private finance

initiative
Lessons Learned
We recently held a series of PFI Roundtable Discussions in collaboration with Trowers & Hamlins
LLP. Finance managers from throughout the UK were invited to share their thoughts and experiences
regarding the current programme, as well as putting forward their views on the initiatives future.
Below is a summary of the key findings.

The future landscape for PFI

The foreseeable future will be shaped by public sector bodies
continuing to face pressure to reduce expenditure in real
terms. Experience to date clearly shows that savings can be
delivered from PFI schemes.
Given the financial pressures facing the whole public sector,
the government will continue to encourage all spending
departments and other bodies (eg local authorities, NHS
Trusts, etc) to deliver cost savings in operational PFI projects
and to improve the cost efficiency of future PFI contracts.
To achieve efficiency savings from PFI contracts the public
sector and the private sector need to work together to
support long-term relationships with a view to identifying
and delivering real cost reductions.

This is already reflected in the high number of private sector

partners who have signed the voluntary Code of Conduct for
Operational PFI/PPP schemes, which was first issued in June
2013. The list ofpublic and private sector signatories to the
Code has grown steadily since then.
Whilst due regard must be had for the contractual provisions
that define PFI projects, all parties are beginning to
recognise the national imperative to work together to deliver
substantial, repeatable savings.

Diagram of a typical PFI

SPV structure

LOCAL
AUTHORITY

The diagram shown sets out the

structure of a typical SPVwithin
a PFI project:

Unitary
Payment

Project
Agreement

Consortium
companies:
Equity and
sub-debt

Subscription
Agreement

Repayment
FUNDER
Debt Finance

SPV
Credit Agreement
and Debenture

Milestone
Payments

Funder takes
security over
the unitary
charge/income
stream

FM
Payments

Building
Contractor

Management
Services Agreement

FM
Contract

Building
Contract
Hard FM

Soft FM

Key areas to consider for savings

SPV costs minimise management charges

The first step for a public body with operational PFI contracts
is to carry out a contract savings review to ensure effective
application and management of existing contract provisions.
To ensure that any discussions with the private sector
contractor generate maximum rewards, the public body
should also review the project generally to ensure it meets
its objectives and set clear outcomes for what it wantsthe
PFI arrangement to deliver following review.

Examine SPV management charges and minimise SPV

mark-up through the supply chain. Accelerate payment
terms and timings to reduce SPV working capital
requirements and optimising basis for variations.

Following HM Treasury guidelines, CIPFA and Trowers

& Hamlins have worked with clients across a range of
sectorsto successfully deliver savings by targeting the
following areas:

Facilities management and services

review requirements
Reviewing the specification of soft services so that the
public sector only pays for services that are needed and
reduces the frequency of non-essential services where
theoriginal specification was higher than is now required
or can be afforded. This can also involve a change in scope
andquantity of services and a re-visiting of the entire
payment mechanism.

Use of assets optimise

Selling surplus assets and utilising third party income
provisions and opportunities to save on or offset asset
costs. Implementing flexible asset management to exploit
facilities more intensively can also reduce waste and
promptgreater returns. Mothballing of unused areas of
serviced accommodation may also be considered.

Financing arrangements optimise

Carry out a refinancing of project borrowings could result in
significant long-term savings from shaving even a fraction
of one per cent off the interest rate. Other changes that can
be made include changing the loan payments to 1-month
LIBOR swap, sharing of equity returns above a threshold,
capital contributions, shares in gains on sale of equity,
aswell as considering the efficiency of current accounting
and tax treatment.

Ensure risk transfer is cost effective

PFI projects transfer risks such as change in law, insurance
costs, maintenance, service provision and lifecycle from the
public sector to the private sector. The private sector prices
for taking on these risks.
As PFI schemes have evolved, theconsensus as to what risks
are cost effective to transfer has changed. Public bodies
should consider their appetite for taking back and managing
such risk in exchange for a commensurate reduction in price.

