PFI equity ‘overpriced’

The UK’s National Audit Office believes drawn-out procurement processes and minimum investor rates of return are not synchronised with projects’ risk profiles and may have inflated PFI equity returns over the years.

UK public spending watchdog the National Audit Office (NAO) has released a report suggesting that “the public sector may often be paying more than is necessary for using [private] equity investment” to fund the country’s infrastructure needs.

The report pertains to the role of equity in helping to fund projects that form part of the UK’s Private Finance Initiative (PFI), the country’s standardised procurement process for public-private partnership projects. And while it recognises that private equity has helped deliver countless infrastructure projects across the UK, it believes returns, as they stand, may be inflated.

“Competition has generally created and expected [a] return to equity of between 12 to 15 percent at the point contracts are signed. [And] while the majority of investor’s returns could be explained by reference to the risks they were bearing, we could not explain a proportion of returns earned by investors,” the report states, adding that a study across three projects had revealed that:

“The parts of the investors’ returns which could not be fully explained were a relatively small amount – around £1.15 million (€1.35 million; $1.82 million) per annum in total across the three projects – but they were equivalent to around 1.5 to 2.2 percent of the [procuring] authorities’ payments and could be significant over the long-term life of PFI projects.”

According to the NAO, the inexplicable part of PFI investors’ equity returns could be due to a number of factors, including “inefficient procurement”, which is bogging investors down in lengthy and costly bidding processes which inflate equity returns.

Another reason is what the NAO refers to as “investors’ cost of capital,” where the equity is mainly priced “by reference to a pre-defined internal ‘hurdle-rate’ required by their investment committees, rather than by reference to the specific risks of the project”.

The NAO’s argument is that most “PFI projects benefit from the secure payments that the government as a costumer provides,” suggesting that the standard PFI equity rate of return may be out of sync with most projects’ true risk profiles.

“In 84 of 118 projects in operation where investors told us their current experience, investors were reporting returns equal to or exceeding expected rates of returns [with] 36 of those projects forecasting significant improvements,” the report pointed out.

In contrast, only 34 projects were under-performing, but the NAO stressed that “in relatively few of the 700 PFI projects [procured to date] have investors reported that they have lost their entire investment, or injected money to save a project”.

The NAO also highlights that profits derived from secondary equity divestments – which typically net sellers “annualised returns between 15 and 30 percent” – could derive partly from these “potential inefficiencies in the initial pricing of equity”.

Investors can take some succour from the Treasury’s response to the report, where it “considers that [value for money] needs to take into account a wider range of issues that together contribute to the overall economics of a transaction, rather than merely looking at equity returns on their own”.

Lower returns the norm

But they should also bear in mind that the winds of change are not blowing in their favour and, with a reform of the PFI model currently underway, lower equity returns may become the norm going forward.

That certainly seems to be NAO head Amyas Morse’s intention when he stated, following the report’s release, that “Treasury should give closer scrutiny to the returns investors are getting from PFI projects and take account of the areas we have identified where there is scope for savings”.

“PFI projects benefit from secure cash flow from the public sector. Public sector authorities should have clear evidence they are paying a fair price for private sector funding considering the stable environment that PFI generally provides,” the NAO chief added.

The implicit message from the spending watchdog, then, is that investors may have been profiting from higher-than-adequate returns for what are essentially low-risk projects backed by a credit-worthy sovereign.

Our advice to PFI investors: enjoy it while it lasts, because if the NAO has its way, it won’t.