Refinancing of PPP projects after a few years of operation has enabled the private-sector party, and in some cases also the public-sector party, to greatly benefit from the maturing PPP market. A refinancing operation involves a change in the financing structure of the SPV under the contract agreed between the public and private parties. Refinancing gains can result from interest rate reductions, extensions of debt maturity, increases in the amount of debt facilities, etc. They may be due to exogenous factors, like a change in macroeconomic conditions (this was the case, for example, in the US mortgage refinancing wave that brought to the current sub-prime market crisis) or the natural revelation of asymmetric information between borrowers and lenders while the project gradually reaches the mature stage; but they may also be due to a particularly good performance of the borrower.
In the UK, early re-financed PFI contracts mainly benefited the private sector, e.g. the Jarvis case, but the situation has changed overtime. The Public Accounts Committee42 argues that the gains made from refinancing should not be 'wholly attributable' to the private sector for the risk that it is bearing., On the recommendation from the UK authorities, new PFI contracts provide for a 50:50 split in refinancing gains. Private partners 'would not have to share 50% of the gains where, at the time of refinancing, they were projecting a shortfall in returns over the life of the contract compared to their expectations at contract letting'. However, 'there would be a requirement for them to give up more than 50% of the gains if they were earning more than expected'. These clauses are rather generic, though, and may create more problems than they solve. As we also discuss later, costs can sometimes be inflated, so that profits can be manipulated and gain-sharing avoided.
A decision to include provisions in the contract implementing a refinancing gain-sharing scheme should address a trade-off. On the one hand, it may be the case that the private-sector party improves efficiency and performance during the contract life, lowering the risks of the project and hence the cost of capital. Thus, refinancing gains can be seen as a reward for such improvements that should be enjoyed mainly by the private-sector party. In this regard, a refinancing gain-sharing scheme could weaken the incentives for the private-sector party to seek for improvements.
On the other hand, refinancing gains may have an impact on the compensations payable by the public-sector party on early contract termination. In the event of voluntary termination by the public-sector party, the private-sector party is generally compensated for the future profits it would have received had the contract not be terminated. Since refinancing increases both current and future profits, the compensations payable by the public-sector party will be higher if a refinancing occurs. Hence, there is an argument favouring the inclusion of a refinancing gain-sharing scheme: termination liabilities for the public-sector party are lower when refinancing gains are shared during the contract life.
Furthermore, to the extent that refinancing gains are due to exogenous factors, or to lenders perceiving less political and legislative risk as the PPP market matures, some form of refinancing gain-sharing scheme may be appropriate, as the merit cannot be solely attribute to the private sector. However, refinancing clauses tend to be rather generic and may create more problems than they solve.
As we have discussed in the companion paper, it is likely that the private-sector party obtains windfall benefits in refinancing its debt liabilities during the contract life. Since refinancing involves a change in the financing structure of the project, the public-sector party should be informed about any refinancing operation undertaken by the private-sector party. Further, the contract should contain provisions giving the public-sector party the right to approve any refinancing proposal and to share the benefits of refinancing.
The public sector should consider positively any refinancing proposal submitted by the private partner as refinancing is likely to be beneficial for both parties. However, in evaluating a refinancing proposal, the public-sector party should take into account possible negative effects of a refinancing operation, such as an increase in the risks faced by the public sector or in the compensation upon voluntary termination, a reduction in the private sector incentives to perform in later years and a weaker financial stability of the private partner.
The method for calculating and sharing refinancing gains should be specified on case-by-case basis. The benefits for the public sector can of course be materialized in different ways. First, the public sector may choose to receive an amount of money at the time refinancing occurs. Second, the public sector may wish to reduce the tariff or unitary payment received by the private sector over the period following refinancing. Third, the public-sector party may prefer to increase the scope of the service as its share of refinancing gains.
There are cases when a mixture of both a cash payment and a service charge reduction may be appropriate. This is when, for example, refinancing involves gains to be realized at the time refinancing occurs along with gains to be made over a long period of time in the future.
As for the share of refinancing gains that should accrue to the public sector, it should be small when refinancing gains are caused by the private partner's good performance, not to curb incentives to perform; and it should be larger when the refinancing gains origin from exogenous changes like improvements in the macroeconomic condition or the natural reduction of information asymmetries taking place while the project implementation goes on in time.
| Case Study: The Fazakerley Prison (UK) The refinancing of Fazakerley prison in the UK was caused by the successful construction of the prison and the increasing confidence of financial markets towards PFI projects (this can be seen in the decrease in the loan margin from 1.5% to 0.7% showing banks' increased confidence in the PFI market). The contract did not specify the Prison Service was to gain from any refinancing, but the consent of the Service was needed. As compensation for taking an increased risk regarding termination liability, the Prison Service received £1 million from FPSL (the consortium), approximately one fifth of the total re-financing gains. It was suggested that the Service could have received more from the re-financing but "the Service did not wish to deter FPSL or other consortia from bidding in future PFI prison competitions by removing opportunities for them to benefit from this type of project" (NAO,2000, paragraph 1.10). However, there is great uncertainty in the re-financing procedure as the Prison Services termination liability could increase as a consequence of extending the loan repayment period. Source: NAO, (2000) Case Study: London Underground (UK) (Part V) Broadly reflecting PFI precedents in UK, the PPP contracts contained specific provisions for sharing the benefits from refinancing operations. In May 2004, 18 months after Tube Lines was awarded the contract, the company conducted an early refinancing operation that turned out to be very profitable as gains amounted £85 millions over time. The contract provisions entitled the public-sector party to receive 70% of the refinancing gains (i.e. £59 million), leaving the remaining 30% for Tube Lines (i.e. £25 million). The refinancing gain-sharing scheme had a proportion 70:30 that differed from the standard 50:50 recommended by HM Treasury for UK PFI contracts. Sources: see London Underground (Part VII). |
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42 House of Commons Public Accounts Committee, 'PFI Re-financing Update', p.8.