It may be hard to tell over the racket of construction that started this month, but on a site next to the the St James’ University Hospital in Leeds there is a quiet revolution going on in PFI, writes Simon Ellis.

On the site Catalyst – a JV between Bovis Lend Lease and HBOS – is building the largest cancer treatment centre in Europe, and one of the most complex technical projects built under the PFI structure.

But it is not the work on site which is the groundbreaking aspect, it is the way the project is being financed.

The St James’ Oncology wing is a PFI project, but HBOS – the project lead arranger – has not raised a pound of debt. In fact, apart from a modest equity stake, the project represents a Private Finance Initiative project without private finance.

The cancer wing became the first project to be signed under the Treasury’s Credit Guarantee Finance (CGF) policy.

Under the CGF, the Treasury raises the whole debt constituent of the project from gilts and passes it to the private bank or insurance company to be ‘wrapped’ as in a monoline insurance policy - thus passing the risk to the private sector.

The private financier acts not as a lender but as the insurer in return for a risk premium from the Treasury.

The rationale behind CGF, which was unveiled by the Treasury's private finance unit (PFU)  in Summer 2003, is to cut the overall financing cost of a project by raising the debt through relatively cheap gilts.

In theory CGF seemed an ideal compromise, but in the Autumn of 2003, Treasury PFU chief Geoffrey Spence badly needed a concrete test to convince sceptics that CGF could work for both the taxpayer and the market.

The project

Leeds Teaching Hospitals NHS Trust’s new cancer care wing was already a high profile project when it went to tender in 2001.

Not only would the centre be the largest specialist cancer treatment in Europe, but it would be one of the first large hospital PFIs in the UK to require the contractor to provide and maintain complex technical equipment as part of the deal.

The centre was due to rationalise cancer care across Yorkshire from a number of scattered and outdated centres to one single centre bringing the region in line with the NHS’s National Cancer Plan.

The centre would house 300 inpatient beds for specialist cancer treatment including radiotherapy, chemotherapy and haematology. The centre will also provide a number of surgical specialties together with a full range of diagnostic, day care and outpatient services.

As it is part of the deal, the consortium would be required to supply and maintain 10-12 linear accelerators for the centre over the 10-year period.

As well as financing, design, construction and provision of medical equipment, the PFI agreement includes the estates facilities management and lifecycle maintenance of the building for 30 years.

The project attracted competition from consortia led by a beauty parade of PFI developers keen to get a toe-hold on the managed equipment services (MES) market - including Sir Robert McAlpine, Skanska, Mowlem and Bovis.

In September 2003, Catalyst – on the back of a recent success winning with the MES contract in Roehampton – saw off its final rival Sir Robert McAlpine and was confirmed as preferred bidder.

CGF and the project

When Catalyst was approached by the Treasury after winning preferred bidder status, reaction at the consortium was mixed.

HBOS senior director of infrastructure finance Gershon Cohen said: ‘Initially the templates did not look very workable, but HBOS took a pragmatic approach. Whereas my other colleague banks rubbished the whole thing very publicly, we attempted to be innovative and constructive in working with government.’

Negotiations on the CGF were held concurrently with negotiations on the project. While the Treasury and consortium teams had to iron out the financing issues, project lawyers also had to resolve complex issues, such as which party should pay the change of law risk when one party represented the country's legislative body.

Despite the complicated new arrangement, the project closed after just 12 months under heavy political pressure.

Nick Maltby of DLA, who led Catalyst's legal team, suggests the prominence of the project was a major factor:

‘Politically it was helpful to have the Treasury waving a stick in terms of pressure to close it because we were doing a project on the top of everyone’s radar,’ says Maltby.

The financing

The £232m (US$438m) funding package, including the CGF facility was arranged, structured and underwritten by HBOS.

The funding was divided into £214m (US$405m) of debt which included a £9m (US$17m) variation facility and a £5.5m (US$10m) change of law credit facility.

Catalyst supplied an £18m (US$33m) risk capital equity bridge split on a 50:50 ratio between Bovis Lend Lease and HBOS.

The debt:equity ratio is 92:8 and the debt tenor was set at 31 years.

In lieu of a margin, HBOS will charge the Treasury a risk premium priced at a similar level as the margin charged on a conventional PFI loan.

The Treasury is due to save around 15 basis points by avoiding the need for a debt swap on the market.‘To some extent it is a disadvantage for the bank inherent in the fact that you do not actually need the ancilliary hedging facilities,’ adds Cohen.

Overall, according to Linklaters partner Stuart Rowson, who advised Treasury,  Treasury stands to save 7-10 per cent, at a conservative estimate, on the cost of each project implemented through CGF.

Project Conclusion - CGF and the market

Even before it is handed over to the health trust in December 2007, the St James' cancer care centre must be counted as a stand-out project for both speed in reaching financial close and  the huge volume of legal and financial innovation completed to make it happen.

The government also seemed convinced by the pilot's progress, as Nick Maltby is keen to point out: 'A measure of the  success of the project is that the government recently announced CGF status for Swindon schools, if Leeds had been a failure they would not have done that.'

Whether the CGF as a nationwide policy can deliver the benefits to the public purse while holding the market's attention, the jury is still out.

Cohen predicts that the success of the CGF in the financial sector  will depend largely on the blossoming of a secondary market in guarantee trading.

'CGF will only take off to the extent that liquidity becomes evident in the syndicated market. As soon as there is a lack of interest in taking a secondary role in the deal then the principal guarantee providers will stop providing the guarantees.'

One sector that looks set to benefit from the CGF is the monoline insurance, with companies able to fill the role in PFIs previously monopolised by banks and investment funds. 

The outlook for CGF

According to Stuart Rowson, the Treasury is set to earmark up to a half of all PFI schemes for CGF, and could launch a full scale policy as early as this summer.

'The fly in the ointment is whether there is a general election because the embargo on civil service procurement could bring things to a halt in mid-March,' warns Rowson. 'Also the Treasury would prefer to close the second CGF pilot in Portsmouth before moving on with the programme.'

The Treasury will determine whether future projects will assume CGF status at ITN stage and divide them between banks and insurers.

'The Treasury wants to maintain equilibrium between banks and monolines. If it announces a CGF scheme, it would also be likely to proscribe whether that scheme should be a bank deal or a monoline deal to keep it distinct,' says Rowson.

We are all insurers now may hardly seem a rousing slogan to whet the market's appetite for the next major wave of PFI.

However after the apparent success of its pilot, and with the Treasury firmly committed to the policy, PFI financers who are unwilling to evolve to the new climate may have a heavy price to pay.