• During the bid period, Authorities have generally accepted interest-rate risk, in the form of potential adjustment (up or down) to the Unitary Charge until this risk is hedged, by the preferred bidder, at (or around) Financial Close when the Unitary Charge level is finally set. |
So far this § Application Note has considered interest-rate risk during the life of the PFI Contract. A further issue, however, is the gap in the time between bidding and Financial Close. When bidding for a PFI Contract, a Contractor would normally offer a Unitary Charge which is predicated upon a specified long-term interest-rate assumption for bonds, or hedging of bank finance whose interest rate is LIBOR-based, or a combination of both, at Financial Close. The market yields on long-term bonds and long-term LIBOR-based fixed-interest (swap) rates vary from day to day, and do not become fixed to a borrower until it commits to these instruments unconditionally.
For a Contractor who is not yet selected as preferred bidder, the cost or risk of hedging the long-term fixed interest rates implied in the Unitary Charge proposed at the time of submission of the bid may be out of proportion to other bid costs; so it could be unrealistic to expect interest-rate risk to be laid off in this way, at such an uncertain time. Even after the Authority has selected a preferred bidder, an uncertain timetable to Financial Close and the residual possibility that the deal may still not eventually reach Financial Close may (in most cases) make interest-rate hedging, at least prior to commercial close, an unjustified expense or risk.11
Consequently, the approach adopted by Authorities has generally been to accept interest-rate risk in the form of potential adjustment (up or down) to the Unitary Charge throughout the development, bidding and negotiating period of PFI projects, right up to the time when this risk is hedged by the preferred bidder at (or around) the time of Financial Close when the Unitary Charge level is finally set.
There are various factors which may reduce the risk of interest-rate movements pre-Financial Close such that the Contractor will be able to absorb it and still offer good value for money in the Unitary Charge. Although current market practice is generally as stated above, such factors could include:
- a short period between bid submission and Financial Close
- bids submitted on a corporate-finance basis where the parent company is able to take and hold a view on interest rates for an extended period of time (cf. §2.1 (a))
- a lower level of gearing (cf. footnote 4)
- if current relative interest-rate stability encourages the Contractor to carry the risk during the bidding period without hedging.
It should be noted that not all elements of the interest-rate pricing will shift before Financial Close, and any adjustment of the Unitary Charge must take this into account:12
- for a variable-rate loan, it is the associated swap rate (if any) which may change, not the credit margins (or commitment fees) on the loan or on the associated interest-rate swap (if any), which would normally be fixed within the Contractor's bid or determined under separate competitive processes (cf. §4)
- in the case of a bond however, both the gilt base rate and the margin over gilts may change,13 but monoline insurance premiums (if any) or bond underwriting fees would normally be fixed within the Contractor's bid, or determined under separate competitive processes.
Private-sector risk assumption and innovation in interest-rate management may increase in the future if timetables to Financial Close shorten, interest-rate market volatility decreases and bidder confidence of reliable timetables increases, for example, as a result of greater standardisation. In which case, the situation may change and it will become more feasible and common for Authorities to consider whether they wish bidders to assume pre-Financial Close interest-rate risk.14
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11 Also, in cases where an Authority has advised in the ITN that it will expect the preferred bidder to hold a funding competition for senior debt, it is unlikely that a bidder will consider carrying interest-rate risk prior to completion of the funding competition (see footnote 12 for reference to OGC guidance on funding competitions).
12 Cf. Office of Government Commerce: "Guidance on Certain Financing Issues in PFI Contracts" (July 2002), Section 2:Using the Capital Markets for Finance for more information on the mechanics of bond issues, and Section 1: Ensuring Competition in the Financing of Contracts for more information on how terms of finance may vary between receipt of ITN responses and Financial Close.
13 The margin, generally known as the 'issue spread', may sometimes be capped. Note also that the rate on the Guaranteed Investment Contract (for which cf. footnote 30) will also change.
14 If an Authority wishes bidders to consider assuming pre-Financial Close interest-rate risk, the ITN should make it clear that this will be taken into account in the bid evaluation-i.e. that a value will be assigned to a Contractor's bid price which is completely fixed (for the period of validity of acceptance) inclusive of all finance costs.