Economics of Appraisal of Projects: PFI and Public Sector Projects

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Introduction

The most common reflectionary package that any government undertakes during a recessionary period as a countermeasure is to enhance its borrowing and spending. Several of these packages involve infrastructural investment, such as the building of bridges, roads, hospitals, railways, and schools (Vinter 2006). It has been a tradition for governments to borrow money, in a bid to enable them finances such projects, a practice that a majority of the countries have retained to this day. Nevertheless, the past two decades have witnessed a break by governments from this traditional form of infrastructural funding (Yescombe 2007), and a replacement of this by public private partnerships (PPPs).

Basically, what this means is that a private company gets to finance a given project, followed by a certain period of operation in which such a company gets to recoup the money that it had invested. This could be in the form of a concession, in which the company charges the users of such a facility, or the company could be reimbursed its investment by the government (Kleimeier & Megginson 2001), like in the case of a Public Finance Initiative (PFI). There are several methods through which the PPP/PFI projects have traditionally been financed, including bank financing, equity, and senior debt, among others. Each one of these individual methods is characterised by various criteria of payback mechanism.

While some of this fund gets released to a project at the inception period, there is that part of the find that is only released at the later part of a project. In addition, some of these sources of financing charges an interest, while others do not. With the credit crunch having impacted on the global financial markets, investors and banks alike are not as enthusiastic as before to lend money to private companies, as was the case previously (Norris 2009). The perception that one may gather here is that companies are running out of ways of borrowing money, so that they can support PPPs.

How have the PPP/PFI projects been funded in the past?

Traditionally, revenues from the government have been responsible for the financing of infrastructural projects (Vinter 2006). In this case, SOEs (state-owned enterprises) have been awarded the mandate of not just investing, but also facilitating in service delivery. Lately however, the trend has been that infrastructure tends to get funding based on the nature of the project, usually developed with the help of the private sector. This is how then that the Public-private partnerships have come about. The PPPs gives a choice for capital investment that would otherwise not be available, if we were to rely on the public funds alone (Yescombe 2007).

In addition, PPPs results in an enhanced delivery of services through the application of entities of the private sector or for the provision of services and physicals infrastructure. Investing into infrastructure, relative to other assets tends to be a long-term venture, and therefore calls for patience (Klein 1997). As a result of the inflated capital costs that are a characteristic of infrastructure projects, a financing that may exceed more that say, 5 years becomes necessary for the attainment of financial feasibility (Yescombe 2007).

PFI/PPP projects have previously been funded thorough a number of ways, as indicated below. It is worth of note that whereas some of these methods of financing may have been used in isolation, nevertheless there has been a case in which two or more methods have been combined, especially in a case whereby the project at hand requires more financing capital injection (Tham 2000).

Corporate bonds

In the case of PFI projects that are quite large, the financing of such projects occurs via corporate bond sales (Vinter 2006). Such bonds are often issued by the company charged with the responsibility of overseeing the PFI. One key feature of PFI is the fact that such bonds so issued should receive a BBB- rating, often done by an agency on credit rating (an example here is Standards & Poor’s). In this case, such a rating represents the lowest investment rating grade. In case a bind goes below this level, it assumes the status of a ‘junk’ or speculative bond (Vinter 2006).

On the other hand, a rating that exceeds the BBB- threshold may prompt the government to opt for a renegotiation of the already concluded deal. This is with a view to reducing the unit price that such a government often gets charged for the service. In case the bonds rating fall below BBB-, what this implies is that a potential investor to a project in hand may not be keen on assuming the ensuing risk (Vinter 2006).

Therefore, even though the rating of a bond often impacts on corporate borrowing, nevertheless with regard to the PFI projects, the viability of an entire deal gets affected. One reason why there must be a treasury team in operation within the company charged with supplying services to the PFI is to enable the PFI acquire a grade rating to the investment at hand (Yescombe 2007). Often times, a PFI company shall approach more than one agency for credit rating revealing their concession contract, financial model details, as well as the solutions to their capital equipment.

Refinancing

It is also a common practice amongst the smaller PFI projects to have these receive a refinancing. Following the completion of a given project, it follows that the risk profile of such a project should have reduced. As such, it becomes quite possible for the project to be awarded cheaper debt (Klein 1997). Such a refinancing may assume the form of bond issuance. For a majority of the contracts that involves the PFI project, refinancing benefits ought to be shared out with the authorities responsible for procuring of such a financing deal.

