92. With the National Physical Laboratory the private sector clearly had taken on some risk and lost funds when the project went awry. But the private sector fared much better when Metronet-a consortium upgrading the London Underground-went into administration in 2007.
93. The London Underground PFP was a unique case. Unlike most other private finance projects Metronet was not building a new asset but maintaining and upgrading an existing asset. Furthermore, Transport for London guaranteed 95% of Metronet's debt obligations. Debt guarantees are not part of standard private finance contracts.
94. The NAO said: "As a consequence of this guarantee, Metronet's lenders did not protect their investment as anticipated because only five per cent of their investment was at risk" (p 88).
95. So when Metronet failed, the Department for Transport had to make a £1.7 billion payment to help Transport for London meet the guarantee of Metronet's borrowing. The NAO estimated a direct loss to the taxpayer of between £170 million and £410 million (p 88).
96. Mr Allen said: "The banks being 95 per cent guaranteed did blunt some of the incentives that you usually expect to see from private finance and some of the rigour that you look for in terms of their policing of the contracts" (Q 387).
97. The guarantees stemmed from the public sector's uncertainty over whether Metronet could borrow enough funds. Mr Allen said: "I think there was a perception at the time that this was what was required, you had three large contracts to design and a limited appetite in the bank market to provide that debt and they wanted some contractual underpinning in order to take on those risks" (Q 387). Mr Allen went on: "I am not sure that the economic arguments were very strong; I think it was more a pragmatic argument of what you needed to do in order to sign a contract" (Q 387).
98. Mr Allen added that any private finance project which needed such extensive underwriting as Metronet should serve as a wake-up call that there may be problems ahead. He said: "When somebody says that in order to get these contracts away we need to be able to offer this sort of underpinning to the banks ... that should be a very strong warning light that this is not a contract that can be let to the market on a sensible basis" (Q 387).
99. Furthermore, the companies behind the Metronet consortium put relatively little of their own money-or equity-into the project. When a company collapses the equity is usually lost. Banks usually get first claim on remaining assets to repay as much of the outstanding debts as possible. Usually nothing is left over for shareholders. So if shareholders have put lots of equity into a company they will be very reluctant to let it collapse because they will nearly always be left with nothing.
100. But when "shareholders have a very limited amount of equity in the company there comes a point when actually they would rather let the company fail than continue to support [it]," said Mr Allen. He added: "The risk you transfer effectively to the company is limited by the amount of equity that the shareholders put in, in the first place, and if the risks that the company is trying to bear are larger than that it may be that shareholders walk away from it. That is certainly what happened with Metronet" (Q 387).
101. The failure of the London Underground Metronet PFP gave private finance projects in general a bad name. Yet this project was exceptional because huge debt guarantees together with a typically narrow equity base limited risk transfer. We recommend that the state should not guarantee large amounts, and a high proportion, of debt as a means to make highly geared PFPs happen. For such exceptionally large and complex projects alternative procurement approaches should be used.