Lip service?

Since the Treasury proposed the introduction of equity funding competitions into PFIs it has remained strangely tight-lipped on the issue. By John Smith and Al Goodwin

In March 2006 the concept of equity funding competitions (EFCs) in PFI projects was first formally – if tentatively – raised by HM Treasury in its document ’PFI: strengthening long-term partnerships’.

Since then there has been no formal communication from the Treasury on this subject. Given the subject’s contentious nature, PFI practitioners (especially lawyers) have been keen to find out more about the Treasury’s plans, but the Government’s various policy representatives have been vague on the details of how the concept would work in practice and on the timetable for its implementation.

Political context
It is important for PFI lawyers to understand the political background to the concept of public sector-driven EFCs, as distinct from the already commonplace practice of bidding consortia securing competitive equity finance from a potential range of investors.

The Committee of Public Accounts has demonstrated a clear preoccupation with what it perceives to be the ’super-profits’ made by initial equity investors in PFI special purpose vehicles (SPVs), especially when those equity stakes are sold on to secondary investors. There are several high-profile examples of this.

At the heart of what enables such returns is the willingness of secondary investors to accept a lower internal rate of return (IRR) on the shares that they acquire. This is often explained by the fact that secondary investors acquire the equity stake after completion of the most risky phase (for example, the construction phase) of the underlying project.

However, the Treasury has apparently also identified instances of secondary investors accepting a lower IRR on their equity investment while the project’s success is still subject to considerable uncertainty. The question facing the Treasury is: if secondary investors can take such a view of risk and reward, why are initial equity stakeholders unable to do so?It seems to be this question, coupled with the demonstrable political sensitivities aroused by certain high-profile returns to PFI consortia, that led the Treasury to suggest EFCs.

Practical challenges
It is unclear how EFCs would work in practice. If the Treasury’s principles for debt funding competitions (DFCs) are applied to EFCs, a number of difficulties arise for law firms. Many of these difficulties (potential delay to the procurement timetable, related additional procurement expense, etc) will be well known to lawyers who are familiar with DFC concerns. However, certain issues have particular relevance to EFCs.

There would be process challenges affecting lawyers: who would determine the participants in any competition? Who would carry it out? And who would bear the risks associated with it?The public sector would not wish to restrict the innovation and flexibility of alternative financing models, but it is easy to see how the funding competition route may do just this. The private sector will be keen for particular equity providers with which they have existing strong positive (or negative) relationships to be included (or excluded) from the competition.

Assuming any EFC takes place following selection of a preferred bidder, as with DFCs, a more fundamental concern for lawyers and clients alike is ensuring that the late involvement of equity providers does not prejudice the overall viability of the project, and indeed the strength of the contractor market. The EFC concept also risks under-estimating the expertise held by sponsor groups in putting together solutions and consortia to deliver these deals and manage the risks.

Indeed, such investors would argue that, for the public sector to lose the benefit of their knowhow and relationship bases, would equate to saving pennies to spend pounds.

Market views
Unsurprisingly, the concept of EFCs is unpopular with those who are active in the PFI equity investment business. In their view most bids are already subject to intense competition and the aspects of bidders’ proposals that ultimately determine the equity IRR are very much a part of that competitive process.

Another concern, voiced by a representative of a major PFI equity investor, is that “the auction process implied by equity funding competitions ignores, and is the antithesis of, the portfolio approach of business-building that we adopt”. The Treasury has acknowledged the possible synergies to be gained through equity investors becoming involved in multiple PFI projects and must surely be mindful of the threat posed to this by EFCs.

Bidding consortia undoubtedly see the potential for upside IRR on their equity stakes as the principal justification for incurring the bid costs and other risks associated with putting a bid together.

There have been intriguing developments on the issue of bid costs in the past few months. Partnerships UK recently indicated that the Treasury is looking at releasing new guidance, stating that “large, complex, one-off schemes” might attract bid cost reimbursement (as is currently the case with the North Bristol hospital scheme). If introduced, this raises plenty of scope for argument over which schemes would meet this test. There would also be significant issues for practitioners in structuring bid documentation to address this appropriately.

There does seem to be a real shift in the Government’s previously stated position on this issue and this area is worth watching closely by lawyers.

Another way?
Given the difficulties dogging the EFC concept, what are the alternative ways to address the issue of high returns on initial equity investments? One solution might be for the public sector to take equity stakes in the projects it procures, as with the NHS Local Improvement Finance Trust (Lift) and Building Schools for the Future (BSF) schemes. However, extending this to PFIs in general creates its own challenges (not least transposing specific Lift/BSF concepts and contracts to a more universal PFI setting), and it seems the Treasury is not convinced by the value for money of this approach.

The political arguments focus on highly profitable deals and ignore the times when equity has to take substantial hits on its initial investment or to provide additional funding. If the real concern is super-profits, then a possible alternative approach could be for lawyers to draft an enhanced profit share formula into the project agreement, to kick in at a particular level of IRR return (as will be familiar to most PFI practitioners having been already seen in some sectors). However, one public sector concern is that it might logically be expected to share more in the potential downside of investments in certain circumstances.

What next?
Undoubtedly the political focus on equity returns is real and unlikely to disappear, in spite of the danger of alienating the PFI equity investment industry. It seems likely that, in the words of one funder, the Treasury was “flying a kite” with the EFC proposal, seeking to balance the mismatch between initial equity investment returns and the returns that are acceptable to the secondary market.

This balancing act is starting to happen anyway, but probably through the more traditional impact of market forces and competition in the currently booming public sector infrastructure investment market. When that boom slows down, private sector lawyers may need to start working with their clients to be more proactive in assuring the public sector of the value for money of projects’ equity funding proposals.

Indeed, there may already be competitive advantages in addressing this political issue in some way in bid proposals. John Smith is a partner and Al Goodwin is an