Equity pricing and risk

2.30  Although London Underground gave some thought to holding a separate funding competition (as reviewed in the NAO report on the Treasury Building PFI deal),4 such an approach would have depended on going to the market with a well defined financial structure appropriately aligned with risk. This could not be followed because the PPP competition was looking to identify the terms on which the market would finance a novel structure and the different PPP bidders came up with alternative and competing funding solutions at the BAFO stage (see Figure 11).

2.31  London Underground, supported by the Department, took steps through the bidders to firm up earlier proposals to arrange long term fixed rate financing. CFO bids consist of fees, margins for lenders and non-binding estimates of the expected underlying cost of funds. London Underground put arrangements in place to fix the underlying cost of funds following financial close (see para 2.15). The fees and margins were negotiated as part of the tendering process and were accepted by London Underground, following benchmarking and advice from its advisers. There was also provision to claw back any future savings through at least a 50 per cent share in refinancing gains (or 60 per cent in the case of an initial Tube Lines refinancing).

2.32  London Underground will be paying equity investors a risk premium about 15 per cent above the risk free rate (see glossary). This is 50 per cent more than most deals with an established PFI structure, but it had arrived at this premium through competitive bidding. Tube Lines, in its base case for lenders, showed a nominal post tax equity rate of return of 19.9 per cent (17.45 per cent real). The risk premium on the nominal rate is some 15.4 per cent above the risk free rate of about 4.5 per cent at Financial Close for Infraco JNP. Metronet's base case shows a nominal rate of return of 17.7 per cent on both Infraco BCV and Infraco SSL, with real rates of return being 15.09 per cent and 14.9 per cent respectively. These rates of return depend on the consortia achieving bid levels of performance - not the lower levels set by benchmarks - and investors are at risk of losing their investment if defaulted for failing to achieve upgrades through inefficient and uneconomic behaviour. The rate of return could be different from the bid rate because payments are aligned to actual performance, but at benchmark levels could still reward investors with real returns of between 10 per cent and 17 per cent. If an Infraco experienced cost overruns similar to those on recent line upgrades managed by London Underground, and delivered performance lower than forecast, returns would fall further.

2.33  In most PFI deals, the risk on the underlying funding costs (excluding the equity and risk elements) remains with the public sector up to Financial Close. London Underground took steps to manage this risk actively. London Underground's Director of Finance submitted a memorandum to the Board on 2 September 2002 setting out detailed proposals to manage interest rate risk through two separate operations:

■  A risk management programme to manage the impact of the Metronet bond financing by selling the bonds that served to benchmark the issue and so, with Financial Services Authority consent, creating a net short position5 immediately prior to the bond launch; and

■  a programme of interest rate swaps for bank debt over the 3 month period following financial close, rather than all at once, with broadly similar arrangements for Tube Lines and Metronet.

2.34  The Royal Bank of Canada reported on the Tube Lines funding on 18 March 2003 and on the Metronet funding on 2 May 2003. In both cases it generally found that market disruption was kept to a minimum and that the underlying cost of funds was in line with the market at the time. This represents an improvement on earlier PFI deals that we have examined.6

_______________________________________________________________________________________

4  "Innovation in PFI Financing: The Treasury Building Project" HC 328 March 2001.

5  Potential investors in the Metronet issue holding reference bonds that they sell in order to purchase the new issue potentially depress the price and increase the yield. In this case Metronet would have to match the higher benchmarked yield. As a result of the short sales, London Underground's agent can meet this demand and minimise the price impact.

6  See, for example, Ministry of Defence: Redevelopment of MOD Main Building HC748 April 2002.