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PF2 unlocked: Is private finance set for a revival?

After several false dawns, PF2 is back in the spotlight following a largely overlooked mention in the last Autumn Statement. But will a pipeline actually materialise and what appetite is there among contractors?

In the 2016 Autumn Statement, the government committed to publishing a new list of PF2 projects “early in 2017”.

That list has yet to be published, but with the chancellor attempting to plug a £2bn gap in the public finances following the National Insurance tax hike u-turn, private finance is under the spotlight once again as a possible funding solution for critical infrastructure.

The PF2 initiative presents a number of ironies. For all his wearing of hard hats and talk about encouraging pension funds to invest in UK infrastructure, Philip Hammond’s predecessor George Osborne did not deliver many new privately financed projects or that much new capital to invest in them.

While the PF2 model was created to much fanfare, only six PF2-badged projects were launched under his six-year tenure: five ‘batches’ under the Priority Schools Building Programme, and the Midland Metropolitan Hospital in Smethwick.

Despite occasional promises of more to come, the pipeline had dried up by the time Mr Osborne was sacked by Theresa May.

Quietly revived

There was no such fanfare when Mr Hammond buried the announcement in his autumn statement last November of a new pipeline of PF2 projects. Yet this line, unmentioned in his speech, attracted serious interest from industry.

It’s particularly ironic given that during his four years at first the Department for Transport and then the Ministry of Defence – traditionally active users of PFI deals – Mr Hammond launched no private finance projects.

So has there been a switch in attitude in the corridors of Whitehall towards PPP?

CREDIT Foreign and Commonwealth Office_Philip Hammond_North Atlantic Council meeting 2014

Philip Hammond construction private finance 2

Source: Foreign and Commonwealth Office

Philip Hammond buried a PF2 announcement in November’s Autumn Statement

Although it’s tempting to see the change of government last year as the cause of this turnaround, sources agree that a PF2 pipeline was already being considered in the last days of David Cameron and George Osborne, and could have been unveiled by them before it was overshadowed by the EU referendum.

In any case, the mood music seems more upbeat now.

Mark Elsey, head of infrastructure at law firm Ashurst, says: “My understanding is that there is now much more of a push from the Treasury to force departments actively to consider what can be done through a privately financed model.”

He adds: “It is unlikely that this alone is going to result in a large short-term pipeline, but I am hopeful that we will see more of a pipeline emerging over the next 12-18 months.”

Banking on talent

A further sign that government was committed to resurrecting PF2 came last November, when the Treasury appointed Matthew Vickerstaff as deputy chief executive of the Infrastructure and Projects Authority (merged from what was Infrastructure UK and the Major Projects Authority). He was also made head of project finance, a newly minted job role in government.

Mr Vickerstaff was global head of infrastructure at Societe Generale, France’s third-largest bank, from 2005 to 2012, during which time it became one of the top five western infrastructure finance banks by lending volume.

A source in the banking sector tells CN that not one deal his team financed ended up making a loss for the bank, despite these high levels of activity.

But it’s not just Mr Vickerstaff’s lending record that impresses. “I think he could be very good, excellent,” says Skanska Infrastructure Development executive vice president of project development Simon Beauchamp.

“There is now much more of a push from the Treasury to force departments actively to consider what can be done through a privately financed model”

Mark Elsey, Ashurst

Banking sources agree, describing him as highly intelligent, capable and persuasive. “A really great negotiator, a great mentor,” says one, adding that even when they were at different banks “he saw me as a collaborator”.

It sounds like a far cry from the early part of this decade when Geoffrey Spence was at the helm of Infrastructure UK, and told project finance professionals that bank finance had dried up.

Having spent the same period proving that some banks are still happy to lend to PPPs, Mr Vickerstaff looks set to be a breath of fresh air. Since the start of 2017, Mr Vickerstaff and his colleagues have begun to drop hints about the new projects to be expected.

Healthcare looks set to make a comeback with two or three new primary care centres and possibly some acute hospitals. New schools are also expected, with several sources raising the possibility of roads and prisons being delivered through PF2 as well.

In 2016, the Ministry of Justice promised to spend £1.3bn creating up to 10,000 prison places through new-build projects.

Carillion_Midlands Metropolitan Hospital CGI

Carillion_Midlands Metropolitan Hospital CGI

Midlands Metropolitan Hospital was one of just six private finance projects launched by George Osborne

Defence could be the biggest source of deals after the Better Defence Estates report last year identified a possible £2bn of capital investment that was being assessed for PF2 out of a £4bn budget, although some of this could be funded through granting development rights instead.

Contractors will have to wait a while before any procurement begins, however: at the time of writing, no specific projects had been pre-announced to industry, indicating that government is still months if not over a year away from market approach.

Look before you bid

But just how keen are contractors on more PF2 projects?

Galliford Try managing director of investments Mark Baxter describes the deals as “very attractive”, but is quick to add a caveat.

“We’ll look at the risk profile of individual projects; we’ll look at the cost to bid for them, both external and internal; and we’ll look at what else the different regional offices have on in pipeline terms at the same time.

“So it might be a really attractive project to us, but we just happen unfortunately to have another attractive project in the same office. You have to be very careful with these projects that you don’t have an 80 per cent go at them… When we go for one, we will put the best team up and we will absolutely go for it.”

Balfour Beatty chief executive Leo Quinn told Construction News this month that the group would also look at the pipeline of PF2 projects.

“We are really keen and mobilised to make the most of these opportunities,” he said. “We are the largest infrastructure fund in the UK with £1.2bn of assets, and we are keen to build on that and we are going to actively participate in [PF2] when we know [the detail].”

