Future financing: the developing market for project capital

In the last two years we have seen the first bundled projects and a significant increase in the number of projects funded by bonds. Mike Matheou, a Partner in Lovells' Project Finance Unit, examines the potential for future developments in the fina

Put at its simplest, there is really only one driver behind all developments in PFI funding: to optimise the effect of the cost of finance on the ultimate cost of the scheme, in a manner which is deliverable in a reasonable time frame. If that is achieved when a bid is submitted, the bidding team improves its chances of success, and if it is done after the PFI contract is underway more efficient financing produces returns for the sponsors. Any developments in the approach to funding of PFI schemes will be driven by these simple principles.

Current thinking

Before looking at how the financing of PFI projects might develop, it is worthwhile summarising the themes dominating PFI funding structures at the current time, and briefly summarising how the market has got to where it is. Writing an article 2 years ago on the future of bond financing would have been far more straightforward than I find it now. Until 1998, the use of anything other than straightforward tranches of senior debt for funding PFI projects had been rare. The Road Management Group consolidated project and the Carlisle and Greenwich Healthcare deals would have been the only significant UK projects to use bond products. The potential advantage of the bond route (lower cost of funds and longer tenors) were well appreciated, but the market had not come to terms with perceived difficulties of a bond structure; being how to manage construction risk, increased paperwork, relative lack of flexibility and the negative carry on bond proceeds during the construction phase.

Since that point, the use of project bonds has grown remarkably. In 1998, bond financing accounted for only 10% of finance raised for PFI deals. By 1999, this figure had increased to 25% (and 31% if the Tay Water private placement deal is included in the figures). Already in the first half of this year, a number of significant bond transactions (including the Treasury Government Offices at Great George Street) have reached the market. A number of factors combined to result in this increased use of bond financing. From my perspective, the key developments have been the following:

  • deliverability: bond financing still comes with considerable baggage, but such a number of deals have been successfully brought to the market, each with an ever reducing timescale, that my sense is that there is now no prejudice against bond financing from a deliverability perspective
  • flexibility: the bond market can now offer more than the rigid, one-off bullet draw down structure that was on offer as little as two years ago. The ability to issue and drawdown bonds in tranches and the availability of add-on variation bonds to deal with contract changes have all made the structure easier to match to the funding requirements of a PFI deal.
  • re-financing: it is still probably fair to say that bond structured deals are more difficult to re-finance than those financed by senior debt. However, this may not be significant if there is little or no commercial scope for re-financing: replacing the existing project funds with new funds which have a lower margin and less stringent covenants enables either a stream of payments to be released to shareholders or the raising of a larger level of funds. Some of these funds can be released as a lump sum to sponsors, but how far this will be possible in respect of deals done in the present competitive circumstances must be the subject of some speculation. Repeating the recent re-financing of the Fazakerley prison scheme where Carillion/Group 4 sponsors' returns jumped from 16% to 39% may not be possible in the future, so the difficulty of refinancing a bond becomes less material.

    So, today bond finance increasingly represents an acceptable face of PFI funding. As one would expect, the banks have not stood idly by as the bond market has taken an increasing share of the overall funding requirements for PFI. Banks (particularly some European banks and the former building societies) are pushing out tenor and responding on margin so as to be able to compete with bond financing on level terms.

    Against that background, what are the likely developments over the next two or so years?

    Going forward

    The relationship between public and private sectors in the development of project and funding structures for PFI deals is largely symbiotic: financiers have sought to develop funding structures which meet the requirements of the public sector client; the index-linked bond is a good example of this. In the same way, the public sector has taken account of funders requirements when structuring schemes. To be bankable, a PFI project must demonstrate certain fundamental characteristics. Recognition and development of both these principles will be the driving force behind new and innovative developments.

    Responding to financing parameters

    The greatest challenge facing the public sector in making a success of the Private Finance Initiative going forward is to make the initiative work for smaller, lower value projects. Interestingly, this challenge is not facing the UK alone. Recently the World Bank laid down a challenge for the international financial community to make project finance more accessible to smaller municipal deals. They recognise that there are only so many flagship projects to be pursued at any one time and the real benefit of improving municipal infrastructure is to achieve incremental progress across the board. Whilst, there is nothing to prevent PFI techniques being used to finance even the smallest of schemes, the costs of putting together a project will in most cases be disproportionate to its value, making it difficult to show good value for money.


    Over the last year, the PFI market has seen the first attempts to solve this problem. In the school sector, the police sector and within the NHS, groups of smaller projects had been bundled together under one umbrella contract to bring the capital value/debt requirements for the scheme up to a level which, from the perspective of managing the transaction costs, makes financial sense. The schools sector has been the most active in bundling together projects, where the approach has ranged from the Glasgow schools, where many schools were brought whether under one umbrella agreement, to the Staffordshire project, which brought together two medium-sized school refurbishment schemes. Much has been made of the ability of the recently formed Partnerships UK (PUK) to take the lead in bundling together smaller projects. This sort of development structuring role, it is said, is exactly the sort of proactive involvement that PUK should have. Indeed, of the 12 "soft-launched" projects announced as part of the PUK launch last month, several (including primary care PFI deals and school projects in East Lothian and Glasgow) focused on bundling projects.

