UNCOVERING TRUE VALUE ACROSS PFI

PORTFOLIOS: THE POTENTIAL BENEFITS OF AN ACCURATELY REPORTED

WEIGHTED AVERAGE COST OF CAPITAL

Caleb-Marcus Butler

MSc Construction Economics & Management

This thesis is submitted in partial fulfillment of the requirements for the degree of Master of Science in Construction Economics & Management from University College London

Supervisors: Andrew Edkins & Alex Murray

The Bartlett School of Construction & Project Management

University College London

25/08/12

Note: This dissertation is an unrevised examination copy for consultation only and it should not be quoted or cited without permission of the Chair of the Board of Examiners for the MSc in Construction Economics & Management.

 

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DECLARATION By submitting this coursework, I affirm it is the product of my effort alone and meets all College and Department regulations regarding student conduct, especially those regarding plagiarism and self-plagiarism. I am aware that demonstrated cases of misconduct are treated with utmost seriousness and may result, for instance, in my failing a module or being expelled from College. I acknowledge that my work also is subject to checks for irregularities, such as through on-line plagiarism detection software. Name: Caleb Marcus Butler Signed: Date: 25/08/12 Word Count: 10,755

 

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UNCOVERING TRUE VALUE ACROSS PFI

PORTFOLIOS: THE POTENTIAL BENEFITS OF AN ACCURATELY REPORTED

WEIGHTED AVERAGE COST OF CAPITAL

Caleb-Marcus Butler

MSc Construction Economics & Management

The Bartlett School of Construction & Project Management

University College London

UCL Bartlett Faculty of the Built Environment 2nd Floor 1-19 Torrington Place

London

WC1E 7HB

 

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ACKNOWLEDGEMENTS

This dissertation topic has been chosen in a deliberate attempt to challenge an issue at the fore

of political and economic agendas. The scope of this work has been extended as a result of the

continued support from Alex Murray, Research Assistant at the Bartlett School of

Construction & Project Management at University College London, without which this study

would simply not have been possible.

John Kjorstad, Editor at Infrastructure Journal and Darryl Murphy, Partner within the Global

Infrastructure division at KPMG both provided critical input. The provision of data and

offering of specialist knowledge enabled this work to go beyond a mere superficial analysis of

a well-documented topic, for this I owe a debt of gratitude.

Additional thanks is given to Andrew Edkins, Director of the School and Graham Ive, Senior

Lecturer at the Bartlett School of Construction & Project Management, University College

London for helping me find value in my work, providing the clarity needed for this study to

come to fruition.

 

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ABSTRACT

Examined is the changing nature of the private finance initiative (PFI) relative to the cost of

debt over the crisis period. An argument is presented for the accurate and transparent

reporting of the weighted average cost of capital (WACC) as a measure of project success and

performance, creating a more investor friendly interface to both domestic and international

PFI markets. The case for micro-level WACC reporting of PFI projects is justified through

the explanation of the technical components that form the metric, demonstrating the ease of

which a more macro-level approach has the potential to project a false image of PFI activity.

Keywords: weighted-average-cost-of-capital, WACC, debt, equity, infrastructure,

investment, PFI, project-finance

 

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TABLE OF CONTENTS

LIST OF FIGURES vi

LIST OF ACRONYMS vii

SECTION 1: INTRODUCTION 11

1.1 Controlling questions 11

1.2 Research aims 12

1.3 Key findings 12

1.4 Scope of paper 13

SECTION 2: CONTEXT 15

2.1 The Weighted Average Cost of Capital: a definition 16

2.2 Benefactors of the explicit reporting of WACC figures 17

2.3 Political origins of the PFI model 18

2.4 Infrastructure and the VfM debate 18

2.5 A case for investment 20

SECTION 3: PUBLIC-PRIVATE FINANCE: COST? 24

3.1 The importance of true WACC values 25

3.2 Swap arrangement fees 27

3.3 Outline capital structure of PFI payments 27

3.4 Investigating the cost of capital 29

SECTION 4: THE IMPACT OF THE FINANCIAL CRISIS ON BORROWING 31

4.1 Project refinancing 32

4.2 An economic climate in flux: the emergent role of PFI 33

4.3 Financial reporting standards and the treatment of national accounts 36

4.4 PFI in the UK as an international comparator 37

 

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SECTION 5: AN EMPIRICAL ANALYSIS OF THE PFI MECHANISM 39

5.1 Methodology 39

5.2 Debt structure and IRR 41

5.3 Summary 43

SECTION 6: CONCLUSION 44

REFERENCE LIST 47

 

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LIST OF FIGURES

Fig. a Infrastructure construction output 2009 - 2011

Fig. b Source of funding for infrastructure investments

Fig. c WACC for different infrastructure funding types

Fig. d Variable rate to fixed rate loan conversion and the composition of loan

interest costs

Fig. e Relative size of payments made by a project company after receiving service

charge payments (cash waterfall)

Fig. f Comparison of interest costs on PFI projects

Fig. g European PPP Market 2008-09 (by value)

Fig. h A typical project company financing structure

Fig. I Transaction financing by year

Fig. j Long-term development of loan margins

Fig. k Placing of an equity bridge loan and sponsor equity

 

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LIST OF ACRONYMS

CAPM Capital Asset Pricing Model

CIL Community Infrastructure Levy

CoC Cost of Capital

CoE Cost of Equity

ESA European System of Accounts

GAAP Generally Accepted Accounting Principles

GDP Gross Domestic Product

IFRS International Financial Reporting Standards

NAO National Audit Office

PFA Private Finance Alternative

PFI Private Finance Initiative

PPF Pension Protection Fund

PPP Public Private Partnership

PSBR Public Sector Borrowing Requirement

PSC Public Sector Comparator

PSNB Public Sector Net Borrowing

PSND Public Sector Net Debt

SMeF Secondary Market equity Fund

SoPC4 Standardisation of PFI Contracts (Version) 4

SPV Special Purpose Vehicle

UC Unitary Charge

VfM Value for Money

WACC Weighted Average Cost of Capital

OBR Office of Budget Responsibility

 

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Clearly, any economic entity is constrained in its investment activity by its ability to raise

capital, which limits its ability to initiate infrastructure projects. In principle, any portfolio of

projects that promises a net positive return adjusted for risk would be worth investment. In

practice, there are competing claims on the public purse for expenditure that is closer to

consumption rather than investment.

(Winch, Onishi & Schmidt 2012).

 

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SECTION 1: INTRODUCTION

The widening gulf of economic uncertainty over the past five years shows little sign of

reconciliation, critically reducing risk and investment appetites. Scores of bailout funds and

stimulus packages have been allocated between the US and Europe that appear to be all but

absorbed by a phenomenon that is showing to be greater than political remedial efforts.

The 2008 crisis rested on the distortion of the risk free rate of capital as a result of mortgage

backed securities both at home and in the US and growing levels of sovereign debt across

Europe. The UK is currently running a current account structural deficit that requires an

innovative approach to financial management and the allocation of resources in order to assist

the economy from again falling into cardiac arrest.

Living in an age of austerity the political climate and spending of public resources is

amplified in the public domain, where the future of a nation’s economic direction is heavily

scrutinised. Projections of the UK’s GDP in the past quarter have been anywhere between

-0.3 and 3%, neither end of this meagre spectrum presents much cause for joy. A resourceful

approach to fiscal and monetary policy and the design of financial mechanisms and

instruments to stimulate growth is now critical.

1.1 Controlling questions

When analysing the potential avenues to a new age of economic growth and the inevitable

part private sector finance will have on the development of the Nation’s infrastructure

portfolio the following four points form the critical juncture for debate

1) The financial viability and agency issues of borrowed capital;

2) The relation if any to market uncertainty and the effect this has on financial gearing;

3) The ultimate tenor of debt;

4) The changing competitiveness of debt facilities over the crisis period.

