15/01/2019

Judith Hopper and Sharon Renouf report on the ongoing ripples in the PFI sphere after the dramatic collapse of Carillion 12 months ago.

 

Timeline

September 2017

Shadow Chancellor John McDonnell pledges to bring existing PFI contracts "back in-house" if Labour wins the next election.

December 2017

Serco agrees to buy portfolio of Carillion’s NHS PFI service contracts for £50 million.

15 January 2018

Carillon groups declare insolvency. Cabinet Office agrees to fund trading liquidation to ensure continuity of public services.

February 2018

Serco buys Carillion NHS PFI service contract portfolio for revised price of 29.7m.

May 2018

International Public Partnerships Limited announces that 22 of the 24 FM contracts in which it invests have moved to new suppliers.

7 June 2018

National Audit Office Report “Investigations into the government’s handling of the collapse of Carillion”.

June 2018

Banks pull out of Midland Metropolitan Hospital.

9 July 2018

House of Commons Public Administration and Constitutional Affairs Committee publishes report “After Carillion: Public sector outsourcing and contracting”.

August 2018

Government confirms it will directly fund the completion of the Midland Metropolitan Hospital.  

September 2018

Royal Liverpool Hospital PFI deal terminated by NHS Trust.

29 October 2018

Philip Hammond announces abolition of PF1 and PF2 for future contracts and promises to establish a centre of best practice for PFI contracts, starting with the health sector.

November 2018

Kier’s shares fall by a third after it launches a £264m rights issue.

December 2018

Shares in Interserve fall by 75%.

December 2018

Ferrovial announces plans to sell Amey.

 

Introduction

On 15 January 2018 the Carillion group of companies declared insolvency. In the PFI market, Carillion was a significant player: as noted in the NAO report dated 7 June 2018, public sector contracts accounted for 33% of Carillion's total revenue and 45% of its UK revenue. Carillion held around 420 contracts with the UK public sector, including contracts for facilities management, road and rail maintenance, accommodation, consultancy and construction, and the Local Government Association calculated that 30 councils and 220 schools were directly affected by its collapse.

On the day Carillion's liquidation was announced, the Guardian declared it a "disaster not just for employees and taxpayers, but for public-private partnership", and reported on "the four contracts that finished Carillion": two of those were the construction of PFI hospitals (the Royal Liverpool Hospital and the Midland Metropolitan Hospital).

Construction is of course arguably the riskiest part of a PFI contract from a contractor perspective, and can be contrasted with contracts which are already operational. In the following months the vast majority of Carillion's PFI contracts were transferred to third parties; indeed, by 23 May 2018, only 21 public sector contracts remained within the insolvency regime. The structure of the contracts means that, although an insolvency event is technically an Event of Contractor Default which can trigger termination, performance can be taken on by a third party. In a contract for buildings, the public authority retains ownership of the land, and grants a licence or lease to the Contractor; on equipment projects, where the Contractor owns the equipment, the Authority's Direct Agreement with the lenders will typically be structured in such a way to allow the public authority to obtain use or, if necessary, ownership of the equipment to allow performance of the contract to continue. In project financed agreement, the Direct Agreement between the lender and the public authority will be structured to allow the lenders to "revive" the project in the event of termination.

Nevertheless, the effects of Carillion's dramatic collapse have continued to be felt in the PFI/ partnerships market some 12 months on: in issues being faced in legacy Carillion contracts; in a turbulent market for Service Providers; and in the political landscape and attitudes to public-private partnership going forward.

 

Pressure on Lenders and Service Providers

In the immediate aftermath of the Carillion liquidation, the share prices of infrastructure trusts fell sharply. The market is now relatively steady from an investment perspective, with a number of foreign based investment companies still showing an appetite for re-financing: PFI contracts theoretically still offer a reliable source of inflation linked income over a course of several years.

However, it is fair to say that the market is more tumultuous from the perspective of Project Companies and Service Providers. There has been a notable slowdown in sales of Project Companies, and the market has also seen significant falls in share prices for Kier and Interserve, with Ferrovial announcing the sale of Amey after it set aside £208 million to cover losses on its 25 year highways PFI contract with Birmingham City Council.

