35.2.1 Any bid should be examined from the perspective of how resilient the proposed project structure is to the Contractor or the Sub-Contractor experiencing financial distress. Relevant issues to consider include:
- Overall Project Structure - Different project structures have an impact on financial robustness. For example, projects structured on a limited recourse basis (as for standard project finance) will necessitate careful structuring as the ability of the Contractor to absorb the cost of crystallised Project risks is limited.
In corporate-financed deals where the Contract is entered into with a corporate entity with a significant balance sheet, the long-term financial standing of the Contractor will be of relevance and as such credit enhancement in the form of guarantees, bonds or letters of credit will normally be required. Such credit enhancement may be required at Contract signature or post-Contract signature on the occurrence of certain events e.g. downgrading in the Contractor's credit standing (see also Financial Robustness of Equity Providers and Sub-Contractors below).
- Financial Robustness of the SPV or Other Proposed Contractor Company -An Authority should analyse bidder sources and terms of funding including whether contingent equity and/or standby facilities are in place, reserve account levels, gearing,626 cover ratios (which are essentially measures of available cash within a project, whether on an annual basis or over the full length of the Contract) and liquidity.
- Sub-Contractors and Sub-Contractor Interfaces - As well as the pass down of obligations from the Contractor to its Sub-Contractors, Authorities should also seek to ensure that the allocation of risks as between the key Sub-Contracts (i.e. construction and FM contracts) is largely market standard (taking professional advice as appropriate). For example, an arrangement whereby the FM Sub-Contractor takes defects liability risk for construction work would be regarded as unusual. Non-market standard Sub-Contracts do cause additional difficulties, where the Contractor or the Sub-Contractor experiences financial difficulties, as any replacement Sub-Contractor would be likely to contract only on the basis of different contractual terms. Accordingly the Contractor itself may assume risks previously borne by the Sub-Contractor that is being replaced, with consequential destabilising effects on the Project.627
- Strong Contractor Management - the Contractor should manage its Sub-Contractors robustly to ensure delivery of the Contract. Authorities should consider whether the Contractor is appropriately staffed to perform such functions and whether it has management services provided to it or will be actively supported by its shareholders.
- Financial Robustness of Equity Providers and Sub-Contractors - Authorities should assess the robustness of equity providers (where they have ongoing funding obligations) and Sub-Contractors, considering issues such as that party's importance to the Project, ease of replacement, credit ratings, length of time and level of overall exposure to that party, and whether parent company guarantees or some other form of performance or financial support is being or should be proposed. Where credit enhancement is considered appropriate, Authorities will need to:
• balance the cost of providing the enhancement against the risk of a substantial deterioration in the financial standing of the relevant party;
• consider the form of the enhancement (e.g. on-demand bonds will be more costly although payment of the full amount of the claim is more certain when compared to other instruments);
• consider the identity of the issuer of such credit enhancement, bearing in mind that the credit standing of a corporate may be susceptible to greater fluctuations than banks or other financial entities;
• consider the timing for the issue of the credit enhancement - if credit enhancement is only required once the party is in difficulties, it may at that stage be unable to procure its issue; and
• consider the application of the proceeds of any credit enhancement.
- Appropriate pricing of Works and Services - Authorities should ensure bidders have reasonable cost assumptions in their financial models (e.g. underestimating costs may lead the Contractor to compromise full service delivery or result in financial difficulty).
- Third Party Income - Authorities should be cautious of over-optimistic assumptions of third party income in the financial model; if such income does not materialise this may destabilise the economic basis of the Project. Unrealistic third party income assumptions can also raise transferability issues. For example, where the economics of a project are dependent on levels of third party income guaranteed under a Sub-Contract, any replacement Sub-Contractor would need to be comfortable with generating the same levels of third party income or the risk will revert to the Contractor.
- Capital Contributions - Capital contributions by the Authority towards project costs should not ordinarily be included as part of the structure of a project, to ensure the normal PFI incentives are not distorted. Section 3.9 sets out further details concerning Authority capital contributions and the impact this has on projects.
35.2.2 A bid does of course need to be looked at in the context of a number of evaluation criteria other than financial robustness, for example quality and price. It is possible for one bid to be cheaper in terms of the Unitary Charge but also more prone to failure and consequentially worse value for money. Authorities must consider financial and structural robustness as part of their evaluation, and a project with a high risk of failure should be regarded as unacceptable.628
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626 For example a high gearing could mean that the Contractor has little ability to absorb the costs of the crystallisation of project risks unless the Contractor has access to other sources of funding.
627 The issue of non-standard risk allocation between key Sub-Contractors is of perhaps of particular relevance where the bidder is proposing an integrated approach to a project (i.e. where it will be contributing equity, constructing the asset and providing facilities management services to the Contractor).
628 See further HMT "Value for Money Assessment Guidance" November 2006 from section 5.35 onwards, published on HMT website at www.hm-treasury.gov.uk.