 

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1.2 Research aims

The intention of this research is to:

• Compile a comprehensive assessment of recent and emerging literature surrounding

the PFI debate, informed by both empirical and subjective policy-based evidence;

• Develop information on the cost of borrowed capital, the relevant components that

effect borrowing rates and the future affordability of the PFI mechanism as method

for the delivery of critical infrastructure provision;

• Observe the difficulty to assess PFI market activity through limited public availability

of key project variables. This paper therefore aims to reveal gaps in the current PFI

marketplace with respect to the availability of information that could assist in the

reduction of overly bureaucratic treatment and excessive margins collected by the

private sector sponsor.

1.3 Key findings

a. Investing in infrastructure is not an option. It is a must.

With the amount of critical infrastructure investment required over the coming

decade, a lack of private sector capital will result in lights switching off, closures

across the rail network a fragmented road system, decaying utilities services and

reduced access to academic institutions and health care centres. Maintenance and

repair of the Nation’s current infrastructure portfolio is not optional, with the

anticipation of economic growth, significant private sector contributions are required.

b. Financial regulation: a double-edged sword

The very same accounting standards (IFRS, ESA 95, GAAP) that present the PFI

model as a lucrative avenue to off-balance sheet accounting also encourages

opportunism at public expense where the lax regulation of accounting principles

continues to allow unsustainably high private sector margins.

c. A ‘locked-in’ state of finance

Evidence suggests that the current hike in finance borrowing costs post 2007 is set to

serve as the new bps floor. Impending financial covenants, upward trending

borrowing rates and the reduction of public sector spending creates a stagnant

 

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environment that can only be overcome by private sector intervention on more

favourable terms.

d. Knowledge gap

Specialist advisory teams that act on behalf of regional public sector bodies to

orchestrate the contracting process prove problematic for a pair of reasons:

a. First, when the specialist project tem leaves so does the knowledge value

gained as a result of being engaged in the PFI contracting and management

process;

b. Second, financial information regarding the capital makeup of projects is

retained by an independent body thus making future studies of the PFI model

neither simple nor attractive to potential investors who wish to assess market

activity.

e. A competitive pricing model?

In absence of a competitive pricing model, as a result of an often thin bidding cohort

Government are required to administer some form of rate capping or project

guarantee in order to resist in-built private party premiums.

1.4 Scope of paper

The following work is broken down into five sections where a comprehensive analysis of

existing and emerging opinion from academic and political sources is complemented by an

empirical study building that builds on existing discourse.

Section 2 outlines the PFI mechanism and the purpose of its application. The weighted

average cost of capital (WACC) is then derived, followed by a brief discussion of the

potential benefactors of explicit, micro-level reporting of WACC figures. The political origins

of the model are briefly discussed and the value for money debate brought to the fore,

discussing the UK’s case for investment and the role PFI has to play.

Section 3 explores the more technical components of the PFI model discussing the underlying

importance of an increased availability of data and its ability to counter current inaccuracies

in PFI project analysis. The capital structure of PFIs are discussed where a fundamental

 

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position is debated on the impact that an increased cost of borrowing has on overall project

cost.

Section 4 details the impact of the financial crisis on borrowing and the potential for changing

contractual arrangements throughout the life cycle of a project. Financial reporting standards

are then discussed and are accompanied by discourse on revised, domestic PFI reporting

standards serving as an international comparator.

Section 5 provides an empirical insight into how PFI reporting is conducted today. A

methodology is explained that details the various steps taken to reveal WACC values for a

sample of 43-signed PFI projects throughout the UK. The results of the study serve as a

critical gap analysis.

Section 6 concludes on the current stance of PFI and its inability to be given a thorough

evaluation on the grounds of a lack of information. As a result the future consequences of not

knowing debt related figures for PFI projects are highlighted, suggestions are made as to how

these deficiencies could be remedied.

 

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SECTION 2: CONTEXT

The Private Finance Initiative (PFI), characterised by the private sector partner adopting a

front loaded risk structure, typically exists over a long-term contracting period of 20-30 years

(Akintoye et.al 2001). Additionally the project sponsor is responsible for the provision of a

range of services necessary to complete the project, to a predetermined standard; facilitating

design, build, operating and financing of an asset that at the point of contract termination is

transferred over to the public sector party (Mumford 1998).

The PFI mechanism essentially facilitates project financing through Public-Private

Partnership (PPP) and is used as a method of deferring typically large Capital Expenditure

(CapEx), that characterises infrastructure projects, from Government balance sheets. The

public sector utilise initial private sector lending with the intent to repay the sponsor through

anticipated revenue streams or unitary charge (UC) payments. The financed provision of

assets is therefore allowed on the basis that they will be supported by a source of long-term

capital (Carrick, 2000 cited in Akintoye et.al.). The cost of finance for such projects is judged

largely on potential risks that could threaten project completion and therefore the ability to

service project related debt (Sarmet, 1980 cited in Akintoye et.al 2001).

Unprecedented cost overruns through state service provision in the 1980s and 1990s

encouraged government to use private sector subsidies to deliver public goods (Parker 2009).

The proliferation of the PPP mechanism and its manifestation as the private finance initiative

in Britain during the 1990s saw the introduction of privately supplied building projects that

were publicly funded and controlled (Parker 2009). This favoured method of co-op funding

saw the emergence of a PPP/PFI portfolio to the value of some £44 billion by January 2008

(Parker 2009).

A 2001 National Audit Office (NAO) Report announced that an approximate 73% of the

UK’s traditionally procured construction projects had exceeded initial budget projections,

thus indicating significant potential for the PFI mechanism to add value to the Nation’s

infrastructure portfolio. Furthermore the format of public-private funding allows the

development of a dialogue between both parties, discussing the most cost effective solutions

that enable building specifications to be met, while the extended management of completed

assets ensures the internalisation of project ‘life-costs’ (Parker 2009).

 

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Conceptually the PFI mechanism makes sense. However in a magnified economic climate the

current controversy surrounding the PFI is concerned with whose money is being spent and at

what cost. When we consider the origin of capital with respect to infrastructure finance, we

are now forced to consider how funding is provided and by whom (Edkins 2012). When

presenting the PFI model as a primary method of procurement we are also now made to

consider, through a stigmatised past, alternative, fundamental or default options (Stacey,

Pickard & Neville 2012).

2.1 The Weighted Average Cost of Capital: a definition

Within a currently over-bureaucratic PFI contracting process the explicit reporting of

weighted added cost of capital (WACC) figures has the potential to counter disinvestment in

infrastructure. The WACC value serves as a proxy for the hurdle rate for PFI projects, and is

defined by project financing rates that indicate the rate of return required by project sponsors

to adopt the project risk (Finnerty 2007).

The anticipated rate of return would depend on the financial gearing of the project. The rate

of return for both the debt holder and sponsor is determined by the degree of leverage

(Finnerty 2007) within the projects financial structure and relative exposures to risk given

project specific risks of debt and equity. The WACC is simply expressed in the formula

provided by Finnerty (2007) where θ represents the ratio of debt as a proportion of total

investment value, τ represents the tax rate, re rate of return or cost of equity and rd represents

the rate of return or cost of debt:

WACC = (1-θ)re + θ(1-τ)rd

Simplified the formula reads:

WACC = (%Equity*Cost of Equity)+(%Debt*Cost of Debt*(1-Tax rate))

The above figure indicates that the component parts of the resultant WACC formula have the

potential to cause major impact on the price that end users are forced to pay, therefore giving

cause for the transparent reporting of PFI financial data. With investment in infrastructure

being essential in order for the UK to not only sustain, but also develop the potential to grow,

the residual impact of efficiency versus effectiveness must be assessed (Edkins 2012).

