Breaking point

UK PFI deals are seeing increasingly aggressive contract management by the public sector. Is this the only way to get private sector engagement, or is it driving short-term deductions at the cost of long-term value?

Over recent years, a trend has emerged in the UK PFI market for some contracts to be managed increasingly aggressively by public sector managers and their partners. 

It may be argued that this is simply the public sector waking up to years of relaxed management by the private sector, and forcing their partners into action by belatedly demanding a high standard of compliance. However, there are fears that an antagonistic approach will harm the UK’s public sector assets in a number of ways over the long term.

There are concerns in the market that the actions being taken by some of those purportedly with the interests of the public sector at heart, risk not only causing existing contracts to collapse, but to trade the principle of good, long-term asset management in favour of some quick short-term cash. Furthermore, there is a human toll to the activity, with facilities managers on the ground facing a daily barrage that undermines the effective running of public sector properties, resulting in a ‘brain drain’ of talent that threatens the future ability of the public sector to manage its properties over the long term.

At present the issue is with only a small number of projects - perhaps one or two in any given portfolio of 20 or 30 - but the concern is that this is growing, and that as other authorities see deductions racking up, they will be inclined to follow a similar path as a way of reducing overall costs. 

The toxicity of these contracts will make it tough for the UK facilities management (FM) sector in the future. A number of companies have admitted that they now rotate their project managers, because it is simply impossible to allow them to work in such a negative and toxic atmosphere for more than six months or a year at a time. 

“The attacks that the people on the ground in these contracts are facing are unbearable,” says one advisor. “Some managers are getting 200 emails per day just on these issues - that is not fair on a human level.

“The approach is to batter people down financially and spiritually, and then ask to do a deal that will make them go away.”

FM providers are feeling under pressure to deliver far more than they are able. Examples include some dirty ceiling tiles, where the private partner had not logged them and so the public sector claimed the room to be ‘unavailable’ since the beginning of the contract; or a small pile of leaves that was penalised even though it was not in fact causing any obstruction. 

Bruce Dalgleish, co-founder of consultancy P2G, which has worked with many authorities and private partners on issues of non-compliance, says that his firm tends to work collaboratively and suggests these examples are not the sort of thing that his team would normally focus on. “We do not make points about the minutiae,” he says.

However, where this is occurring, FM providers and managers warn that issues can quickly multiply. The tactics of some are also at issue, with stories of issues being saved up, only to be sent to the helpdesk or FM manager late on a Friday, knowing that by the time they are dealt with the following Monday, they will be in breach and therefore deductions can be imposed.

“This is not how the contracts were ever intended to be run,” says one lawyer who works with both public and private sector clients on PFI deals. “I am not denying that there are some problem contracts that need to be fixed,” the lawyer admits, “but there are also contracts that are being turned into problem projects that don’t need to be.”

“We are in the middle of a health crisis and people are putting pressure on the supply chain,” bemoans one asset manager, referring to issues being faced on a hospital project.

At least one major FM provider is known to have stopped negotiating any variations on its PFI contracts as a response to the overly adversarial and contractual nature of the relationship in some deals. 

Unsurprisingly, this approach is also driving people out of the FM sector.

“A lot of people are leaving the industry and then it becomes harder to solve the issues because you are losing the experienced people,” says one investor. “It is also harder to recruit, because people don’t want to be in a position where the other side is deliberately treating them irresponsibly and taking advantage of them.”

This means the public sector is storing up problems for when these projects are handed back into public ownership, as the quality of the workforce will not be there to take projects forward. “Who would want to be TUPE’d into an organisation that has spent the last few years constantly berating your work?” asks one asset manager. 

“We are haemorrhaging people from this industry,” concludes one lawyer. 

Another issue will be how the private sector, including investors, view public sector assets in the future. For one, ratings agencies have already cut the ratings on a number of deals in the face of mounting deductions and wider contract management issues.

“It is not a big number of projects, but in terms of the time for both us and the public sector, and the wider market impacts, it is significant,” argues one asset manager. “For example, the downgrades don’t make much difference to the individual projects, but they send a message out which makes funders nervous, so it is harder to convince them when considering new projects, and they will also charge higher fees on those new projects.”

Experts also argue that while the approach may make public sector organisations some money in the short term, it will end up costing more over the life of the contract. The concern is that the private partner will stick to the letter of the contract at handback, meaning the public owners will get the asset they contracted for, but not necessarily an asset that is fit for the 2020s or 2030s.

Adversarial or tackling non-compliance?

Is the talk of “unscrupulous” behaviour and advisors  “decimating relationships” simply the whingeing of the private sector, upset at being unable to simply cream profits off their PFI deals while doing the minimum of work? 

One source suggests such complaints are hard to swallow when private partners have been happy to take the annual repayments without doing the full work to uncover and deal with underlying problems.

However, there is a feeling from some in the sector that they are being targeted in a way that makes it almost impossible for them to successfully deliver the contract, with a belief growing among some private sector parties that the ultimate aim is to claw back cash, rather than focus on successful project delivery. 

“There is nothing wrong with following the letter of the contract,” says one PPP portfolio manager. “From the equity point of view, we are aligned with the public sector in wanting the subcontractors to be following the contract. However, some approaches lead to behaviours that do not result in better services, outcomes and partnerships.”

As one investor puts it: “We know that if we were to challenge these in court, we would more than likely win, but going to court adds significant costs to both sides - and it is at that point that the public sector will get to the real reason it has been causing all these problems, by suggesting that we sit down and agree to give some savings to the public sector instead of spending that money on a legal fight.

