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


Examination of Witnesses (Question Numbers 449-459)

Mr Adrian Olsen, Mr Philip Turville and Mr Laughlan Waterston

8 DECEMBER 2009

  Q440  Baroness Hamwee: I should quite like to pursue whether the availability of European funds in the Republic of Ireland made a difference, at any rate to the timing, but I will not.

  Mr Olsen: I could not possibly comment.

  Q441  Baroness Hamwee: Coming back to the script, we have asked you about the current financial situation. Do you think that pension funds are going to become a significant source of funds for private finance projects in the future?

  Mr Turville: The answer is that I think they should be. Pension funds are a natural source of long-term financing and therefore a very good fit for PFI projects. To date we estimate around 25% of PFI projects were financed in the capital markets and a significant proportion of those bonds have been placed with pension funds, particularly with the UK institutions. You can take some statistics I have been provided with by my bond colleagues. There have been over £50 billion sterling issuance in the corporate bond market to date and that compares to 2008 at about £18 billion and £23 billion in 2007. So in difficult times for the financial markets the corporate bond market has been booming and a lot of that issuance has been dominated by the utilities; the figure for utilities is around 25 to 30%. We have seen BAA in the last 10 days issue £935 million into the capital markets. That is a huge source of liquidity. To date they have played a significant role but moving forward as banks have withdrawn from the markets and term has become an issue for banks, the banks are looking to lend shorter term that they were 24 months ago. The pension funds are the natural source of financing.

  Q442  Baroness Hamwee: If you were advising a pension fund, would you say there are any particular risks for it? I ask that question just to get at it from the other point of view. Are there any constraints that pension funds, because of their own nature, might encounter? So, though they should be a good source of finance, we might find that they are not.

  Mr Turville: The risk profile of transactions is one of the issues for pension funds. The UK model historically has been to use mono-line intermediation; so the mono-line would use his former triple A rating to credit enhance and that makes it easier for pension funds to purchase the debt. A lot of PFI projects have been rated at very low investment grades, really triple B minus. A lot of deals the banks were undertaking at the peak of the market were actually non-investment grade. That is very difficult for pension plans. I talked about utility issuance. Utilities are generally rated in the single A category. To really tap into the huge popular resources available from pension plans the projects need to be structured to a higher credit level and that is something we see in overseas markets. The UK is heavily dependent on mono-lines. In Canada there has been huge unwrapped issuance but the projects have generally been rated high triple B to single A range and the Canadian pension plans have bought that paper.

  Q443  Lord MacGregor of Pulham Market: May I just be clear? Were the figures you gave us related to bonds for UK banks' PFI projects?

  Mr Turville: No, total sterling corporate bond issues.

  Q444  Lord MacGregor of Pulham Market: I thought they were. Could you break it down for PFI projects?

  Mr Turville: Our estimate is around 25% of PFI deals have been funded in the capital markets since the inception of PPP, generally focused on the larger transactions, transactions like the Royal London and Bart's hospital projects and Allenby/Connaught, the MoD accommodation transaction, deals which were over £1 billion. There was a time when the majority of large PPP projects, say £200 million plus, were funded in the capital markets.

  Q445  Lord Griffiths of Fforestfach: Why, in your experience, do you think people who have equity stakes in PFI projects sell them on? Do you think it is a good thing they do sell and do you think there is any case for putting any restriction on the proportion of their equity stake which they can trade?

  Mr Olsen: The balance sheet of construction and operation companies in particular, who would historically have come in to the PFI space, ostensibly to win contracts for their discipline, is obviously constrained in the same way as any other balance sheet is constrained and their ability to recycle that capital into a secondary or even a tertiary market is important because it frees up that capital capability for them to come back into the primary market and deliver the thing they are actually really there for and their expertise is designed for which is building and operating these projects. There is also an increasingly growing financial investor market which is buying these assets, this equity. That obviously is part of the food chain.

  Q446  Lord Griffiths of Fforestfach: Which is a good thing.

  Mr Olsen: Which is a good thing because it frees up the contractors in particular to move on to the next phase in the wave of projects. My sense is that if any limitation were to be placed on that process, it would skew the market.

  Q447  Lord Griffiths of Fforestfach: And increase the cost of capital.

  Mr Olsen: It would presumably increase the cost of capital at the primary end. My sense would be that the free market process—

  Q448  Lord Griffiths of Fforestfach: Because they would be taking on more risk in holding their equity stake.