 

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2.2 Benefactors of the explicit reporting of WACC figures

The detailing of WACC figures on a micro-level, project by project basis has the potential to

create a series of benefactors, that with easier access to PFI project related variables, will be

able to make more informed decisions surrounding the procurement of and investment in PFI

schemes:

• Potential investors

Whereby knowing a hurdle rate prior to making a financial commitment massages

investor appetite while providing additional confidence and a transparent operating

environment for international financiers;

• HM Treasury & Infrastructure UK

Together with the Treasury, IUK and other auxiliary bodies influencing policy on

infrastructure portfolios at both the national and regional level could benefit from

additional project-related data. With a current absence of regionally responsible

bodies to guide infrastructure investment, the case is presented to establish what

should be present in regionally sensitive portfolios. Where the true value of

infrastructure projects is not currently known, the accurate reporting of project

specific WACC figures could help determine;

The real value of a regionally specific asset base; and

How much the PSBR needs to be in order to maintain existing

infrastructure while developing additional capacity for economic

growth.

• Banks & lenders

Added clarity of the financial returns associated with PFI projects would provide

greater confidence when assessing future revenue streams from speculative

development.

• Project proposers

Those putting forward proposals could, with the advent of additional project related

metrics, benchmark their speculative project against similar anticipated development.

Consider a prospective WACC value, this figure could be tracked across a project

longitudinally, through refinancing phases and the selling of debt on the secondary

market.

 

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The above reasons give cause to argue for the reformation of current reporting standards

demonstrated in existing PFI markets.

2.3 Political origins of the PFI model

In 1979 Margret Thatcher served as a fulcrum for neo-liberal and neo-conservative activity,

very much in agreement with the then Conservative notion of business growth and economic

prosperity (Atkinsion & Moon 1994). The deregulation of national services in the 1980’s

driven by a free-market conservative regime pre-empted an era of private-sector sponsorship.

Introduced in 1992 by the Conservative Party and then Chancellor of the Exchequer Norman

Lamont under Prime Minster John Major, the Private Finance Initiative served as a favoured

option in light of the lack of available public funding (Heinecke 2002). Presenting an off-

balance sheet form of accounting that proved favourable to national accounts the New Labour

government, through to the economic failure of 2008, relied upon this same method of

collaborative procurement.

The current climate presses the issue of whether this form of financing still proves a viable

option given the volatility of bond and equity markets and the cost of borrowing; reducing

available private sector capital and thus adding more pressure on Government to increase the

Public Sector Borrowing Requirement (PSBR). Where the Maastricht criteria, an

administrative rule that governs the Nation’s potential for investment, states that annual

public sector net borrowing (PSNB) should not exceed 3% of gross domestic product (GDP)

and net debt (PSND) should not exceed 60% of GDP (Winch, Onishi & Schmidt 2012) the

cost of private sector capital has the capacity to severely limit the investment potential of a

nation and thus possibly cap future economic potential.

2.4 Infrastructure and the VfM debate

The Economic definition of infrastructure is rather uncertain. Past research on infrastructure

and its role in the propulsion of economic growth often defines it as publicly owned capital

assets (Gramlich 1994 cited in Winch, Onishi & Schmidt 2012), this classification seems to

satisfy the neo-classical position on the definition of public goods. However, where

contemporary focus on infrastructure tends towards the enabling ability of building projects to

deliver increased economic activity (Winch, Onishi & Schmidt 2012), the current economic

climate forces policy makers to remain conscious of the source funding of our built assets.

 

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For the purposes of this study the provision of critical infrastructure on a national scale

focuses on the channels that facilitate the movement and distribution of people and goods. In

considering the current state of the nations infrastructure portfolio and how it is financed the

following points should precede any further thought:

• How much investment should be provided?

• How much attention is given to improve the performance of existing stock?

• How to tackle legacy issues from depreciating stock?

• How to handle the critical nexus of value added versus cost adage?

The current portfolio of critical infrastructure on offer across the nation is inadequate to

support changing demographics and population growth (Pickard, Rigby & Gray 2012).

Unease over government leadership around infrastructure spending populates much of the UK

while cost reduction remains a controlling factor in the organisational culture of critical asset

provision (KPMG 2012). The issue of underinvestment currently has no formal mechanism to

monitor its operation, where government accounts fail to accurately document the allocation

of funds whether they be for enhancement of existing assets, maintenance or operation

(Davies et.al. 2011).

Despite the reported negative changing circumstance of the construction industry over recent

times the demand for infrastructure has remained consistent, where citycentric growth is

anticipated to rise some 70% by 2050 (KPMG 2012). However, with increased capacity

comes complexity and the financial development of infrastructure projects is now more

preeminent than ever (KPMG 2012). Lock & Evans (2011) further this debate raising a series

of prominent questions when addressing the growing funding gap for national infrastructure

including qualms over the protection of government investments and subsequent shielding of

an unbalanced risk burden.

Risk transfer serves as a primary concern of prospective PFI sponsors. Where the majority of

project related risk is transferred to the private sector, investor premiums demanded as

remuneration for the tenor of risk play a large role in the Value for Money (VfM) debate

(Mumford, 1998).

The issue is then raised of how Government should attempt to de-risk a programme of

investment, countering the inverse relationship between private sector leverage and risk; a

relationship that has historically resulted in a lack of private sector funding or funding at

premium prices, contesting the overall value of the partnership financing method (Stacey,

 

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Pickard & Neville 2012; Shah & Thakor 1987). Furthermore the non-availability of data and

lack of transparency throughout the PFI contracting process has served to damage the

reputation of PFI and thus challenge the evaluation of VfM. In the absence of appropriate

frameworks to deliver complete project information on a transparent platform, financial

failure and the under-deliverance of anticipated infrastructure will arise as a derivative of an

economic environment rife with poor accounting standards, lax regulation and structure

(Ackerlof & Romer 1993).

2.5 A case for investment

The HM Treasury 2012 Infrastructure Cost Review: annual report 2011-12 highlights the

intent to make efficiency savings of at least 15 per cent on an estimated £15-20 billion

allocated to infrastructure spending between 2010-15. Fig. a indicates an estimated net

increase in infrastructure output of £4 billion from 2009 to 2011 reported figures. The HM

Treasury National Infrastructure Plan 2011 for the first time illustrated the state of the UK’s

infrastructure networks using objective data on the back of somewhat unfavourable reporting

by the World Economic Forum (WEF) Global Competitive Index, and the World Bank’s

Logistics Performance Index placing the UK in 28th in 2011 and 16th in 2010 respectively

(HM Treasury National Infrastructure Plan 2011).

In an environment where overseas investment currently proves paramount, the outward image

and focus on infrastructure investment the UK needs to project is more suitably presented in

the 2011 report. The publication highlights the underperformance but anticipated route to

recovery across road, air and container port divisions of the transport sector relative to

indexed cost values.

A Memorandum of Understanding has been signed with the National Association of Pension

Funds (NAPF), with an estimated £800 billion worth of assets under management and the

Pension Protection Fund (PPF) with the intent to release investment for UK infrastructure

growth. These institutions however will require transparent accounting procedures and value

for money returns on their investment in order to make the anticipated investment a reality

(HM Treasury National Infrastructure Plan 2011).

 

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Infrastructure construction output 2009 - 2011

Fig. a

Source: ONS

Fig. b illustrates the reliance of the transport sector on public-private funding frameworks. It

is therefore crucial that affordability and ultimately the burden placed on the tax –payer is

where possible kept to a sustainable minimum through the careful management of the costs

associated with PFI. Acknowledging the option of raising project finance in overtly

constrained debt markets the 2011 Report raises the issue of asset quality and skepticism of

Eurozone banks historically involved in infrastructure lending markets (HM Treasury

National Infrastructure Plan 2011), an ongoing topic for debate as the series of global

economic woes continues to unfold.

