C10 The PwC study takes the returns that the private sector expected to make when bidding for the PFI contract as the key benchmark for its calculations. PwC focus on the nominal, post-tax, Project IRR as projected in the cashflow forecasts prepared by the private sector at financial close of the project. The Project IRRs compared with its calculation of the Weighted Average Cost of Capital (WACC) for each project.
C11 This WACC is calculated as the return that "should" be expected from a project by a diversified investor, taking account of the project's risk, calculated in accordance with the Capital Asset Pricing Model (CAPM) used in conventional corporate finance theory. Using CAPM, it is possible to derive an appropriate cost of equity for a project and, by adding the cost of debt for each individual project, produce a rate of return equivalent to the WACC. This approach is possible provided an appropriate benchmark is established for the type of project and risks taken by the equity investor. The study suggests that the most appropriate benchmark to use for the WACC is the regulated utility sector. Further assumptions used in the study are the risk free rate of return, being the long term government bond yield, and the equity market risk premium, which is assumed to be 5 per cent.
C12 There are certain aspects of the study which need to be carefully considered in interpreting its results as the future experience of investors may differ in practice from that posited in the report. The PwC study:
• looks at "ex ante" results. This is the rate of return bid by the private sector participants, not the returns actually received from their PFI projects. As yet, insufficient data is available to either private sector participants or observers on the returns actually achieved over 15-30 year contracts to estimate whether the rate of return bid is likely to be matched by the actual outturn;
• compares bid returns with a calculation of WACC using the CAPM, which uses various assumptions and benchmarks which may not prove an accurate benchmark for PFI's real risks; and
• uses the water and gas utilities sector as a benchmark, citing this as a comparable sector. This analysis of the relative riskiness of a PFI project to a regulated utility may not be shared by all private sector participants in the PFI market and may not be a true estimate of PFI's riskiness.
C13 The conclusions set out in the PwC study are set out in Box C2, but in summary, the PwC study calculates that taking account of various factors, the rate of return bid seems to be 1.7 per cent p.a. above what one would expect, given the benchmarks used. The report shows this conclusion can vary given small changes in some key assumptions, one being the effect of bid costs on bidders behaviour.
Box C2: Conclusions of PricewaterhouseCoopers study • "The average spread between the project IRR and benchmark WACCs has been some 2.4 per cent in total; • on our assumptions about unsuccessful bid costs this reduces to between 1.1 per cent and 1.7 per cent - say 1.4 per cent. To the extent that the assumptions on bid costs are changed it affects conclusions on the allocation of the spread but not the total figure of 2.4 per cent; • some 0.7 per cent of the spread is explained by swap costs; • after considering other factors, we believe the other 0.7 per cent indicates excess projected returns to investors, and that this is due to structure issues that limit competition in the PFI market; • bidders' target equity returns average 14.5 per cent over the period before adjustment for bid costs, whereas the cost of equity implied by a traditional WACC calculation is in the range 8.3 per cent - 9.4 per cent depending on the assumptions used; • there is some evidence that spreads were increasing until 1998 but that since then this has reversed; • changes in the general capital market environment - such as declining interest rates and margins - have been reflected in PFI financings to the benefit of the public sector; and • we expect the trend towards reduced returns to continue. The effects of steps already taken to standardise processes and share market information have not yet been fully reflected in closed deals because of the length of the procurement process." |
C14 The PwC study identifies certain features of PFI which could give rise to such a spread:
• the risks of political intervention given the novel nature of this form of contract, the long term nature of the commitment and perception of political risk;
• corporate investors may use corporate hurdle rates, based on for their core business on pricing their investors, which in PwC's view will nearly always be higher than is appropriate for PFI projects;
• returns may be influenced by the requirements of debt funders and their cover ratio requirements;
• long periods of negotiation which result in financing terms being agreed early, but closed at a later date after financial markets have moved favourably.