  Mr Olsen: Exactly.

  Mr Waterston: If you were a typical building contractor, you have a limited capacity on your balance sheet to put equity into projects. So if you want to continue building PFI projects year after year, 10 years, 15 years or whatever, you need to find a way of releasing that capital so you can put more of it into projects. It has been very fortunate that there are these secondary funds which have come in and taken up that capacity. I would add that in terms of the restrictions mentioned there is currently a form of restriction in the SoPC4 standard contract whereby, during the construction phase, there is a limitation on the equity providers selling equity without the approval of the local authority. So the local authority has effectively to approve the sale for that period of two to three years during the development phase. After that, once you are into the operation, then it is up to the equity providers to sell. Even so, within the SoPC4 there are still more criteria about whom they can sell to and there is a number of potential investors to whom they cannot sell which are defined in the standard contract. One further point to add is that in terms of liquidity of the secondary market, it is very much the case in other European countries where we see PPP that there is this similar lack of restriction on selling equity stakes and projects, particularly after the construction phases.

  Q449  Chairman: I can see the benefit from the point of view of the equity holder or the construction company, but a number of witnesses have said to us that from the point of view of those who are on the receiving end of a PFI contract the bundling of the long term with the investment in the asset itself was a great benefit because that persuaded those who were producing the asset to think long term. If those who are the initial equity holders can simply sell off their equity without constraint if and when they want, does that not water down and weaken the apparent benefit from the point of view of the receiver of the asset?

  Mr Olsen: It is particularly the case of the construction contractors and/or the operators that they come into the process to do a job. The contractor is a builder and his job is to come in and build the entire thing, whatever the asset is, to spec on time and on budget and hand over that asset in a fit state, fit for purpose et cetera. The operator then comes in and operates it. There is symmetry to those two things because the operator will want to be very sure that the asset he is taking on and managing for 25-30 years is fit for purpose. The funders, in particular the banks, will—coming back to my point about policing these contracts—need the contractor through his contractual obligations to continue to operate and deliver under that contract through the life of the loan or the asset as a whole. There is a degree of horses for courses in this question. You have different parties coming into the project and applying their expertise at the time it is most needed, policed in particular by the funding community, whether that is banks or capital markets. I suppose it is clear that the pure financial equity houses are in it for the longer term equity returns of course and, again, they have a commonality of interest with the banks to ensure that the project is operating in a way that ensures the cash flows continue to happen. So from all directions it is almost like a symbiotic relationship between the parties, all producing and providing their pieces of expertise to ensure the thing remains intact for everybody's benefit, including the public sector of course. In policing the project the public sector is getting what it asked for.

  Mr Waterston: It is important to note that the buyers of this potential equity that is sold also have a vested interest. The incoming buyer of an equity stake in a PFI project is going to have a strong interest also in maintaining the project for the user. It is not as though the fact of selling it could result in a lesser degree of due diligence by the new owner. It is a niche market, a niche infrastructure specialist market. The infrastructure funds which are out there are very experienced in PFI projects and would certainly be expected to maintain the assets as well as the previous owner.

  Q450  Lord Griffiths of Fforestfach: To me the acid test would be—let us assume you take a primary equity stake in something and then you feel after a certain time you have done your bit or you need cash for something else so you sell it on—whether the person you sell it to will say "Ah ha, they were very generous in the costs that they imagined for servicing this project. Could we now embark on a cost-cutting exercise and through that deliver a lesser quality of service to the customer?" If we could find examples of that, I think it would support what you are saying. Whether there are any or not I do not know.

  Mr Olsen: I am certainly not aware of any examples. We come back to the specification set out at the outset that the school, the hospital, whatever the project is, has to deliver a certain standard of service and there is obviously a cost for that. Clearly any private enterprise will look to optimise its costs versus its deliverability. We are back to the due diligence process that we all went through at the beginning of the process before financial close. I am interested to hear what the equity says about this, but my sense is that there is actually very little fat built into these things and there are not very many costs, if any, to take out of the process. They are very, very optimally structured.

  Mr Waterston: If a new owner did try to run down the costs in that way, they would soon find that parts of the school were unavailable because the operator was not doing its job because it was not getting the money. It would then have deductions and its equity stake would be greatly underperforming.

  Mr Olsen: And it would have a lot of lenders on its back, banging on the door asking why it was not performing and indeed the public sector saying exactly the same thing.

