25.5.1 Where there is the potential for alternative use, and hence alternative users of the Service or any Assets, there may be scope for the Contract to include provisions that transfer some residual value risk to the Contractor.9 It is crucial that this issue is dealt with as part of the competitive bidding process if it is to deliver real value.
25.5.2 There are a number of issues for an Authority to consider. First, is it likely to require long-term use of the Assets? If so, it is unlikely to derive best value from transferring residual value risk. Second, if the Authority has no clear long-term requirement for the Assets, is it possible for the Authority to pass on any residual value risk to the Contractor? Third, will transfer of residual value risk provide value for money? Finally how will transfer of residual value impact on any payment on termination on expiry of the Contract?
25.5.3 It will not be possible in all cases to leave the residual value risk of the Assets with the Contractor, even if there is some potential for alternative use. The difficulty of estimating value and the required length of the initial Contract may make it uneconomic for the Contractor to estimate the residual value of the Asset at anything other than an insignificant amount. In such circumstances, financiers10 are unlikely to accept being exposed to significant residual value risk. It will in such circumstances generally not represent value for money for the Authority to transfer this risk as the Contractor will expect to obtain its return over the life of the Contract.
25.5.4 If transfer of residual value risk will enhance value for money, the Authority can pay a Unitary Charge which does not enable the Contractor to cover the complete cost of financing its investment through the service payments it receives during the Contract. The Contractor instead has to rely on value being left in the Assets remaining on the Expiry Date to recover all such cost. This leaves some real risk with the Contractor in relation to the residual value at the end of the Contract. Where this is the case it will be possible to have a shorter Contract length (see Section 3 (Duration of Contract)). When residual value is to be transferred, an appropriate leasehold (or freehold) structure should be used and the definition of Assets amended accordingly. Authorities should also consider Residual Value Risk when setting any capital expenditure contribution limits or liabilities (for example on a Qualifying Change of Law, see Section 16.6) (Allocation of risk on Change of Law).
25.5.5 The options exercisable by the Authority on the Expiry Date in relation to Assets with an alternative use where the Contractor is taking the residual value risk are:
• to take over the Asset, in which case a payment should be made to the Contractor (see Section 25.6 (Valuation of Terminal Payments on Expiry where Residual Value Risk has been Transferred));
• to re-tender the Service, in which case the successful Contractor in the re-tendering exercise should make a payment to the previous Contractor reflecting the value of the Assets (see Section 25.6 (Valuation of Terminal Payments on Expiry where Residual Value Risk has been Transferred)); or
• if the Authority has no further use for the Assets, to walk away at no further cost, leaving the Contractor to realise their value.
25.5.6 Each of these options affords the Contractor the ability to realise the value of the Assets upon expiry of the Contract, and accordingly the NPV of the total Unitary Charges payable under the Contract should be lower than if the Residual Value Risk had been retained (subject, of course, to there having been a well run competition).
25.5.7 Residual value projects require very careful structuring. In addition to financial and legal advice, Authorities should seek early guidance from their Private Finance Unit on such schemes. In addition to value for money, balance sheet, termination payment and other derogation issues, the relevant property and security interests would need attention. Commonly in such Projects, the Contractor would assume a certain residual value for the relevant asset at the end of the Project term (which would be bid as part of the tendering process and appear in the bidder's financial model) and, in the light of this, the amount of Unitary Charge bid by the bidder would be reduced. Authorities must however be clear as to:
• who is taking the residual value risk in the Project (i.e. the risk of the actual value of the asset being greater or less than the assumed value either at expiry of the Term or on early termination in any of the early termination scenarios);
• how this may impact the balance of risk and incentive in the project;
• how this is best and most securely structured (in terms of property interests and options and possible value sharing arrangements);11 and
• the precise basis on which the residual value is valued at expiry or termination.12
25.5.8 On a facilities Project (where the assumption is that the underlying value of land will go up) Authorities will want to ensure that they have a proper interest in increased land values. For instance, In housing projects there is commonly some overage provision (for the Authority to share in gains) and an option for the Authority to buy back the property at the end of the PF2 contract at market value. The overage will constitute a share of the amount by which the actual or estimated market value exceeds the originally assumed Residual Value. Where the Authority itself buys the property, the overage will be deducted from its purchase price. Care needs to be taken in assessing amounts payable to the senior lenders in various circumstances. For instance, if they were wholly relying on the residual value to repay their debt, on expiry or early termination, then the Authority would pay no additional compensation to them (and the lenders would receive either the market value of the houses, where the Authority bought them, or the houses themselves where the Authority did not buy them). Residual value provisions may also impact on other provisions in the PF2 Contract. For instance, where the Contractor is to take the benefit of the residual value the Authority may wish to decrease its liability for capital costs of a general change of law where the change of law happens towards the end of the PF2 contract term (because the benefit of the capital works will largely flow to the Contractor).