As a result of a depressed global financial climate we are now experiencing a primary issue of

how to prevent systemic failure from pulling the UK into deeper recession; critically

impacting one of the only channels, infrastructure development, that has the potential to drive

growth and economic reform. Government and potential investors are challenged with

overcoming increasing complexity (Agarwal 2010; Pickard & Plimmer 2012), inherent when

assessing the current face of infrastructure finance in Britain. Acknowledging the investment

potential behind the PFI mechanism Government must accept that in order to capture

potential economic stimuli behind such investment activity the time taken, and thus money

spent to approve, procure, design and raise finance collectively must be significantly reduced

(Abadie 2011).  

 

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Source of funding for infrastructure investments

Fig. b

Source: ONS

In mid November of 2011 the Chancellor George Osborne made explicit his intent to reform

the then existing PFI model (NAO 2012). The Chancellor acknowledged the current

importance of the private sector stake and its correlation with initial equity contributions,

however it is the added and changing cost of debt facilities that give reason for concern.

Drawing on Ackerlof & Romer (1993) a simple model of borrowing to maximise economic

benefit reflects the recent state of the PFI mechanism in the UK and possible loss of economic

sense and ultimately wider social benefits as a result of mortgaging off the Nation’s assets;

where the firm represents the Nation and owners represent Government:

…the normal economics of maximizing economic value is re- placed by the topsy-turvy

economics of maximizing current extractable value, which tends to drive the firm's economic

net worth deeply negative. Once owners have decided that they can extract more from a firm

by maximizing their present take, any action that allows them to extract more currently will

be attractive-even if it causes a large reduction in the true economic net worth of the firm. A

dollar in increased dividends today is worth a dollar to owners, but a dollar in increased

future earnings of the firm is worth nothing because future payments accrue to the creditors

who will be left holding the bag.

 

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The wider public call for increased transparency (HM Treasury 2011, HM Treasury 2012)

throughout the PFI contracting process is expected to be supported by the current

Governmental call for evidence; anticipated to contribute to the reformation of partnership

finance and provision of national infrastructure. Currently the Standardisation of PFI

Contracts Version 4 (SoPC4) literature entitles public parties to private sector financial

information. Available information however is normally limited to the Special Purpose

Vehicle (SPV) or project company and therefore fails to reveal the financial stance of project

owners and sub-contractors (HM Treasury 2011). The fundamental position of PFI reporting

is thus being challenged where current ad-hoc methods make it difficult to assess whether

raised rates in project finance are justifiable. It is this core, micro-level clarity that requires

further assessment.

 

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SECTION 3: PUBLIC-PRIVATE FINANCE: COST?

It has been announced through Government’s National Infrastructure Plan 2011 that an

estimate two thirds of infrastructure investment in the period 2011-2015 will be privately

funded with the remainder being either publically provided or reliant on some form of hybrid

finance (House of Commons Treasury Committee 2012). Private sector support in the

delivery of public assets therefore proves lucrative, where an estimate £30 billion a year is

gained by the private sector, with £20 billion in central government contracts and £5 billion in

health and education sectors, that in 2008 combined for a reported 13% of the nations GDP

(Wilkinson & Reed 2008). Off-balance sheet accounting through private sector assistance

provides a critical avenue to circumvent an increasing PSBR (Stacey, Pickard & Neville

2012) where an initial CapEx is transferred from capital to revenue accounts through the PFI

unitary charge mechanism. Shah & Thakor (1987) further clarify the benefits of project

finance and off balance sheet accounting and the private sector retention of borrowing

capacity (Debande 2002) in stating:

Project financing is defined as an arrangement whereby a sponsor or group of sponsors

incorporates a project as a legally separate entity, with project cash flows kept segregated for

financing purposes from its sponsors, thereby permitting an appraisal independent of any direct

support from the participants themselves. Project financing usually involves the sponsors

providing equity and management.

In the 2012 report by the House of Commons Treasury Committee Private Finance Initiative:

Government, OBR and NAO Responses to the Seventeenth Report from the Committee it was

widely acknowledged that the PFI model ‘has a higher cost of capital than that of

government bonds’ while accepting the remaining incentive for the application of the PFI

mechanism where current rules ‘exclude PFI liabilities from calculations of Public Sector Net

Debt, and, second, privately finance investment allows government departments to spend

more than their allocated capital budgets (House of Commons Treasury Committee 2012).

Maximising utility from public funding and the additional cost of private finance forms the

primary reason for this investigation exploring the potential hike in borrowing costs when

considering the Private Finance Alternative (PFA) to the Public Sector Comparator (PSC) or

the notional cost using public finance (Winch, Onishi & Schmidt 2012). However we must

question how the PSC is determined, typically in a rather mechanical fashion based on

 

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estimates from previous work (Locke 2006). Alternatively with the argued case for more

abundant reporting and WACC calculations the cost of capital in relation to VfM can be

assessed more scrupulously.

3.1 The importance of true WACC values

A more accurate set of PFI related figures could potentially enable project parties to define

exactly where compensatory savings must be made in relation to the true cost of capital.

Savings will typically be made in construction (C) and facility management (F) costs

offsetting transaction costs of procurement and the cost of capital, two areas that PFI projects

prove more expensive than an alternative method of financing (Office of Budget

Responsibility cited in House of Commons Treasury Committee 2011). Therefore when a

project is deemed VfM, with added clarity through the true reporting of WACC values, the

point at which savings are made for example at either C or F can be critically located. If

however the cost of capital cannot be widely observed then all we have left is the formality of

the public sector comparator that is vulnerable to manipulation (Ive 2012).

The below table highlights ‘typical costs’ defined by the weighted average cost of capital

from a series of differing forms of infrastructure finance options illustrating percentage point

increase on direct public-funding streams in the UK during 2010.

WACC for different infrastructure funding types

Fig. c

Source: IUK cited in Winch, Onishi & Schmidt 2012

 

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In short these additional percentage increases are due to additional project (and in some cases

demand) risk taken on by the public sector, the cost differential or premium that exists

between regular unitary change payments and the base cost of the project. Such premiums

have the potential to exceed according to a European Investment Bank conventionally

procured road projects at the tender stage by some 24% per kilometer (Blanc-Brude et al 2006

cited in Winch, Onishi & Schmidt 2012). Acknowledging the reporting of Fig. c WACC

figures by funding type, there is a case that more value can be derived from reporting PFI

project figures on an individual basis, where in the absence of micro-level project data the

rationality with which a decision to embark on a PFI financed project is questioned.

Example

Where the cost of construction is equal to £ 100,000,000, the cost of capital is equal to 8%

and facilities management services are procured at £5,000,000 per annum, if this project were

deemed VfM despite the public sector cost of capital lying at 3% savings of 5% would have

to be demonstrated elsewhere within the PFI capital structure in order to justify a higher

capital borrowing rate. With the current absence of project data surrounding PFI this cannot

be done.

To date the efficient pricing model within PFI contracts is assumed to emerge from a

competitive bidding process. . However, many projects attract only the most capable outfits

and therefore very few potential contractors (NAO 2012). As a result in-built premiums and

investor return to equity remain uneconomically high in the absence of a systemic pricing

format (NAO 2012).

Variable rate to fixed rate loan conversion and the composition of loan interest costs

Fig. d

Source: NAO

 

  27  

The NAO 2012 report mentions how private sector partner investment committees price

equity by a pre-defined hurdle rate intended to cover a range of project ‘risk factors’

including recoverable costs lost through unsuccessful bids. Where the WACC potentially acts

as a proxy for this unregulated measure, intuitively a floating loan reference rate (interbank

rate or LIBOR plus loan margin) will leave government out-of-pocket when making

repayments. Furthermore it can be seen from Fig. d that in order to convert a variable rate

loan to a fixed one an upward trending base rate will, albeit marginally, adversely effect the

fundamental long term swapped rate (HM Treasury 2011) thus raising project hurdle rates

and the cost of private finance on the public purse.

