Private Finance Projects and off-balance sheet debt - Economic Affairs Committee Contents

Supplementary memorandum by the National Audit Office on PFI Secondary Equity Market

  1.  The Committee asked for a note on the PFI secondary equity market (secondary market). We set out some background on the secondary market below, our view of the benefits and potential risks it brings, and our view on its effect on due diligence.


  2.  The secondary market is a general term referring to the trade of equity shares in PFI project companies (special purpose vehicles) after the project company has already been set up. By way of contrast, the primary market refers to the financing of share capital at the point the project companies are set up.

  3.  Similar terms apply to the markets for raising and trading in debt financing. But PFI contracts contain clauses allowing public authorities to veto changes in the debt financing and to share in any benefits. We generally refer to such changes in the debt financing as refinancing. This note relates solely to changes in the equity ownership and not to refinancing.

  4.  In general, the shareholders of a project company are allowed to trade their PFI shares freely, as they would any normal shares of a limited company. Only occasionally would a public authority have a say in such trades, such as a right to consent (not unreasonably withheld) in certain Defence contracts. The public authority is not a party to such trades and does not share in any proceeds. It is therefore important that the expected return to the shareholders over the course of the whole contract be carefully scrutinised during the contract tendering.

  5.  Typically, the primary market equity investors will be party to the contractual arrangements, often as either senior debt lenders or subcontractors to the project company. The secondary market equity investors will usually not have a direct involvement in the project company, except as owners.


  6.  There is generally good information on the holders of PFI equities, but little information on the terms in which PFI equities are traded or how they are funded. Public authorities will normally be aware of any change in the ownership of a project company, but will not normally be provided with details of the terms of the change of ownership, including how much was paid for the shares. The Treasury publishes a database on PFI share-ownership on its website.[111]

  7.  It is also difficult for the public authority to assess how the shares are financed, including whether they are leveraged or securitised, unless such information is published by the shareholders (for instance as part of a portfolio brochure or market return).

  8.  Most of what happens in the secondary market falls outside the remit of the National Audit Office. Whilst the National Audit Office has access rights to the documentation of PFI sub-contractors (where they relate to the accounts of a body we audit), we do not have access rights to documents belonging to shareholders. Our information on the secondary market is thus restricted to data collected from public authorities and contractors, as well as our general monitoring of the sector.

  9.  Nonetheless, the National Audit Office has an interest in the effect of the secondary market on the value for money of PFI contracts. We have been monitoring the development of the secondary market for some time. For example, we are currently undertaking a study on the Performance and Management of Hospital PFI Contracts, in which we are asking NHS Trusts for details of how any changes in share ownership may have affected the contractors' performance.

  10.  Our analysis of Treasury's data on share-ownership indicates that the market is consolidating. Since February 2008 there have been slightly over 50 transactions in the secondary market, with around 30 companies purchasing shares. Amongst these, two investment funds have been particularly active in buying shares: Semperian (formerly known as Trillium PPP Investment Partners) and Barclays Integrated Infrastructure.


  11.  Given the lack of visibility over the secondary market it is difficult to ascertain the effects that the secondary market has had to date.

  12.  In theory, the secondary market is likely to have had a positive effect on the availability and cost of equity capital in the primary market. The secondary market provides some confidence to primary market investors that they will have an exit opportunity and that they will not be tying up capital for the full length of the contract. This confidence could mean more investors and more capital in the market, which in turn drives competition and reduces the cost of equity finance.

  13.  But the consolidation of equity in the secondary market also brings a number of a risks:

    — Firstly, it may provide the consolidated owners of shares with disproportionate market power, and particular asymmetry of power over small public authorities tendering and managing single PFI contracts. We would be concerned if we started to see a few consolidated owners dictating contract and commercial terms. We do not have evidence that this is happening.

    — Secondly, consolidated owners are able to bring more expertise and knowledge to bear in managing their contracts, whilst being less tied to the individual relationship between the project and public authority. This can be beneficial, if it means they bring expertise in the management of their sub-contractors that will aid the aims of the project. But it could also mean more challenge to the public authority's contract management. For instance, a consolidated owner might be in a better position to challenge a claim or to demand extra payment where the contract specification is unclear. Again, there is no clear evidence that this is happening.

  14.  On the other hand, a change in the share-ownership of the project company has few direct effects on the operational aspects of the project. The contractual terms are unchanged, and the organisations and people delivering the project will rarely change. The project company will remain responsible for the delivery of the project, but will seek to pass as much of the risk associated with that delivery to sub-contractors. Consequently, the key relationships between the public authority as client and the Project Company's sub-contractors will remain unchanged.


  15.  There are a number of parties involved in agreeing a PFI contract, including the public authority, the project company, its shareholders, potentially parent companies (who normally provide a guarantee), the sub-contractors (who agree the specification, and sign sub-contracts to the PFI contract), and the lenders. Each will conduct their own due diligence on the contract.

  16.  Their due diligence will cover a number of aspects including the feasibility of the specification, construction risks, finance risks and operational risks, as well as the commercial and contractual terms.

  17.  PFI secondary market transactions of equity normally occur once construction is complete. As construction is considered to hold much of the risk of a PFI project, a project that is into its operational stage is often considered to be a safer investment. Consequently the equity becomes worth more and is attractive to a different type of investor seeking a lower but more constant return.

  18.  In theory, it is possible that a party to the contract might undertake less due diligence than they otherwise would if they believed both 1) that the secondary market provided them with an exit before risks will arise; and 2) that the buyers of equity in the secondary market would not undertake their own due diligence and will underestimate the risks involved in the project.

  19.  It is also possible to argue that where buyers of equity in the secondary market are securitising the equity and are highly leveraged, that they retain less exposure to the project's risks. But we have no evidence that this means that they have such little exposure that they are unconcerned about due diligence.

  20.  However, even if the secondary market were leading to the shareholders undertaking less due diligence, it is not clear what the effect on the contract would be. The sub-contractors, lenders and public authority would still need to work together to deliver the project and their due diligence would still be crucial.

November 2009

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