From PF1 to PF2: the reform of the Public Private Partnership model in the UK

From PF1 to PF2: the reform of the Public Private Partnership model in the UK Andrew Buisson Norton Rose Fulbright LLP - November, 2013

From PF1 to PF2: the reform of the Public Private Partnership model in the UK Andrew Buisson

Norton Rose Fulbright LLP November, 2013

2

From PFI to PF2: the reform of the Public Private Partnership model in the UK The British government has issued a wide-ranging series of reforms to the Public Private Partnership (PPP) model used in the UK. This follows various commitments made by the Conservative Party prior to the last general election in May 2010 to either abandon or radically reform the model, known as the “Private Finance Initiative” or “PFI”, following concerns over value for money of the scheme. The revised model, launched on 5 December 2012, is now known as “PF2”. The similarity of the name reflects that the new model is an evolutionary change rather than a wholesale replacement. Many of the concepts developed in the original PFI model in the UK were adopted in other countries as they developed their own PPP programmes, so a major change to the UK model is likely to be of wide interest to market players and practitioners globally as well as those proposing to invest in such schemes in the UK. This article will examine the key areas of change and highlight some of the issues this raises for investors and funders. Development of the PFI model in the UK The PFI model was first launched in the UK in 1992 as part of the then Conservative government’s initiative to increase the level of private sector involvement in the delivery of public services and tap the funding capacity of private sector financial institutions, and followed a series of successful privatisations of publicly owned utilities. It was then adopted by the succeeding Labour government from 1997 onwards with increasing vigour, and eventually became the default method of procuring major public sector projects in a large number of sectors. By the end of 2011, a total of 712 projects had reached financial close under the PFI model, with an aggregate capital value of £54.3 billion1. These projects showed PFI to be a versatile model covering a wide variety of public facilities and services: from conventional accommodation projects such as new schools, hospitals, prisons, courthouses and central government offices; transport projects covering roads, bridges and metros; to more esoteric output-based projects such as defence training simulators, coastal defence projects and air traffic control. The PFI model was widely acknowledged to have delivered some clear successes. Most notably, the National Audit Office reported in 2003 that the number of public projects being delivered late had reduced dramatically (from 70% to 24%) compared to similar projects conventionally funded by the public sector. Similarly the number of projects over-spending during construction also sharply decreased, from 73% to 22%2. Whilst the model had always been the subject of vocal criticism from those on the left (such as the unions, who saw it as a means of privatisation by stealth), in recent years it also came under significant criticism from the opposition Conservative party, who believed that the PFI model had become an extremely inefficient method of financing projects. With the formation of the new Conservative-Liberal Democrat coalition government in May 2010, the stage was set for change and the new government launched a public consultation on how best to reform the PFI model. PF2 - the new model

1

TheCityUK, PFI in the UK and PPP in Europe, February 2012, p.1. http://www.thecityuk.com/research/our-work/reports-list/ 2 National Audit Office, UK. PFI: Construction Performance (2003) http://www.nao.org.uk/publications/0203/pfi_construction_performance.aspx

From PF1 to PF2: the reform of the Public Private Partnership model in the UK Andrew Buisson

Norton Rose Fulbright LLP November, 2013

3

On 5 December 2012, the Government publicly launched the new model, called “PF2”, through the issue of a new policy document “A new approach to public private partnerships”3, and a revised guidance document entitled “Standardisation of PF2 Contracts”4. Despite some previous indications from those in government that the PFI procurement model might be scrapped entirely, it was immediately clear that the basic structure of the PFI model had remained unscathed within PF2. In other words, PF2 remains a procurement model which obliges the private sector to: 

integrate design, build and maintenance to achieve a whole-life solution



establish the best solution to meet output-based requirements defined by the public sector client and deliver services on a no-service, no-fee basis, based on a detailed payment mechanism



obtain the majority of finance from the private sector and perform rigorous due diligence to mitigate the risk of project default, where the compensation risk profile remains unaltered.

