How investors seek to limit their risks
2.2 Primary investors design the project company's contracts with various subcontractors to incentivise them to manage the risks they control and minimise the risks for both senior debt lenders and investors. Investors retain some risks, especially contractor failure, but these tend to reduce over time (Figure 3).
2.3 Senior lenders also dictate the minimum level of financial reserves required to cover risks borne by the project company. They require the project company to have sufficient financial resources projected in each period over the life of the project to mitigate project risks so that bank loans can be repaid in full. They thus apply a set of standard cover ratios.
2.4 Investors also carry the risk involved in project development and contract negotiation. A key part of this risk, which significantly impacts on investors' costs and therefore their required returns, is the length and uncertain cost and outcome of the procurement phase. Primary market investors bid for PFI projects during average periods that range from 25 months (for schools) to 38 months or longer (for hospitals and complex projects).3 Investors told us that, in order to stay in this area of business, they generally need to win one in three tenders.
Figure 3 Changes in investors' exposure to risks | ||
Type of risk Bidding risk and failed negotiations at preferred bidder stage | Primary Investor
| Secondary Investor n/a |
Construction risk and/or inability to meet output specification | Contractor failure | Reduced risk of construction disputes |
Incorrect assumptions in the financial mode (e.g. deposit interest rates, inflation) | ∙ | Mainly depends on diligent enquiries at time of purchase |
Inadequate protection for inflation | Varies between contracts | Varies between contracts |
Failure to deliver output specification consistently | Contractor failure | Contractor failure |
Inadequate reserves for life-cycle risk | ∙ | ∙ |
Unreasonable behaviour and/or non-payment by the Authority | ∙ | ∙ |
Source: National Audit Office Semi-structured interviews and survey 2011 | ||
2.5 Once appointed as preferred bidder, investors negotiate binding contracts between the project company and the Authority, and with senior lenders and subcontractors. Bidding costs increase during this phase, and there is still uncertainty about the timing of signing contracts. Before signing, there is a risk that the project may be cancelled without reimbursement of bidding costs. As a matter of general policy, the Government does not reimburse bid costs, although it has done so in exceptional circumstances.4
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3 Improving the PFI tendering process HC 149, 3 March 2007.
4 Treasury guidance sets out the principles to follow on the reimbursement of bid costs. On an exception basis, this is included in an invitation to tender. For example, this has applied to some more complex defence and waste disposal projects.