Summary and implications

Much has been written over the last month about the launch of PF2 (HM Treasury Standardisation of PF2 Contracts, draft guidance dated December 2012). There are undoubtedly some interesting features to the new model, not least the introduction of public-sector equity. But the question on everyone’s lips is “where is the PF2 pipeline?”

Three sectors have been mentioned as initial target areas for PF2: education (the Priority Schools Building Programme); defence (construction and maintenance associated with the MOD’s “Future Force 2020” requirements); and health (initially, a hospital scheme being procured by the Sandwell and West Birmingham Hospitals NHS Trust).

The health sector has been heavily criticised in recent times for its track record in PFI funded hospitals. Many of the Trusts on the Government’s most “financially vulnerable” list have PFI contracts which, it is claimed, the Trusts can no longer afford, particularly given the pressure of budget cuts.

So, could PF2 make health schemes more affordable and what issues are investors likely to be looking out for?

Institutional investors

Encouraging pension funds and other institutional investors to provide support to new schemes should improve liquidity and therefore margins. However, hospitals remain challenging to build in terms of design complexity, technical interfaces and risk allocation (e.g. decant, medical equipment, ICT). Institutional investors may conclude there are easier or less risky markets in which to invest. That said, the steady cash flows generated via long-term hospital developments fit well with a pension fund’s preferred investment profile – particularly if there is confidence in the covenant strength of the procuring foundation trust (FT) and/or a deed of safeguard.

Competition

When funders/investors are considering the financial viability of a procuring FT as part of their assessment of the risk profile of a project, they need to understand local markets, i.e. the nature and mix of services, local commissioning practice, the extent of demand for treatment in a community rather than acute setting and the degree of competition among providers in the area (both NHS and private). All of these issues will require careful consideration when assessing the long-term financial viability of an FT.

Public-sector equity

While the availability of public-sector equity could help to improve gearing on some schemes and reduce risk from a senior lenders’ perspective, it is unlikely to have a positive impact on the affordability of schemes; further equity, even at a discount, will always be more expensive than senior debt. In addition, equity contributions by the public sector will need to be carefully structured to ensure they are state aid compliant, particularly as FTs are now competing with the independent sector for the delivery of NHS-funded services.

Public-sector capital contributions

Capital contributions from a procuring FT will reduce the annual unitary charge payable over the project life and, if contributions are made during the construction phase (as opposed to following construction completion as has mainly been done on previous schemes), there will also be a reduction in the overall level of funding required. However, capital is not readily available to some FTs and the complexity of advancing and protecting such contributions, particularly during the construction phase, may persuade some FTs that it is only worth pursuing this option if the sums involved are substantial and the financial benefits over the project life are significant. One potential avenue available to access capital for these purposes is for FTs to release capital through the sale or redevelopment of surplus land. This could be tied into the PF2 scheme itself or transacted separately before the PF2 scheme is brought to market.

Soft services

Institutional investors may look positively on the absence of soft services from PF2 schemes. It has the potential to improve the risk profile of projects since it limits the range of services exposed to payment mechanism deductions, making it easier for the project company to manage termination risk. However, it does bring its own challenges, particularly in hospital projects where there are multiple operational interfaces between the FT (i.e. staff, patients, visitors and third party contractors) and the project company.

Risk transfer

PF2 signals a change in direction for the public sector in some areas of risk transfer. However, many feel that HM Treasury did not go far enough. The key areas in which the public sector is likely to retain an element of risk (including, for example, insurance premiums, ground conditions and change in law) come as no surprise but how big an impact these adjustments will have on the affordability of schemes is questionable. Greater transparency in relation to ongoing lifecycle surpluses (and the related provisions dealing with the sharing of such amounts) is likely to reduce the ability of the private sector to cash in on lifecycle upside in PF2 schemes through the secondary market. While this may bring benefits for the public purse over the longer term, it could also result in reduced flexibility for the private sector in the management of lifecycle arrangements which may mean a negative impact on upfront pricing of hard FM services for PF2 schemes.

So in light of the above, is PF2 likely to trigger an appetite for growth in hospital projects in the UK? It’s early days but there are some positive aspects to PF2 which could help to unlock new schemes; public-sector equity and/or capital contributions, if properly structured, could provide pension funds and institutional investors with a more balanced investment opportunity.

That said, there continue to be challenges inherent in the UK health sector, particularly as a result of greater competition in some areas between FTs and the independent sector in the provision of NHS-funded services. Business cases for new hospitals will remain tough notwithstanding the introduction of PF2. However, where there are good clinical and commercial reasons to develop or redevelop a hospital (and it can be justified in light of local market conditions), there are clearly some aspects of PF2 which are capable of improving the affordability, fundability and marketability of a scheme.