The Private Finance Initiative (PFI) has always endured a more pronounced political flavour than other financial markets in the UK. Its use as one of the public sectors' main procurement tools brings PFI into the murky transitional zone between private and public finance. The usually competing, if not necessarily always exclusive, imperatives of the public and private sectors ensure that controversy is never far away. But despite this, its importance as a business for the private sector and as a mechanism for the government to deliver infrastructure off its balance sheet means PFI is here to stay.

Over the three years covered by the government's Comprehensive Spending Review, approximately £11 billion of infrastructure investment will come from private finance ? roughly 30% of net publicly sponsored or funded investment during that period.

But it is easier said than done.

PFI has been troubled through its life by the slowness and complexity of its deals, and by the lack of knowledge and experience in the public sector over how these types of financings are structured.

Since the 1997 election of the New Labour government, these PFI glitches have been tackled with some success. The overall deal flow and the actual number of signed deals across a range of sectors has increased ? largely due to the work of the Treasury Taskforce, a public body proposed by Sir Malcolm Bates in his first PFI review in June 1997.

Staffed partly by private sector transactors, the Taskforce was mandated by the government to improve departmental procurement through PFI. And coming to the end of its two-year term, the Taskforce is playing a central role in the two latest PFI developments ? both of which have thrown the PFI's sometimes awkward position into sharp relief.

Setting standards
The first of these developments was the publication on July 14 of the Taskforce's ?Standardisation of PFI Contracts'. These guidelines were designed to reduce the need to ?re-invent the wheel' (a stock phrase of PFI professionals) each time a public agency was procuring under PFI by providing the groundwork of any particular deal's contractual structure.

That some of the pain needs to be taken out of the PFI process is widely accepted. Often these are deals struck by public sector departments that have never done one before.

Most NHS Trusts, for example, will only do one big PFI deal each. For each procuring authority, PFI seems to have to be learnt more or less from scratch.

?The new contract guidelines would act as a blueprint for the development of PFI, and ensure that future PFI deals across the various sectors will be able to follow a consistent approach by incorporating standard conditions into contracts,? says a spokesman at HM Treasury. ?This approach was widely consulted and has widespread backing both in the public and private sectors.?

There was indeed consultation and the Taskforce earned praise for attempting to meet the concerns of both sides of the business. ?The British Banker's Association (BBA) went thoroughly over the draft text of the guidelines twice and did have a number of serious concerns at that stage,? says Paul Chisnall, director at the BBA in London. ?However, the Taskforce did a good job of taking on board the majority of these concerns with the final draft.?

It is difficult to find those who disagree with the aims behind the guidelines. ?The guidance is comprehensive and should push the process forward,? says Jason Fox, partner, at Herbert Smith in London. ?The Taskforce has achieved a middle of the road position between the public and private sectors.? But there is disagreement in the market with both its overall implementation and with specific issues. The guidelines are, at the same time, too prescriptive and too vague ? both generally and specifically.

A fair price?
The biggest area of concern for financiers is the guidelines' treatment of compensation payments under contractor default concession termination. According to the guidelines the public sector will only ever pay out what the contract was worth to it, or what it receives from a third-party buyer.

However, to prevent concerns over the public sector being motivated to terminate contracts in the knowledge that no market for the contract existed, the concept of a liquid market was attached to the guidelines. Under the liquid market proposal, if there is no market for a contract under default then its value will be calculated under a cashflow valuation.

Before these guidelines, lenders could be confident that their debts would be paid off by the public sector and banks were comfortable to enter deals under this concept.

Now, they are required to take on a greater exposure to performance risk from the contractor.

Equally, they are being asked to take a view on what the value of a concession may be in, say, 20 or 30 years, and to gauge whether it will be sufficient to repay the outstanding senior debt. That is not an easy thing to predict and banks are uncomfortable with it. ?The question is how do you define fair market value,?asks Jacco Brouwer, head of infrastructure, at ABN Amro Bank in London. ?In particular, if and when a contract is terminated and it is re-tendered, how do you decide if the bids received reflect fair value??

Within the guidelines' treatment of compensation there is both a prescriptiveness and a vagueness which characterizes the overall process. ?The guidelines feature a draft clause for market value compensation, so this is a very carefully detailed treatment,? says Fox at Herbert Smith. Yet, while the methodology is finely set out, the results in terms of actual compensation are now less easily predicted.

This may be no bad thing. Perhaps previously banks enjoyed returns disproportionate to the risks they were taking in terms of default compensation.

And while lenders initially opposed the idea they are now coming around, albeit slowly. ?The Taskforce has been putting a huge amount of pressure on banks to sign up to a PFI contract which incorporates the guidelines' treatment of fair market valuation compensation for contractor default,? claims a PFI specialist. ?This pressure is also being applied to the public sector to get such a deal done and advisors are more or less being bullied to get the banks to sign in. But so far, no bank has signed such a deal. They need time to get comfortable with the new process.?