Insurance provisions optimise

Many PFI contracts acknowledge the varying cost of
insurance over time and existing provisions should be varied
and cost/gain share mechanisms in relation to insurance
costs applied.
Further, existing insurances could be scaled back or may no
longer be needed as part of the PFI project, so these could be
stripped out with the reduction in premiums paid by the SPV
being reflected in a reduction in the Unitary Charge.

Other negotiating points consider as part of

overall contract renegotiation
If a public body is embarking on a renegotiation of its PFI
contract, wider possibilities for obtaining better value for
money should also be considered. Extension to the term of
the contract or changes to the operation of the payment
mechanism could well result in savings from leveraging
economies of scale. If there are grounds (eg Contractor
Default) and/or a compelling financial case, the option of
terminating the contract should not be overlooked.

Other further issues identified as relevant to

thespecific contract under review
The extent to which savings will be available across
operational PFI projects will depend upon the bespoke
nature of the services being delivered under each contract,
the degree of active management which has already been
applied and the extent to which the specification exceeds
requirements. In conducting any review, opportunities in
addition to those described above may present themselves.

Managing the variation process

One key method for accessing real terms savings in
operational PFI projects is to vary the terms of thePFI
contract (to address some or all of the matters set out
above). Realigning the contract with the changing
requirements of the public body can make the operational
project more cost effective.
An often-repeated criticism of PFI is the complexity involved
in varying the contract terms after financial close.
This is still the case even with the governments Code of
Conduct, guidance and standard documents developed to
assist the process.

However, with appropriate planning and strategies in place,

it is possible for public bodies to drive the process forward
to achieve their objectives. The stages through which public
bodies should approach PFI cost saving are set out below:

Stage 1 Options Appraisal

Public bodies should ensure that they have a good
understanding of the existing contractual terms and are
effectively managing the contract. For example, is the public
body levying all of the deductions that it is entitled to and
are there existing provisions such as insurance cost sharing,
benchmarking or market-testing that could be utilised to
secure quick wins.
As part of effective project management, the public sector
body should engage commercial and legal advisors (if the
contract is being amended) and, where relevant, technical
and financial advisors to assist the public body with
understanding and validating underlying costs, financial
concerns and payment mechanism implications. Advisors
will also be able to set out any market and sector-specific
changes that have occurred since signature of the original
agreement that could benefit the relevant project.
It must also be borne in mind that a business case will need
to be made that supports the changes envisaged that arise
from the type of exercise described here. Such a business
case will be required by the entity undertaking the review
as well as other legitimately interested stakeholders, eg a
spending department, funders, etc.
At this stage public bodies should also consider any
procurement issues (noting the new provisions in relation
to the variation of procured contracts under the Public
Contracts Regulations 2015) as well as considering whether
to consolidate changes that have already occurred such as
historic notices of change.

Stage 2 Agreeing Variation Strategy

Once an options appraisal has been undertaken, the key
outcomes sought by the public sector should be set.
Therelevant contractual mechanisms to be used, such as
a formal change notice, use of surveys, benchmarking,
refinancing or insurance cost sharing can be identified.
If a renegotiated variation (outside of any existing
contractual mechanisms) is required, the public body
should evaluate whether there are any compensation sums
to be paid to the Contractor (eg if any services are to be
terminated), what principles should apply to negotiations
(for example, no better no worse or using PF2 as a
benchmark), whether there are any employee issues and
theextent of any construction defects.
In practical terms this means carrying out the above
preparatory work prior to engaging with the SPV, making
sufficient resources available and clearing the project plan
with a designated project manager.

It is also helpful to establish an empowered project

management team and set out clear lines of communication
for instructing advisors and conducting negotiations with
the private sector party.
Regular internal meetings should beheld to monitor
key milestones and project plans, ensuring that relevant
timeframes are being adhered to. Lastly, the document
update methodology will need also need to be agreed.

