Improved value for money

2.8  A key objective of the review of PFI has been to create a new approach to public private partnerships that is sustainable for the longer-term. Given the diminished availability of long-term bank debt, future projects are likely to need to be structured in such a way that they facilitate access to the capital markets or other sources of long-term debt finance. A greater proportion of equity (i.e. a lower gearing) in the capital structure provides a credit enhancement to the underlying debt rating of the project, which will make the debt more attractive to a wider diversity of long term-debt providers, including institutional investors such as life insurance providers.

2.9  Equity finance comes at a higher cost than debt finance. Including a larger proportion of equity in the structure may, at a project company level, make the project more expensive if the price of debt does not decrease proportionately. However, as the public sector co-investor will earn a return on its investment, assuming appropriate management of project risk, the overall cost to the public sector will be lower under PF2 than would otherwise be the case if the public sector did not invest.

2.10  The target equity return of the public sector will be matched to a market rate (see Box 2.C). Chart 2.A gives an illustrative presentation of the expected equity return profile on a £10 million public sector equity stake over a 25 year contract period that achieves an Internal Rate of Return (IRR) of 10 per cent.

2.11  The funding for the public sector equity investment will come from the procuring authority or sponsoring department. The returns made from investment, in the form of dividends, interest payments on shareholder loans or gains in the eventuality of any sale of the public sector equity stake, will be recycled to the same authority net of the Treasury's costs for managing the investment. Therefore, the risks and rewards from the equity investment will fall to the authority's budget.