3.21 In the absence of systematic information to prove the pricing of equity is optimal, we show here how more detailed analysis can assist an assessment of equity returns. To illustrate this, we analysed the component parts of proceeds from three sales to see if we could relate the return to our estimate of the value of the risks borne by the investors. We choose these sales because the projects were in our survey sample and we had access to the financial models and sales data (Figure 13 and Appendix Four).
3.22 Proceeds from the three sales ranged from about £2.8 million to £31.3 million. We estimate that the proceeds of each sale is composed of (Figure 14 on page 34):
• changes in the valuation of the project's future cash flow since the project started including changes in cash flows, movements in the secondary equity market, and the elapse of time between financial close and the sales. These account for between £0.1 million and £17.5 million of the proceeds;18
• the original equity investment ranging from £1.3 million to £7.2 million, giving annualised exit rates of return ranging from 30 per cent to 39 per cent (Appendix Four);
• the primary investors' risks including additional payments for project development and credit risk in construction contractors. These amounted to between £0.6 million and £3.2 million; and
• an unexplained residual element - after subtracting estimated allowances for each of the component parts above from the total proceeds, there is a residual difference of between £0.3 million and up to £3.4 million.
Figure 13 The three equity sales analysed by the National Audit Office | |||
Project | Queen Alexandra Hospital, Portsmouth | Bradford Schools, phase one | Derbyshire Mental Health |
1 Capital cost1 | £360 million | £95 million | £36 million |
2 Service charges2 | £560 million | £137 million | £41.6 million |
3 Months in procurement3 | 52 from August 2001 | 26 from October 2004 | 43 from February 2004 |
4 Equity return at date of contract | 15 per cent | 13.7 per cent | 14.25 per cent |
5 Date of equity sale and proceeds | June 2010 sale of 50 per cent for £31.3 million | November 2010 sale of 25 per cent of Bradford (£4.7 million to £5.6 million) and 50 per cent of Derbyshire (£2.8 million to £3.3 million)4 | |
Short description | Combined three re-existing hospitals at one site. Thirty-five year provision of estate services, portering, housekeeping, linen and laundry, catering, retail, and car parking. | By 2008, built three fully operational new schools. Twenty-five year provision of facilities management, cleaning, ground maintenance caretaking, and security. | Adult high and older persons' high dependency and dementia health units, a resource centre and a clinical services building. |
NOTES 1 Row one shows the construction costs and funding during the construction phase. 2 Row two shows the present value of the aggregate service charges over the life of the contract (finance charges and operations and maintenance). 3 Months in procurement are taken from the date of the original notice in the Official Journal of the European Union 4 Equity interests in these two projects were included in a portfolio that was sold. The seller provided information to the National Audit Office that allowed us to estimate ranges for sale proceeds relating to the two projects. 5 As the scope of this report is specifically limited to the role of PFI equity, it does not deal with all the issues that would be relevant to assessing the value for money of each project. For example, Portsmouth Hospitals NHS Trust encountered budgetary difficulties, which in March 2011 contributed to its decision to close 100 of the Queen Alexandra Hospital's 1,200 beds. Source: National Audit Office summary | |||
3.23 This analysis suggests that most of the primary investors' returns are explainable. Investors told us that the difference between rates of return demanded by primary investors at contract award and the lower rates of return in the secondary market could be explained by the primary investors' main risks. These are:
• costs associated with unsuccessful bids for other projects;
• the risk associated with the construction contractor defaulting; and
• the increased price of funds for projects in the tender and construction phases.19
Figure 14 Our estimates of the component parts of the investors returns1 | |||||
| Queen Alexandra Hospital Portsmouth | Bradford Schools | Derbyshire Mental Health | ||
| (£m) | (£m) | (£m) | (£m) | (£m) |
Sale price | 31. 3 | 4.72 | 5.62 | 2.82 | 3.32 |
Less Estimated increases in the value of the project since it started3 | (17.5) | (1.5) | (2.4) | ( 0 .1) | ( 0.7 ) |
The primary investors' risks4 Contractor default (estimate) | (2.3) | ( 0 .1) | ( 0 .1) | ( 0 .1) | (0 .1 ) |
Cost of failed bids (estimate) | (0.9) | (0.5) | (0.5) | (0.9) | (0.9) |
The primary investors' original investment | (7. 2 ) | (1. 9 ) | (1. 9 ) | (1. 3 ) | (1. 3 ) |
Unexplained residual amounts (rounded present value at the point of financial close) | 3.4 | 0.6 | 0.6 | 0.3 | 0.3 |
Unexplained amounts within 2011 unitary charge (rounded 2011 prices) and totalling £1.15 million | 0.9 | 0.2 | 0.05 | ||
Portion of unexplained annual unitary charge | 2% | 2.2% | 1.5% | ||
NOTES 1 Detailed assumptions are set out in a technical paper (Appendix Four at www.nao.org.uk/pf -private-equity-2012). 2 Equity interests in Bradford schools and the Derbyshire Mental Health project were included in a portfolio that was sold. The seller provided information to the National Audit Office that allowed us to estimate ranges for sale proceeds relating to the two projects. 3 Includes accrued profit at the secondary investor's rate of return - i.e. those relating to operational risks. 4 Includes only those risks that primary investors are exposed to, but secondary investors are not. Source: National Audit Office analysis | |||||
3.24 However, after allowing for changes since the project started and the primary investors' main risks, we found residual differences between our estimated values and bid prices. We used conservative estimates to value the risks, checked the results using an alternative method, and used sensitivity analysis, but could not eliminate these residual differences. In our main estimates, these residual amounts had present values (at fnancial close) ranging from £0.3 million to £3.4 million (Figure 14).
3.25 We cannot, therefore, discount the possibility that market and other inefficiencies in the initial pricing of equity add to the investors' profit. This possible pricing inefficiency is equivalent to an increase of 1.5 to 2.2 per cent in the service charges and annual payments to the investors of these three projects, in total, of £1.15 million in 2011 prices.
3.26 These illustrative findings highlight how aspects of investors' returns may be worthy of further consideration. The results are not conclusions on the value for money of the three projects and should not be taken to indicate experience across the whole population of PFI project sales.
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18 The calculation is shown in Appendix Four at www.nao.org.uk/pf-private-equity-2012
19 One overseas investment fund told us that, because of protracted and uncertain public sector procurement arrangements, its funding costs are 1 per cent higher when bidding in the UK.