This is a pragmatic approach, as these were the areas where the majority of stakeholders would have agreed that the PFI model worked well at delivering long-term projects with a reasonable allocation of risk and reward on each side. Nevertheless, the reforms initiated through PF2 are still significant, and seek to address a number of perceived problems. At a high level, the PF2 issues and reforms can be split into seven areas and summarised as follows:

Issue

Perceived Problem

1. Equity Finance

Insufficient collaboration Excessive providers

2. Transpare

Key Proposals Public-Private

gains

by

Lack of transparency accountability

Government to take an equity stake on all projects

equity

Part of equity to be subject to a funding competition

and

Broadened regarding obligations, including levels 4 equity return

ncy 3.

Skills deficit in local procurement

Procurement to be routed through new centralised procurement units

Procurement timetables too long

Ensuring greater preparedness before launching tender and introduction of an 18 month cut-off

Lack of flexibility

“Soft” services (cleaning, catering etc) to be removed and ”call-of” provisions introduced or minor maintenance etc.

Procureme nt

4. Service Provision

3

HM Treasury: A new approach to public private partnerships http://cdn.hmtreasury.gov.uk/infrastructure_new_approach_to_public_private_parnerships_051212.pdf 4 HM Treasury: Standardisation of PF2 Contracts: Draft http://cdn.hm-treasury.gov.uk/infrastructure_standardisation_of_contracts_051212.pdf

From PF1 to PF2: the reform of the Public Private Partnership model in the UK Andrew Buisson

Norton Rose Fulbright LLP November, 2013

4

5. Risk Allocation

Inefficient risk transfer

Take certain risks back to public sector to avoid private sector pricing inefficiently for these

6. Debt Finance

Lack of competitive long-term debt finance

Implementation of various measures to increase the credit rating of the project to encourage institutional investors/pension funds to participate

7. Value for Money and Efficiency

Perceived inefficiency in the PFI model

Implementation of periodic reviews and requirement to tender proposals for continuous improvement

Equity Finance The most radical changes introduced into the new PF2 model relate to the provision of equity finance. Firstly, the Government has announced its intention to act as a minority co-investor in the project’s special purpose vehicle (SPV) on all future projects. Whilst public sector investment had occurred in a number of recent projects, notably in the health and education sectors, the central government stake had never generally exceeded 10%. Moreover, the stake was not generally seen as being actively managed by the public sector and was eventually sold to a private equity investor to recoup cash for the public purse. With PF2, the Government clearly sees a different approach. Notably, the proposed minority interest will be much larger - between 30% and 49% - which will certainly require much more active management. The Government is mindful of this and has proposed that a separate “commercially focussed” central unit be established, engaging appropriately skilled individuals to oversee the investment from a commercial basis. One of the desired outcomes from this larger equity stake will be a more collaborative approach and a genuine environment of partnership between the private and public sectors. At first glance, it seems inevitable that the private sector investors will have to pay more than lip-service to the interests of their new and significant minority co-investor, however one must remember that all of the SPV’s directors, whether appointed by the public or private sector, will be obliged under companies law to act in the best interests of the company at all times, as opposed to the interests of the project. Logically this would suggest that some obvious conflicts may arise between the public sector’s procurement arm and its investment arm. It will be interesting to see how this issue plays out when the shareholder documentation is produced on the first few projects. The second major change is the proposed introduction of equity funding competitions. Funding competitions for debt funding have become relatively common on PPP projects in recent years. Many funders were finding it difficult to provide debt at reasonable margins over the long pay-back period anticipated by a PPP project. Accordingly, the funding costs offered to the procuring authority as part of each bidder’s proposals would suffer from this reduced competitive environment, particularly if the procuring authority expected each of the three or four bidders to put together fully funded bids with an exclusive club of funders. Accordingly, the new requirement for equity funding competitions seems a logical extension. The equity funding competition will be carried out at preferred bidder stage and will relate to a portion - not yet defined, but anticipated by some to be up to 50% - of the equity not being taken up by the Government. As the parties bidding for this portion of the equity will not have to bear the risk and

From PF1 to PF2: the reform of the Public Private Partnership model in the UK Andrew Buisson