Insuring uninsurability
The second big area of contention within the specifics of the guidelines concerns treatment of uninsurability, which again passes more risk to the private sector. In effect, the new guidelines place the risk of obtaining insurance solely onto the contractor. If a certain insurance cover required under the concession is no longer available then the contractor must assume the risk.

Some allowance has been made in the guidelines. ?The guidelines indicate that the public sector is prepared to accept that in exceptional circumstances there may be undefined sector specific risks,? says Rob Tucker, head of the PFI practice group, at Willis Risk Solutions in London. While there are no precedents for this, an example could be where a waste management concession is awarded and is based on a landfill site where there was previously unregulated tipping. The contractor may take the view that pollution cover may not be available in the insurance markets for the duration of the concession as a result of increased gradual pollution claims being made on the market and its removal from cover.

As such, if a specific risk becomes uninsurable during the period of the concession, the contractor is not in breach of its contract and the public sector can either call either a force majeure termination of contract or elect to act as insurer of last resort.

Indeed, solutions may be at hand, certain specialists within the insurance market are already working on providing cover for uninsurability itself. While this is unlikely to match the door-to-door tenors of concession agreements and debt life, insurance policies are expected to soon be written providing cover against uninsurability for between five and 10 years.

?In general, the guidelines are a good advance for PFI,? says Ed Marlow, head of PFI at Denton Hall. ?They set the parameters for risk allocation but some parts have been left open for both sides to interpret and apply to the nuts and bolts of an actual deal.? But being allowed to interpret the guidelines according the nuts and bolts of a deal implies a certain freedom of manouevre for procuring departments which is inconsistent with the stated government intention that the guidelines should be adopted across all government departments.

Mandatory or not?
The Treasury, the National Audit Office (NAO), the Chief Secretary to the Treasury and Bates all commit the guidelines to the full range of applicable public sector procurement. The head of the NAO, Comptroller and Auditor General, John Bourn, is on record as saying: ?In looking at future PFI deals, the NAO will take a close interest in the extent to which these standard terms have been followed and the reasons for any departures from them.?

He may want to do this sooner rather than later. Already, some bankers are arguing that certain departments are ignoring them in favour of their own practices. Three departments in particular are noted for this ? the Ministry of Defence, the Highways Agency and the Prisons Authority.

But if some departments are allowed to follow their own processes doesn't this negate the effect of the guidelines which are designed to ensure that ?future PFI deals across the various sectors will be able to follow a consistent approach by incorporating standard conditions into contracts'?. ?The key is that the public sector should use the guidelines,? says Matthew Webber, director, at Innsifree PFI Fund in London. ?While some departments may already have developed their own templates for contracts, and we are sympathetic to this, all of the public sector should follow the same guidelines.?

But there is undoubtedly an element of ambiguity in the market as to how the guidelines should be treated. ?Our key concern is that it is not clear whether these standardisation documents are intended to be mandatory or purely guidelines,? says Anthony Forshaw, director and head of PFI at Deutsche Bank in London. The Treasury responds by arguing that while these guidelines are not mandatory, in the sense that there is no legislation backing them, government departments are required to adopt and follow them. In effect, deviation is permitted but not encouraged.

This is a more pragmatic approach but it does underscore the limitations of standardizing PFI procurement across such a diverse range of activities facing the public sector.

But of more concern is the view that sectors ignoring the guidelines are seeing more results than those that are following them. ?It's interesting to note that sectors in which the guidelines have not been as prominent, such as roads and prisons, have not seen any related interruption in their deal flow,? says Forshaw at Deutsche Bank.

These particular departments have as much experience in PFI deals as any. But other less experienced departments appear to be having problems understanding that they are allowed to exercise some discretion in negotiating contracts. ?Having bid with consortia using the standard terms from the Taskforce's guidelines there is a lack of recognition from the public sector that these contracts still need to be tailored to the specifics of each project,? says a PFI specialist at a UK clearing bank. ?Some aspects of the guidelines have been purposely left vague and cannot just be signed off as a draft clause.?

Perhaps these departments are too in awe of the Taskforce to deviate from its guidelines but, whatever the reason, they appear to hindering some deals rather than helping. ?The whole thing has really stymied a number of PFI deals,? says one market practitioner in London. ?Some departments are not prepared to enter into dialogue on issues which are covered in the guidelines. Trying to communicate with them over specific issues is almost impossible.?

A further criticism of the guidelines, leveled by some of PFI's newest participants, is their focus on project finance. ?Not surprisingly, given the early history of PFI, the guidelines are very project finance orientated and do not reflect the new entrants to the market who are promulgating new methods of financing,? says Simon Phillips at the Norwich Union Public Private Partnership Fund, an institutional based fund specifically set up to provide 100% of the funding requirement and be the long term operator of PFI deals. ?As more appropriate financial products are brought to the market to reflect the developing nature of Public Private Partnerships, the guidelines will need to evolve.?

