Contract termination requires significant upfront funding

2.18 Most departments told us that they would be interested in buying out their PFI deals, but this requires upfront funding and is rare.52 PFI deals that were financed with bank debt use financial instruments called interest rate swaps. These replace a variable interest rate with one that fixes the interest rate for the life of the contract. Fixing interest rates provides cost certainty for public bodies as it means the unitary charge will not increase if interest rates increase. Most PFI deals were agreed before 2008 when interest rates were significantly higher than currently. As interest rates have fallen, these swaps have become 'out of the money' for the SPV, so any public body wishing to terminate a PFI deal would need to cover the cost of the swap breakage fee.53 Our analysis of the largest PFI deals shows swaps would cost more than £2 billion to break, on average an additional 23% on top of the outstanding debt of these deals.54 The SPV equity investors would also need to be bought out, and in most cases this would require a compensation payment (Figure 12).

2.19 Over 10 years ago, HM Treasury recognised the risk that interest rate swaps could make terminating PFI deals difficult.55 However, public bodies had little option but to agree to PFI contracts that used interest rate swaps. Public bodies and the PFI companies didn't want to be exposed to interest rate movements. HM Treasury was not willing to provide protection against future interest rate movements.

2.20 Although terminating deals requires significant upfront funding it has been done in the past. For example, Transport for London (TfL) terminated three deals achieving reported savings of £476 million, which are some of the largest that have been recorded.56 These deals included break clauses that could be applied part way through the contracts and helped reduce the cost of the termination. Most PFI deals do not include these break clauses. In 2014 Northumbria Healthcare NHS Foundation Trust bought out a PFI hospital deal. IPA told us that they have significant doubts about the value for money of the Northumbria PFI termination. Both of these organisations have borrowing powers that government departments do not have.

The compensation calculations are complex and will vary from project to project

Upon public sector default or voluntary early termination, Private Finance Initiative (PFI) and Private Finance 2 (PF2) contracts provide detail of the compensation for investors. The standard contract form guidance used since 2004 requires compensation for:

Debt holders

• the amount of debt outstanding; plus

• the cost of terminating hedging arrangements (such as interest swaps) in the case of bank financed deals or in the case of bond financed deals a premium to allow investors to get a similar return from investing in another bond (known as the 'Spens clause').

Equity investors

The level of compensation to be paid to equity investors (including equity provided in the form of shareholder loans) will depend on the calculation chosen by the investors when the deal was initially agreed. This will be one of the following:

• the return expected at the start of the contract compared to actual return so far. If the investors have already achieved the return there will be no compensation required; or

• the expected return for the remaining part of the contract; or

• the market value of the equity and shareholder loans - assessed as if the contract was to continue to run.

Other considerations

Any cash held by the Special Purpose Vehicle (SPV) will be netted off these amounts.

If there are redundancy payments these will also need to be paid.

Arrangements may need to be made to replace services provided under the contract with new suppliers or in-house provision.

As the PFI structure relies on debt more than equity the cash amount required to pay off debt holders is likely to be higher than the amount required to buy the equity. Another option for the public sector wanting to gain full control of a project, but requiring less cash up-front, would be to buy the equity. The public sector could then decide to refinance the debt at a later date if appropriate. This would likely require negotiation with the equity holders as the investors would be under no obligation to sell.

Note

1 The compensation payments set out above are those included in the standard contract form guidance in issue since 2004 (SOPC 3). Earlier PFI deals may have different arrangements for compensation and contracts can depart from the standard form. It is therefore not possible to know the terms and conditions of compensation on termination unless the underlying contract is reviewed.

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52 A total of 9 out of 10 departments that provided a response to the question said they would be interested in buying out PFI deals if funding was available and it provided value for money in the long term.

53 Lower interest rates also mean that bond-financed deals would need to compensate bond holders at a premium to the outstanding value of the debt under the 'Spens clause'. Also see National Audit Office, HM Treasury, The choice of finance for capital investment, March 2015.

54 As part of this study we reviewed SPV accounts (years ending December 2015 and March 2016) of the 75 largest PFI deals by capital value. These 75 SPVs represent approximately half of the capital value and half the unitary charge payments of all operational PFI deals. A total of 33 disclosed the use of interest rate swaps. These 33 projects had total outstanding debt of £10.0 billion and swaps that were £2.3 billion out of the money.

55 HM Treasury, Application Note: Interest Rate and Inflation Risks in PFI Contracts, May 2006.

56 Comptroller and Auditor General, Savings from operational PFI contracts, Session 2012-13, HC 969, National Audit Office, November 2013, Figure 7 and paragraph 4.7.