So why has the market been so challenging for Service Providers? Arguably they have faced a double squeeze: from public sector clients on the one hand, who in an austerity climate are seeking to either implement costs savings across the contract or, depending on one's perspective, to rigorously enforce contractual rights to ensure value for money can be demonstrated; and from bankers and lenders who require the returns to justify the investment.

When projects were tendered, price was often a determining factor and Contractors and Service Providers often had to make assumptions about risk. The ability to model risk appears to have proved more challenging in some markets than others: in highways, for example, the scope and condition of the asset is theoretically more difficult to assess than in a new build, although of course as we know new builds (whether it be schools or hospitals) have not been without their problems either, including a range of problems with fire safety which have taken on a new significance post-Grenfell.

Finally, whilst the general assumption is that in PFI contracts risk transfers from the public to the private sector, the position is somewhat more nuanced. Generally, the Service Provider Vehicles are not heavily capitalised and therefore have little scope for risk: as debt and equity holders also sought to avoid risk, it tended to be the Contractors who bore the brunt– and for some the ability to hedge/ insure against those risks has proved challenging.

These factors combined have meant that, although in the public imagination PFI has come to be associated with "fat cat" private sector companies ripping off the public sector, the profit margins at delivery level are sometimes slim – as Carillion demonstrated. Although Carillion's contracts spanned the UK education, justice, defence, transport and health ministries, the NAO report noted that, whilst its local government contracts had a 13 to 15% operating margin, facilities management services were only just profitable (1%), and construction projects such as Midland Metropolitan and Royal Liverpool were incurring significant losses.

 

The Political Landscape

PACAC reported “The Government needs to better understand the true quality of leadership and governance of its major commercial partners, whose greed and appetite for risk in Carillion was significantly at odds with public service values.” It was similarly scathing about the benefit of PFI:

While we are confident that PFI costs more than conventional procurement, neither we nor the National Audit Office nor the Public Accounts Committee can find any evidence of the benefit the Government claims for it”.

In October, Philip Hammond used his Budget to abolish PFI and PF2, saying “the days of the public sector being a push-over must end”. In essence, this made official what was already known in the sector: only 5 12 PF2 projects had been brought forward been 2012 and 2016, with no new PF2 deals signed since then. Contributing factors to the official announcement presumably included the Carillion fall-out, as well as a response to the Labour party's stated aim to nationalise PFI contracts, but the underlying reason for the slowdown is a concern about whether PFI or PF2 can really deliver value for money.  

 

Management

For private sector providers, investment companies and the public sector, there remains the challenge of managing PFI contracts. Pronouncements about the "death of PFI" are clearly overstated when over 700 PFI deals are currently operational in the UK with a capital value of over £60 billion. Those include the transferred Carillion contracts, where some public sector bodies are struggling with legacy issues such as fire defects, a lack of paperwork and incoming service providers refusing to accept liability.

For those working in the health sector, it will be hoped that the Centre of Best Practice will promote a more balanced approach to project management by the public sector.

 

Conclusion

The last 12 months have proved turbulent in the PFI sphere. Clearly there is the possibility of future turbulence: the market is watching with interest, but it is certainly feasible that another large contractor could face insolvency given what has been seen with the share prices, and that is before the impact of a possible change of prime minister or even government is factored into the analysis.

In the meantime, with most of the government's energies and efforts focused on Brexit, the real question is how future infrastructure will be delivered if not via PFI or PF2. The government had announced in 2017 that PF2 would be used as part of its stated aim of increasing infrastructure by 60% over the next 4 years. It must be questioned whether that target will be met, and if so, how. It seems unlikely that it will be through public sector capital – so new models need to come forward to find the gap.

Even if a new PPP model can be agreed with Treasury, it remains to be seen whether bruised Contractors, Service Providers and investors will re-engage with a model that has been so challenging for them in recent years.

 

 

 

Originally published by Building magazine online on 15th January 2019.