• Interest-rate risk can be a significant risk in PFI projects, both before and after Financial Close.• There are various approaches to managing this risk and an Authority must determine, prior to issue of the ITN,2 what is right for its particular project.• Most PFI projects use debt whose interest rate has been fixed, either in the interest-rate derivatives market,3 or in the capital markets. |
Long-term interest-rate movements can be a significant risk for the Contractor in projects where:
- long-term debt financing is required;
- this debt financing provides most of the funding (typically 90-93%); and
- there is limited debt-service 'cover' (i.e. surplus cash flow to protect the lenders against fluctuations in costs including interest-rate movements) or debt-service 'tail' (i.e. the period between the final scheduled debt repayment and the end of the PFI Contract).
In this situation, long-term lenders are generally not willing to have the interest-rate risk left with the Contractor, or would only do so if large contingencies were built into the Unitary Charge, which are unlikely to be value for money for the Authority.4
In such cases, the options for covering interest-rate risk are:
(a) The Contractor's parent company absorbs the risk within its corporate treasury function, which manages a full portfolio of funding arrangements supporting all of its business operations.5 In such cases Authorities should have no involvement in interest-rate risks in the ways discussed in this Application Note.
(b) The Contractor passes on the risk to the Authority through future adjustments in the Unitary Charge reflecting movements in interest rates.
(c) The Contractor passes on the risk to investors by raising fixed-rate bond finance,6 carrying a coupon linked to gilts.
(d) The Contractor raises variable-rate finance, typically adjusted 6-monthly7 based on LIBOR, but passes on this risk to financial institutions through long-term interest-rate hedging (e.g. in-terest-rate swaps).
It is important for the Authority to address interest-rate risk, and the Authority's financial adviser should consider it early in the procurement process, certainly before issue of the ITN.
The Authority should thus review:
- whether it is good value for money to absorb interest-rate risk on a long-term basis as set out in (b) above (cf. §2.2)
and if not:
- how to deal with movements in market rates from bid to Financial Close (cf. §2.3)
- the interest-rate assumptions and any hedging-strategy requirements in the ITN (cf. §2.4)
- the Contractor's choice of instruments used to fix or hedge the interest rate (cf. §2.5)
- the timing for fixing or hedging interest rates (cf. §2.6)
- how best value for money can be ensured in execution of this fixing or hedging (cf. §2.7)
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2 From 31 January 2006 it is expected that Competitive Dialogue will become the standard procurement procedure for PFI contracts rather than the Negotiated Bid procedure. 'ITN' is used throughout this Application Note nonetheless in the interest of consistency with current accepted language.
3 The terms 'hedging market' and 'derivatives market' are used interchangeably in this Application Note.
4 Lenders (and investors) should be more willing to absorb the risk where the level of gearing is substantially lower than the 90-93% indicated above.
5 This is likely to mean that the Contractor is financed on a corporate-finance not a project-finance basis (cf. H.M.Treasury: "Standardisation of PFI Contracts" (v.3, 2004) ('SoPC'), §32: Alternatives to and Variants of Project Finance, and §35.4.3: Corporate Finance Exemption).
6 Or other fixed-rate financing, e.g. from European Investment Bank
7 Or for shorter periods during the construction phase