Stage 3 Legal, Technical and

Financial Management
Prior to the Project Agreement mark-up, a commercial
principles table and Deed of Variation should be prepared.
The specifications should be updated to reflect any new
service delineation and the performance mechanism
and financial model should be reviewed. New interface
arrangements and stakeholder engagements also need to
beconsidered.

Stage 4 Negotiation Process

A PFI contract has a finely balanced risk profile and
contractual mechanism, integrating construction
and service provisions into one contract through a
deductions mechanism. This adds levels of complexity
to varying PFI contractual provisions, insurance clauses,
paymentmechanisms and specifications because any
change can have knock on effects.
Some obligations in relation to the project must remain with
a particular party (and cannot be terminated) and there are
likely to be new interface issues between subcontractors
which need to be addressed (eg how the parties could affect
each others ability to perform their obligations).
Given these complexities, the public body must consider
how to incentivise the private sector to engage with the
variation. Although some PFI contracts have a change
mechanism which provides for some level of engagement,
the private sector often has little incentive to negotiate
avariation.
The reason for this is that the variation could result in a
different risk profile to the project as it stands and SPVs
are reluctant to incur the cost of investing time in the
variation process. Unless the private sector counterparty is
receiving an increased return or some of the benefit, it could
take the view that there is no benefit to being involved in
thevariation.

To bring the SPV to the table and achieve the variation it

seeks, the public body should leverage any contractual
mechanisms that it has. For example if there is a particular
KPI that is giving rise to significant deductions, this could
be used as a bargaining chip to encourage engagement.
From our experiences, the relevant mechanisms vary from
project to project. Once engaged, a cap on the costs that
the public body will pay should encourage the SPV and its
advisors to move swiftly in negotiations. At the same time
it is important to avoid damaging the relationship with the
private sector partner.
The PFI contract ties in all parties for the long term and so,
regardless of the outcome of the negotiations, a working
relationship must be maintained.

Stage 5 Execution Stage

At the execution stage, the approval process for public sector
and funders (syndicate issues) needs to be considered.
Thecorrect authorisations and conditions precedent will
be required. Public bodies should bear in mind that it is not
just the SPV consent which must be obtained but also lender
consent, third party shareholders, FM sub-contractors,
parent company guarantors and sometimes central
government bodies.
The incentives of some of these parties can be even further
removed than those of the SPV and so delays can arise
at this stage. Due diligence of finance and sub-contract
documents will need to be done to ensure relevant approvals
have been obtained and contract variations have been
properly flowed down. Once executed, there will be a
mobilisation and bedding-in period.

Financial Implications
Typically the private sector partner will request that the
public body bears the costs the SPV incurs in the negotiation
of the variation. Lenders are also likely to ask the public
sector to bear its advisor costs along with any arrangement
or variation fees that they might charge.

the PFI contract can result in the public body paying a

significantly lower Unitary Charge. Savings therefore amass
over the long-term. The trade-off for paying less could be the
public body taking on more risk, such as the risk of carrying
out the services itself.

As mentioned above, the public body should seek to

agree caps on these fees to avoid costs spiralling and to
encourage progress in the negotiations. However, a variation,
particularly for the reduction of services provided under

Inthe context of a variation to reduce the services

provided under the PFI contract, the public body will
needto provideorprocure an alternative method/source
forprovision of the services.

Contact us
If you would like further information about any of the above, please do not hesitate to contact us.

Amardeep Gill
Partner Public Sector and
Commercial Contracts
T: 0121 214 8838
E: agill@trowers.com

Alan Jessop
Senior Consultant CIPFA
77 Mansell Street, London E1 8AN
T: 07725 600 961
E: alan.Jessop@cipfa.org

Registered office:
77 Mansell Street, London E1 8AN
T: 020 7543 5600 F: 020 7543 5700
www.cipfa.org
The Chartered Institute of Public Finance and Accountancy.
Registered with the Charity Commissioners of England and Wales No 231060

2015/06