The clue is in the name – private finance is at the heart of PFI. It is what distinguishes PFI from other forms of contract and other ways of providing public assets. What this means, in practice, is that whoever is providing the private finance will want to protect their investment. On the positive side, this means they will have an interest in ensuring the project goes smoothly. However, conversely it also means they will want to maximise income and minimise costs.
Clients who understand how their contracts are financed, and what motivates those who provide the finance, will be in a better position to manage both performance and affordability of these contracts.
PFI Financing – How Contracts Are Financed
The successful bidder in a PFI project will usually be a consortium, typically led either by a construction company or by an investment company that specialises in PFI and similar types of projects. The consortium may also include a facilities management (FM) company, which will often be part of the same group as the construction company. These consortium members are known as the ‘project sponsors’.
When a PFI contract is entered into, the project sponsors set up a new PFI company, specifically for the project. This is often known as a special purpose vehicle (SPV) or special purpose company. This is the company that enters into the contract with the client organisation.
The project sponsors become the shareholders in the PFI company and the value of their shares is known as equity. In the new PF2 model the client organisation also becomes a 10% shareholder. This was also the preferred approach for PFI contracts in the Building Schools for the Future (BSF) programme. This means that the client organisation has two roles: (1) as a shareholder in the PFI company, and (2) as the client under the PFI contract.
The PFI company is responsible for raising the finance to provide the company with working capital and cover the construction costs. The main source of finance is usually bank loan or senior debt, but part of the finance also comes from the shareholders in the PFI company in the form of both equity and junior debt. A typical apportionment is:
- Senior debt – 90%
- Junior debt – 9%
- Equity – 1%.
This means that the bank provides the lion’s share of the financing, but the project sponsors also have a significant stake. The reason for this is that there are risks in a PFI project that banks will not accept and which therefore have to be ‘buffered’ by the junior debt contribution from the projects’ sponsors.
Bank debt,therefore ,takes precedence over junior debt, which is why it is called senior debt. This means that senior debt is repaid first and junior debt is only repaid towards the end of the contract, once senior debt has been repaid. For example, if there is £90m of senior debt and £10m of junior debt invested in the contract, but only £98m available to repay total debt, senior debt will be fully repaid, but £2m of junior debt will remain unpaid. Only in the extremely unlikely event of there being less than £90m available to repay total debt would senior debt take a hit.
The key risk for the bank is contractor default. This is where the client has the right to terminate the contract, most commonly because the contractor has performed very badly over a protracted period or because the PFI company is insolvent. The bank’s main objective, therefore, is to ensure that neither of these events occurs. This determines the extent of the bank’s involvement in the project, e.g. signing off of major variations, monitoring the PFI company’s financial position and monitoring the levels of availability and performance deductions. In extreme situations the bank has the right to step in to prevent or rectify contractor default, usually by bringing in a new contractor.
Variations on this standard model are bond finance, used in place of senior debt in large PFI projects, and mezzanine debt, which sits between senior and junior debt in terms of which takes precedence. Each of them has only ever been used in a minority of PFI projects, becoming even less common since the financial crisis of 2008.
What Clients Need To Do
Clients need to:
- Understand how their contracts are financed – proportions of equity, junior and senior debt and who owns them – and therefore what the drivers are for the different parties
- Keep track of any changes in the ownership of the PFI company and therefore of equity and junior debt
- Keep track of any changes in who holds the senior debt, e.g. due to a change in ownership of the bank or the transfer of the debt to another bank
- Keep track of any refinancing, i.e. changes to the terms on which senior debt is provided, and ensure the client receives its share of any refinancing gain
- How the project is financed is of key importance to clients in PFI schemes, as it determines the influence that the different private sector parties have on the project
- Bank lending is usually the major source of funding for a PFI project, but the project sponsors also provide a significant amount of funding
- Under PF2 and the standard BSF model, the client organisation becomes a shareholder in the PFI company and also provides part of the funding
- Senior debt, provided by the bank, takes precedence over junior debt, provided by the project sponsors
- Senior debt is at risk where there is contractor default and so the bank’s main objective will be to prevent this
- Clients need to be aware of how their projects are financed and keep track of any changes, including refinancing.
Equity Investment in Privately Financed Projects (National Audit Office, 2012) – click here.
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