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April 2012

The private finance initiative (PFI) and public private partnership (PPP) are two familiar options used for capital spending projects. But rising costs have placed a question mark over the way projects will be funded in the future. We look at some of the current issues facing players involved.

Why is the PFI model likely to change?

First set up by the Conservatives back in the early 1990s, private sector contractors, assisted by banks, paid upfront for the building of schools and then leased them back for a period of up to 30 years. During this time, the buildings were to be repaired, maintained and upgraded. The deal being that by the time the leases ran out, the buildings would be in an ‘as good as new’ condition. But, ever since the credit crisis, the whole arrangement has grown expensive and last year the coalition government was effectively warned off PFI by the National Audit Office. Right now, a parliamentary select committee is consulting with interested parties from both private and public sectors to establish a new model to finance the building, maintenance and upgrading of the country’s infrastructure, including schools, hospitals, prisons and road networks.

But didn’t construction companies make a profit from PFI?

While there is no doubt some contractors and lenders did make money out of PFI, construction companies were finding it increasingly difficult to put in the millions needed at the outset to bid for a project. If you are looking to build a typical secondary school for a capital expenditure of £25m, a contractor might have anything up to £5m worth of costs including bank lending fees, advisory fees plus the necessary equity and working capital to get the project up and running. As a result, construction companies have to put in 10-15 per cent of their own cash upfront, which is a lot of risk to carry at the outset. And, whereas that money is repaid over time, it is still locked in for at least 25 years. Multiplied by the number of projects that they have invested in, this can add up to a significant amount.

Can construction companies sell on their financial commitments?

Happily for those in the construction sector who need to sell on their debt and equity, a number of new investors — notably pension funds and equivalent institutional investors — have been looking to diversify their long term investment positions away from low-paying cash accounts. Encouraged by the government, institutional investors, including fund management companies looking to add to their portfolio of infrastructure investments, see many of these assets as effectively having quasi-gilt status. This is due to the fact they are viewed as government-backed revenue streams, with just a small element of risk on top.

So what about the future for public private partnership?

Many believe that any new funding arrangements will retain an element of public private partnership. The question for those involved will be: how much of a partnership is required? Much will depend on the project in question. For example, if a university is looking to build student accommodation units, then having a partnership that also includes ongoing maintenance and upgrade work may be advantageous. But it will be crucial going forward to ensure there is enough flexibility offered in any long-term partnership. For example, who knows what the demand for student accommodation will be in 20 years time. For both sides it is important to retain enough flexibility in any partnership to ensure demand is met at an affordable cost.

What about other funding options?

The current block on funding caused by the government’s review process of PFI, will force those looking to build to focus more sharply on what it is they need to spend money on and where that money will come from. Taking universities as an example, some will have the cash saved to build a new sports hall or teaching block, but if they have to go to the market for funds, then a project will be judged on its individual merits in order for a lender to agree to a long-term funding programme. The reality is that a top institution will be able to access funding easier than, say, a university somewhere down the pecking order.

Stephen Fuller is a Partner, Infrastructure Tax and Accounting at Mazars, London.

If you would like to ask the author a question on this or a related topic email: masterclass@mazars.co.uk