3.2 Swap arrangement fees

The cost of capital is equal to the variable interest rate plus the cost of the swap instrument.

Here the swap fee, an undisclosed charge is incorporated into the total cost of the project,

potentially effecting any pre or post VfM evaluation. Over the years leading up to the collapse

of Lehman Brothers bank in the autumn of 2007 widening bank margins were compensated

somewhat by reductions in swap spreads; resulting in little alteration to the total cost of funds

(Murphy 2012).

The swap fee is partly dependent on the project where the amortisation of debt is taken into

account, and is as a result composed of a number or ‘basket’ of different swap instruments on

the market. Implicit within the gathering of numerous swaps will be assumption where the

credit spread is expected to change over time. Where the LIBOR swap rate changes on an

individual transaction so the position of the basket alters, however in today’s market the swap

arrangement fee serves as mere detail, ca. 10bps of the total capital value of a PFI scheme

(Murphy 2012). In order to provide an empirical analysis of the swap market comparing

LIBOR swap spreads with the underlying LIBOR would reveal a difference between the two

trends highlighting the change in bank pricing.

3.3 Outline capital structure of PFI payments

The added ‘risk factor’ or exposure to risk on behalf of the private sector sponsor makes

project finance more expensive than government borrowing (NAO 2012). Banks, or

bondholders, typically provide 90 per cent of the project funding required as an agreed debt

facility. The dominant effect in the structure of PFI funding being the cost of debt, given its

weight proportional to sponsor equity contributions, gives reason for the focus of this work to

 

  28  

centre around the debt component of the WACC model. The facility termed ‘senior debt’ is

provided on condition that the project presented has been developed in detail by the investor

who must agree to the loss of investor equity or ‘risk capital’ should the proposed project

encounter financial difficulty (Ive 2012). Risk capital is provided largely as the product of

additional loans, favourable to investors as loan facilities reduce corporation tax while

providing a source of operational income, a nominal amount in the form of a share

contribution may also be added (NAO 2012).

The payment structure within a project financed asset is outlined in Fig. e, illustrating how

equity investors may only claim interest on loans and cash surplus in the form of dividends

once senior debt payments have been honoured. The added premium applied by the private

sector as a result of adopting an exposed position partly exists where the private sector party

takes a higher rate of return from the project; this includes remaining cash flows once third

party debt has been repaid (NAO 2012)

Relative size of payments made by a project company after receiving service charge payments

(cash waterfall)

Fig. e

Source: NAO

Uncertainty plays a major role in the successful financial backing of infrastructure projects.

Resultant cash flows from assets serve as the key form of credit support in a project finance

arrangement, these flows require careful monitoring throughout the life of the asset. As a

 

  29  

result bank loans emerge as the most fitting form of financial instrument; reducing

negotiation costs while resisting excessive liquidation (Debande 2002). Once the first year of

operation is passed project risk is significantly lessened and borrowing rates have the

potential to be reassessed in light of a more favourable risk profile (Debande 2002).

3.4 Investigating the cost of capital

Observing the unitary charge payments made to the private sector, by deducting the operating

costs of a given PFI project the residual provides the aggregated cost of capital. Therefore, if

the total CapEx of a project is known the overall average return on capital can be calculated,

thus leading to the below method in principle. Ive (2012) explains that where UC is

representative of the unitary charge payment, OC of operating costs and Net UC of the netted

operating cost or amount available to pay for capital:

UC – OC = Net UC

The above formula results in a set of cash flows that with the application of discount

formulae, knowing C or total capital outlay in year zero, one and two and having net cash

flows from year 3 to year x, the discount rate that makes the net present value (NPV) of the

project zero can be calculated thus serving as a proxy for the project internal rate of return

(IRR) (Ive 2012). When considering the IRR metric intuitively, if the return on investment

exceeds the required rate of return, or hurdle rate, then the project is considered appealing,

where the IRR is represented by i0, project inflows by Et and project outflows by At, the NPV

or Cn of a project is equal to:

EIB & European Union Regional Policy 2010

However from the above formula we can deduce that where At is representative of associated

project costs that it is critical to have accurate reported figures for the component parts of

unitary charge payments, without which the IRR cannot be properly determined thus a

 

  30  

discount rate making the NPV of a project zero is not realized and the true value of an asset is

thus disguised.

Calculating the project rate of return can be calculated through the following options:

a. Ex ante

At the bidding stage on assumed operating costs; when preparing the bid the SPV

must make assumptions on operating costs, where a resultant estimated IRR can be

compared with the cost of debt and capital structure of the project.

b. Ex post

Knowing the actual operating costs the deduction of know values reveals the actual

ex post IRR

It can now be seen that where the cost of debt is properly understood, the savings required to

be made through C and F can be more accurately determined. This much required clarity

(Pickard & Plimmer 2012)  enables a more informed bidding process, more precise figures for

anticipated returns on equity and the reduction of possible costly renegotiation.  

 

  31  

SECTION 4: THE IMPACT OF THE FINANCIAL CRISIS ON BORROWING

In the years 1999-2007 interest costs relating to project risks and PFI loan margins stood at

ca. one per cent or less (NAO 2010). The House of Commons Treasury Committee 2011

report Private Finance Initiative states explicitly that the cost of capital (CoC) for a typical

PFI project now is in excess of 8%; double the long term guilt rate. Fig. f illustrates the

changing costs of PFI finance over the life of a project, highlighting the deviation from pre

2007 lending figures.

Comparison of interest costs on PFI projects

Fig. f

Source: KPMG & NAO

An increased premium on the use of debt facilities, as an integral component of the cash

waterfall, pushes unitary charge payments up increasing the cost of PFI project payments by

some 6-7 per cent, with some projects exceeding this value (NAO 2010).

Case Study

Benchmarking the M25 Design Build Finance Operate Project

The single Design Build Finance Operate project for the M25 will widen two sections (38

miles). The 30-year cost includes maintaining the Dartford crossings and operating 250 miles

of existing motorway. This cost increased by 23 per cent from a net present value of £2,756

million before the banking crisis, to £3,400 million by the time the financing was complete in

May 2009.

 

  32  

We estimate that the largest component of the increase faced by the Highways Agency was an

increase, arising from debt finance costs, of around 15 per cent compared to market terms

available in 2007.

(NAO 2010)

When attempting to answer the question of how or what to guarantee investment against in

order to lower the cost of capital attention points to UK pension funds, Community

Infrastructure Levy (CIL) receipts and the Insurers’ Infrastructure investment Forum as

having key roles to play in the potential future innovation of the PFI programme (House of

Commons Treasury Committee 2012). On a more macro level Government in their 2011

Private Finance Initiative publication mention the application of PFI in some cases replacing

capital investment by 2015-16 reducing the short-term level of PSND as a percentage of

GDP.

4.1 Project refinancing

The refinancing of PFI projects or the rearranging of payment terms of a co-financed scheme

fundamentally alters the initial cost of debt and thus the resultant [revised] WACC value. The

refinancing of PFI projects and related distribution of [PFI] backed securities allows investors

to withdraw equity invested in the refinanced scheme, capital that is typically used for further

investment. Gains from refinancing activity provide the opportunity to diversify existing

investor portfolios, while providing an optimal, accelerated return to shareholders.

Refinancing can take place at different stages throughout the project lifecycle through both

construction and operating phases. However should a project be refinanced prior to

completion of the construction phase, the construction risk is carried forward and is reflected

through an increased cost of borrowing (Fu 2009, NAO 2012).

