ࡱ> `b_q` GbjbjqPqP .`::>%ZZZZZZZ84, 62,,"NNNNNNa6c6c6c6c6c6c6$8h|:j6Z,"NN,","6ZZNN6&&&&&&,"`ZNZNa6&&,"a6&&&&y4hZZ5N  @~M#4a66064:P$: 5:Z5N&&PNNN66%NNN6,",",","  nT6ZZZZZZ Scottish Parliament Finance Committee Inquiry into the methods of funding capital investment projects PFI: Refinancing Margaret Cuthbert Jim Cuthbert May 2008 1. Introduction 1.1 This note to the Scottish Parliament Finance Committee Inquiry into the methods of funding capital investment projects provides a description of PFI refinancing and highlights a number of issues which have arisen in refinancing deals. The note relies heavily on information available in current PFI literature, and gives illustrations from some refinancing deals in Scotland and elsewhere in the UK. 2. The Process of Refinancing Refinancing is the process by which the terms of the funding put in place at the outset of a PFI contract are later changed during the life of the contract, usually with the aim of creating refinancing benefits for the contractor. (National Audit Office) 3. Why Refinance Dundas and Wilson have summarised some of the principal reasons as to why refinancing is popular with the private sector. Namely, for the buyer, PFI assets are: an attractive risk/return profile compared to property, bonds and equity in the current market; the inflation-linked nature of many of the assets provide a profile of returns attractive to institutions such as pension funds with long-term liabilities to match; there is an opportunity to add further value by using expert knowledge of project structures to optimise the value of individual projects beyond that which would normally be carried out by trade investors in PFI; further value-added opportunities exist through portfolio effects (including efficiencies across insurance, SPV management and life-cycle management). For the seller, sale of the assets can release cash to allow them to finance further PFI deals. refinancing can allow additional capital receipts for the equity holders whilst retaining their equity stake. 4. Some Examples of Private Sector Gain from Refinancing a) Among the refinancing cases examined by the UK Public Accounts Committee (PAC) was that of the PFI hospital contract run by Octagon for the Norfolk & Norwich University Hospital NHS Trust. PAC reported that, in 2003, just two years after the hospital opened, Octagon refinanced the project, increasing its investors rate of return to over three times the level Octagon had predicted when bidding for the contract. The Trust only received 29% of the refinancing gains despite taking on substantial new risks following the refinancing. Octagon achieved this outcome by increasing its borrowings by 53% from 200 million to 306 million. Octagon then used the increased funds to accelerate the financial benefits which the investors would receive from the project. After other financing adjustments, the total refinancing gain was 116 million. 82 million of the gain was retained by Octagon increasing its investors internal rate of return, which it had said would be 19% when it bid for the contract, to 60%. In securing the right to receive 34 million of the gains the Trust accepted that the money it would have to pay to end the contract early could increase by up to 257 million following the refinancing as its termination liabilities are related to the amount of Octagons outstanding borrowings. The Trust also agreed to extend the PFI contract from 34 to 39 years and to receive its share of the refinancing gains over the life of the contract, rather than as an immediate payment. b) Another early refinancing deal which attracted a good deal of publicity was that of Fazakerley Prison. This PFI deal was refinanced in 1999. The consortium was able to renegotiate its bank borrowings and increased its expected rate of return over 25 years from 17.5m to 31.6m - an 81% increase. The prison service managed to negotiate a share of 1m. More importantly from the perspective of risk transfer, the private sectors debt repayment profile was restructured, leaving the public sector exposed to additional termination liabilities, should the contract be terminated for any reason. The restructuring allowed the private sector to take out of the project the net present value of future profits: thus if maintenance bills etc were larger than expected at some point in the future, the reserves might not be enough to cover them. In other words, the refinancing served to increase public sector risk and by implication lessen that of the private sector. It is estimated that the refinancing exposed the Prison Service to an increased risk of up to 47m if for any reason it terminates its contract with the PFI consortium. Having already covered its costs, the consortium could look forward to a very profitable 23 years. As quoted in the Sunday Herald in 2000 on the Fazakerley deal, Amanda Methven, senior associate at Dundas & Wilson, (and one of the witnesses to the Finance Committee), said: "Until the late 1990s the Treasury Taskforce Guidance on PFI discouraged the public sector from seeking to share windfall profits derived from refinancing. This may explain the absence of such provisions in some older but recently-signed deals. In the light of Fazakerley, I can understand the reasons for the change from a policy and PR perspective, but from a logical perspective, if the public sector is not prepared to