Timing is money
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The Treasury Department has indicated that it proposes to widen the use of funding competitions for PFI projects. It also plans to change current practice so that funders become involved much later in the process. Once the commercial basis for the risk transfer to the private sector has been settled, two or more separate groups of funders will then compete to provide the most efficient form of financing. The stated aim is to reduce cost and increase efficiency.
In almost every financed transaction, there is a debate about the optimum time to involve the financiers. Do it too soon and negotiations can become protracted and you need to involve a greater number of individuals at every stage; leave it too late and you run the risk that the financiers do not like the deal agreed in their absence.
Sponsors of PFI projects have always sought to create competitive tension between potential financier groups. Traditionally, this is achieved at the mandate stage against a term sheet, which summarises both the underlying project and the terms of the financing available. But term sheets may not be exhaustive and inevitably the devil of the commercial deal will only be found in the detailed negotiations. In a funding competition, the commercial transaction is exposed to the funders before they commit on price, thereby meeting the public sector's need to establish in advance of financial close that a project provides value for money and is affordable to it.
To date, funding competitions have been run in parallel with the commercial negotiations, although increasingly the financiers have been excluded from the negotiation meetings themselves. Sponsors are careful to ensure that the risk transfer they accept will, in turn, be acceptable to their funders. This involves careful checking with the various groups of funders. Admittedly, this can be both time consuming and, on occasion, gives the sponsors an opportunity to take a second bite at rejecting any particular risk they do not like on the pretext that their funders will not allow it.
The proposal now being made is that the competition will be delayed until after the commercial parties have settled the risk allocation and the funders will be offered the deal on a 'take it or leave it' basis.
In complex and innovative transactions, this could be a high-risk strategy. It is reliant on the ability of the commercial parties and their advisers to guess correctly the attitude of the financiers to particular questions of risk transfer. The aim to reduce cost might come unstuck in those cases. However, it is true to say that the PFI market does not consist solely of highly complex and innovative transactions. Great strides have been taken in recent years to develop standard form contracts, which govern the relationship between the public and the private sector parties. Deviation from these standard form contracts is not welcomed and the basic risk transfer position seldom changes. There is an enormous volume of smaller projects to which these standard forms are being applied rigorously and efficiently. In many of those cases, the new approach is likely to work. Provided there is confidence in the risk position established by the standard form (and, generally, there is), then potential funders will on the whole be able to adopt a tick-box approach to the project documentation.
This paves the way for a straight fight on cost alone, although we should perhaps not let that thought pass without a note of caution. Experience shows that, when financiers are forced to compete on cost in order to win deals, then on occasion ill-discipline can set in. In the worst cases, this may result in some deals being undertaken which should not be done.
Another concern is that, by delaying further the involvement of the funders, the public sector could be denied opportunities to compete with the funders on their respective appetites for risk. Funding competitions have been operated in a way in which separate groups of funders are played off against each other on particular points of risk transfer. The final deal is better for the public sector.
Often, a project might equally well be funded in the bank market as in the bond market. In others, deal size restricts the potential funding to one solution only. Where there is scope for an innovative financing solution or something slightly unusual (for example by utilising lease finance), there is often a requirement for structural change in the project documents to facilitate that form of finance. The new approach might deny the opportunity for sponsors and funders to work with the public sector at an early stage to develop an ultimately more efficient funding.
There is one final consideration, which admittedly some may consider old-fashioned. The use of funding competitions in this way moves the market yet further away from the concept of relationship banking. Relationship banking should not be allowed to promote expensive or unnecessarily inefficient arrangements. However, PFI projects are generally intended to create arrangements that last for a quarter of a century. There may be ups and downs in the life of a project. Where funders have been reduced to a homogenous and interchangeable commodity (and treated as such), then they may feel less personally and institutionally inclined to roll with the punches when a project gets into difficulty. Furthermore, we have seen real, logistical benefits flowing to projects negotiated between sponsors and funders with longstanding relationships in this area. The cost savings here are hidden. However, where two or three parties have worked well together in the past and have a precedent bank of mutually acceptable documentation, there are efficiencies which cannot be replicated simply by inserting at financial close the cheapest financing alternative.
But to return to the main point, funding competitions do drive efficiency and, when combined with accepted standard forms, economies will be seen. For the majority of PFI projects, the Treasury's proposals are sound. Applied too rigidly, however, and other benefits to the public sector might be lost.
Nick Avery is a partner at Ashurst