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Industry breaks new ground on finance

SPECIAL REPORT: Funding for construction projects is being squeezed from all sides, threatening the future pipeline of work that the industry needs to sustain itself.

The private finance initiative has become politically toxic, the banks are facing their second crisis in three years and local authority funding cuts are now really starting to be felt.

As new research from Davis Langdon shows, the effects are becoming evident in the industry’s secured order books.

But there are alternative funding mechanisms. These can extend public sector budgets, lower the cost of borrowing or tap new sources entirely.
Some are already being used by forward-thinking contractors, others are new, but all look set to play an increasing role for contractors.

So what are these mechanisms and how should they be used?

The Local Asset Backed Vehicle

 

  • Works well across sectors including social and economic infrastructure and residential;
  • Highly flexible - can be moulded to fit clients’ needs;
  • No public sector cash needed;
  • Can help secure long-term pipeline of construction work;
  • Will only work in regions with stable land values;
  • Procurement can be lengthy;
  • Can tie up cash for long periods so requires strong balance sheet.

 

LABU_diagram


The public sector asset base is estimated to be worth £370 billion, so a lot of thinking around alternative funding has focused on capturing more value from those assets.

The Local Asset Backed Vehicle has become the best known of the asset-based models.

Every LABV is structured differently, but the basic principle involves capturing the underlying increase in the value of assets for capital investment.

This often involves the creation of a special purpose vehicle to which the public body - this could be a local authority, NHS trust or government department - commits certain land or buildings.

The private sector matches that public sector input with a cash contribution.

The SPV then undertakes development work, adding value to the assets involved and profits are split on a 50:50 basis.

Two of the best known examples of LABVs in the UK include the Croydon Urban Regeneration Vehicle - a partnership between John Laing and the London Borough of Croydon - and the Bournemouth Development Company - a Morgan Sindalland Bournemouth Borough Council partnership.

The ‘CCURV’ was among the first major LABV formed in this country and was structured around three council-owned buildings.

The deal was led by developer John Laing, with construction work carried out by Sir Robert McAlpine and Wates under separate contract agreements.

Bournemouth’s LABV takes an ‘investor contractor’ approach in which Morgan Sindall Investments effectively buys work for its construction, housebuilding and fit-out divisions.

The deal captured the industry’s attention, as it offered an encouraging example of how contractors could shore up their order books by creating innovative partnerships.

Showing the way

Morgan Sindall Investments managing director Ernie Battey was instrumental in its creation.

He believes the model will be “an important way forward” as it becomes better understood by both public and private sectors.

“Investment units in most construction groups strategically are looking to produce a much higher percentage of their turnover than in the past,” he says.

Early LABVs often involved lengthy procurement processes - and higher costs - but for Morgan Sindall and Bournemouth the deals were comparatively painless.

While Mr Battey puts this down to the “extraordinary commitment” of Bournemouth councillors, the experience suggests LABVs could lead to much lower procurement costs than PFI.

Mr Battey says: “The procurement costs for Bournemouth were one quarter of what they would be on a large PFI project, and yet in terms of gross domestic value, potentially twice the size of even a large PFI project.”

Morgan Sindall is now looking to capitalise on the success and Mr Battey is “discussing similar opportunities with more than 20 more councils, NHS trusts and a department of state”.

Wates investment director and head of education Stephen Beechey agrees the model will play an increasing role for contractors, predicting “a glut” of LABVs will soon hit the market.

He believes the NHS represents “huge opportunities” for those contractors interested in pursuing the LABV.

Indeed, Watford Borough Council is currently seeking a partner for the £550 million Health Campus LABV, while Portsmouth City Council is also expected to produce an OJEU notice later this year.

Sir Robert McAlpine was named as a preferred bidder by Torbay Development Agency on its LABV earlier this year and Thurrock, Slough and Sutton are all progressing towards similar deals.

And with the summer riots providing a backdrop to regeneration debates at this autumn’s political party conferences, it is expected the Department of Communities and Local Government will add to the momentum.

Note of caution

But LABVs are not without their disadvantages.

The structure of the vehicles can mean contractors’ cash becomes tied up for lengthy periods.

That means only contractors with sufficiently healthy balance sheets can look to capitalise - and even then they must be sure there is no urgent call on their balance sheets in the short to medium term.

Mr Battey accepts the use of the LABV does have an impact on balance sheets and says he is always conscious of investing shareholders’ cash.

“We are expected to use it in the same way to other parts of our group in that we have to aim to supply better than normal returns for using their cash not just internally but better than other alternatives outside.”

Another potential disadvantage can be the length of time a LABV takes to negotiate, with no guarantee of construction work at the end of it.

One developer who did not wish to be named said he was immediately put off the model after advising and negotiating with a council for 18 months, only to find the council’s lawyers insisted the vehicle must be procured through an OJEU notice and his company lost out to a
rival developer.

But Mr Battey counters this view, arguing it is better that the public sector understands the mechanism, despite not always agreeing on the need to tender through OJEU.

He says: “Several councils receiving advice from other sources have not fully understood the degree of flexibility available, nor the range of options that can be pursued.

“We can combine two or three projects at a time and we can integrate across different sectors.

