The public sector and the private sector work well

together, innovate and create significant efficiencies,

but poor public sector preparation and inappropriate

risk transfer lead to unnecessarily expensive and

inflexible contracts. This is the broad theme of the

Treasury's reforms contained in "A new approach to

public private partnerships" and the accompanying

"Standardisation of PF2 Contracts" (SOP2C)

which were issued alongside George Osborne's

Autumn Statement this week.

To the relief of the infrastructure community, Treasury

has not "thrown the baby out with the bathwater" and

has taken much of the learning generated since the

launch of the Private Finance Initiative in 1992 to

form the foundation for what it has rebranded as

"PF2".

In this client alert, we take a closer look at five of the

key themes emerging from the reforms:

■ Improved credit enhancement;

■ A greater role for equity investment;

■ Streamlined procurement;

■ Appropriate risk transfer; and

■ Flexible transparent service provision.

CREDIT ENHANCEMENT

In light of the constrained market for longer term bank

debt, one of the key drivers of the Treasury's reforms

is enhancing the credit rating of PF2 projects with a

view to accessing the broader financial markets.

The Treasury is not convinced by mini perm options,

or structures where bank debt is applied solely to the

construction of the asset. In its view, better assets are

created where the funders' due diligence takes into

account long term maintenance risks and obligations.

For that reason, and to avoid the budgetary uncertainty

of any public sector underpinning of refinancing risk,

the Government continues to support financing

through long term debt.

Whilst some banks can still offer long term finance at

affordable rates due to their funding strategy or

country of origin, they are in the minority, and PF2

has been shaped to take into account discussions with

other players in the financial markets. Along with

Treasury Guarantees and co-lending (implemented by

the Infrastructure (Financial Assistance) Act 2012)

and increased public sector capital contributions

(previously restricted to 30% of total project value), it

is hoped that increasing the proportion of equity

invested in the project company will provide the

BBB+ to A- rating needed to attract capital market

investment.

PF2 – THE BIG REBRAND

02 | PF2 – the big rebrand

EQUITY INVESTMENT

Through additional equity injection (in the form of shares

and sub-debt), PF2 will reshape the familiar 90:10 debt/

equity ratios, to a broader 75/80:25/20 capital structure

for accommodation projects (and perhaps even higher

equity ratios on more complex projects). As the most

expensive financing stream, the government argues that it

can create subscription mechanisms which do not

undermine value for money, although some of the

infrastructure community query whether this will in fact

be the case. As well as the traditional risk capital

provided by project sponsors, government intends to tap

two further tranches of equity investment from the public

sector and from institutional investors:

■ Public sector equity contributions can be up to 30-

49% of the overall equity requirement. Although a

standard shareholders' agreement has yet to be issued,

the guidance states that investment will be made on

the same terms as those agreed by the private sector

for the particular project, and the first draft of SOP2C

(section 5) states that pricing of public sector equity

will be determined competitively through the project

procurement process. Attaching returns to public,

rather than private sector, investment reduces the

overall project costs but creates potential conflicts of

interest between public sector procuring obligations

and the opportunity to invest. In recognition of this, a

central government unit (CGU) will be established

within HM Treasury to make commercial investment

decisions and manage what will become a portfolio of

PF2 investments. CGU is not obliged to invest in

every PF2 project.

■ Equity funding competitions will be introduced at

preferred bidder stage (when negotiation on key

commercial and financial risk is concluded) to attract

institutional investors interested in earning long term

stable returns, rather than maximising returns in the

short term. This tranche will be piloted on live

projects in 2013, and is specifically aimed at reducing

the number and size of secondary market

transactions, which have attracted criticism because

of excessive gains achieved by equity investors.

Treasury also hopes to improve transparency. Public

sector representation on the project company's board of

directors will provide access to the project's financial

performance, as well as more involvement in its strategic

decision making. This has already worked effectively on

projects following the Scottish Government's NPD (Non

Profit Distributing) model and in sector specific models,

such as LIFT. Whilst PF2 proposes no specific cap on

equity returns, profits will be curbed by mechanisms to

share unutilised lifecycle reserves. Some in industry are

concerned that this may have the unintended effect of

inhibiting the potential for creative risk sharing solutions.

Equity involvement provides a "hands on approach" to

transparency, which will be reflected in the government's

wider plans to manage PFI and PF2 liabilities. PFI

liabilities are already publicised in Whole of Government

Accounts. A "control total" for commitments arising

from off-balance sheet PF2 contracts will now be

introduced and further reported in Budget 2013. The

government will also publish an annual report detailing

"full project and financial information on all projects

where government is a shareholder."