And it is still too early to gauge whether the guidelines have met with success or failure. It will be an evolutionary process. ?People need to see how these guidelines work when applied to actual PFI deals, at the moment we are in a bedding down phase,? says Chisnall at the BBA. ?At some stage in the future, we will sit down with our members and see whether these guidelines are doing the job they are intended to do of speeding up and simplifying the process.? Once the Taskforce is disbanded, its two year remit nearing completion, the newly formed Office of Government Commerce (OGC) will take on the responsibility of developing and keeping the guidelines up to date through the Taskforce's policy arm which will be transferred there.

Partnerships UK ? a bank by any other name
But in Bates' second review he identified the need for a continuation and development of the work done by both the policy and the projects arm of the Taskforce. Bates considered four options relating to the expiry of the Taskforce's mandate ? disbanding the projects arm, extending the life of the projects arm; the introduction of a public sector fee-earning agency; and, a new public/private partnership.

While the news that the policy team will move over to the OGC was hardly commented upon, news that the projects arm was to be reformed into a 51% privately owned, public limited company with the government holding the remaining 49% caused uproar among the private sector involved in PFI.

Initially, the new body was to be called UK Capital, but according to some bankers, too many comments that it sounded like an investment bank prompted the name to be quickly switched to Partnerships UK (PUK).

In essence, PUK will assist and advise, including project managing, the public sector on PFI deals. In addition, it would be able to provide development financing to help the public sector reach financial close on a project and take equity stakes in PFI deals to recoup these costs.

Bates notes in the review that: ?An early decision on the arrangements to follow the Taskforce would avoid damaging market confidence?. Yet, so far, almost everything to do with PUK has had precisely the opposite effect. It has enraged the trade unions (who are admittedly generally opposed to PFI) and caused a deep division among banks.

Perhaps some of this was intentional. A leaked memo from Adrian Montague, chief executive of the Taskforce, published in the UK newspaper, The Sunday Telegraph, on August 22, but dated May 31, suggests delaying the announcement on PUK until after two important trade union conferences. Of more direct concern for PFI deals, the memo also suggested splitting the financial sector between those institutions that are ?agnostic or hostile' to PUK and those that support it: ?We will cosy up to the proposal's supporters (of which we already know we have a reasonable number) and try to bring them to the point of being willing to express support'.

This seems to have had a strong effect. ?The approach taken has been to practically blackmail the City,? says one leading PFI banker at a major foreign bank in London. ?It is scary when these proposals appear to be based not on openness and common sense but on insinuation and political machination.?

At the moment, little is known in detail about what exactly PUK will bring to PFI and this is unsettling the market. A group of banks ? Abbey National Treasury Services, Barclays, Halifax, Prudential, Royal Bank of Scotland and the EIB ? have been appointed to prepare a business case for PUK and outline capital raising plans which is expected to be finished by March 2000.

Until then, however, bankers will continue to speculate on PUK. Much of this speculation pivots on its attempt to straddle both private and public sector interests. At first glance, it is difficult not to notice the potential conflict of interests that PUK faces ? a majority privately-owned firm which is mandated to advise and assist the public sector in procurement under PFI arrangements with the opportunity to recoup its costs through acquiring equity in the very deals it worked on.

?We can see why ministers want to retain the skills of the taskforce and we can see space for the provision of advisory services for the public sector through PUK but we remain to be convinced that equity participation in PFI deals should be part of its remit,? says Chisnall at the BBA.

However, others see a beneficial role for PUK through equity participation. ?If PUK, because of its position and reputation is able to give the market a lead in certain areas which have struggled, that will be a big help,? says Jim Boags, senior director, PFI and infrastructure, at Bank of Scotland in Edinburgh. ?For example, if it was to take a higher than normal equity stake, say 40%, in an IT deal it could give lenders the encouragement to back the deal.?

The provision of development finance to the public sector has been an area neglected by the private market and here PUK could play a useful role. However, if it recoups this through equity stakes it has to accept the fact that some will see this as anti-competitive. There is also concern that because of its position, PUK will have too much intimate knowledge and access to PFI deals. ?It depends on the role of PUK ? it could have a strong role in assisting in the project management and financial closure of projects,? says one PFI equity specialist in London. ?If, at the same, time they are warehousing schemes then this could cause a conflict.?

At a recent conference on PFI, Montague outlined his concept of PUK ? enhancing the public sector's intelligent client capability, majority owned by the private sector, providing core private sector skills, in a business environment and dealing with conflicts of interest. If this can be achieved then there will be support for PUK. ?The PFI process is not simple,? says Richard Millward, director, head of PFI advisory, at Dresdner Kleinwort Benson in London. ?If PUK can improve the process then that has to be a good thing.?

And despite the sometimes uneasy alliance between the public and private sectors, it is worth remembering that within a year a flurry of highly efficient, quickly delivered projects will come on-stream. Hospitals, roads, prisons and various other projects will be available to the UK which without PFI, despite its problems, would never have been procured. The results of PFI, however tortuous to the professionals involved, will provide material benefits to the lives of the public.

And that is not something to be discounted.