Bank finance

This refers to the ‘senior debt finance’ that is often made available by through the assumption of a loan from a bank. In this case, the bank loan provided usually accounts for almost 90 percent of the funds that are required (Klein 1997). In addition such a funding could also involve more than one bank consortium. Those banks responsible for financing PFI projects get a reimbursement from the government, after the government receives its share for the period that such a contract shall be in operation (Tham 2000). Assuming a private sector perspective here, borrowing for a PFI project is taken as a low risk undertaking, since the authorities from the public sector have a much reduced chance of defaulting payment. In fact, national governments, under the rules of IMF, may not be allowed to declare a state of bankruptcy.

Senior debt

Debt from a bank might as well be regarded as a form of funding that is quiet flexible. In addition, it is usually structured in such a way as to facilitate an easier refinancing of such a debt, in comparison to other options of funding (Grout 2003). Nevertheless, bonds usually tend to be a bit cheaper, especially in a case whereby a large project is involved. Still, bond financing may not be a suitable option for all the various PFI/PPP projects that are there. By and large the bond market is characterized by an enormous capacity although fund raising timing relative to such a capacity, in addition to the presence of other forms of projects within a given market may be an issue worth of exploring (Grimsey & Lewis 2004).

There is a possibility that the banking market could be characterized by a liquidity shortage, in effect meaning that the considerably larger projects may fail to get hold of attractive margins. As a result of such a development than, bidders for ma PPFI/PPP projects are more and more turning on to the bond market for the provision of long-term debt. At the moment, the kinds of bonds that are available for these types of projects could either be the ‘fixed’ kinds, or even the ‘indexed linked’ kinds, (Esty 2006), both of which bears a certain amount of interest.

By and large, debt cost shall differ, on the basis of the risk that is connected to such a debt, in addition to the debt size and its maturity (Finnerty 1996). PFI/PPP cost of bonds could as well be reduced by way of debt payment insurance, commonly referred to as ‘wrapping’. In this case, the overall ‘wrapped’ debt cost consists of insurance premium.

In 2004, the government of the United Kingdom came up with the CFG (Credit Guarantee Finance) scheme. This is a scheme that enables the government to give out debts to finance for example, PFI/PPP projects, while the repayments of such a loan is often guaranteed by either an insurer, or a bank. Senior debts typically tend to be a bit costly, in comparison to bonds (Esty 2004). In this particular case, the bank would make an argument that the reasons behind this is these senor debts reflect on how more accurate and comprehensive given PFI deal in terms of its worth to credit.

Through the act of hedging such a debt by way of a fixed ‘swap’ rate, a vulnerability to variable rates of interests for such a loan may be reduced (Esty 2004). What this means is that that interests rate that shall be payable against such a loan obtained remains fixed, at least for a definite period of time. In addition, such a debt may also be ‘swapped’ either with a different provider, or with a senor lender. The cost of construction of various projects constitutes a remarkable portion of a project’s concession cost.

Mostly, such costs get funded through senior debt, which is in return payable for the entire period for which a concession is in place. In this case, the senior debt lenders shall often demand for the creation of a re reserve account, to take care of debt repayment should there occur difficulties in within a certain project, or should such a project be terminated for a variety of reasons. In the event that a project does indeed get terminated, the bank shall always have priority over the project’s investors, in as far as its debt recovery procedures are concerned (Esty 2004).

Equity

With regard to PFI/PPP projects, equity investment usually takers the form of risk capital. In this case, shareholders often get to share a project’s risk together with the senior lenders to such a project, thanks to the financial interests that they show to such an initiative (Esty 2006). In the event that such a project gets plagued by one form of problem or another, in effect leading to its termination, the equity investment could either be eroded, or lost entirely.

Equity shares come in two forms, loan stock and shares, and the subordinated debt. Share equity refers to that fund that gets paid during the initial period of a give project. Upon repayment, following a successful project completion, no interest gets charged on the share equity. Nevertheless, the issuance of dividends takes place several years following the completion of a project (Esty 2006). In this case, the timing period for dividend payment hinges upon cashflows and available earnings.

A sub-debt, otherwise known as a loan stock, refers to a kind of a loan that is usually supplied by shareholders. This form of a loan often gets injected into a project during the later parts of the construction period of such a project (Brealey et al 1996). In this case, the shareholder gets repaid at the project’s operational period, depending of course on the cashflows of such a project. Moreover, this form of a loan usually attracts interests, an interest payable on capital. On the other hand, shareholders could also receive payments on interests only so that their return on capital comes as a lump-sum at a time when the concession ends.

