do now include profit sharing clauses and that they will become standard practice. He reckons, however, that a 75:25 split between private and public sector is equitable, and says that 50:50 is ?a bit rich?. But he does agree that deals do need to include ?anti-embarrassment? clauses to avoid gains such as those rumoured for the Norfolk and Norwich refinancing happening again.
While critics are largely impotent in being able to do anything about this situation, there is evidence that the brouhaha has caused some sponsors to reflect on what the word ?partnership? actually means ? no matter how loathe they are to do so. One source close to the Norfolk and Norwich refinancing reveals that ?the heat has definitely been taken out of the deal. They are now looking at their options and if there are other ways for them to get some of the value out of it.? But he expresses frustration at the situation. ?If the refinancing does not happen then the business is less efficient than it should be.?
This whole dispute is a prime example of the clash of ideologies that PPP espouses. Calling such deals ?partnerships? is a piece of typical New Labour spin-doctoring: both public and private sector partners are in these projects for what they can get out of them and are primarily concerned with protecting their own interests. Despite protestations that the first PFI deals would not have been able to get done with profit-sharing clauses, this latest row again raises questions over the advice that the public sector has received in negotiating its PPP contracts. ?The public sector has not been particularly clever in selecting advice,? says one market participant. ?It has often bought advice on the basis of price and locality. A local law firm might get the deal because they did the conveyancing on the chief executive's house: the result is sloppy deals with a lot of slack left in them.?
Profit sharing clauses are ? for better or worse ? now likely to be a permanent feature of PPP contracts. But they will not be the deal-breaking horrors that supposedly would have sent potential sponsors running for the hills in the early days. Indeed, they will be largely irrelevant as the likelihood of any substantial refinancing gains going forward is so remote. ?This is all a storm in a teacup,? says Tim Stone, at KPMG in London. ?It is a natural consequence of a mature market and the injection of a bit of common sense into these deals.? But in the highly-charged political atmosphere following the bitter tussle between the government and Mayor Ken Livingstone over the merits of PPP as a financing mechanism for London Underground it is not surprising that the issue has been capitalised on by the anti-PPP lobby. ?This has been ?Son of Fat Cat'. There have been a lot of cheap shots scored by broadsheet journalists who should know better,? fumes one PFI participant. But while nothing can now be done to rewrite history, refinancing gains are a graphic illustration of the true nature of the ?partnership? that exists between the public and private sector in these contracts.
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