Norton Rose Fulbright LLP November, 2013

5

time of bidding for the project, it is anticipated that this portion of the debt should automatically be cheaper, which will assist with the affordability of the project. One would assume that the existing private sector sponsors would have an in-built advantage in the competition, given their existing knowledge of the project and proximity to the due diligence material. Given the Government will already have its own significant minority interest, if the project sponsors do not succeed in the equity competition, it would be quite possible for them to become a minority interest themselves (for example, each of government, sponsors and competed-equity could each end up holding a stake over 30%). This would create an unexpected dynamic, and the perceived risk of this occurring might inadvertently increase the equity return sought by the original project sponsors. The Government was due to issue to further guidance on how these competitors would work but to date have not done so, which may mean that this concept will be quietly dropped. Transparency Part of the reason for securing a mandatory government equity stake was to increase the transparency of the private sector’s approach to managing the project. In the early years of PFI in the UK, many projects were refinanced very profitably by the private sector creating large windfall gains. Similarly, private sector investors were seen to be making excessive profits in other areas as they managed the project’s risk allocation to their benefit. For example, some investors were able to pool their interests across a number of projects and achieve economies of scale on matters such as insurance premiums or vandalism risk contingencies. Each individual project may have had a higher contingency which reflected that project’s risk as a single project; the savings made by the investor in pooling its contingencies across different projects would significantly increase its equity upside, without any return for the individual procuring authorities. Given the politically sensitive nature of some of the projects, where budgets for new teachers or nurses might be being cut back, this smacked of profiteering. Various changes were made in successive iterations of the PFI standard form contract to address some of these issues (for example, obliging the private sector to hand over a share of such “portfolio”-type savings), but the public sector counterparty would still struggle to police these requirements without significantly improved access to the actual costs and equity returns being made by the private sector. In addition to the information it will receive through its equity stake, the Government has now imposed obligations on the project company to provide specific information to the procuring authority on actual equity returns and proceeds from equity sales, which were previously confidential in nature. Not only this, but the equity return information will also be made public by the Government to help other public sector bodies to benchmark their own projects. Procurement One of the criticisms with the previous PFI model was that procurement was delegated to the ultimate public user of the facilities and services, which could be a local authority (city, county or borough level) or a local primary care trust (an entity responsible for local healthcare provision, delegated by the National Health Service). For many of these entities, they would be procuring a PFI project for the first time and their procurement team would have to undergo a significant learning exercise to understand what a PFI project was and how their interests would be best protected. Central government provided assistance and guidance through a number of private finance units specialised in each sector, which also monitored and managed local progress through gateway reviews and other approval processes. Nevertheless, many projects were taking significantly longer than desired to proceed through the stages from project inception, call for tender and, preferred bidder selection through to financial close. The steep learning curve in terms of PFI delivery techniques was perceived to be a factor in this, and the Government openly drew on success stories of centralised procurement elsewhere, such as Infrastructure Ontario, and has already started to

From PF1 to PF2: the reform of the Public Private Partnership model in the UK Andrew Buisson

Norton Rose Fulbright LLP November, 2013

6

procure centrally the next wave of education projects under PF2 through a recently-formed Education Funding Agency. The Government has also indicated that it may impose a guillotine on projects that do not reach the preferred bidder stage within 18 months of issue of the call for tender. Details are sketchy but the implication is that if the project fails to comply with this milestone, it will be cancelled. There is an indication that the bidders will receive some measure of compensation to reflect the cost of preparing their bids that far, but not necessarily the full cost. It seems possible that the mere threat of outright cancellation is likely to act as a significant impetus for all stakeholders to comply with the project timetables, making compromises or commercial decisions as necessary, to avoid being the first project of which the government chooses to make an example to others. Service Provision Most PFI projects in the accommodation sector assumed that the private sector would provide a full service delivery solution. In addition to the “hard” facilities management and lifecycle replacement required to ensure that the new facilities satisfied the procuring authority’s output requirements on every day of the project period, it was perceived to be beneficial that the private sector should also take over the various “soft” services (cleaning, catering, security etc) taking place in the facilities. Traditionally, these were often provided by the in-house staff of the procuring authority, and existing contract service levels may have been felt to be lacking. Many of these staff were unionised and their transfer to, or replacement by, private sector contractors often created political difficulties for the local authorities and issues that a “two-tier” workforce had arisen within the local authority area between different staff working within PFI and non-PFI facilities. Additionally, if the local authority did wish to use its superior bargaining position to re-procure, say, all of its catering services on a city-wide basis, it would not be able to include the PFI facilities as these were mandated to the PFI project company. The Government’s radical solution to this is to exclude all soft services from PPP projects going forward. Some exceptions will be made for soft services which may be intrinsic to the overall project delivery (for example in prisons, where there will be a very close interface between all staff and separate soft service provision might be more problematic). This will create some interesting interfaces. For example, the project company on an education project would usually rely upon the school janitor to provide an immediate temporary response to a problem causing unavailability deductions, and mobile off-site staff would arrive later to effect a permanent rectification. If the project company is no longer providing a security service, it will no longer have access to the janitor and will not be able to meet the same rectification times without the expense of an additional on-site member of staff, or a revised rapid response team. Alternatively, the procuring authority will have to accept a different effective service level. There will clearly be a level of detail to be worked up on the new PF2 projects to address these new issues. Risk Allocation The Government has taken advantage of its oversight of over 700 signed PFI projects to conclude that some of the standard risk transfer assumptions under the PFI model probably did not represent best value for money for the public sector. In the early years of PFI in the UK, the contract had to pass sufficient risk to the private sector so that the project would sit off the Government’s balance sheet, which was advantageous in terms of compliance with EU rules on national debt. Although this ceased to be a motivating factor for government, the strict risk allocation in the PFI standard contract persisted, and in many cases the risk allocation was predicated on the project company having a similar risk profile as a private commercial owner of the premises. Whilst this can be managed effectively in some scenarios (such as procuring insurance and managing reinstatement after damage), in other cases (unknown ground conditions and risk of contamination arriving from