  Q451  Lord Forsyth of Drumlean: On the secondary markets, has the stalling of the securitisation markets effectively made it impossible to have a secondary market?

  Mr Waterston: In terms of the secondary market for senior debt, I would argue yes, it certainly has affected the secondary market. SMBC has an active securitisation programme, we have closed two synthetic securitisations, senior debts in PPP projects and we are working on our third one. There are several other banks which have done this. That is important to banks such as SMBC because it frees up capital which we can then use to lend in the products on a primary basis again. I would say that the fact that has stalled has meant that it has not been possible to free up capital to allow more lending to projects. That has affected the market on a fairly wide basis. We are starting to see the securitisation markets recover to a certain extent because we are working on the third securitisation vehicle at the moment but we need to see a much wider recovery of securitisation markets to have a marked impact on the market as a whole and improve the primary market and secondary market.

  Q452  Lord Forsyth of Drumlean: Given the previous answer to Lord Griffiths of Fforestfach about the importance of the secondary market to reduce the cost of capital, does that mean that PFI will be less attractive as a way of moving forward because it will be more expensive.

  Mr Waterston: I do not necessarily think the securitisation markets are solely linked to that. The securitisation markets are important to some banks that use securitisation to create capital so they can lend to the projects. What is resulting is that there are fewer banks in the market to lend long-term debt to PFI projects because the securitisation markets have dried up. So some of the banks that had been lending are doing less. It is really a question of whether there are enough banks in the market to lend. There is certainly no doubt that banks' liquidity costs have gone up across all forms of lending not just PFIs. It is not solely related to securitisation markets drying up but that has certainly had an impact on the amount of liquidity available to lend to PFI.

  Q453  Lord Forsyth of Drumlean: Just to be clear, in simple terms, as I understood it the previous answer said that the benefit of the secondary market is that contractors would be able to refresh their balance sheets and go on to the next project and if that were not available, the cost of capital would be higher. Does it not therefore follow that if there is less capital available and if the cost of capital is higher, that the effect will be that the contractors' costs under PFI will be greater than they were before?

  Mr Waterston: We need to differentiate here between the secondary market for contractors' equity stakes and the secondary market for senior debt. Being on the banking side, commenting on the secondary market for senior debt, what I am answering particularly there is the availability of a secondary market for senior debt and the fact that a securitisation market that is liquid allows us to free up capital for new primary lending. It is important to differentiate between that and a secondary market for equity stakes.

  Q454  Lord Forsyth of Drumlean: I understand that but if there is less debt available, does that not mean there has been more equity and equity is more expensive and the overall thing will be more expensive.

  Mr Olsen: Yes; correct, if it were the case that the debt markets dried up to a point where we needed to inject more equity to make the funding whole.

  Q455  Lord Forsyth of Drumlean: For clarity, does that not mean in the current circumstances that PFI will be more expensive?

  Mr Olsen: Yes, in the current circumstances, it would tend to be more expensive.

  Q456  Lord Best: I would like to hear your views on the creation of a government-backed national infrastructure bank along the lines of the Scandinavians on the grounds that this potentially gives the best of both worlds. It brings all the PFI benefits, on budget, on time, whole life contracting and all that, with lower interest rates as well. What do you feel about that?

  Mr Turville: Yes, the discussion on a national infrastructure bank is very topical at the moment. It really depends on what the objectives are for that bank. There has been less liquidity in the PPP market but liquidity is returning. I think we have seen the high watermark in terms of the cost of debt. Projects like the M25 where 16 or 17 banks came into the syndicate for that transaction and at one stage it looked likely that the TIFU, the Treasury bank that was established was going to be needed to fund a shortfall in debt for that transaction, that turned out not to be the case. That demonstrates that very large PPP projects can still be done but size is very much a driver of the terms which are achieved on transactions. From my perspective, it is unclear what a national infrastructure bank would actually achieve, what its purpose would be. Is it to fund shortfalls in the debt markets? As TIFU demonstrates, they have done one transaction and that need was perhaps there six or 12 months ago; perhaps there is less of a need today, apart from absolutely jumbo projects which, to be honest, we are not really seeing in the UK. We are seeing them more in continental Europe, in France in their high-speed rail projects for example. A national infrastructure bank which is there to bridge that gap perhaps is not required. There is no doubt a national infrastructure bank could apply the PFI principles that the banks apply and go through the same due diligence process as any of the bankers active in the PFI market and that is really what TIFU has already done; it has applied those principles. Yes, it could happen but the actual need to bridge liquidity has past.