Renegotiation of contractual arrangements therefore often occurs during the operational phase

of the PFI scheme when the initial construction risk is removed (House of Commons CPA

2007). A significantly reduced risk profile provides an elevated bargaining position and the

levering of “more favourable terms” (NAO 2006). However, the slump in market liquidity

has made refinancing as an option far less prolific, where post crisis the prospect of highly

levered debt vehicles proved a fairly unattractive location in which to invest equity.

The emergence of secondary equity markets has resulted in increased activity surrounding

transactions that involve PFI backed securities (NAO 2006). The additional investment

 

  33  

capacity that comes with increased interest in PFI initiatives from secondary market equity

funds (SMeFs), vehicles that specialise in the development of portfolios built on

shareholdings from PFI schemes, is at risk of failing to be maximised where the poor

publication of project metrics has the potential to cause secondary equity markets to

experience significant reductions in efficiency.

The 2010 NAO Report on Financing PFI projects in the credit crisis further develops the

case for ‘groups of projects’ to be assessed for their potential to be refinanced simultaneously;

thus reducing transaction costs while enhancing the ‘public sector bargaining position’. The

aspect of rationalised portfolio management proves particularly interesting where SMeF

DEPFA, a Dublin based institutional investor, formulated an SPV that enabled a ‘synthetic

securitisation’ of 24 PFI loans within its portfolio (NAO 2006). The out transferring of risk

factors to external financial institutions resulted in DEPFA reducing its regulated contingency

capital cushion, thus enhancing the return on investment (ROI) of the firms PFI debt portfolio

(NAO 2006). Ownership issues, resultant difficulties in the structuring of refinancing activity

and large reduction in incentives as a result of revised refinancing gains (NAO 2006) keep

refinancing activity low. Funds often look toward enhancements; making savings through

reassessing the management of facilities while utilising economies of scale with the

application of pooled investment vehicles across a single portfolio (Murphy 2012).

4.2 An economic climate in flux: the emergent role of PFI

The (financial) crisis caused a market transformation; shifting from a buyer to a seller

controlled forum. The collapse of inter-bank lending resulted in a severe liquidity shortage

resulting in turn a ‘spike- increase’ in margins and fees (Thadden 2009). This occurred

simultaneously with a 58% reduction in PFI activity across Europe in the first half of 2009;

seeing 120 PPP/PFI transactions experiencing financial close in the same year to an estimated

value of €15.8 billion (Jennett 2010, Fig. g).

With demonstrably lower debt/equity ratios due to reduced market liquidity banks are now

tending towards syndicated lending as opposed to single source finance on major

infrastructure projects (Agarwal 2010). Furthermore the concept of market-flex or the right

for lending institutions to increase interest rates is becoming more widely applicable

(Agarwal 2010). The current requirement to foster deficit reduction programmes looks to

target capital build and maintenance budgeting as a means to reduce current spending (Abadie

2011). There is however current concern over increased Government debt and its possible

 

  34  

classification as a positive attribute on balance sheet due to the growth-fueled nature of the

investment, potentially offsetting initial borrowing requirements to fund construction (Locke

& Evans 2011).

European PPP Market 2008-09 (by value)

Value (€m)

Fig. g

Source: Thadden 2009

PFI projects are not signed off consciously as a poor value for money option, however public

sector due diligence must ensure that the capital value of the initial deal is not lost as the asset

ages (Henderson & Lane 2011). Furthering this the timing of payments and contributions

from the public sector party over the duration of the project may further incentivise the

private sector party to deliver a quality end product. With a stronger, more structured capital

covenant from the outset with intervention in the form of Basel III, Solvency II and the

Independent Commission on Banking (HM Treasury 2011; ); increased cover ratios and

higher volumes of private sector capital injections earlier on in the project lifecycle (NAO

2010; Pickard, Rigby & Grey 2012) lessens losses of “at-risk” capital. Furthermore stronger

equity commitments will resist Government being lumbered with a thinly capitalized private

sector vehicle with greater risk of special purpose vehicle (SPV) (Fig. h)(Locke & Evans

2011). It is the placing of this SPV in receivership that places added financial stress on the

public sector illustrated by Professor Martin Ricketts and Dr. Robert Jupe in their accounts of

 

  35  

the collapse of Metronet, a contracted party responsible for the part-operation of the London

Underground that folded due to substantial cost overruns (Parker 2009).

A typical project company financing structure

Fig. h

Source: NAO

Consideration for the development of private financial markets, instruments and channels for

government investment is key to the future success of partnership finance (Locke & Evans

2011). The method of funding chosen, whether through PFI pricing reform or otherwise

should be analysed for its potential to offset market inefficiencies providing a more stable,

long-term return to investors. The UK’s signed project list and more specifically transport PFI

projects have been used as a vehicle for investigation, where unlike other government backed

initiatives, transport projects allow the analysis of stand alone revenue streams as a result of

imposed charges on infrastructure facilities. Due to project size in the UK the transport sector

forms the largest share of PPP/PFI activity followed by health and defence respectively

(Parker 2009).

 

  36  

Transaction financing by year

Fig. i

Source: Infrastructure Journal Online

The UK is currently unable to define the levels of investment required to maintain and expand

it’s current asset base, therefore with the goal of reaching a sustainable level of investment

during times of fiscal uncertainty the acute identification of project costs are now required

(Davies et.al. 2011). The current savings level of the nation is below the required level, and

consumption funded by debt above the favoured level for a sustained maintenance regime of

the UK’s current asset base (Davies et.al. 2011). This funding of infrastructure through debt

facilities is reflected on a global scale exhibiting an upward trend during pre-crisis years (Fig.

i).

It is only through a holistic re-evaluation of our the current asset base and comprehensive

calculation of expenses, depreciation, current asset condition and required investment that

maintenance and future building projects will be best placed with respect to changing

economic circumstance.

4.3 Financial reporting standards and the treatment of national accounts

The Government 2011 report Private Finance Initiative discusses the use of the PFI

mechanism for the purposes of favourable accounting treatment and classification of debt. As

part of the Report Professor David Heald explained that it is without doubt that the PFI

 

  37  

mechanism would have been utilised to a far lesser degree had PFI debt been on-balance

sheet (House of Commons Treasury Committee 2011). Heald also goes on to explain the

halting in part of accounting arbitrage due to the adoption of International Financial

Reporting Standards (IFRS) in the year 2009-10. However an alternate form of government

accounting in the from of National Accounts (ESA 95) still provides an avenue for UK

projects to not be held present and accounted for on national balance sheets; where national

Spending Reviews such as that of 2010 are conducted on a National Accounts basis

(exploiting the loose criteria of Eurostat (2004) rules), a fundamental distortion of project

activity throughout the nation is presented (House of Commons Treasury Committee 2011).

Where PFI project risks are recorded as being passed to the private sector party, National

Accounts rules therefore allow project related debt to not appear as a proportion of headline

debt figures, eliminating PFI debt as a share of the total PSND calculation. This non-

accountability serves as a deterrent to the challenging of excessive private sector margins and

the reported increased cost of borrowing. If the accounting rules were consolidated and true

debt figures exposed the Office for Budget Responsibility (OBR) estimate that government

borrowing and debt figures would rocket by £35 billion or 2.5% of the nations current GDP

(House of Commons Treasury Committee 2011).

4.4 PFI in the UK as an international comparator

In a globally sensitive financial climate the UK’s assets must be considered in the context of

an international marketplace (Edkins 2012). The European 2020 Bond Initiative serves as

another tool to combat public indebtedness on a European scale through the provision of an

instrument that intends to lessen the current infrastructure-financing gap (Parisse 2012). The

initiative especially serves the interests of institutional investors who operate over extended

periods of time similar to the contract term of the typical PFI project where the purchasing of

an instrument backed by the European Investment Bank (EIB) will enhance investor profiles.