take on any of the downside risks, why should it share in the upside?" c) Carillion built the first PFI hospital, the Darent Valley Hospital in Kent, which opened in 2000 with 75 fewer beds than the hospital it replaced. Carillion has since sold its equity stake in the hospital to its consortium partner, Barclays UK Infrastructure Fund, for 5.2m. Refinancing this yielded a profit of 16.4m on an original investment of 4.1m. 5. Some of the projects which have been refinanced in Scotland are: Kilmarnock Prison, Balfron School, Dundee Ninewells Psychiatric, Mearns Primary and St Ninians High, Central Scotland Family Quarters Bannockburn, Royal Infirmary Edinburgh, and Hairmyres Hospital. The public sector eventually purchased the assets of the Skye Bridge and the Inverness Airport terminal from the PFI consortia, paying a substantial premium. 6. Changes in Public Sector Approach to Refinancing In early PFI projects, contracts were drawn up without reference to the public sector client receiving any share of a gain if the consortium chose to refinance the PFI project. As it became evident that refinancing gains could be substantial, public sector clients attempted to negotiate a share of the refinancing gain. In 2002, a Treasury Task Force was set up which developed a Standard code of practice to be observed in the refinancing of all future PFI projects such that the public sector was entitled to a 50% of the gains : a Code of Conduct was also developed to apply to projects where there were no sharing provisions such that the public sector in this case should voluntarily receive a 30 per cent share. The provision allows the private sector to take the benefit of refinancing gain to the extent required to bring actual equity returns up to base case returns, before there is a requirement to share gains. 7. In 2003, the Office of Government Commerce (OGC) reported that it expected the public sector to receive 175200 million from the voluntary sharing arrangements on early PFI deals. But, as Ernst and Young have written the definition of refinancing gain is complex. In fact, for a refinancing to qualify as one where gains should be shared, it must fall within the definition set out in the revised OGC guidance on refinancing published in July 2002. Transactions excluded from the definition (which do not therefore require gain sharing or a departments consent) include: Refinancings of a contractors general finances (as opposed to project specific finance, which would be a qualifying refinancing). Gains made by contractors and other investors from the sale of shares in PFI project companies. Arrangements to fix interest rates at rates lower than those assumed at contract letting where the contractor has borne all interest rate movement risk since contract letting. In addition, situations known as rescue refinancings where a project is in serious difficulties will not require the sharing of gains. This arises from the method of calculating refinancing gains which only requires refinancing gains to be shared if the projected returns to the contractor are above those assumed at contract letting. Source: The OGCs Standardisation of PFI Contracts (2002) 8 Potential Problems with Refinancing There are a number of concerns in the UK around the refinancing of PFI projects, particularly with regard to the adjustments which are then made to the risk profile of the PFI project and to the large amount of profit taking by private shareholders. Some of these concerns are as follows:- a) Refinancing brings additional risks to the public sector in the form of higher liabilities towards the end of the PFI period and extended contract periods. An example given by Dundas and Wilson is: a typical PFI might have a life of 30 years, with a 25 year senior debt profile, so that in the last five years all senior debt had been paid off. Should the PFI consortium decide to refinance the project at the end of the construction phase when the project becomes operational, then it is quite possible to reduce the debt-free tail to one year (effectively borrowing against an extra four years of revenues). The costs of borrowing more money for the PFI project are likely to be substantially reduced as the risks attached to the construction phase are over. But the major benefit (to the private sector) is the potential to borrow additional funds, (such that total senior debt borrowing is substantially larger than the original cost of the project) which can be returned to shareholders. b) Despite changes to the Code of Conduct, refinancing deals are not yielding the expected return to the public sector. The House of Commons Public Accounts Committee held an inquiry into PFI refinancing in 2007. It observed that up to December 2006 the government had secured the right to gains of only 93 million, rather than the 175-200 million expected. But, at the same time, some of these early refinancings had generated very high rates of return to the private sector investors. c) There are also concerns arising with the development of secondary markets in PFI equities. These secondary markets enable investors to acquire shares in PFI projects which are already in progress and some investors are building up portfolios of PFI investments. There is no requirement for the gains on selling shares in PFI projects to be shared with the government. As a result of its investigations the Public