From PF1 to PF2: the reform of the Public Private Partnership model in the UK Andrew Buisson

Norton Rose Fulbright LLP November, 2013

7

neighbouring properties) the approach was often conceptually difficult, because in most PFI projects the project site had been chosen by the public sector and not the private sector. In other words, if choice of the site dictates the project risks then there may be little that the private sector can do (within a reasonable budget) to manage the risk, and given the risk-averse nature of the senior debt provider, it may have no option but to price a contingency for the worst case scenario that may occur over the lifetime of the project, even if the public sector site owner had in all likelihood managed the risk without any contingency for several decades. Whilst an obvious solution would have been to seek to pass such risks back to the public sector on a value-for-money basis, in practice this was quite difficult to achieve because any proposed derogation from standard form risk allocation was strictly scrutinised by central government, and most often rejected, on the simple grounds that such a derogation had never been granted before and it would open the floodgates for future projects to grant it now. The Government has therefore considered these thorny risk allocation issues and chosen to pull a number of these back to the public sector. One notable development in the new documentation is to remove the requirement on the private sector to take a level of risk of capital costs arising out of general (non-discriminatory) changes in law during the operating phase. The private sector would usually be obliged to accept a potential liability of up to 3% of the capital cost of the facilities; in practice, the Government realised that the actual capital costs incurred under general changes in law were significantly lower than this and the contingencies allowed for by the private sector in the financial model were simply inflating the equity return. Debt finance The current shortage of long-term debt in the UK (and European) market has added to the difficulties of ensuring that PPP projects proceed efficiently from tender to close, and in some cases will have prevented projects coming to market or reaching financial close. The PF2 documentation acknowledges the issue, and whilst it does not have an immediate solution, the Government expresses a clear intent to put in place measures to reduce the reliance on bank debt and open up opportunities for funding to other entities such as pension funds and other institutional investors who have not traditionally had the appetite or skill-set to take full project risk contemplated under a PPP project. The UK Government has already implemented a number of credit-enhancement measures in this regard, such as a guarantee scheme to underwrite a portion of debt on “nationally significant” projects which are ready to start construction, but are dependent on a guarantee of this nature to secure project funding. One of the credit enhancements also arises out the government equity stake itself, which is envisaged as an additional provision of equity on top of the 10% stake normally provided by the private sector, and which will thereby reduce the debt:equity ratio. A typical PF2 project may therefore be funded on a 75:25 basis, which provides an additional buffer for the senior lenders in the event of failure which, together with the revised risk allocation structure and other credit enhancements that may be available through public sector underwritings or private sector security packages, may be sufficient to bring the project up to the investment grade necessary to secure pension fund involvement. Notably, it is a stated requirement that bidders for PF2 projects will be obliged to present a funding solution that is not wholly dependent on bank debt. This may require bidders to look at structures which have already been implemented in other jurisdictions (such as the index-linked debt structure adopted on a recent Netherlands PPP project to allow pension funds to participate) or which are currently being developed for the UK market with a similar intent (such as