PROCUREMENT

As well as enhancing credit conditions, the government

recognises that confidence in an efficient procurement

process will also help to attract new players into the PF2

market.

The Cabinet Office's LEAN review has already identified

the need to train public sector procurers, if time frames

for infrastructure procurement processes are to be

reduced. A new version of the LEAN sourcing

requirements amended to cover PF2 projects is currently

being piloted on the Department for Transport's civilian

search and rescue helicopter service procurement. In

addition, Infrastructure UK and the Major Projects

Authority will run a review of capabilities within

Whitehall to report by Budget 2013. Once skills are

entrenched within central government, there will be a

move towards more centralised procurements - following

the example of Infrastructure Ontario in Canada. The

Education Funding Agency, a unit within the Department

for Education (DfE), which will be responsible for all

procurements connected with the Priority Schools

Building Programme, is the first example of this working

in practice.

The government is keen to go one step further and set up

a single central procurement office to reap the benefits of

repetition and batched procurements, but acknowledges

that the business case for such a structure should be

reviewed further during the IUK and MPA review.

Inevitably, procurement costs are factored into private

sector contract costs. Shorter procurements should mean

cheaper contracts. The time limit for PF2 procurements

will be eighteen months from publication of OJEU to

preferred bidder appointment. Unless an exemption has

been granted, Treasury approval for project funding will

not be given if the project has not been closed within that

timescale. The government reserves a discretion to make

a contribution to failed bid costs and anticipates more

detailed information being provided at OJEU than the

www.dlapiper.com | 03

current norm. This time "guillotine" has been meet with

initial concern from the private sector, but it remains to

be seen the extent to which it will pose a serious

deterrent to bidders.

The message is not simply to work faster. The

government wants to see both the public and the private

sector creating opportunities to discuss solutions for a

project before it has been advertised. The government is

therefore proposing a transparent system for business

case approvals, and a business case approvals tracker (to

be published on the Treasury website Spring 2013), to

allow early planning and innovation.

Any public sector business case must include evaluation

of at least one other contract structure option, as an

alternative to PF2. The government is clear that PF2

must not be considered in a vacuum. Other structures

such as local asset backed vehicles, tax increment finance

structures and joint ventures should also be investigated,

if they are appropriate procurement possibilities.

An Infrastructure Procurement Routemap will be

published in January 2013 to address weaknesses in

appraisal practice.

APPROPRIATE RISK TRANSFER

■ Capex from a general change in law

Work on creating savings in operational PFI contracts

has already identified that transfer of future risks

generally results in the creation of reserves to cover

scenarios which may or may not happen. Previously,

the Treasury therefore issued guidance that PFI

contracts cease to follow SoPC4 provisions requiring

the private sector to underwrite a share of any capital

expenditure arising on a general change in law. PF2

now confirms that the public sector will retain the

entire capital spend risk. Taking out the cost of

setting up and maintaining change in law reserve

accounts will enhance a project's value for money.

■ Site risk

Similarly, the private sector is not in any stronger a

position than the public sector to control risks, such as

contamination of the project site from third party

sources, but historically that risk has been transferred

to it, with resulting contingencies increasing the

contract sum. Under PF2, this risk will remain with

the public sector. Where the project site is owned by

the public sector, it will also warrant ground

condition surveys and title investigations relating to

the site which will reduce the due diligence burden on

bidders.

■ Utilities

Much time has been spent in the past drafting risk

sharing provisions for the volume and price of

utilities used at the project site. Under PF2, volume

risk will be allocated to the public sector, but the

project company retains responsibility for the design

of the building against agreed energy efficiency

standards. A rigorous two year hand over procedure

will test whether utility usage is higher than the

efficiency standards. If so, the project company will

be required to rectify thermal or other deficiencies

within the building, or make a compensatory payment

to cover the public sector loss.

■ Insurance

Risks associated with insurance have also been

revisited. The Government now recommends self-

insurance and provision of a public sector indemnity

for projects with a dispersed asset base and reduced

risk of catastrophic loss. Any indemnity will be

subject to government accounting and FSA regulatory

controls. The new SOP2C guidance gives examples

of where insurance risk should not be transferred to

the private sector. The examples include:

■ not requiring material damage and business

interruption insurance on a street lighting project

(where the project company can simply take the

risk of replacing street lights which are damaged);

■ providing an indemnity, rather than material

damage and BI cover, during the operational

phase of a roads project; and

■ retaining damage risk in sectors where there is a

shallow or inefficient insurance market for

situations where an asset is used in hazardous

conditions.