Thomas Barrett a Director at the EIB in a 2005-update European Investment Bank Group 1 -

2005 report outlined the ability of the Bank to assist the development of infrastructure with

specific reference to the water sector in the UK. Barrett comments on the cost of EIB finance

as being incorporated in the WACC by the Regulator, stating that a lower cost of capital is

indeed reflected in lower WACC or hurdle rate figures acknowledging that these savings are

then transferred to the user (EIB 2005). The 2010 EIB report Public and private financing of

infrastructure: Evolution and economics of private infrastructure finance acknowledges the

 

  38  

issue of the weighted average cost of capital of a project SPV. The Report comments on the

consideration of risk within PFI contracts; averaging the cost of equity capital and the cost of

external funding to arrive at an increased sponsor cost of capital that satisfies lending

requirements (EIB 2005). This method is however not further discussed nor does it document

the potential differences between asset type and geographic location. In order to achieve a

suitable IRR for category A-Projects that coincide with the performance goals of private

sector investors the 2010 report JESSICA – UDF Typologies and Governance Structures in

the context of JESSICA implementation again enforces the need for a financially viable

WACC value to offset the added cost of capital, that is as stated ultimately shouldered by the

public sector.

Darryl Murphy, Global Infrastructure at KPMG (2012) further argues the cause for clarity in

an international marketplace, announcing the country specific differentials in economic risk

and the fundamental impact this has on credit ratings. Murphy explains the relative parity in

European PPP pricing pre crisis and highlights the increasing disparity today due to changing

national credit scores, in doing so clarifying the current lack of value-added analysis

conducted on a project-by-project basis in the PFI market.

It is therefore clear that with the explicit presentation of WACC figures at the micro level that

significant competitive advantage could be gained when marketing the UK as a transparent

business environment within which to invest. The implementation of these additional steps to

a more complete assessment of the PFI sector would serve as a template for other European

countries to follow, individually presenting their case through empirical observation and

objective reasoning for further investment from external parties; developing an investment

strategy with foundations of longevity, opposing the ‘short-sell’ attitude of the past decade.

 

  39  

SECTION 5: AN EMPIRICAL ANALYSIS OF THE PFI MECHANISM

In the instance of PFI it is impossible to disassociate the cost of an asset from the delivery

model. It is therefore essential that a lean procurement procedure is designed that serves as a

transparent method for partnership financing, helping to clearly define total inputs, resulting

in an end product representative of the services being purchased. However to-date such clarity

has failed to come to fruition. The following study attempts to develop a more suitable

method for the analysis of the PFI model, identifying critical gaps that if filled could

potentially add to the clarity and credibility of the existing model.

5.1 Methodology

The empirical study began with a sample of 62 transport schemes from the Partnerships UK

(PUK) database, the SPV names of the 62 projects where then cross referenced with an

accounts database FAME, the Thompson Reuters DataStream facility, HM Treasury’s PFI

signed projects list as of March 2012 and supplemented by additional data from Infrastructure

Journal Online. The initial sample of 62 was reduced to 43 after deciding to filter out street

lighting projects, with the reasoning that the revised sample proves far more representative of

complex-funding infrastructure projects.

Information gathered from the FAME database included all data expected on company

balance sheets, however at times large data gaps occurred; furthermore figures for costs of

debt and equity fail to be reported. Navigation of the Thompson Reuters DataStream

attempted to supplement existing data, building a fuller picture of capital structure of each

individual project. Despite a comprehensive reporting of equity and bond activity for

individual investor entities, the inability to locate single SPV investments made the

calculation of SPV activity as a percentage of standalone company performance in relation to

balance sheet figures impossible. HM Treasury’s signed project list provided additional detail

on the accounting standards applied to each project and the payment schedule with respect to

UC payments, however as outlined, the component parts of the UC figures prove key.

Additional data regarding the capital structure of PFI projects was discovered in the

Infrastructure Journal Online database, however the facility, relative to the study, proved

thinly populated to the point where only a pair of projects, the Carlisle Northern Development

Route A595 and Birmingham Highways initiative, presented the degree of data that enabled

each case to potentially be modeled (See attached Appendix A .

 

  40  

The capital asset pricing model (CAPM) provides a method of estimating the cost of equity.

The model essentially illustrates the relationship between the risk and anticipated return on

(project) securities (Finnerty, 2007). The time value of money is represented in the risk free

rate (Rf) of the formula, where an averaged value from the yield of British Government stock

can be used as a proxy. Remuneration for additional risk adopted by the project sponsor is

arrived at by multiplying a market risk premium (Rm-Rf) where Rm is equal to market return,

by the projects beta value (β), a micro level variable that measures project returns against

market performance. Factoring these variables into the CAPM we can then solve for cost of

equity (CoE):

CoE = Rf + β*(Rm-Rf )

This value can the be factored into the WACC formula where a positive NPV and WACC <

IRR indicates favourable investment potential. However both the Carlisle Northern

Development Route A595 and Birmingham Highways initiative are 100% debt financed thus

making the first half of the WACC calculation zero (Infrastructure Journal Online 2012):

WACC = (%Equity*(Rf + β*(Rm-Rf ))+(%Debt*Cost of Debt*(1-Tax rate))

Where % of equity is 0:

WACC = (0*(Rf + β*(Rm-Rf ))+(%Debt*Cost of Debt*(1-Tax rate))

We are left with an initial pre-tax WACC value equal to:

WACC = (%Debt*Cost of Debt)

The Net Present value of a PFI project or the sum of present value inflows minus initial costs

(Brealey et.al. 2008) is fundamentally flawed where cost of debt figures prove inaccurate or

fail to be available. Where C1 represents the project payoff, C0 represents initial costs and t

represents the annual debt servicing of each period the project NPV in principle is equal to:

NPV = [C1 /(1+(WACC)^t] - C0

Brealey et.al. 2008

 

  41  

It is thus seen that the net-present-value of an asset and indeed an asset class is fundamentally

dependent on the accurate presentation of cost of debt figures. Where there is no currently

established shared method for calculating a periodic, aggregated cost of debt through the

summing of variable rates the potential cost of debt and indeed performance of the PFI

mechanism will continue to be contested.

At the time of constructing the 2011 Private Finance Initiative report James Wardlaw of

Goldman Sachs explained to government officials that the cost of finance from peak time to

now has risen from 60 to some 250 basis points (Fig. j) and that this upward trending market

seems locked in for the foreseeable future.

Long-term development of loan margins

Fig. j

Murphy 2010

The dramatic hike in bank pricing post 2008 and resultant increased focus on project related

risk (Murphy 2012) has the potential to adversely effect IRR figures. Furthermore the size of

transaction typical of large scale, complex infrastructure projects, that pre 2007 would have

been carried out on the bond market using monoline insurers, now tend toward syndication

and therefore have the potential for an added premium.

5.2 Debt structure and IRR

When analysing the sculpted nature of PFI backed debt facilities, attention is drawn towards

the timing of flows throughout the duration of contract and how the placing of funds could

effect the IRR of a project thus requiring increased UC payments to satisfy a higher sponsor

Spread in bps

 

0

100

200

300

400

Jun-00

Aug-02

Oct-04

Dec-06

Mar-09

 

         

                                                                   

                                         

                                                                         

                     

 

                                       

                                                 

                                                                                               

   

                                           

                                                 

                                                         

   

 

  42  

rate of return. Modeling such assumptions would enable the impact of component parts of

structured debt to be quantified against a project WACC value.

Example

One such component that may alter the IRR and in turn WACC of a project exists in the form

of an equity bridge loan. This instrument (Fig. k) serves to replace sponsor equity at period t0

of a project, moving it to period t3, post construction (Brealey et. al. 2008). This

rearrangement of flows is done with the intent of increasing equity return due to the injection

of capital being back-ended and thus being assessed against a more favourable risk profile.

