An alarming number of PFI schemes have collapsed in recent months after contractors found themselves unable to deliver on their promises. As the aftershocks of the economic recession continue, will more badly designed deals be exposed? Rebecca Omonira-Oye

It is a fact of business life that from time to time businesses will fail. And that gets worse when there is an economic downturn," says Kevin Magner, a partner with consultants Deloitte. "PFI can’t totally be a proof against that ever happening."

Four PFI schemes have in recent months either collapsed completely or been hit by contractors going bankrupt. The common thread, sources say, is that the contractors got their pricing wrong, either through naivety or on the back of the construction boom. Although partnerships projects remain safer than many other construction deals, the worry now is that, as the economic situation remains dire, more and more problems will be exposed.

Partnerships projects have traditionally been protected against widespread contractor failure by the lengthy procurement process and detailed due diligence required on every project. The schemes that have run into trouble – such as the disastrous Metronet London Underground contracts, or Jarvis’s projects – have fortunately been rare, industry sources point out, compared to the hundreds of successful and safe deals signed in the last 15 years. Not everyone is sanguine, however.

James Stewart, chief executive of Partnerships UK, believes there could even be a rise in the number of subcontractor collapses in the coming year. "We have already seen some failures and we have got to expect more in the next 12 months," he told a conference earlier this month.

Some like to claim that the collapses have little to do with PFI per se, and more to do with the economic climate. "The broader economic circumstances do affect the strength of relative contractors," argues one senior ‘big four’ accountant. "As with all other sectors, a number of them are weaker as a result of the general economic circumstance.

"But I would strongly suggest that there is no fundamental reason why the nature of PFI contracts and funding structures should affect the robustness of the respective contractors that are operating in that field."

At least two out of the four projects hit by contractor collapses this year, however, would have gone wrong even in perfect economic conditions. What they show, according to sources close to both deals, is how a badly structured project can go horribly wrong.

One of the projects is the £10m Defence Animal Centre (DAC) in Leicestershire, which trains and houses the dogs and horses working for the Armed Forces. Realm, the special purpose vehicle (SPV) managed by support services company Parkwood Holdings, filed for administration this summer after relations with the Ministry of Defence soured.

Construction on the deal is complete, but the problem, sources say, is that the maintenance and management terms placed demands on Realm that were just too high. "The specification for performance was set out at a level that just wasn’t sustainable," says a source close to the project. "And then the penalties that were applied were hugely aggressive, and as a result of that the contract just wasn’t really deliverable." The final dispute said to have led to the project’s collapse was to do with an ongoing disagreement about the upgrade of dog kennels.

A defence ministry insider describes it as a "shockingly poorly done contract" that "wasn’t really deliverable". Others close to the project say the relationship between the ministry and Realm has deteriorated to such an extent that neither "comes out smelling of roses".

A terse statement from the ministry – all parties involved, including the main funder, Barclays, refused to discuss the project – reveals that relations were so bad that a third party had to be called in.

"The defence ministry is pursuing termination of the DAC PFI contract as a consequence of a material breach of contract, validated through independent adjudication. "This action demonstrates that, where a contractor fails to deliver the required outputs, the Ministry of Defence is prepared to take decisive action, up to and including termination, to enforce the contractual obligations and hence ensure value for money is achieved."

Sources close to the project point out that it was an early PFI deal – and one with problems that will not be repeated. "It was one of the first [PFI projects] – it wasn’t well structured. Had it been done today, it wouldn’t have been exposed to the issues that contract clearly was exposed to," says one source close to the deal.

Right from the start, the private partner was "naïve" in signing the contract without realising that the work requested was not "sustainable" for the price being paid, the source adds.

He insists there is no chance of its happening again. "It was not something that you would ever see again. I don’t think it is anything to do with the structure of PFI. The fact of the matter is that these contractors are in, more broadly, a very difficult market.

"Jarvis is a good example of where contractors get it wrong and it takes them under. But again it is not a factor of the structure of PFI. It is a factor of contractors bidding a pricing that is not sustainable and no matter what the contractual framework, if they get that wrong it is going to put them under severe pressure."

Cornwall County Council might not agree that the animal centre deal was a one-off, though. The SPV delivering its first phase schools contract, signed in 2001, filed for administration in July. Having built and refurbished the 29 schools as stipulated, News Schools Cornwall (whose sole investor is Innisfree) then struggled to maintain them.

From the council’s point of view, News Schools simply failed to deliver. "The whole basis of PFI is that you provide certain services," says Miranda Lingard, of Cornwall Council’s PFI team. "The services were not being delivered.

"There was a complete breakdown. The schools were phoning in and saying, ‘This is broken, this doesn’t work. This needs replacing.’ And they [the contractor] weren’t fixing the elements and our schools were being more and more let down."

In 2008, the council carried out a review of the project that found that the schools were "in very poor condition and very badly neglected". The council did not escape criticism. "To be fair, the authority didn’t help itself by its management team," Lingard admits. "Part of the process, when I came in to do the review in early 2008, was that we had to change our management structure as well."

Following the review, the council says, Innisfree promised to improve its facilities management services and get the schools back up to "contract standard". So the contractor set about replacing its FM provider, Atkins.

But after starting the benchmarking process for getting another FM contractor on board, Innisfree discovered it was going to cost more than it had allowed for in the original contract. The firm was also concerned that the council’s availability payments weren’t high enough to cover maintenance costs for the rest of the contract.

Innisfree put these concerns to the council earlier this year, along with a plan to restructure the contract, which would have involved Cornwall injecting more funding into the project. "We said absolutely not, this is a private sector risk," says Lingard.

