Major Project Variations – Fitting a Square Peg into a Round Hole?

As the governments of Europe are committed to improving and modernising their infrastructure, all eyes are and continue to be on the UK’s Private Finance Initiative. Whilst it is arguably one of the most successful alternatives to the traditional procurement systems for procuring public infrastructure and services, it is worth reflecting on one key structural issue currently being considered as this may highlight a concern that other governments may well have to grapple with in the near future.

This structural issue is the tension between the medium of project financing, with its inherent rigidity and funder controls and the need for future flexibility by the public sector authorities. On the one hand the public sector requires the most cost-efficient finance the market is willing to provide and on the other the tide may be turning, with the world-wide requirement for private sector resources to support governments with too few resources, leading to a buyer’s market of investment opportunities. What this means is that flexibility may be forthcoming by the private sector, but at a price.

By way of example, numerous NHS Trusts in the UK have found a ready supply of sponsors willing and able to design, build, finance and operate new hospitals on greenfield sites. Many NHS Trusts required “design flexibility” when the original deals were procured given the expectations of changes in the way acute care is delivered by the NHS. This is now being tested as a number of NHS Trusts are looking to diagnostic and treatment centres (DTCs) to satisfy their various patient service targets for 2005. Accordingly, those Trusts that have already procured their new hospitals pursuant to the PFI have turned again to the PFI to procure these DTCs.

The conventional starting point under most PFI projects is that a major change or variation involving capital expenditure does not have to be undertaken by the project company if it declines to do so (or its funders refuse to consent), or if it is tasked with raising the necessary funding but cannot. The reality is slightly different: the public and private sector is in “partnership” and therefore every effort is usually made to accommodate the public sector’s requirements.

However, the different expectations of the parties means that consideration will need to be given to some or all of the following issues:

Rebalancing of the risk profile

Neither the shareholders nor the funders to the existing project are likely to countenance a major variation requested for the benefit of the public sector that has the ability to materially – or possibly just incrementally -- adversely affect the “risk profile” of the existing project. There are a number of elements to balancing risk profile including amending the payment mechanism so that the inclusion of the potential revenue to be generated as a result of a variation such as, say, a DTC and the potential for availability and performance-related deductions as a result of the DTC, leave all parties in a no better-no worse position from a risk perspective. But, can all risk be priced? And if not how is additional risk relating to the major variation allocated among the public sector, the sponsors/project company and its funders?

Ring-fencing of the existing project

If the project variation is requested after the original asset – say a hospital or a prison – has already been completed, then the public sector procuring a major project variation re-introduces construction risk into a relatively low-risk operational project. Therefore, to what extent will the public sector have to deviate from market-standard allocations of risk in order to minimise the impact and effect on the existing project of the new construction period? Certainly some element of “ring-fencing” will be required i.e. detaching the new construction from the existing hospital in relation to default and non-performance. The intention being to give certainty that failure to complete the variation as contractually required will have no adverse consequences on the existing project and the cash flows generated by the project during its operational phase, but “ring-fencing” contemplates many different facets, not all of which will be appropriate for many projects.

Financing and intercreditor issues

Unless a variation facility or variation bonds have been built into the project structure from the outset that is sufficiently large/available to fund the requested variation, how is it meant to be funded? Will all existing banks agree to provide the additional debt on a pro rata basis? If not, will some banks agree not only to fund a portion of the new debt but also take-out any “recalcitrant” banks? What would be the analogous approach if the financing has been provided by way of a wrapped bond?

Assuming funders are keen to fund the new variation, and at a price acceptable to the public sector, but these “variation funders” form a creditor group different from that funder group financing the existing project, will the difficult intercreditor issues this raises be able to be dealt with effectively from all parties’ perspective in the time available, and within the cost parameters envisaged?

Accession of new debt

A few PFI projects have attempted to address the funding issue by putting into place up front a regime which allows for the accession of future senior secured debt, that is, future debt which ranks pari passu with existing senior debt and shares in the existing security package on an equal-ranking basis. The benefits to both the public sector and the project company/sponsors of having this flexibility are obvious, however, careful consideration needs to be given to whether the upfront structuring costs are worth the benefit, and in particular whether the benefits are more than illusory. Specifically, agreeing the “accession criteria” that allow a project company to “automatically” require its existing funders to permit it to incur additional senior secured debt can be time-consuming and difficult unless the specific circumstances under which debt will be required can all be contemplated upfront, and objective parameters agreed. Certainly cover ratios provide a measure of objectivity, but funders have sometimes required a host of other accession criteria. The more onerous the accession criteria, and the less objective they become, the less and less useful a future funding regime becomes.

Conclusion

In many ways the financing of major project variations on PFI transactions presents a challenge that is not usually seen in other project finance sectors such as power, oil and gas and mining. As health provision in the UK, in particular, is likely to change over the next 30 years, and increasingly innovative structures sought to be introduced in the transport, defence and law and order sectors where PFI is an integral part of the procurement process, the issue will only become more acute. Perhaps the highly unique London Underground PPP model, with its periodic review of LUL’s required service provision and associated future funding regime, or the utility regulatory models with their 5-yearly reviews, may provide some of the answers, but this is clearly an area that needs a bit of creative thinking….now.

For further information please contact Nancy Eller at [email protected].