8.1 Debt funders have historically played in an important role in undertaking project due diligence on PFI projects. Debt funding is exposed to potential loss from poor performance, for example, if the project fails during construction or operational performance criteria are not met, as the public sector will not be obliged to pay some or all of the project's unitary charge. Debt providers' returns are also effectively capped as the repayment of principal repayments and interest charges are fixed at the project's outset, in particular:
• debt providers take a conservative view of risk and, prior to contract signature, ensure disciplined risk mitigation and allocation taking a firm view in dealing with problems revealed by due diligence reports;
• during the construction and operational phase of the project they continue to play an important role in monitoring of project performance and timely resolution of any issues arising; and
• lenders provide an interface between the project investors and the public sector client. In conventionally procured projects the public sector has often in the past accepted price increases as a result of cost overruns or delays. Banks play a vital role in providing corporate funding and often support contractors with whom they have a business relationship. Consequently the contractor is heavily incentivised to act swiftly in resolving any project performance issues and thus insulating the public sector from any such exposure.
8.2 These vital due diligence and monitoring disciplines have contributed significantly to the successful delivery of robust contract structures resulting in extremely low default rates on project finance loans for infrastructure assets.
8.3 However, whilst the due diligence provided by the debt providers has been, and remains, valuable, the highly geared capital structures in past PFI projects1 has tended to restrict operational project flexibility. The driver for highly geared project structures tended to be competitive pressures for bidders to offer lower unitary charges to the public sector authorities2. However, the high proportion of fixed payments to meet debt service requirements left little flexibility for equity to respond to public sector requirements.
8.4 PF2 will retain private sector disciplines in undertaking a robust approach to whole life project due diligence but will seek to enhance flexibility. This is described further in 8.16 to 8.19 below but it is important to set this in the context of a brief recent history of debt sources for PFI projects and why current market circumstances present an opportunity for new sources of debt and equity investment.
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1 In excess of 90:10 debt to equity.
2 Projects were able to achieve these highly geared ratios due to the contractual payment mechanism (which allowed bidders to form an accurate forecast of project revenues) combined with subcontracting arrangements which pass on performance deductions.