  Q457  Lord Best: Why do you think then the Americans seem likely to set up just such a bank?

  Mr Turville: It may be to do with the scale of the transactions. The largest projects in the UK, the two I have mentioned, Allenby and Bart's, and the London Underground PPP programme, are all £1 billion or £2 billion transactions. In a number of projects in the US and high-speed rail in Europe you are talking about £5 billion to £10 billion transactions and the banks and the market are just not there for those transactions.

  Mr Olsen: In the US, the banks have historically been absent from this market, the project finance market, not just the PFI market. Most of the US banks, if not all of them, prefer not to lend long term and they have been very conspicuous by their absence over many years.

  Q458  Lord Best: It is just a matter of scale though. In Scandinavia the banks, who all participate in this central bank, have total lending of only about £4.5 billion, something like that over a period of 25 years or however long they have been going. It is not because of the scale; there must be a lot of relatively small projects in Scandinavia. They seem to be very enamoured with this.

  Mr Olsen: Yes, that would be the case. I am not personally familiar with the process up in Scandinavia. From my perspective, I would mirror Philip's comments. What is the infrastructure bank going to do? What is its raison d'être? Is it to provide cheap finance? It can certainly do that on the basis that the state can borrow far more cheaply than the banks can at the moment; most banks anyway. Is it to fill a funding gap? I think that funding gap has largely disappeared. We are certainly not out of the woods yet but it has largely disappeared. Or is it something else? Those questions have to be asked before you can decide whether it would make sense to go ahead with that NIB.

  Q459  Lord Lipsey: Sorry to jump about but can we just go back to where Lord Forsyth of Drumlean was, about the equity proportion in some of these things? I take your point that in current market conditions the equity share when funding a project may tend to be rising. Taking a layman's view, some of the examples before this Committee have rather suggested that there is really quite a small equity share in some of these projects and as a result, if they do go belly up, the people who are ultimately responsible are not losing much money and that really brings out the question of whether a true risk transfer is taking place to begin with. I would welcome your observations on that problem.

  Mr Olsen: Project finance, which is the style of finance which we use in PFI, has been around for about 30 years. In particular it grew out of the financing in the North Sea in the early 1970s and it has always been the case that project finance uses a very high gearing rate, which is the ratio between debt and equity, typically something between 90:10 and 80:20, something of that order. The structures which have grown up around PFI therefore grew out of that method, that system of finance. The passing of risks, yes, you are right, if equity has only 10% say in the total funding you could argue that equity is only taking a relatively small part of the risk. However, what one must not forget is that the remaining 90 or 80% is still coming from the private sector, albeit in the form of debt rather than share equity. The risks are still being passed to the private sector, it is just that banks, or the capital markets in the case of bonded projects, are taking the lion's share of the risk with equity providing an equity net. They sit at the bottom of the pile if a problem happens. Equity takes the first risk with senior lenders taking the second or third layers of risk depending on the financial structure.

  Mr Waterston: The other point to add to that is that the sub-contractors also take a high degree of risk even if they are not putting equity into the project. If you are an operational contractor, you are typically taking 200% of your annual fee as a risk and if you under-perform you get terminated, which is a very large incentive to a lot of operational contractors; a building contractor is also taking a massive risk if it cannot complete the project on time.

  Q460  Lord Griffiths of Fforestfach: If, on the other hand, equity holders were to walk away when things went wrong, would it not be disastrous for their reputation? If they want to survive in this market and play a role going forward, it seems to me that is not the way to go about it.

  Mr Olsen: Yes, it is a small market. It is a relatively small group of institutions which play and, absolutely right, there is a reputational risk for everybody in this market. You do that once; I suspect you might just get away with it. You do it twice; you are going to have banks and funders walking away and not supporting your bids and presumably the public sector too will get a very clear steer as to which bidders are reputationally sound and which are not. Yes, there is a very strong reputational risk in the process. Again, I suspect a kind of self-policing goes on.

  Chairman: That probably covers most of the ground that we were expecting from this session, so if no members have any other questions, we will draw to a close. Thank you very much indeed for spending the time with us and for your answers. We look forward to that additional little note on Norwich. Thank you.


 
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