The Government has taken some stick for its unfriendly policies concerning private investment in public projects. But, as Mark Hollowell reports, it is finally listening to lawyers' complaints

The Government plans to invest £32bn of private capital in public services over the next three years, but the private finance initiative (PFI), its central means of doing so, is under threat. Political controversy has always dogged the PFI, but the quality of parliamentary scrutiny has increased substantially over the last three years, forcing the Government to harden its stance on the balance of risk and reward. For the private sector, things are getting tougher.

A report published in April by Standard & Poor's (S&P) found that the level of risk in PFI was increasing for investors, with many projects exposed to more complex and demanding structures “as the Government allocates a higher level of risk to the private sector”. S&P's report, based on the 30 projects it had rated since 1996, says that on the whole, newer projects would receive lower investment ratings, and in some cases non-investment ratings.

Craig Jamieson, S&P's credit analyst, says: “Combined with more aggressive financial structuring, this transfer of risk has resulted in an overall risk profile that may no longer be consistent with an investment-grade rating.”

Treasury officials believe this is merely a sign of a maturing market, a situation brought about naturally as a more capable industry works with an increasingly intelligent client. But not everyone in the private sector takes that view. According to many senior market players, the Government is making life increasingly difficult for its private sector partners.

Edward Marston, a partner at Altheimer & Gray, says: “To a large extent, this downward trend is due to the Government's position. Its policy has been to ask the private sector to take on ever greater quantities of risk. If we look back to the early years of PFI in 1996 and 1997, the private sector was extremely risk-averse. The level of risk being taken on by the private sector now would have been unthinkable then, but now it is completely standard.”

This is already starting to have an effect on the appetite of the market. The withdrawal of Abbey National and other big players sent a shockwave through the market. This is also likely to have an effect on pricing and ratios, an effect which, although immaterial to the affordability of projects, puts still more pressure on the sponsors to adopt riskier financial structures. Overall, though, the risk profile in PFI continues to be attractive to funders.

Philip Grant, head of infrastructure finance at Bank of Scotland, says: “A view is emerging that the balance of risk and reward in PFI may have shifted too heavily in favour of the public sector. Sponsors are re-evaluating their strategy and appetite for PFI in light of their experiences to date, and some contractors now consider the cost and effort to outweigh the benefits, a view illustrated by a marked reduction in bidders for certain projects.”

The first signs of this new reality emerged in 2001. In response to an outcry over the high profits given to the sponsors of a refinanced prison project, Peter Gershon, chief executive of the Office of Government Commerce (OGC), warned the private sector “not to kill the goose that lays the golden egg” by cashing in on projects. Government guidance specifying a 50 per cent clawback for the public sector on windfalls made from refinancing followed.

The market did not like it, but it took Gershon's advice anyway, all too aware of the political realities of the situation. But since then the market has become increasingly concerned about the quantity and the character of the Government guidance being imposed on their public sector clients. When the OGC issued its draft guidance to the public and private sectors for consultation in 2002, that was the final straw. There was a major backlash in the latter sector.

In the event, the Government had to change its preferred position that, following the precedent set by the NHS guidance, the updated standard terms would become mandatory, unless the sponsoring department could be persuaded that there were deal-specific or sector-specific reasons to justify a departure. The uproar in the private sector was such that the OGC had to assume a watered-down position.

Accordingly, the guidance that took effect from August 2002, while making it clear that advisers would have to make a case for departing from standard terms, only recommended that procuring authorities adopt the drafting on refinancing as mandatory. It demonstrated an awareness that its standardisation document had created problems in the market. But the empathy stopped there and the substance of the guidance remained largely the same.

Four key issues emerged: refinancing; insurance benchmarking during the life of the project; the definition of what constitutes a 'liquid market' when contracts have been terminated; and the definition of what constitutes a qualifying lender for the purposes of refinancing. In each case, the result was to give the public sector client more teeth in the post-contract arrangement, while offering the private sector very little in return.

Bidders are, for example, being asked to price insurance on the basis of the OGC side letter issued last year, pending a longer-term solution being agreed regarding the indexation of insurance costs, which is expected shortly. Given the sharp increase in insurance premiums in the past couple of years, particularly following 11 September, the private sector is finding it increasingly difficult to accept an uncapped liability for insurance costs.

The Government's response to this was to propose a risk-sharing mechanism based on a percentage share of increases in insurance premiums after taking account of indexation. The OGC side letter allocates risk between the public and private sector on this basis. The private sector is unhappy with this solution; it believes the Government's position is inequitable, and could even damage value for money for the public sector in the long term.

However, insurers are now arguing that the threshold is too high to alleviate the problem. Many charge higher rates for PFI anyway because they have little loss data on which to base their pricing. Furthermore, in the current market it is very difficult to predict what insurance cover will be available in six months, let alone the 30-year commitment that PFI normally involves. This has led to a discussion about who should bear the additional costs and increased risks; but not everyone is satisfied with the Government's position.

Marston says: “I don't believe the Government has been very helpful on the insurance issue. There were a total of four different versions of the side letter issued before it finally settled on the current one, which was very unhelpful in terms of dealing with the problem.

“Unfortunately, its position on insurance is symptomatic of a wider attitude. The Government looks at the market as a soft target. It knows that an industry which is financially backed by government is extremely attractive to the private sector. But I think it needs to be careful: at the moment it's getting pretty close to pushing the market too far.”