“It would be far more constructive to have that conversation first, rather than get to the point where the SPV is on the verge of collapse and going into default or a dispute are the only other options.”

The lawyer agrees, but also points out that the way in which many contracts were drafted means they can be interpreted in an overly strict way. For example, a contract specifying that walls will be “free from scuffs and marks” means that any scuffs or marks, found at any time in the contract, day or night, and no matter how recent or incidental, could be considered a breach.

Some may argue that this is then the fault of the lawyers who originally drafted the contracts, and that the public sector is merely taking advantage of clauses that put them in a strong position to claim some money back. However, most in the market agree that such interpretations of the contracts were never envisaged by those creating and signing them.

This issue has been seen across the UK PFI space over recent years, but it has become, as one lawyer puts it “pretty endemic” in the health sector. Part of the reason for this is the decision by the Department of Health when first establishing PFI deals, to link the annual repayments to RPI inflation. 

This has resulted in contracts becoming an increasing burden on trusts’ finances. When many of these deals were signed, it was assumed spending on public sector services would continue to rise at the very least in line with inflation. However, the 2008 global financial crisis, followed by a decade of austerity imposed by the coalition and then Conservative administrations, has meant that annual PFI repayments have continued to rise while budgets have shrunk. This has resulted in PFI contracts taking up ever-increasing portions of each NHS trust’s pie, putting more and more pressure on them to find ways to cut costs.

Many in the market argue that a practical solution to this problem could - and still should - be found. However, they suggest that instead, the Department for Health & Social Care (DHSC) has taken an approach to create savings in these deals by forcing a series of deductions via overly strict interpretations of the contracts.

“There are people in the DHSC who don’t like PFI for political reasons and are happy to see deals fall over,” argues one asset manager.

“[One of these advisors] is so embedded in one of our projects that they are the people we are negotiating with rather than the trust,” says another. “They are effectively in control.”

One investor reports that his portfolio currently has huge claims that are multiples of the original equity that can’t be passed through to the FM provider. “We have to go into a standstill period where we are relying on the public partner paying the SPV month-to-month. 

They are ignoring how the contracts were constructed in the first place, and simply want to pay a discounted price, and are doing that by forcing deductions.”

However, Dalgleish argues that such financial concerns ignore the many years prior to the issue being raised when the private partner was being paid annual sums to maintain and manage the asset. “In our experience, SPV cashflow issues typically arise as a result of a failure to effectively manage sub-contractors, inaccurate reporting of the issues under the payment mechanism and a lack of engagement to rectify faults until the consequences of those faults have risen to a significant value (often exceeding sub-contractor caps on liability,” he explains.

Dalgleish says his company does not take an adversarial approach when working on contracts to ensure compliance - adding that in the majority of cases the public and private parties are able to work on issues collaboratively.

However, he says that the level of non-compliance among the private sector is “huge”. He explains: “Traditionally what has been done has been a visual, non-intrusive assessment when carrying out condition surveys,” but this won’t always show up some of the underlying problems with a building and therefore a more proactive approach is needed. “We have spent the last two years developing a scope for compliance surveys, working collaboratively with the private sector.”

Dalgleish points to examples of serious non-compliance - such as a failure to maintain fire-stopping facilities in a hospital - and suggests this is the kind of problem that P2G is working to tackle.

“When you see some of the things that are picked up by advisors, you can see it is not acceptable for the private sector to be doing this,” adds one source who has worked both on the private and public sector sides. “However, some public authorities don’t have the internal resources to manage their advisors and so it can sometimes get out of control, and the element of partnership can be lost.

“The authority needs to make sure there is a settlement to give the private sector the time to fix issues, rather than ratcheting up deductions.”

Having been on boards of SPVs, the source understands “the games that equity investors and public sector representatives can play”.

“There is a time when it is appropriate to use a more aggressive approach, as in some cases it is talking the language of the private partner,” suggests Tim Care, partner at Ward Haddaway. 

“The public sector is being challenged more as to why it is not challenging its private partner: it needs a good reason for not following through on issues.”

However, he and others agree that there is a balance to be struck: “It should be about the beneficiary [ie the patient/pupil in the hospital/school] seeing an improved service.”

“You don’t have to go through lawyers and a dispute to show that you are an ‘effective’ contracting authority,” says one expert who has worked for both the public and private sectors. “It is right that the parties in a contract are held to account, but there are ways and means of doing that.”

“We don’t claim that everything is perfect,” admits one asset manager. He points out that all managers will have people on their SPV boards who are legally tasked to make sure projects are being undertaken properly. “If a client has a genuine concern about compliance, we take that extremely seriously and we would be proactive in ensuring services are as compliant as they can be.”

The issue in a number of projects where consultants have been brought in is that these schemes had been performing with little or no concerns previously being raised. For example, ratings agency Moody’s last year downgraded two hospital projects - Tameside and Salford - because of a rise in problems and deductions. In its rationale, Moody’s expressly referred to the change in the nature of the relationship since P2G had been involved.

While that might mean that the public sector had not been properly monitoring its contract, one investor says such a situation makes everyone on a deal “suspicious” as to the motives of those coming in.

“It is important to try to understand why they have been brought in,” he says. “One of our first conversations when that happens is to question what it will do to the relationship.”

Dalgleish, however, has another perspective: “When we are engaged as advisors on a project, the public sector is spending money on us. It is unlikely that they would do that if everything is going well.”