The government recognises that self-insurance will

raise concerns that senior debt service may not be

covered, or that the public sector could become

responsible for risks that should be the subject of PI

cover. It therefore intends to pilot potential

approaches to self-insurance in future pathfinder

schemes, which submit a business case predicated on

self-insurance.

SOP2C continues to include provisions relating to

insurance premium risk, but the public sector can now

choose its own "nil change" band of between 5 and 30

per cent up and down from the agreed premium

baseline (30% in SOPC4). This is intended to reduce

04 | PF2 – the big rebrand

the level of contingencies currently factored into

unitary payments to cover increased premiums.

FLEXIBLE AND TRANSPARENT SERVICE

PROVISION

Review of existing PFI contracts unearthed a number of

practices that undermined value for money in their long

term service element: either because they precluded

flexibility to reduce or change the scope of service

provision, or because elements of the contract included

inflated pricing.

Recognising that continued responsibility for asset

maintenance enhances design, the government has

retained so-called "hard" services, but excluded

"soft" (eg catering, cleaning and security) services from

the contract structure. They will now be provided

separately through shorter term contracts, to provide the

flexibility to alter service specifications over time. There

will be additional flexibility within the contract structure

to add or remove certain "elective" services (the

examples of periodic redecoration, portable appliance

testing and snow and ice clearance are given - the type of

services which can reasonably be provided from the

maintenance contractor's existing skill set). Elective

services will be provided at a pre-agreed price and can be

added or removed from the project without the need to re

-run the financial model.

PF2 will introduce efficiency reviews to assess service

and efficiency improvements. Efficiency reviews will be

carried out to coincide with the five yearly review of

actual / planned lifecycle expenditure. In line with

regulated businesses such as the water industry, and to

recognise the continuous improvement relic of the

previously more extensive Best Value duty, SOP2C

"recommends" qualitative monitoring obligations to be

measured through customer satisfaction surveys.

Although the mechanism is not clear, seventy-five per

cent of savings realised as a result of an efficiency review

will be paid to the public sector, and twenty-five per cent

to the private sector.

STANDARD DOCUMENTS

SOP2C, like its predecessor "Standardisation of PFI

Contracts", follows a format of explanation of principles,

followed by required/recommended drafting. It remains

to be seen, as PF2 is applied to further sectors, whether

standard project agreements will be issued in the same

way as the DfE has done for the Priority Schools

programme. The benefits of standardisation are also to

be applied to output specifications to ensure

proportionate design commitments.

Consultations on standard form services output

specifications, shareholders' agreement and payment

mechanism have been promised for "soon" after the

Autumn statement.

THE WAY FORWARD

Successful implementation of PF2 will depend on a

prioritised project pipeline. The government has

confirmed that PF2 will be applied to the government's

£1.75bn privately financed Priority Schools programme.

The Government has also marked out projects to improve

parts of the MOD estate as possible candidates for a PF2

structure, as well as Sandwell and West Birmingham

hospital projects and potentially some roads schemes.

However, industry remains sceptical about the speed with

which such identified projects will come to market and

the volume of future projects further down the pipeline.

While the immediate PF2 pipeline is focused on

accommodation projects, the Treasury has confirmed it

will work with departments to ensure all suitable projects

are able to take advantage of PF2.

It will also be interesting to see how PF2 is applied and/

or modified (in particular the government's stated equity

ratio requirements) on schemes that may incorporate

other credit enhancing structures being promoted in the

market, such as the EIB 2020 project bond, Hadrian's

Wall Capital Fund, PEBBLE and CLIP.

Whilst no formal timeline has been published, further

PF2 developments to track are:

■ Consultation on standard form services output spec,

shareholders' agreement and payment mechanism -

"soon" after Autumn statement;

■ Infrastructure Procurement Routemap to be issued for

consultation in January 2013;

■ Updated value for money assessment guidance to be

issued for consultation in Spring 2013;

■ Voluntary code of conduct to improve efficiency and

transparency in operational projects to be issued by

end of March 2013;

■ Pension Fund Platform report in early 2013;

■ Review of procurement capability within Whitehall -

Budget 2013; and

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■ Business case approval tracker for PF2 projects to be

published on Treasury Website from Spring 2013.

■ Central unit for managing public sector project equity

to be developed as an arm of HM Treasury

■ Pilot projects for equity funding competitions post

preferred bidder to determine third party equity

■ Insurance pathfinder projects - by authorities who

prepare a business case predicated on self-insurance