Accounts Committee concluded that, In light of the lower than expected gains for the public sector from refinancing, the committee makes recommendations forgovernment departmentsto employ more flexible sharing arrangements as well as better tracking of the PFI equity market and greater transparency of information. (Source: HC158 2006-7.) The development of this secondary market in PFI equity raises concerns:- that since the potential to sell off equity offers the original equity owners the possibility of exiting completely from the PFI project, they may be less concerned about encumbering the project with long term risk arising from, for example, an earlier debt refinancing. That taking profits by way of selling equity may be a way of sidestepping mechanisms designed to allow the public sector to share in refinancing profits. d) There are also some possible down sides to the development of a secondary market in PFI debt. Ernst and Young note that As the secondary market evolves, further financial efficiencies will be sought and the financial engineering to achieve these will become more advanced. There is likely to be an increased amount of batching of PFI assets and their debt facilities, which may lead investors to refinance several projects in groups to squeeze further financial benefits from these assets. This can be achieved by refinancing portfolios under a Hold Co ownership structure or an assignment of debt service flows. This provides an opportunity to benefit from risk diversification and the capacity to use the portfolio to enable the refinancing of an incremental (perhaps less mature) asset. There must be some concern that, under such an arrangement, those ultimately owning the PFI debt may become so remote from the actual operation, and the debt instruments so bundled, that they are unable to form a true assessment of the actual risks involved: and be unable to play an effective role in scrutinising the management of the project. (At its worst, this could involve similar features to the bundling of debt instruments in the sub-prime market.) 9. Will A Not-for Profit Offer Less Scope for Refinancing The NPD model which is being used increasingly in Scotland would at first sight offer less opportunity for refinancing. Unlike a traditional PFI, the decision of when to refinance is taken by the independent director and not by the junior debt shareholders. According to Lindy Patterson, a partner in Dundas and Wilson, This means that the timing of any refinancing isnt necessarily geared to maximising profit for the junior debt shareholders. For senior debt holders a refinancing under an NPD model makes little practical difference. There is speculation that those most likely to find this model attractive are contractors and facilities managers that are also shareholders. They will be able to get returns from elsewhere in the project. One concern is that, if refinancing does take place under a NPD scheme, then the potential for burdening the project with an undue level of risk may be much greater than for a conventional PFI refinancing. This is because an NPD scheme should, in principle, have much less projected free cash to convert into future debt repayments through refinancing: so the danger is that refinancing will bite more deeply into any margin of free cash which should be reserved for risk. This is not, in itself, an argument in favour of traditional PFI as compared to the NPD model: rather it is an argument against simply taking over into the NPD scheme practices which have grown up under PFI. 10. Conclusions. 1) Substantial profits have been realised through PFI refinancing deals: but the public sector has proved to be very poor at accessing a reasonable share of these profits. 2) Traditional refinancing can involve burdening the PFI project with a significant amount of extra debt: and the development of secondary markets in PFI debt and equity may also weaken the oversight role which those owning debt and equity should exercise over the project. There are therefore real issues about increased risk associated with refinancing. 3) This suggests that, when there are excess profits associated with a PFI scheme, and the public sector wants a share of these, then seeking to share in the proceeds of refinancing is probably not the most cost effective approach for the public sector to adopt. For past schemes, the appropriate approach would probably be for the public sector to open up direct negotiations, using its considerable muscle to secure future reductions in unitary charge payments directly. For future schemes the best approach is surely for the public sector to ensure that deals are more tightly monitored and negotiated to begin with, so that the potential for future refinancing profits is much reduced. 4) What would be very damaging would be if the public sector knowingly allowed slack deals to continue to be negotiated, in the hope that the public sector would benefit from a share of the profits from future refinancing deals. This approach would amount to the public sector knowingly undertaking long term financial commitments, in return for an early capital sum: in other words, it would just be a form of borrowing, under another name. But it would be such a disastrously expensive form of borrowing that this approach should not be countenanced.     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