25.5.9 On an equipment Project (where the assumption is that the value of equipment will go down) Authorities may again want to ensure access to the equipment at a value for money price should they continue to need it at expiry or early termination of the Contract.
25.5.10 On the Department of Health LIFT programme13 the LIFT companies bought the properties at the start of the Contract and took the residual value risk on them. Public sector gain sharing provisions applied on disposal of surplus property, and the public sector had to pay open market rates if it wanted continued use of the properties at the end of the term.
25.5.11 Suitable drafting (where residual value risk has been transferred) is as follows:
25.5 Assets with an Alternative Use
(a) On or before the date falling [six] months14 before the Expiry Date, the Authority shall notify the Contractor in writing whether it wishes to:15
(i) purchase the Assets by paying to the Contractor an amount equal to the Terminal Payment;
(ii) retender the provision of the Service;16 or
(iii) do neither (i) nor (ii) above.
(b) If no notice is given under paragraph (a) above, then the Authority shall be deemed to have exercised its option under paragraph (a)(iii) and the Assets shall remain with the Contractor.
(c) If the Authority wishes to exercise its option under paragraph (a)(i) above, then:
(i) the Contractor and the Authority shall do all necessary acts (including entering into any contracts) to ensure that on the Expiry Date, the Assets are transferred to the Authority;
(ii) Within [30] days of effective transfer of ownership of the Assets to the Authority, the Authority shall pay to the Contractor the Terminal Payment.17
(d) If the Authority wishes to exercise its option under paragraph (a)(ii) above, then:18
(i) it shall carry out the retendering with the aim of entering into a new contract with a successor contractor to provide the Service on and from the Expiry Date;19
(ii) a condition of any retendering shall be that the successor contractor must pay the Contractor the Terminal Payment on transfer of ownership of the Assets to the successor contractor; and
(iv) the Contractor and the Authority shall do all necessary acts (including entering into any Contracts) to ensure that ownership of the Assets is transferred to the successor contractor with effect on and from the Expiry Date.
25.5.8 The Contract will also need to take account of Assets retained by the Contractor in the various scenarios where the Contact may be terminated prior to its expiry date. See Section 24.6 (Retention of Assets by Contractor on Termination).
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9 See for instance the social housing sector and see Section 4.3 (Property Purchase and Disposal and Residual Value).
10 Senior Debt is usually profiled to be repaid in advance of the Expiry Date. This may not however be the case on a corporately financed housing project.
11 See Section 4.3 above.
12 Any definition of Market Value used should be as precise as possible to avoid future disputes. See footnote 5 above. See generally Section 25.5 (Transfer of Residual Value Risk).
13 See standard LIFT documents on the Community Health Partnerships, Department of Health website: www.communityhealthpartnerships.co.uk
14 The precise wording will depend on the specific circumstances. This wording assumes that effective ownership of the Assets is already with the Contractor and that, if the Authority wishes to continue to use the Assets, the Authority will need to make a payment or hold a new tender competition. If the Authority already owns part or all of the Asset (or will do so at the end of the Contract) these provisions would need amending accordingly.
15 Any relevant procurement implications should be taken into account. To the extent option (a)(ii) is likely, the process may have to start earlier.
16 The Authority will also need an option to purchase the Assets to allow any new Contractor to provide the Service.
17 This Clause should not be used and no payment should be made by the Authority if the Contractor did not accept any residual value risk during the term of the Contract so that the Authority paid a Unitary Charge which was capable of providing the Contractor with sufficient funds to fully amortise its capital debt and equity in accordance with its base case financial model. The meaning of "Terminal Payment" is explained in Section 25.6.1.
18 If the incumbent Contractor wins a retender then it should still be entitled to receive a Terminal Payment, reflecting the market value of the Assets unless such value has been included within the incumbent Contractor's tender price.
19 Any retendering would have to follow any applicable procurement rules.