From PF1 to PF2: the reform of the Public Private Partnership model in the UK Andrew Buisson

Norton Rose Fulbright LLP November, 2013

8

the PEBBLE structure)5. On the new education projects (Priority Schools Building Programme), the Government has taken the lead by mandating a novel form of funding, called the “Aggregator” model, whereby a new funding vehicle is created that can bring together different forms of finance to provide funding on a portfolio basis to a batch of projects. The Aggregator role is currently being procured separate from the underlying projects and is due to conclude in mid-2014. Value for Money and Efficiency Many of the above proposals address perceived shortfalls in the efficiency of the old PFI model and so by themselves may be expected to contribute toward an improved value for money environment under the new PF2 projects. In addition, the Government has proposed some further specific changes in this regard. At a “soft” level, they are proposing periodic reviews of the project company’s service provision which may indicate where changes may be made to the service scope to better suit the needs of the users or deliverability for the private sector and deliver savings for the public sector. This has been happening over the last two years on existing PFI projects on an ad hoc basis as part of a central government austerity drive, and the implication is that the procuring authorities should continue to remain alive to the possibilities of such savings. In practice, the £1.5bn of “savings” touted by the Government under this initiative have principally been driven by actual scope reductions (i.e. lower service, lower fee). The second and somewhat more robust development is to require bidders to present continuous improvement plans as part of their proposals which will be worked into the contract. As these will be evaluated as part of the bid and will be subject to competitive pressure, the procuring authority may expect to receive some true cost reductions under these provisions. A positive development? On the whole, market response to the reforms has been positive. This should however be considered in the light of a domestic PPP market which has seen significant shrinkage of its pipeline in the last two years. Most private sector market participants are simply hoping that the Government’s intent to create a new PPP delivery model will be matched by an equal intent to create a pipeline of projects to use that model. As noted above, the UK PFI model was exported to a number of jurisdictions (in some aspects, wordfor-word), and some of those jurisdictions have closely followed updates to the UK PFI model, whilst adapting the model to their own local requirements. This has started to come full circle as the UK Government now draws on the experiences of successfully implemented PPP programmes overseas. Nevertheless, some of the latest developments represent a radical change of approach to public procurement and we believe that those with an interest in PPP trends globally should keep a close eye on the next wave of UK projects procured under the new PF2 model.

5

These and other structures are discussed further in the Norton Rose briefing paper “Infrastructure Development: attracting institutional investors to close the funding gap” [http://www.nortonrosefulbright.com/knowledge/publications/75967/infrastructure-developmentattracting-institutional-investors-to-close-the-funding-gap]

From PF1 to PF2: the reform of the Public Private Partnership model in the UK Andrew Buisson

Contacts

London Andrew Buisson Partner Norton Rose Fulbright LLP Tel +44 (0)20 7444 3949 [email protected]

Norton Rose Fulbright LLP November 20, 2013

9

nortonrosefulbright.com

Norton Rose Fulbright Norton Rose Fulbright is a global legal practice. We provide the world’s pre-eminent corporations and financial institutions with a full business law service. We have more than 3800 lawyers based in over 50 cities across Europe, the United States, Canada, Latin America, Asia, Australia, Africa, the Middle East and Central Asia. Recognized for our industry focus, we are strong across all the key industry sectors: financial institutions; energy; infrastructure, mining and commodities; transport; technology and innovation; and life sciences and healthcare. Wherever we are, we operate in accordance with our global business principles of quality, unity and integrity. We aim to provide the highest possible standard of legal service in each of our offices and to maintain that level of quality at every point of contact. Norton Rose Fulbright LLP, Norton Rose Fulbright Australia, Norton Rose Fulbright Canada LLP, Norton Rose Fulbright South Africa (incorporated as Deneys Reitz Inc) and Fulbright & Jaworski LLP, each of which is a separate legal entity, are members (‘the Norton Rose Fulbright members’) of Norton Rose Fulbright Verein, a Swiss Verein. Norton Rose Fulbright Verein helps coordinate the activities of the Norton Rose Fulbright members but does not itself provide legal services to clients. Law around the world

nortonrosefulbright.com