I’m a fan of Jeremy Clarkson and laugh along with the rest at his digs at the Prius.
Hybrids- not worth the effort – a good diesel will do the job better.
But I’m not sure you can deride hybrids in every arena. A project we’ve been working on has made me look hard at the merits of a blended approach to funding in public sector projects and wonder whether it offers more opportunities in our current market than straightforward PFI.
Public sector borrowing and the PFI
It’s always been the case that government departments and local authorities are able to borrow more cheaply than their private sector counterparts, but the flipside for the public sector if they funded capital projects through public sector borrowing (also known as prudential borrowing) was that the full responsibility for managing the design, construction and maintenance of a capital asset remained on public sector books. Central government began to question whether there might be more efficient ways to procure large public sector projects and PFI was born. Hallelujah!
Everyone extolled the virtues of the new model, which allowed funding of the land purchase, construction and/or refurbishment phases of the project by the private sector. No up-front capital expenditure by the public sector; off-balance sheet liabilities; services (including maintenance of the new building) delivered for a pre-agreed long term fee.
All the up-front funding, plus the long term fee, offered a tangible incentive to the contractor to get the facility built properly and completed promptly. Yes, the private sector borrowing costs would be higher, but the reduced risks to the public sector represented by removal of the construction phase responsibility and long term maintenance of the asset were amongst the compensations for this.
Significant current uncertainty affects PFI and PPP funding
As the economic and political landscape has changed in recent years, the public sector has begun to look again at the PFI model. I saw this first-hand when we acted for a local authority on a recently-closed project. In response to uncertainty in the PFI/PPP funding market and in the face of severe budgetary constraints, the authority adopted a new approach. Alongside a private sector equity investment, the authority is funding project capital expenditure through prudential borrowing (from the Public Works Loan Board). This funding will be used to make payments for the construction works at specified milestones, and to repay the debt and equity investment of the SPV (with an element of interest) following completion of the construction phase.
There are many possible variants of a hybrid approach. Here are three possibilities:
- Private sector funding during construction, with partial or full repayment of the debt and/or equity by lump sum payments following completion.
- Division of the project into low risk and high risk capital expenditure, with injection by the public sector of its borrowing only for the low risk aspects of the project while construction is ongoing and for a specified period after completion. This could be accompanied by a lump sum repayment at a point after completion of construction.
- Payment by the authority of a proportion of construction costs at agreed milestones, with the SPV retaining a proportion of equity/debt investment for the duration of the project.
In whatever form it takes, a hybrid model of this kind can take the best of both worlds – private sector commitment during the construction phase and cheaper public sector money to fund it. The potential cost savings are significant. Of course, the downside is a full circle return to the public sector taking risk, which historically it has been perceived as being ill-placed to manage. However, that risk can be offset with increased security measures and still produce a more cost-effective project.
Consider additional security for the authority
A hybrid does mean that standardised PFI forms have to be re-worked. The parties need to consider additional levels of contractual security to supplement the usual measures like direct agreements with all the key sub-contractors, collateral warranties from the professional team, a performance bond and retention bond. For example:
- Do you need to go beyond obtaining a parent company guarantee in favour of the SPV from the construction sub-contractor’s parent company and procure one in favour of the authority, to be relied upon in the event of a step-in on SPV default or insolvency?
- Are there mechanisms along the lines of advance payment bonds that can be used to secure authority payments for the works as they progress?
- Should termination and default events be tightened-up, both during the construction phase and the operation phase, so that the authority can step-in if necessary?
- As security for continued performance, look hard at the retention options – should the authority be protected by asking for a larger retention, to be held for a longer period, than would be standard?
On our project, the authority took the freehold title to the sites on which the facility was being constructed at the outset, so that in the event of any termination of the project agreement along the way, it will not be exposed to the risk of having to pay a premium to re-procure the site. That approach may not be right for all projects, but it is certainly worth the thinking about.
When moving away from the standard funding position, nothing should be a given. Stand back and take a completely fresh look at the way in which you can secure the authority’s position, while still making the project viable for the private sector.
The future
Will this hybrid provide a model for the future? In a gloomy, uncertain economy, where private sector borrowing ability is still restricted, I’m optimistic that it will offer an alternative way for public sector capital projects to continue. Long live the hybrid!
