Returns under the spotlight

The National Audit Office (NAO), the UK’s spending watchdog, has concluded in a recent report that “the public sector may often be paying more than is necessary for using equity investment” to fund the country’s infrastructure needs.

That’s private equity investment the NAO is referring to, which has been funnelled over the years into projects forming part of the Private Finance Initiative (PFI), the UK’s standardised procurement process for public-private partnerships.

While admitting that its conclusions are based on a limited data set, the watchdog went on to say that PFI’s “expected return to equity of between 12 to 15 percent” seems to be on the high side given the risk profile of most PFI projects. 

As the NAO sees it, there are many factors potentially increasing the price of PFI equity. One of them is the “inefficient” nature of the PFI procurement process, which tends to take too long and is too costly, thus inflating equity returns from the onset. 

Another is that investors tend to determine their cost of equity mainly “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”. 

Put differently, the NAO is saying PFI projects are very secure and the UK government is a fairly reliable customer. So much so, in fact, that current PFI equity returns are not really aligned with the risk profiles of these projects.

“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 essence, with PFI reform around the corner, the NAO is basically telling the Treasury that it has let investors profit from PFI for too long and that it’s time for tighter oversight of private sector investments in public infrastructure.

In a way, this is not entirely surprising. UK utilities, for example, are already much more regulated than PFI projects, with returns capped at a lower level. Many argue that a successful adaptation of the regulated asset base model to PFI could help lower the cost of capital for these projects.

It’s also worth bearing in mind that the UK government is aggressively courting increased pension fund investment in infrastructure through a model which would, presumably, decrease the costs of their engagement when compared with the traditional fund route. 

In that sense, it’s arguable that while a slight decrease in PFI returns might be egregious to the developers and funds active in the space, it might still be agreeable to the pension funds the government hopes to attract in greater numbers.

Whatever the outcome, the message from the NAO is clear: investors seem to have been profiting from higher-than-adequate returns for what are essentially low-risk projects backed by a credit-worthy sovereign – and the Treasury should put an end to that. 

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