1.135 Although it can vary from project to project, equity capital typically accounts for around 10% of the funding introduced under a project finance PFI Option. Pure equity may actually account for a much smaller proportion (this is occasionally referred to as "pinhead" equity) as risk-bearing funds are often introduced by the PFI partner as deeply subordinated debt. Given that this type of funding is largely doing the job of equity, the Spreadsheet treats subordinated debt as equity capital. Whilst some larger PFI transactions have seen the introduction of a separate, "mezzanine" layer of private finance, its use is far from widespread. The Spreadsheet therefore makes the simplifying assumption that private finance is introduced into projects either by way of orthodox senior debt or of equity.
1.136 Equity is the capital introduced at the outset of the project and which suffers the first loss should the financial performance of the project (from the PFI partner's perspective) fall below expected levels. As it is the first in line to absorb losses, equity providers demand returns that are commensurate with the risks that they take and which are somewhat higher than those demanded by senior lenders.
1.137 Although it can vary depending on the level of perceived risk in a particular project, (nominal) pre tax equity returns typically range between 13% and 18%. The Spreadsheet can be run using a (nominal) pre tax return on equity of 13%, 15% and 18%. Procuring Authorities can vary the equity return in the Spreadsheet between these three levels by clicking on the relevant IRR Switch. However, conclusions regarding VfM should be made by Procuring Authorities based on the level of equity return that best reflects either sector-specific experience or the particular risk characteristics of the project being assessed.
1.138 Distribution of dividends is the principal way in which equity providers secure the return on their investment. The level of distributions allowed are governed primarily by company law but also by the cover ratio covenants agreed with senior lenders. The Spreadsheet assumes that dividends distributed equate to the free cash flow generated by the project throughout the Contract Period.
1.139 In certain circumstances, additional equity returns can be generated from refinancing. The opportunity for refinancing arises primarily from the change in risk profile as a project progresses from its construction and development phase into its operational phase. Once the operational phase has been reached, a number of the risks that dictated the funding structure at financial close will have been negotiated. A more stable environment now remains, with more predictable cash flows and this presents the PFI partner with the possibility of recalibrating its funding structure so that it better reflects the lower inherent risks that now characterise the project.
1.140 Whilst refinancings are not an unusual feature of PFI projects, they remain the exception rather than the rule. Equally, there is little evidence that prospective PFI partners are placing any reliance on their ability to refinance a project when setting their target rates of return at the time they bid for projects. Furthermore, it is now standard PFI contractual practice that Procuring Authorities share in refinancing gains achieved; see HMT website18 for further guidance. Given the unpredictable impact of refinancings at a project level, the Spreadsheet assumes that no refinancing takes place.