The increased time and cost associated with bidding for a PF2 project – where every bidder tends to hire financial, legal and technical advisers – make indiscriminate bidding prohibitive.

Galliford Try secured a £103m contract in March 2015 as contractor for the PSBP North-east batch, and invested 45 per cent of the PF2 project’s equity.

“I think they’ll be a lot of interest in [PF2 projects], provided that there’s a pipeline”

Simon Beauchamp, Skanska

The schools are now operational and earning revenues, which Mr Baxter says are in line with the firm’s projected returns: “They’ve done what we expected them to do – no better, no worse; in today’s [project finance] market no better / no worse is good. That’s what we want.”

Mr Baxter puts social infrastructure like schools, healthcare facilities, prison and accommodation on his wish list. He is comfortable with “simple roads”, but cautions about the risk profile and how it is determined by issues like utility diversions and river crossings. “From an investor point of view I’m fine with roads projects; from a contractor-investor point of view they are more risky than accommodation projects, and those projects are better suited in my opinion for PF2.”

Skanska’s Mr Beauchamp is equally keen for PF2: “Clearly we’re very interested. They’re part of our core business. We’ve got a long track record in the sector. We feel that we’ve got the skills to do them.”

He acknowledges that Skanska did not bid for any PF2 projects last time around, but says this was not because they were “bad” projects. “They weren’t right for us at the time. We had a close look at Midland Metropolitan Hospital and decided not to bid for it… you take a look at the project and our likelihood for success and decided it wasn’t one for us.”

Generic-education-schools-classroom-resized

Generic-education-schools-classroom-resized

Education has been a particular area of focus amid discussions on private finance

Mr Beauchamp expects to see healthy competition from his rivals: “I think they’ll be a lot of interest in them, provided that there’s a pipeline. I think that’s the key thing the market is looking for. It’s one thing to come out with a couple of projects, but that’s not going to get the market interested.”

Balance sheet ballet

The Treasury has been reviewing the structure of PF2 projects – the standardised documentation is currently under review – and there is already speculation that some of the changes introduced by PF2 may go back to the drawing board.

One priority will be making sure that projects are off-balance sheet to avoid contributing to public sector debt.

In 2014, the UK adopted the latest set of accounting rules drawn up by EU statistical authority Eurostat, which made it harder for public authorities to keep PPP investments off-balance sheet. This is thought to have led to the Treasury rowing back on its plans to invest stakes of up to just under 50 per cent in the equity of PF2 projects. In the end, it took no more than 10 per cent stakes in all but one of the six deals, a trend that looks likely to continue.

For the same reason, the amendments may need to curb the amount of refinancing gain (the increased rate of equity return due to cheaper borrowing costs) taken by the public authority when the debt on a PF2 project is refinanced. This should increase the potential returns that contractors investing in PF2 equity can make.

On the wish list

Not all the innovations of PF2 have been unwelcome, however. In contrast to the Building Schools for the Future programme that preceded it, the PSBP projects used standardised designs and centralised procurement, with no variations permitted after financial close.

“It’s been a tremendously successful project,” Mr Baxter says of his firm’s PSBP batch. “And the reason it’s been successful is that the client knew what they wanted and was unequivocal about the designs and no changes were allowed, full stop.”

He adds: “My gut feeling is that the success of the PSBP schools will naturally lead the government to say, ‘Let’s take as many elements of that procurement as possible’.”

He also speaks highly of the ‘bootcamp’ used during PSBP procurement, where each bidder and its advisory team would spend a week in back-to-back meetings with the client and go through their tenders, flagging up issues and then allowing the bidder to amend their submissions in real time.

“If you want a larger infrastructure programme, either the government bites the bullet and accepts that it is going to have a bigger budget deficit or, wherever possible, deals are structured on an off-balance sheet basis”

Mark Elsey, Ashurst

“The quality of the output’s much better, because you’re sitting there discussing the mark-ups,” Mr Baxter comments. “I’d be a fan of that being a feature again.”

In last year’s Autumn Statement, Mr Hammond said government was “working with industry to understand the demand for construction-only guarantees” in light of the UK Guarantees scheme that provides cover for loans and bonds financing infrastructure projects.

As of yet, no details have been published. In theory, bidders on PF2 projects could ask for such a guarantee, though it is questionable whether they would want one: contractors and their lenders have been broadly happy with the risk profile of PFI and PF2 projects until now.

Sources tend to agree, however, that if construction guarantees do appear, they will serve a strategic purpose for government in attracting additional, risk-averse investors rather than helping contractors.

“I don’t think it would change our thinking much on the contracting side,” Mr Beauchamp says. “From an investment side, I guess if it does open up new avenues of financing, a new type of investor, then that should help with the project affordability and delivery.”

Mr Baxter agrees, saying that if the guarantee simply means the government will ensure payment of lenders if the contractor goes bust, “it’s pretty irrelevant for me and my peer group”, though not so irrelevant for mid-sized contractors who have failed to break into any of the PF2 deals so far.

With market appetite seemingly assured, the only question is whether a climate of austerity will choke off the pipeline too soon.

“If you want a larger infrastructure programme,” Ashurst’s Mr Elsey says, “either the government bites the bullet and accepts that it is going to have a bigger budget deficit or, wherever possible, deals are structured on an off-balance sheet basis.”

With Brexit looming, however, there is an argument that government must be seen to invest to help reassure business and ride out any economic shock waves. It is an argument that has already been deployed to reiterate the case for High Speed 2, and in the face of rising demand for school places and hospital beds, one that will be hard to ignore.

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