Q441 Baroness Hamwee: Coming back to the script, we have asked you about the current financial situation. Do you think that pension funds are going to become a significant source of funds for private finance projects in the future?
Mr Turville: The answer is that I think they should be. Pension funds are a natural source of long-term financing and therefore a very good fit for PFI projects. To date we estimate around 25% of PFI projects were financed in the capital markets and a significant proportion of those bonds have been placed with pension funds, particularly with the UK institutions. You can take some statistics I have been provided with by my bond colleagues. There have been over £50 billion sterling issuance in the corporate bond market to date and that compares to 2008 at about £18 billion and £23 billion in 2007. So in difficult times for the financial markets the corporate bond market has been booming and a lot of that issuance has been dominated by the utilities; the figure for utilities is around 25 to 30%. We have seen BAA in the last 10 days issue £935 million into the capital markets. That is a huge source of liquidity. To date they have played a significant role but moving forward as banks have withdrawn from the markets and term has become an issue for banks, the banks are looking to lend shorter term that they were 24 months ago. The pension funds are the natural source of financing.
Q442 Baroness Hamwee: If you were advising a pension fund, would you say there are any particular risks for it? I ask that question just to get at it from the other point of view. Are there any constraints that pension funds, because of their own nature, might encounter? So, though they should be a good source of finance, we might find that they are not.
Mr Turville: The risk profile of transactions is one of the issues for pension funds. The UK model historically has been to use mono-line intermediation; so the mono-line would use his former triple A rating to credit enhance and that makes it easier for pension funds to purchase the debt. A lot of PFI projects have been rated at very low investment grades, really triple B minus. A lot of deals the banks were undertaking at the peak of the market were actually non-investment grade. That is very difficult for pension plans. I talked about utility issuance. Utilities are generally rated in the single A category. To really tap into the huge popular resources available from pension plans the projects need to be structured to a higher credit level and that is something we see in overseas markets. The UK is heavily dependent on mono-lines. In Canada there has been huge unwrapped issuance but the projects have generally been rated high triple B to single A range and the Canadian pension plans have bought that paper.
Q443 Lord MacGregor of Pulham Market: May I just be clear? Were the figures you gave us related to bonds for UK banks' PFI projects?
Mr Turville: No, total sterling corporate bond issues.
Q444 Lord MacGregor of Pulham Market: I thought they were. Could you break it down for PFI projects?
Mr Turville: Our estimate is around 25% of PFI deals have been funded in the capital markets since the inception of PPP, generally focused on the larger transactions, transactions like the Royal London and Bart's hospital projects and Allenby/Connaught, the MoD accommodation transaction, deals which were over £1 billion. There was a time when the majority of large PPP projects, say £200 million plus, were funded in the capital markets.
Q445 Lord Griffiths of Fforestfach: Why, in your experience, do you think people who have equity stakes in PFI projects sell them on? Do you think it is a good thing they do sell and do you think there is any case for putting any restriction on the proportion of their equity stake which they can trade?
Mr Olsen: The balance sheet of construction and operation companies in particular, who would historically have come in to the PFI space, ostensibly to win contracts for their discipline, is obviously constrained in the same way as any other balance sheet is constrained and their ability to recycle that capital into a secondary or even a tertiary market is important because it frees up that capital capability for them to come back into the primary market and deliver the thing they are actually really there for and their expertise is designed for which is building and operating these projects. There is also an increasingly growing financial investor market which is buying these assets, this equity. That obviously is part of the food chain.
Q446 Lord Griffiths of Fforestfach: Which is a good thing.
Mr Olsen: Which is a good thing because it frees up the contractors in particular to move on to the next phase in the wave of projects. My sense is that if any limitation were to be placed on that process, it would skew the market.
Q447 Lord Griffiths of Fforestfach: And increase the cost of capital.
Mr Olsen: It would presumably increase the cost of capital at the primary end. My sense would be that the free market process-
Q448 Lord Griffiths of Fforestfach: Because they would be taking on more risk in holding their equity stake.
Mr Olsen: Exactly.