Addleshaw Goddard partner Mark Dunlop agrees. “It is slightly odd that the amended standardisation deals with third party insurance cover quite so specifically because what it doesn't do is deal with the issue of uninsurability generally. This remains a very important issue,” he says.

The adoption of a fairly strict approach by the Treasury has come at a time of general contraction in the industry – a development that should, in theory, worry the public sector more than the private. Public bodies submitting projects to market are finding it increasingly difficult to achieve the required number of suitable bidders. A schools scheme launched recently in Lewisham, for example, had to be delayed because of a lack of market interest.

The issue here goes wider than just risk. The cost of bidding has become a major concern among private and public sectors alike. A number of formerly significant players are leaving the market as their outlay on bids becomes too high, leading to falling share prices. Other players have been forced from the market as the size of projects has grown. However, for the contractors that are remaining in the PFI industry, the risks continue to increase.

“More risk is being borne by a progressively smaller group of providers,” stated Marston. “What we've seen over recent years is a process of elimination as projects have got bigger and fewer contractors have been able to bear the financial risks. Now the remaining contractors are becoming overloaded with risks.”

The uncomfortable effect of both these developments is combined with another – namely, the increasing pressure on the bidder to assume ever more aggressive financial structures to keep bid prices down. There has always been a tension between 'maximum' risk transfer to the private sector and 'optimum' risk transfer. Although everyone agrees that the latter is the Holy Grail, in practice this often translates into a rather more crude market-testing exercise.

Andrew Rolfe, a partner at Clifford Chance, says: “Some bidders have assumed too much risk. They've taken insufficient mitigating steps such as laying off by the special purpose vehicle through the usual cocktail of subcontracts, contingent equity and shareholder support arrangements, because those steps cost money and bump up the price of the bid.

“Lenders have also been under severe pressure. If they want to win mandates in a cut-throat market that's seen a number of major players go under in the last year, they have to reduce reserve fund requirements and relax debt service cover ratio tests, both of which are key controlling protection mechanisms in any project loan. As advisers, we have to analyse those risks so that the consequences are clear and priced accordingly.”

Bidders know that the cheapest bid, coupled with the maximum risk transfer, will often win the day, even if that winning bid is less than financially robust. As deals become more sensitive to adverse events, their ability to achieve investment grade ratings will be in doubt.

Allen & Overy (A&O) partner David Lee believes there is a chance that this trend could get out of hand. “The concern that people have is that, because coverage ratios have moved the way they have, people think they might continue to do so, and then you could have a real problem,” he says. “There's a limit to how much this kind of thing can be pushed.”

There is also a possible effect on areas such as refinancing, or the creation of a secondary equity market – both areas that law firms are gearing up to becoming involved in.

“If you push the financial structures close to their limit at the bidding stage, the scope for reducing the coverage ratios further through a refinancing are that much reduced,” says Lee. “When you couple this with the demand in the standardisation that you have to share the windfall 50-50 with the public sector, and the fact that interest rates have fallen to a such a historically low level, then clearly the desirability of refinancing is significantly reduced.”

On the development of the secondary equity market, however, Lee is more upbeat. “Of course, this will have an effect on the number of equity transfer deals done in the secondary market,” he says. “But we're unlikely to fully understand whether the balance of risk and reward has been meted out properly for another 5-10 years. For certain types of investor, particularly those looking to the long term, PFI portfolios will still have an appeal.”

There are also signs that the Government is reaching out to the private sector to try to find a way through some of the difficulties. The latest amendments to the guidance, published on 14 April, are regarded in the private sector as overwhelmingly positive.

The new changes include refinements on contractor default and retendering, which have increased the risk for investors. Under the amendments, the private sector will no longer have to demonstrate the absence of a liquid market before transferring the contract to the public sector. That will be of immense help to investors, who under the former guidance could potentially have been forced to maintain ownership of a project, for example a hospital, even with no contractor to operate it and no genuine possibility of selling it.

The amendments also refine the provisions on the replacement of subcontractors, so that the public sector will now be expected to offer contractors a “period of relief” to get its house in order where the amount of penalty points accrued have left the contract vulnerable to being terminated, or even cancel penalty points if necessary. Again, a step forward. Under the former regime, contractors could have found it difficult to replace a failing subcontractor when the replacement could have been affected by penalties that were not of their making.

Concerning refinancing, the Treasury responded to industry concerns over the scope of its definition of what constitutes a refinancing. It has conceded that a number of day-to-day administrative matters undertaken by banks may now be added to the list of refinancing exemptions. Contractors will wait with baited breath to see if that suggestion is realised.

Finally, on the unavailability of third-party liability cover – another thorny issue – the public sector client will now be expected to meet with the private partner to discuss how to divide the risk if the problem was not the partner's fault. Again, a shift in favour of the private sector. Not surprisingly, the industry's response has been one of relief.

Lindsey Grist, director of the PPP [public-private partnership] Forum, which represents 51 of the largest private sector players in PFI, including many law firms, says: “It's heartening to see that the Government is still willing to listen to us and make changes where that makes sense.”

The Government's willingness to take stock is indeed welcome. At a time when the market is maturing, private sector profit margins are tightening and the size of the industry is contracting, the overall interests of the public sector are better served by working with the private sector, rather than trying to force more and more risk onto it.

PFI has led to a private sector investment in public services of more than £25bn in just over 10 years. It is crucial that the Government does not kill its own golden goose.