    Divided responsibility

    There are clear difficulties to overcome when looking at bundled projects. Typically, there will be no common management or organisational structure which links together the bundled projects in any meaningful way. In school projects, each school has typically had a good deal of autonomy in terms of managing its facilities and balancing the often competing requirements of the individual elements of a bundled project represents a considerable challenge. Similar issues will need to be addressed for bundled healthcare deals. This contrasts with the existing large office accommodation bundled projects - PRIME for the DSS and the STEPS for the Inland Revenue and Customs &Excise, where strong centralised management of the relevant portfolios are key features of the deal.

    From the private sector perspective, bundling brings some advantages. By spreading the risk across a number of project sites, the risk of total loss can be significantly reduced, making it easier for the private sector (and particularly their funders) to form a view as to the robustness of any income stream. It also presents an opportunity for more imaginative timetabling of the works to promote efficient programming and generate a more efficient use of resources. Structurally, a bundled PFI project more closely resembles the type of structure with which the capital markets are familiar from securitisation transactions.

    Another development that the public sector might consider is to run its competition on the basis of "unfunded" commercial proposals and then to work with its preferred commercial partner together to raise finance for the deal. The objective of such a process is to obtain the optimal commercial structure for the deal and the optimal cost of funds by sourcing them independently. The main argument against adopting this approach is significant negotiation with banks might be needed in any event to ensure that the banks were prepared to lend. This is a problem which a number of healthcare deals ran up against in the early days of PFI.

    There is no reason why this should be so. Internationally, PFI or public private partnership type contract awards are commonly made on the basis that finance will be raised post-contract award; recent announcements in the water sector in Eastern Europe have adopted this exact approach. The fact that everyone involved in the PFI in the UK is becoming increasingly aware of the sorts of concerns funders will have will also make it feasible, given experienced players and advisers, to do a commercial deal keeping one eye on bankability issues.


    This approach was used for the first time recently in the UK PFI market to finance the Government Offices of Great George Street (the GOGGS project). In that project, which closed earlier this year, the Treasury and their chosen commercial partner, the Exchequer Partnership Consortium, reached commercial close on the basis of settled and executed project documentation before running a funding competition, not only to find the best form of finance available but also the party best able to provide it.

    A further consideration is that any project structured in this way would need to be large enough to attract a sufficient number of financial institutions to generate the meaningful competition, and yet not so large as to cause illiquidity in the market. Given a project of the right scope and size, it will be interesting to see whether and to what extent this approach is adopted going forward.

    Developments by the Financial Community

    The financial community is equally aware of the need to bundle projects in order to finance smaller schemes cost effectively. One solution is to provide for a framework financing agreement where a slug of money is raised (whether through the launch of a guaranteed capital markets issue, or through private placement investment) on the basis that the fund would only invest in schemes that fell within certain predetermined parameters. This approach transforms the financing process from a financing decision to a "corporate decision" of the fund to invest. In principle, if the funds and the investors in them can be sufficiently autonomous in terms of decision making, this approach could significantly streamline the provision of finance to smaller deals. The recently launched Rotch Investors Finance Programme is an example of how this type of structure might be put into place and it remains to be seen how this will operate in practice.

    Another way in which smaller schemes could be bundled financially is to make use of well established securitisation structures to bring a portfolio of small deals within one securitised vehicle. To have a meaningful effect on financial costs, and be capable of use on new smaller schemes (rather than as a way to refinance existing deals) the cost of putting the schemes together initially would need to be reduced. On this basis it may be possible to finance schemes initially on balance sheet (which should be possible for a limited flow of smaller schemes) before their transfer into the securitisation vehicle.

    Whether there is the appetite for this type of approach and what sort of safeguards would be necessary to ensure that each investment was acceptable to the ultimate investors will be interesting to see.

    Moving on

    A discussion of securitisation brings us neatly on to my third and final area of future developments in PFI funding. As the volume of PFI deals in the market increases (both in terms of opportunities and closed operating projects), there will be a requirement for increased liquidity of investment. In other words, investors will need to recycle their investments in order to keep market liquidity.

    Until the beginning of this year, there had been little in the way of recycling of PFI investments. One explanation for this is that many PFI deals have restrictions on financial recycling (particularly in terms of recycling equity) until the completion of construction phases. Moreover, until the completion of the construction phase (with the concomitant reduction in the perceived risk profile of the project) there is little financial benefit or incentive to recycle or refinance. One or two early projects have now undergone refinancing. Given that the simple refinancing of the "debt" element of a financing structure is unlikely to be that exciting for PFI deals that are being signed now and in the future. More imaginative packages to recyle funds will be needed.

    There have been a number of trade sales of PFI deals, notably the sale of Kvaerner's PFI and project interests to a Macquarie Bank owned infrastructure fund. More recently, Morrison, the Scottish construction company, effectively sold a 50% interest in their PFI contracts (other than Scottish Water projects) to Edison Capital, in order to generate funding for future deals. The development of new and innovative ways to structure PFI investments and to improve the liquidity of the PFI finance market will be a key feature of the next two years. For example, one can see the prospect of a sponsor who has been successful in (say) one school project and several hospitals "swapping" their school investment with another sponsor who has had greater success in schools than in hospitals, and then seeking to refinance the bundle of more or less homogenous projects together. Other such "swaps" may also be driven by different sponsors being successful in different regions of the country, and then seeking to gain operational efficiency by concentrating their various PFI investments in one region.


    When considering PFI funding structures, it is important not to lose perspective. The cost of funds, or at least the relative cost of funds, is only one element of the evaluation process which takes place whenever a PFI scheme is being brought to the market. Other factors are just as significant in determining whether and to what extent a project represents value for money. Nevertheless, what is clear is that, driven by the search for increased efficiency and deliverability, funding techniques will continue to evolve.