Mr Waterston: If you were a typical building contractor, you have a limited capacity on your balance sheet to put equity into projects. So if you want to continue building PFI projects year after year, 10 years, 15 years or whatever, you need to find a way of releasing that capital so you can put more of it into projects. It has been very fortunate that there are these secondary funds which have come in and taken up that capacity. I would add that in terms of the restrictions mentioned there is currently a form of restriction in the SoPC4 standard contract whereby, during the construction phase, there is a limitation on the equity providers selling equity without the approval of the local authority. So the local authority has effectively to approve the sale for that period of two to three years during the development phase. After that, once you are into the operation, then it is up to the equity providers to sell. Even so, within the SoPC4 there are still more criteria about whom they can sell to and there is a number of potential investors to whom they cannot sell which are defined in the standard contract. One further point to add is that in terms of liquidity of the secondary market, it is very much the case in other European countries where we see PPP that there is this similar lack of restriction on selling equity stakes and projects, particularly after the construction phases.
Q449 Chairman: I can see the benefit from the point of view of the equity holder or the construction company, but a number of witnesses have said to us that from the point of view of those who are on the receiving end of a PFI contract the bundling of the long term with the investment in the asset itself was a great benefit because that persuaded those who were producing the asset to think long term. If those who are the initial equity holders can simply sell off their equity without constraint if and when they want, does that not water down and weaken the apparent benefit from the point of view of the receiver of the asset?
Mr Olsen: It is particularly the case of the construction contractors and/or the operators that they come into the process to do a job. The contractor is a builder and his job is to come in and build the entire thing, whatever the asset is, to spec on time and on budget and hand over that asset in a fit state, fit for purpose et cetera. The operator then comes in and operates it. There is symmetry to those two things because the operator will want to be very sure that the asset he is taking on and managing for 25-30 years is fit for purpose. The funders, in particular the banks, will-coming back to my point about policing these contracts-need the contractor through his contractual obligations to continue to operate and deliver under that contract through the life of the loan or the asset as a whole. There is a degree of horses for courses in this question. You have different parties coming into the project and applying their expertise at the time it is most needed, policed in particular by the funding community, whether that is banks or capital markets. I suppose it is clear that the pure financial equity houses are in it for the longer term equity returns of course and, again, they have a commonality of interest with the banks to ensure that the project is operating in a way that ensures the cash flows continue to happen. So from all directions it is almost like a symbiotic relationship between the parties, all producing and providing their pieces of expertise to ensure the thing remains intact for everybody's benefit, including the public sector of course. In policing the project the public sector is getting what it asked for.
Mr Waterston: It is important to note that the buyers of this potential equity that is sold also have a vested interest. The incoming buyer of an equity stake in a PFI project is going to have a strong interest also in maintaining the project for the user. It is not as though the fact of selling it could result in a lesser degree of due diligence by the new owner. It is a niche market, a niche infrastructure specialist market. The infrastructure funds which are out there are very experienced in PFI projects and would certainly be expected to maintain the assets as well as the previous owner.
Q450 Lord Griffiths of Fforestfach: To me the acid test would be-let us assume you take a primary equity stake in something and then you feel after a certain time you have done your bit or you need cash for something else so you sell it on-whether the person you sell it to will say "Ah ha, they were very generous in the costs that they imagined for servicing this project. Could we now embark on a cost-cutting exercise and through that deliver a lesser quality of service to the customer?" If we could find examples of that, I think it would support what you are saying. Whether there are any or not I do not know.
Mr Olsen: I am certainly not aware of any examples. We come back to the specification set out at the outset that the school, the hospital, whatever the project is, has to deliver a certain standard of service and there is obviously a cost for that. Clearly any private enterprise will look to optimise its costs versus its deliverability. We are back to the due diligence process that we all went through at the beginning of the process before financial close. I am interested to hear what the equity says about this, but my sense is that there is actually very little fat built into these things and there are not very many costs, if any, to take out of the process. They are very, very optimally structured.
Mr Waterston: If a new owner did try to run down the costs in that way, they would soon find that parts of the school were unavailable because the operator was not doing its job because it was not getting the money. It would then have deductions and its equity stake would be greatly underperforming.
Mr Olsen: And it would have a lot of lenders on its back, banging on the door asking why it was not performing and indeed the public sector saying exactly the same thing.