"We gave them the opportunity to turn around the contract after we found material breaches and it was a step too far for us to put more money in. It was just not correct for us to do so."

But Innisfree saw no room for manoeuvre, because it felt that News Schools did not have the funding and revenue stream needed to maintain the schools to the contract standard. "It is regrettable that the parties to the contract have decided that the Cornwall Schools PFI project is no longer viable," says Matthew Webber, a director at Innisfree.

"We have endeavoured to restructure the project for some time, but ultimately have been unable to reach an agreement that would enable the contract to continue."

Both Innisfree and Atkins claim that, contrary to what the council suggests, it was an under-priced and overly complex contract that led to the collapse. "The contract was awarded at a time of intense competition, and as a result projections of the costs of managing the assets have proved over-optimistic," says Webber. "While the circumstances are unfortunate, it should be noted that, at least for the council, they have had the benefit of the under-priced contract for some time."

A spokesperson for Atkins says: "Atkins has worked extremely hard in very challenging circumstances over the past eight years to deliver for schools in Cornwall.

"However, this was an early pilot PFI contract which was onerous, overly complex and loss-making from the start, which meant it was not sustainable in the long term."

Again, the scheme’s difficulties show up some weaknesses of the early PFI deals, experts say. "You could look at any of the earlier ones and ask, is there a problem? Who knows, only time will tell," says a council source. "Common sense says that this is an early PFI pathfinder contract; the market has learnt terrifically and changed how it operates and how it perceives risk."

Deloitte’s Kevin Magner agrees: "We are now onto the fourth generation of what is called the standardisation of PFI contracts. So there has probably been a certain amount of refinement."

He points out that, in both the Cornwall and defence centre cases, it is "somewhat surprising" that the collapse occurred in what would usually be seen as the lower risk operational phase of the project.

"Normally the most risky part of the PFI is the construction period. It is more risky than the ongoing steady state operation. But perhaps it [the contractor’s failure] raises other questions."

In both cases, local government experts add, there are serious questions over how well the contracts were being managed. "A lot of projects could be improved by putting in proper contract management arrangements," says Norman Ballantyne, a senior executive for delivery agency Local Partnerships.

The skills needed on both sides to manage a PFI scheme are different to those needed during procurement, he adds. Guidance produced by the agency also encourages partners to identify smaller changes in advance to give certainty on the contract’s structure. All this helps to ensure failure in PFI is a rare event, Ballantyne says.

So will it happen again? "A small number of projects may fail," he says, "but by and large most don’t fail." But two other projects have already been hit by builders going into administration this year. In the summer the opening of a new pool at the Alfreton Leisure Centre in Derbyshire – already behind schedule by a year – was delayed a further two weeks when a subcontractor went bust.

The pool was part of a larger £22m PFI project to build and refurbish leisure centres. Though the main contractor, Carillion, and the senior SPV partner, DC Leisure Management, soon found a replacement, the Amber Valley Borough Council says it was "disappointed" by the problems.

A council source close to the project points the finger at the slow progress of the scheme. "The main issue with the project is the delays," he says. There have been ongoing issues on the project around "building quality" and disagreements over "the authority’s requirements as set out in the project agreement", he adds. Neither Carillion nor DC Leisure would comment.

Earlier this year, Hackney Council’s secondary schools project was hit by the collapse of William Verry, an FM subcontractor, which filed for administration in May. The recise reasons for its collapse are unclear, but at the time the company filed for administration it had several winding-up orders and county court judgements against it. The company’s administrators, BDO Stoy Hayward, refused to comment on the cause of the company’s failure.

For the briefest moment, the £167m contract wobbled as the lead contractor, Mouchel Babcock, searched for a replacement. "The receivership of William Verry, which was nine months into its construction programme for the Hackney Free and Parochial School, has tied up a significant amount of LEP [local education partnership] management time," admits Marcus Fagent, a director at Mouchel Babcock. But a new contractor, McLaren Construction, was found, he says, without additional cost to the LEP or the council.

Fagent argues that the task of keeping the project on track was made easier by Mouchel Babcock’s use of the integrator model, in which the company procures a series of building firms to carry out construction rather than doing the work itself. Officials in charge of the school building programme "recognised that this was a situation in which the integrator solution showed benefits of transparency and demonstration of best value", he says.

Whether more deals will be hit by subcontractor collapses is, experts say, a question of how many other companies got their pricing wrong during the boom times. On an optimistic reading, the numbers may not be huge. "I don’t think it is that common for these businesses to go bust," says Roger Wakefield, a partner with lawyers Nabarro.

"It is difficult merely to walk away from loss-making contracts and I think that most people will say, ‘I have got to keep going until the next market-testing and then I have got an opportunity to re-base my proposal, including my pricing.’

"That is unnecessary alarmist, to say that lots of firms, who have been selected following a careful pre-qualification review and tender process, are going to go bust. That suggests that lots of these firms have got their pricing wrong."

Others believe more failures are likely. Many contractors priced too cheaply when times were good "because they wanted work", one partnerships veteran says. "Now the market has changed," he adds. "Things are moving against them and they are struggling. Construction is a very difficult market – all you need is a few contracts to go wrong. In times of recession builders do go to the wall and get bought up. So it isn’t particularly a surprise."

Partnerships UK’s James Stewart, too, remains convinced that the industry must brace itself for more collapses. "The important thing is not to panic and see this as a failure of PPP – which is often the case," he says.

"The main challenge for the public sector is accepting there’s always going to be some delay in the event of a contractor failure ... and actually having the patience to let the contractual mechanisms do their work."