Impact the current crisis in the financial market might have on the financing of public infrastructure

The difficulties that have plagued the global financial market in recent months have had their impact on both the private and public sectors, not to mention individuals. The credit crunch has especially dealt a deadly blow to the global financial markets, resulting in profound impact on banks’ liquidity on a global scale, due to accelerated financial system “deleveraging” (Rose 2008). Little wonder then, that the funding of PFI/PPP projects has also been affected by the turn of events. This notwithstanding, the model of PPP in the UK has maintained its robustness, where over 630 projects have already been signed, with 540 of these being in operation.

Ever since the current global financial crisis became imminent, over 25 projects have had to be terminated. The UK government now appears keen on salvaging such other sectors of the economy as hosing, education and waste (Rose 2008). For the past 18 months, the financial landscape in the UK could be said to have changed dramatically, so that now, new lending capacity fro PPP/PFI projects appears quite constrained, and this has had a profound impact on this market.

For the last 10 years or so, the ‘monoline wrapped bond market’ has ideal financial structure for a majority of the large PFI projects. However, this bond market seems not to admit newer transactions. The implication here is that the PPP/PPP projects have to depend more on the banking market. Reduced liquidity, capital sufficiency requirements, coupled with higher costs of funding has acted to put a strain on the banking model for project finance (Stewart 2009).

According to some 208 estimates of a global review that was undertaken by PriceWaterhouse Coopers (PWC), the rates of interest for infrastructure projects lending had increase by between 1.5 percent and 2 percent over and above the least amounts of rates that governments may be in a position to get hold of (Rose 2008). The case is even worse for countries that are developed. There has been a remarkable slowdown with regard to PPPs flow in the United Kingdom. In 2008, just about 34 new projects got assigned. This is the smallest number of PPPs to have ever been signed in one year, sine 1977 (Rose 2008). In the month of January, 2009, a PPP for a motorway stretching to about 11-meter got signed, although this was greatly influenced by the decision by EIB (European Investment Bank), after this public sector bank agreed to avail over half of the project finances.

Following the decision by the bank of England to embark on quantitative easing, in a bid to salvage the United Kingdom out of the woes of the prevailing economic recession, what he ought to be asking ourselves, at least within the confines of this research paper, is if this move shall mean more money for banks to lend (Stewart 2009). Without doubt, the direct beneficiaries of quantitative easing shall be the banks, along with related investment institutions, not to mention big companies (Rose 2008). With banks having extra money in their coffers, one might expect that borrowing would be easier than before. Nevertheless, we still have anxious banks that are quite unwilling to give loans to either business or individuals, notwithstanding that the lending rates are at an all time low.

In the event that quantitative easing does work out, what this would mean is that individuals would find it easier to assume a loan, perhaps even a mortgage. This is because quantitative easing shall result in the banks in the UK flooded with ‘hard cash’ (Budworth 2009). Nevertheless, seeing that the base rate is at a dismal low figure of 0.5 percent, it follows that banks may end up earning nothing just by ‘sitting on that money’ (Budworth 2009). One can only hope that this shall be enough reason to convince banks that is worth lending out the money, in the process overcoming the problem of lending freeze that appears to have almost crippled the economy. The implication here then is that the private companies shall get their share of these loans, and then assume their rightful place in the PPP system.

Conclusion

Project financing is often a long-term undertaking that requires massive investments. Typically, the development of the infrastructure of a given country is the responsibility of the government of such a country (Yescombe 2007). However, a government may lack both the financial capability as well as quality service delivery mechanisms to establish, operate and oversee developmental infrastructure, in partnership with a state-owned enterprise (Vinter 2006). For this reason therefore, the private companies comes in to offer these vital services. As such, the recent trend in the financing of the infrastructure has been the formation of Public-Private Partnership (PPP), as well as the Public Finance Initiative (PFI).

The current global financial crisis has not spared the PPP/PFI projects either. For example, in the United Kingdom, the number of projects that were signed last year was the lowest ever in 32 years (Rose 2008). One can only hope that with the decision by the bank of England to embark on quantitative easing, this shall mean more money for bank to lend and a chance for the private sector to strongly force an alliance with the public sector for the development of infrastructure.

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