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PFI projects have at their heart the need to transfer the risk associated with delivering capital works projects from the public sector to the private sector and to more clearly link the public sector’s payment for an asset to its ongoing usage, availability, condition or service provision over the life of the asset. PFI does this by typically asking the private sector to raise capital to finance the creation of an asset, to take the financial and technical risk on its construction and, thereafter, on its subsequent operation and maintenance. In return, the public sector agrees to pay for this mixture of capital asset and service provision over an extended period, typically 30 years.
The Organisation Structure
In most cases, the private sector will form a project company to enter into the contract (the “concession”) with the public sector. The project company will in turn enter into two principal subcontracts, one with a construction company and one with a facilities manager or maintainer, to build and maintain respectively the project asset, together with other contracts where necessary with ancillary service providers. The project company will fund construction through a mixture of equity/subordinated debt from promoters and long-term debt (without recourse to shareholders) raised from the banking or the bond markets (typically in a 10/90 ratio). The project company will be remunerated, once the asset is available for use, by receipt of regular payments, indexed to inflation, over the 30 year period to cover service of capital together with operating, maintenance and ancillary service costs.
The cost of financing these assets is a significant part of the economics of the transaction. Both the public sector and private sector have an interest in attracting cost effective financing, with failure to do so resulting in an uneconomic project. Cost effective financing, in any situation, is typically achieved by demonstrating the credit worthiness of the entity seeking to raise the funds. Further, it is accepted in the financial market that financing these transactions through the use of long-term bank debt or bonds is cheaper than the equity alternative.
Therefore, as the income stream from PFI projects is received from UK Government, or quasi UK Government, entities (such as the Highways Agency, an NHS Trust or other public sector Authority) the most efficient method of financing is to use the high credit standing of this income stream to raise as much private senior debt funding as possible. Such a financing solution is commonly referred to as Project Financing, as it is based upon the project's cashflows. It is also known as limited or non-recourse financing, as the recourse available to lenders, in the event that the debt is not serviced, is only to the assets and contracts of the project company and not to the shareholders themselves.
Structuring a PFI project therefore involves, inter alia, putting in place a contractual structure with the aim of insulating, as far as possible, the repayments to debt providers from project risks, whilst providing the optimal amount of true risk capital in the form of shareholder funding.
The timing of these cash distributions to shareholders is dependent on various covenants within the project and available distributable profits. As a result, the cashflows to the investor lag behind the profitability of the project company until the end of the project. This can be seen in the following graph:
Generic project – Balfour Beatty Profit & cashflow
Profits are earned from the start of the concession. At the start of the concession profits are small as the construction profit and notional interest income during this period are offset by the net interest expense. Profits then grow rapidly as the financial asset is constructed, and the base upon which the notional interest is calculated increases. Profits are then relatively stable for the remaining life of the concession as the notional interest and interest expense profile match each other, with profits being generated as the effective interest rate of the financial asset is higher than that of the debt, and there are small operating profits. The profits fall toward the end of the concession as the debt and financial assets are paid off, and operations come to an end.
Cashflow to the shareholders does not follow the same patterns, and is dependent on various covenants within the project. In the early years, cashflow is negative, as the equity and subordinated debt is invested in the project company. The initial cash receipts, commencing in year 5, are in the form of subordinated debt interest. Free cash is used firstly to pay subordinated debt interest, then to repay subordinated debt principal, and finally to pay dividends. The large distributions toward the end of the concession are in the form of dividends.
Furthermore, free cash in the project may not be immediately available for distribution to the shareholders as it is initially used to fund the cash reserve accounts required under the financing arrangements. The obligation to fund the reserve accounts decreases over time as the loans are repaid, and that cash becomes available for distribution to shareholders.
