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The Actuary The magazine of the Institute & Faculty of Actuaries

Investing in the future

T he private finance initiative (PFI) was developed in the early 1990s as a way of resolving the difficulties faced by successive governments in spending the amount of money necessary to improve the social and transport infrastructure of the UK. PFI generates large sums of money, most of which is borrowed from financial institutions. PFI can act as a gilt or bond and is an ideal opportunity for private and institutional investors.
Much like private individuals, there are two ways in which a government can find the money to make a significant investment either save or borrow. Traditionally, governments have found it nearly impossible to save, as the electorate is impatient for improvements and dislikes taxation. We do not want to be taxed now for improvements that will benefit future generations only. Indeed, any government which imposes taxes on the population has only five years to demonstrate the resulting improvements or it is unlikely to be returned to power. The alternative is to borrow, and traditionally this has been from the World Bank. This, however, has its own problems: such borrowing generally weakens sterling and the UK economy in the eyes of the world, especially since the advent of closer European ties and moves towards a single currency.

Finding a solution
The solution found under PFI and other publicprivate partnerships (PPPs) is for the government, instead of buying buildings itself, to rent the facilities from a private company for a period of about 30 years. Contrary to the adverse publicity of some commentators, the private sector company is required under the contract to refurbish the facilities at the end of this period and hand them back to the government at no cost.
The opportunities for investors in the PFI or other PPPs come from the requirement for the private company to put in 10% of the capital required (mostly the construction costs). As the buildings now being procured can cost anything between £20m and £500m, this amounts to a significant sum on each project. The 186 projects that have started operations have a total value of £13.5bn, offering £1.35bn of investment opportunities, and the Office of Government Commerce expects that a further £25.5bn-worth of projects will be signed in the next three years offering £2.55bn-worth of opportunities.
There is no sign in the UK that there is going to be any let-up in this renewal of social infrastructure. It is supported by both major parties, and who can imagine an incoming government either cancelling a program to build schools and hospitals, or adding £25bn to the public sector borrowing requirement at a stroke? Indeed, many countries have been closely watching the progress of PFI in the UK and are beginning to consider copying the process to renew their own ailing infrastructures.

How does it work?
The way the government pays for these facilities is surprisingly similar to the way we all pay for our houses through a mortgage, although it is as if the bank or building society were also to provide us with a cook and a cleaner as part of the deal. The government enters a contract for the facilities and services with a single intermediary company which then in turn enters contracts with a construction company and service providers to deliver the buildings and services. The intermediary company borrows the money to build and operate the facilities from a bank, or series of banks, but has to put in at least 10% itself (very similar to the deposit we need to put down when buying a house on a 90% mortgage). The government then pays for its use of the facilities with an agreed annual payment which is agreed before the private company is awarded the contract. If the facilities are not available for use by the government during the term of the contract then significant deductions are made to the annual payments, and in extreme cases the government may pay nothing at all, or can even remove the private company and take over the facilities.
The value of this approach to the procurement of public facilities to the government especially in the health and education sectors is threefold:
– the risk of construction cost overruns (and certain increases in the cost of service provision) is passed to the private sector provider;
– the government is able to launch the biggest renewal of social infrastructure since the reconstruction after the World War II without adversely affecting the economy; and
– the generation of taxpayers who use the services in the future pay for them at the time they are used.
The common criticism of the system is that it is more expensive than the traditional method of procurement. This is true (though mitigated to some degree by the transfer of cost overruns), but how many of us consider the fact that it is more expensive to borrow money from a building society to buy a house now than it is to stay in a one-bedroomed flat for 20 years while we save the necessary amount of money ourselves?
An investment opportunity
PFI/PPP will become the standard procurement method for the UK government for major facilities and as such will form a recognised asset class for institutional funds and funds investing the savings of private individuals. The risk profile of these investments will sit somewhere between those of government bonds and corporate bonds issued by the major subcontractors to the intermediary company (the construction company and the facilities management company). This is because the matrix of contracts and guarantees provides either that the government makes the annual payment (which includes the investor’s return), or in the event that a service is not provided satisfactorily and a deduction is made to the annual payment, that that deduction is passed through in its entirety to the defaulting subcontractor. It is only in the event of catastrophic failure to provide the facilities and services to the government and a subsequent termination of the entire contract that the investor’s stake is at risk, hence the similarity with the corporate bond.
In assessing the investment risk, the quality of contractual documentation is paramount and some of the early projects suffered in this regard from being pioneers of the balance of liabilities between the parties. In current and future projects in settled procurement areas, such as health and education, much work has been done and standard-form contracts have been developed which are clear and reasonable to all parties and their risks are easily understood. This provides a much more palatable investment opportunity. Indeed the process is now settled to the extent that the market for the provision of the senior debt (the 90% of the capital required) has become very competitive, with many foreign banks seeking to provide significant funds.
The rates charged by banks for the senior debt have reached 8595 basis points over LIBOR during the construction period, dropping to 7585 basis points over LIBOR after one year of successful operations. This is extremely competitive in a project finance environment, but the key issue for investors is the expected rate of return on the top 10%. In the early deals this was a very high figure, reflecting the perceived risk in these types of deal, though as the contracts have become more standardised, the requirement for returns has fallen. It has now reached a base from which it seems that it cannot fall (at least not very far), and that is a return in the region of 1313.5% per annum. The reason for this floor is that, in a project finance structure, the bank lending the senior debt requires that the intermediary company charge sufficient margin to the government to cover unforeseen eventualities. This is known as the cover ratio and is expressed as a multiplier of the interest rate charged on the senior debt it has the effect of setting the minimum level of return to be charged on the top 10%.