“For example, we could revive BSF projects using the land assets that are available in completely different sectors.

“In my view there is a lack of imagination and there is also a lack of proper in-depth explanation by the private sector of what the public sector might achieve by using LABVs.”

However, one obstacle they cannot overcome is the need for stable land values.

A model based on value capture from assets will only succeed where land values are robust. This makes large swathes of the country - particularly in the Midlands and the North - unviable.

Where the asset base is not an option then local authorities and developers may look to models which focus on income.

Most of these models look to ringfence certain types of local taxes or charges to enable investment in capital works or infrastructure.

The ringfenced tax stream is used to repay borrowings that have been used to finance infrastructure. The best known of these models is tax increment financing.

Tax increment financing

 

  • Good for funding commercial infrastructure;
  • Could unlock long-stalled developments;
  • Particularly effective tool for areas of deprivation;
  • Potential to combine with multiple funding sources;
  • Tried and tested in the US but not available in England until at least 2013;
  • Significant risks may deter private lenders;
  • Unlikely to fund schemes on its own;
  • Unlikely to work for social infrastructure.


Ringfenced_diagram


TIF is widely used in the US and is also being piloted in Scotland. English local authorities will have to wait for the introduction of enabling powers currently tied up in the local government resource review and likely to take effect from 2013.

Under this model, a local authority designates a TIF zone within which business rates can be retained.

These future increases in the business rates are then borrowed against - either by the local authority from public or private funds, or by a developer from private funds.

The most likely route looks set to see local authorities borrowing from the Public Works Loan Board in order to get the cheapest rate.

Where the developer raises the funds then the growth in rates will be diverted to them to repay the finance taken out.

The principal risk associated with TIF is ensuring the tax cashflows arrive quickly and in sufficient volume to repay the investment.

Other payments, including the Community Infrastructure Levy and New Homes Bonus payments, may also be eligible for some TIF schemes.

In reality, most TIF zones will generate insufficient gains to fund a development in its entirety and other forms of funding, such as the Regional Growth Fund and section 106 contributions, will be needed to get schemes off the ground.

But with Regional Growth Fund allocations heavily biased towards the North, this may prove a boon to those looking to capitalise on TIF.

Where traditional forms of government spending are available but in shorter supply, it will be vital to ensure the cost of alternative finance is kept to a minimum.

There are cheaper sources of finance which have not been well utilised, such as pension funds, sovereign wealth funds and infrastructure funds.

One option that allows these sorts of entities to invest in infrastructure is the Regulated Asset Base model.

Regulated Asset Base

 

  • Reduces the cost of capital;
  • Potential to extend use to economic infrastructure;
  • Requires political will to make consumer pay;
  • Potential competition issues.


The RAB is a number which represents past investments in an asset, comprising what investors paid when the asset was originally privatised, plus subsequent capital expenditure adjusted for depreciation.

Once assets are in the RAB there is nothing that can be done to change their value.

The RAB is protected by the requirement which is placed upon regulators to finance the business.

This requirement gives rise to an effective guarantee that the regulated company’s investment will be recovered over time from consumers.

This guarantee contributes towards making investments in regulated utility companies relatively low risk, meaning the cost of financing the RAB should be close to that for financing government borrowing.

Extending the RAB model to assets and sectors which are not currently regulated may create a similarly low-risk structure and a lower cost of capital.

Various civil engineering groups cite waste, roads and transport as sectors which could benefit from an extension of the RAB model.

Any extension depends in large part on political will. While the government has not publicly stated its desire to explore an extension of RAB, many Whitehall watchers believe the infrastructure funding crisis it faces may now make such a move more likely.

Industry leaders convened by the Institute of Civil Engineers at a recent roundtable discussion concluded the RAB was a “UK success story which gives investors the certainty they need to invest capital in renewing and rebuilding existing networks”.

However, the participants agreed the model is not always suitable for large-scale new build projects.

Contractors using these models

Some contractors have already moved to make the most of the models available. Balfour Beatty, Morgan Sindall, Kier, Sir Robert McAlpine and Wates are among those already securing work through the asset-led approach.

The TIF model has yet to materialise but is already a target for many regional players, while the RAB is familiar to those contractors working in the water and energy sectors.

In each case it will be those firms with strong balance sheets and healthy cash reserves that are best placed to innovate.

Mr Battey predicts companies that operate across different sectors, such as Morgan Sindall, will benefit because they can agree the terms on which sister companies are engaged at the earliest stages of negotiation.

But with only a handful of the biggest players able to compete on such terms, it is likely smaller players will look to joint ventures and partnerships to secure local authority deals.

Davis Langdon managing director for Europe John Hicks expects mid-tier players that operate in the £20m-£40m contract range to target the TIF and LABV models as the largest contractors continue to focus on PFI, overseas markets and major projects such as Crossrail and High Speed two.

Consensus suggests no single model will replace the major spending programmes of the past decade or reportedly rich pickings of PFI. But a basket of funding options is on offer and where they can be combined and contractors can innovate, opportunities will emerge.

More details on the Bournemouth Development Company LABV

Luton Borough Council and CBRE propose £77m TIF scheme

 

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