7 The equity investment plays an important role in the structure of PFI projects. Investors have helped to secure the debt finance that forms the bulk of the funding. Banks, or bondholders, have provided around 90 per cent project finance on condition that a project has been fully developed by investors whose equity will be lost first if the project company encounters difficulties. Investors have also brought together the private sector teams to deliver the required service. The design of the investors' PFI subcontracts, and the investors' oversight of contractors, has contributed to a good delivery record for PFI projects.
8 However, there is a reputation risk to a private finance programme when investors are perceived to be earning high returns from government projects. In return for bearing the risks of losing their equity first, equity investors receive all of the remaining cash flows once the project has paid off its third party debt. Where the potential risks have not arisen, this residual value will be sizeable compared to the original amount of equity. Investors will naturally seek to maximise their returns and their aims may not always be consistent with optimising value for money for the taxpayer throughout the contract period.
9 Investors bear some risks, particularly in the early stages of projects, but these risks are limited. The main risks PFI investors bear are:
a not knowing whether their bids will be successful and whether their bid costs will be recovered in PFI procurements. Procurement has often taken around three years or longer, with losing bidders often involved for a substantial part of the procurement;
b that their selected contractors may fail, or persistently underperform. This risk is particularly critical during the construction;
c that lifecycle costs will be higher than estimated over the life of the project (often 30 years, sometimes longer); and
d adverse events affecting the original investment assumptions on certain other risks including insurance, disputed subcontract responsibilities, rates of inflation and project company running costs.
The risks that investors have borne have, however, been limited in that:
e investors usually pass most cost risks to their contractors by giving them mainly fixed price contracts;
f the Government, as the procurer, is a very safe credit risk. This reduces the investors' risk and also their cost of obtaining bank finance;
g as the PFI market has matured many projects, such as hospitals and schools, have been repeat projects where the format and risks of the projects are well understood;
h in 84 of 118 projects in operation where investors told us their current experience, investors were reporting returns equal to or exceeding expected rates of return. Thirty-six of those projects were forecasting significant improvements. The remaining 34 of the 118 projects were, however, currently performing below expectations; and in relatively few of the 700 PFI projects have investors reported that they have lost their entire investment, or injected more money to save a project.
10 To date, the Treasury and departments have relied on competition to seek efficient pricing of the contract, without systematic information to prove the pricing of equity is optimal. Competition has generally created an expected return to equity of between 12 to 15 per cent at the point contracts are signed. The Government has considered the role played by equity investors and has previously published an earlier study on PFI returns and policy documents intended to place downward pressure on equity pricing. However, any improvement in pricing has not been sustained and information on the investors' experience has remained limited. To date, the Treasury has not systematically gathered data from investors on their actual and forecast returns from operational PFI projects or on their pricing when selling investments.
11 Our findings suggest that the public sector may often be paying more than is necessary for using equity investment. We explain in Part Three of this report why there are potential inefficiencies in the pricing of equity:
• Inefficient procurement. There is scope for reducing the time and costs of bidding for privately financed projects which is one of the main factors influencing investor returns.
• Investors' cost of capital. Investors told us they tend to price equity by reference to a pre-defined internal 'hurdle-rate' required by their investment committees, rather than by reference to the specific risks of the project unless there are higher risks involved (such as traffic demand risk). But PFI projects benefit from the secure payments that the Government as a customer provides.
• Lender requirements. The minimum investor returns which are priced into PFI contracts have been strongly influenced by banks through requirements (known as 'cover ratios') for a defined level of cash flow. This provision increases the protection of their loans but is not always needed.
12 In the absence of systematic information more detailed analysis of project returns can help to assess whether equity pricing is reasonable. To undertake this more detailed analysis, we made informed assumptions about the relationship between risks and returns in three projects to identify those aspects worthy of further consideration. Our estimates suggested that, while the majority of investor's returns could be explained by reference to the risks they were bearing, we could not explain a proportion of the returns earned by investors. The parts of the investors' returns which could not be fully explained were a relatively small amount - around £1.15 million per annum in total across the three projects - but they were equivalent to around 1.5 to 2.2 per cent of the authorities' payments and could be significant over the long term life of PFI projects. These illustrations do not represent a conclusion on the value for money of those projects and should not be taken as indicative of similar questions in other projects. But they do suggest that there is merit in further analysis of the composition of equity returns.
13 Authorities have, generally, not been equipped to challenge investors' proposed returns rigorously and may require better support to do so. Our previous reports on Commercial skills for complex projects and Lessons from PFI and other projects have highlighted that the public sector needs to use commercial skills better when negotiating with experienced private sector counterparties. Public sector negotiators need accurate data for decision-making, for good project assurance and to challenge options that have been selected.
14 Some primary investors have sold their equity in successful projects to release their capital and fund new projects which resulted in accelerating the receipt of their returns. The typical profile of project cash flows provided investors with their returns towards the end of contract periods of 30 or more years. Once projects successfully reached the phase of full operations, some investors accelerated their returns by using either of the two following options, or both:
• Debt refinancing. Investors refinanced the bank debt, mainly in the early days of PFI when the banks offered better terms as the PFI market became established. Our previous reports showed examples of debt refinancing resulting in investors increasing their returns from between 12 and 15 per cent to 50 to 70 per cent. Such high returns from debt refinancing have not arisen in subsequent contracts, since the Treasury introduced new terms for sharing gains with the public sector.
• Sale of equity. Share sales have enabled primary investors to release their capital and fund new projects, thereby also accelerating their returns. The increased rate of return reflects mainly the higher risks associated with developing and delivering projects. Our analysis has shown that investors selling shares early have typically earned annualised returns between 15 and 30 per cent. In exceptional cases, returns have been higher (up to 60 per cent) or lower (as low as 5 per cent). These returns were mainly driven by the prices secondary investors were prepared to pay to invest in an established project. We consider the potential inefficiencies in the initial pricing of equity will also have been a contributing factor.
15 There are other potential methods of remunerating investors that the Treasury's current review of PFI is able to consider. In some government projects there have been certain limits to the investors' returns or the public sector has shared in both upsides and downsides by investing in the project. Other potential mechanisms include sharing equity gains from share sales or separate contracts for construction and operations, each priced according to the respective risks. This is, however, a complex area and all of these potential mechanisms have both possible advantages and disadvantages.