Placing of an equity bridge loan and sponsor equity

Fig. k

Source: Author

Where the majority of PFI projects will be arranged through long term debt facilities the tail

of a project (post construction phase), is typically an approximate period of 28 years at fixed

rate (therefore swapped) debt (Murphy 2012). Once the initial CapEx, (construction ‘C’) of

the project has been overcome there is scope for the movement of additional contingency

facilities to impact the IRR and WACC values of a PFI project.

Due to a high premium attached to bridge facilities the point to which a bridge facility is

utilised, and the resultant impact the facility has on the overall debt structure of a PFI project

presents an important topic for debate.

 

  43  

5.3 Summary

This micro-level assessment of long term complex infrastructure projects and determining of

the WACC thereof is essential in order to report on the current state of PFI and the potential

future performance of the procurement method. We now ask what is to be done? Without the

collation of private data surrounding PFI projects with specific reference to the 43 projects

intended for assessment, accurate conclusions cannot be drawn on the capital makeup of each

project.

The inability to complete the initial task is a derivative of the required data not being readily

available. However, the ability to access a small portion of the necessary information

demonstrates that this same information is not commercially confidential. Therefore we are

forced to ask why this information is not available in the public domain, highlighting the

fundamental lack of transparency that characterises PFI reporting. With such a guise placed

over hard-to-reach, however commercially available data the question of whether or not

complex debt facilities remain competitive in the current market compared to those pre-2007

remains. Intuitively one would assume that they are not, however, without accurate

assessment of individual projects the PFI mechanism is not given a fair platform to prove its

value.

The current absence of discourse surrounding the accurate reporting of the financial stance

facing PFI is therefore not idleness on the research community’s part. The proper evaluation

of the PFI tool requires research and practitioner communities; equity investors, banks and the

public sector to agree a method that sums multiple sources of capital, at variable rates,

arriving at an overall representative cost of debt (Edkins 2012). Through this an empirical

benchmark can be derived that builds on the current foundations set forth by IUK, and

impending initiatives within the macroeconomic environment.

 

  44  

SECTION 6: CONCLUSION

There are two plausible reasons why to date the vital WACC data explored in this paper is not

more widely reported. First the metric is easily arrived at through a series of simple

calculations and is retained by industry insiders in order to keep information undisclosed,

citing commercial confidentiality as a security buffer (Ive 2012). Second the arrival at

accurate WACC values is indeed a complex procedure that merits the demonstrable degree of

confidentiality on the grounds of misrepresentation of data, should further manipulation of

data be attempted by external parties; thus the case for a universally accepted method for the

calculation of the WACC metric that consolidates variable and fixed rate debt facilities is

required (Ive 2012, Edkins 2012).

HM Treasury together with auxiliary bodies should where needed lend procurement support

to complex financial and funding arrangements for PFI projects (Locke 2006). The data

needed to better detail and aid the evaluation of the PFI model lies with the specialist project

teams assembled on a project-by-project basis for a fixed-term. It is therefore essential that

the knowledge gap is efficiently bridged between public and private project teams;

transferring project information and PFI related skill sets to the public sector. From here a

framework can be developed from which the effective management of an expanding asset

base will be within the ability of the assigned managing body post-handover. Increased

discourse has the potential to stimulate the sharing of project data; this data need not be

confined to local authorities, nor regional growth funds or similar representative bodies but

fed into a centrally accessible system to the benefit of market analysts, lending institutions

and potential investors alike. The current fragmented presentation and recurring knowledge

gaps within financial data surrounding PFI is reflected in its poor implementation, increased

transaction costs and persistent lack of trust in the mechanism as a method of efficient asset

delivery (NAO 2009).

Irrespective of the changing fiscal stance of PFI as a method of procurement the fundamental

ethos of the tool still stands as highlighted in 1981 by the then Chief Secretary of the Treasury

Leon Brittan that, ‘funds for investment should be taken under conditions of fair competition

with the private sector; that is, that the latter should not obtain a normal equity profit without

accepting a normal equity risk.’ (Parker 2009). The current Government call for more direct

forms of capital investment to supersede the PFI mechanism believed to be lacking in a

derivation of public value (House of Commons Treasury Committee: Private Finance

 

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Initiative 2011) raises the question of where else are direct forms of capital investment can be

accessed.

Maintaining the focus on public value arguments for the calculation of simple metrics with

specific reference to WACC values are as follows:

• According to the HMT Current Projects List as of March 2012 some £28,830,000,000

of public sector capital is tied up in PFI activity, government therefore owe a duty of

care to see the correct handling of public resources;

• With widely available reporting on the capital structure of PFI deals much needed

clarity (Pickard & Plimmer 2012) would be provided allowing the tracking of public

capital both how much is being used and where;  

• With respect to this anticipated independent analysis of the transport sector a fairly

homogenous sample (prima4rily road projects) wouldn’t be expected to report the

WACC as a function of the asset but of the financial structure, investor type and risk

appetite of sponsor parties, thus providing added lucidity on the capital makeup of

individual PFI projects; sensitive to the allocation of public sector resources;

• This then suggests that WACC values could be compared between different assets

within the same class, thus allowing asset classes as a separate entity to be compared,

illustrating the level of asset performance, based on objective information over

supposition, on a sector-by-sector basis.

A commercial sense must be maintained over the life of PFI assets where concern is given to

the material value of the movement of cash flows around a project. Where a changing

financial climate demands higher repayment charges the future benefit of the project must be

re-evaluated, and alternative methods of funding considered. To offset higher borrowing rates

a continued monitoring of the performance of all public assets remains key to tracking

expenses and areas in need of (further) investment. Additionally the selective monitoring

(Davies et.al. 2011) of the nations assets [water and rail] need be applied across all sectors in

order to reveal pockets of investment demand. Without increased levels of transparent

reporting government is not to know what the provision of its national assets should cost. A

lack of financial project data creates an agency problem where the public sector is exploited

as it proceeds to make contributions unknowing to the amount and true value of a project.

In order to encourage investors to purchase project-backed securities that prove a profitable

 

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low-risk alternative to reduced bank-lending charges, a demonstrable market recovery and

supporting government policy that addresses infrastructure development must be presented.

The political climate as a result of the FSA Solvency II directive placing ‘stronger

requirements on capital adequacy and risk management for insurers’ currently places doubt

on the operational extent of insurance companies to partake in the generation of growth

through the sponsoring of infrastructure development (Pickard et. al. 2012, FSA,

2012).

With benefits of knowing these currently hard to define values comes adverse consequences

should such information continue to be widely unknown. In the absence of revised reporting

standards the PFI process will continue to experience significant cost problems that will cause

the nation to lose potential investment, resulting in a lack of new building and the neglect of

current assets. In the case of micro-level reporting on a multinational platform, if the risk

profile of assets can be differentiated between classes then a nation-linked beta value for

respective asset classes has the potential to be formed, providing a comprehensive list of

countrywide asset performance. This revised model for portfolio evaluation would provide

the critical clarity needed in the PFI market place to attract demonstrable international

investment.

In order to dismiss the tag PFI has gained as an autocratic instrument that places a heavy

financial burden on the public sector (Stacey, Pickard & Neville 2012), the independent

collation and presentation of financial project data needs to be made available through

currently established channels like that of Infrastructure Journal Online and InfraDeals

electronic facilities. To ensure a successful outcome practitioners involved in arrangement of

PFI schemes are required to work with those in data processing roles to monitor the correct

reporting of project related data in a format that lends itself to little chance for

misrepresentation. Ownership is required over the current issue of inefficient reporting, where

a regimented body is required to pursue the correct reporting and maintenance of PFI related

variables, installing a fundamental framework, building a knowledge transfer chain.

“If you had the data framing the story is interesting.” Murphy 2012

 

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