One of the better ideas introduced under the hopeless John Major government was the Private Finance Initiative. The idea of getting the private sector to build and run new schools and hospitals under 30-year contracts from Whitehall got a lot of criticism at the time – and has done ever since. People complain it is a costly accounting wheeze designed to keep the true cost of public spending off the government’s books. Many wonder how it can be cheaper for the private sector to finance the construction of a new hospital when the government can borrow more cheaply. And the unions have always hated PFI because it involves transferring workers – such as hospital cleaners and caterers – from cushy public sector jobs to the evil private sector.
But the reality is that PFI has been a success story, both for Britain and the City. The Tories themselves were too inept to make PFI work, so it was left to Labour to simplify bidding processes and milk the idea for all it’s worth. Since 1997, Labour has signed 749 PFI deals with a total capital value of £49bn. It has been central to Labour’s ability to reverse decades of underinvestment in public services without breaching its rules on national borrowing. Indeed, so successful has it been that the model is now being copied elsewhere, creating lucrative fees for City deal-makers, whose expertise in putting together these kinds of transactions is in hot demand.
The reason other countries are interested is that PFI meets its objectives. Public sector projects used to be notorious for their delays and cost overruns. But PFI deals are overwhelmingly delivered on time and on budget; only about 20% are late or over budget, compared to over 70% under traditional contracts, according to the National Audit Office. And on the occasions the final bill is more expensive than the original tender, it is invariably because the government has changed its specifications. Since private sector contractors are in the frame if anything goes wrong over the project’s lifetime, the chances are the building will be better constructed and more efficiently managed, so the government gets more use out of the facility.
The big question is whether the private sector can bring sufficient efficiencies to make up for its higher financing costs. That’s difficult to tell – particularly so early in the life of most projects. But what’s clear is that financing costs are falling all the time. When the first PFI deals were struck in the mid-Nineties, PFI developers demanded returns of up to 15% on their equity. These days, they tend to require returns of around 10% on new projects, less on completed projects. What’s more, about 90% of the capital in a PFI project is debt – and since the market believes this debt is effectively underwritten by the government, it is borrowed on very low terms. So the overall cost of financing a new-build PFI project may be only 6%, a tiny premium to government bonds, which is the government’s own cost of financing.
Why has the cost of financing fallen so much? First, PFI developers are a lot more experienced at running these types of deals so they are familiar with the risks. Second, there is more money available, not least from infrastructure funds whose pension fund investors are attracted by the long-term, stable, inflation-proof cash flows from PFI projects since these match their liabilities. There are now funds specifically created to invest in completed PFI projects, which means that PFI developers can now be far more confident of finding a buyer for projects in the secondary market. That releases capital for new deals and makes the whole business less risky for them, which means they don’t have to demand such high returns.
Some of these PFI funds are now available to retail investors via the stockmarket. The HSBC Infrastructure Fund was listed earlier this year with £250m of PFI assets, including a mixture of schools, hospitals and other public buildings. And this week, Babcock & Brown, the Australian investment bank, floated BBPP, a £300m fund which will include £200m of PFI assets, including some Australian projects plus a few PFI deals still under construction. The fund also aims to raise £100m of cash to spend buying assets in the future. Should investors buy into these funds?
That depends what your expectations are. The big gains have already been made. As the cost of PFI financing has fallen, the value of PFI projects has soared. That’s why developers are so keen to sell. The only way values are likely to rise further now is if developers can find ways to run projects more efficiently or find new ways to make money from the buildings. Both HICL and BBPP are targeting returns of only about 8%, little more than the long-term average return on the stockmarket. But the key is that much of this return will come via the dividend. Both funds yield around 5.25% – well above the market average – and this is virtually guaranteed, regardless of what happens to the economy and market. For income investors, that’s not bad at all.
Simon Nixon is executive editor of Breakingviews.com