PFI – Model business magnet

The stand-off between government and the Accounting Standards Board over who should bear the risk for Private Finance Initiatives seems to have resulted in an impasse. The question for developers, property specialists and the government remains – is there a way forward for both public and commercial PFIs?

On 10 September, the ASB published its amendment to FRS 5: ‘Reporting the Substance of Transactions: Private Finance Initiatives and Similar Contracts’.

The board says: ‘The application note has been prepared in response to the need for clarification of how the principles and requirements of FRS 5 should apply to transactions conducted under the UK government’s PFI. The note will also be appropriate for other contracts of a similar nature’ – in other words, commercial PFIs.

But what is the impact?

Does the amendment give the government what it wanted? Will this mean more ‘commercial’ PFIs in the public and private sectors?

History of ASB criticism

The ASB’s original proposals for the amendment, published in December 1997, were much criticised by government. This was because the ASB suggested that PFI projects – which contain a multiplicity of supplies such as building, cleaning and catering – should be split into separate supplies for asset allocation or balance sheet purposes.

The government was of the contrary view and stated that the unitary payment should be considered as a whole, with all the variable cash flows relating to the service components contributing to the imprecision of the building amortisation payments. If the government’s approach were to be adopted, many PFIs would not be recognised immediately, if at all, in the national debt and would be treated as operating leases – despite the fact that the combined unitary payment, like any rental and services payment, would have an impact on annual revenue. Ultimately, this could also result in a PSBR impact if government expenditure was not in balance.

The macro-economic background to the government’s view may be difficult to fathom immediately as the volumes of ‘done’ PFI deals are freely published. Thereafter, the market is well able to judge the extent to which immediate government debt is being substituted by a close cousin of hire purchase. Furthermore, the government has said that PFI was about efficient procurement rather than balance sheet treatment.

The reasons behind the government’s standpoint are to be found elsewhere.

EMU entry has always been restricted to countries with a national debt of no more that 60% of GDP and annual PSBR of 3%.

Indeed, Paymaster General Geoffrey Robinson said at a spring Treasury conference that there would be an accommodation. ‘PFI has got to be off balance sheet otherwise it will count against the PSBR and all the restrictions that that imposes’. He went on to say, however, that ‘value for money is the key to PFI, and balance sheet treatment should not be allowed to dispense with it’.

Unfortunately for the government, the ASB has gone for an even stricter slicing of PFI transactions than could have been inferred from their exposure draft – in a written form that is the very model of clarity.

The result of this will inevitably mean a slowing down of PFIs brought to the market. This will be combined with a reappraisal of many projects so as to increase the level of risk imported into the true property component of such transactions and so removing these from the user’s balance sheet.

But nothing comes without a price. Historically, many public PFIs have been achieved with little equity injection by the supplier because there was little true risk in the cash flows.

If, however, greater imprecision and risk is to be incorporated into the property amortisation proportion of the project cost, then this will increase the equity injection required. This, in turn, will trigger a higher necessary return and potential cost and impact on the users’ ‘value for money’ evaluation. Hopefully, the public-sector comparator which is used to judge this will be amended to take account. Without such action many projects could be cancelled.

There is little doubt that public PFIs have triggered a thought process in the corporate sector. Companies now see a way of releasing the capital they have tied up in specialist commercial buildings – those buildings that the property market would not ordinarily buy at a decent price because of lack of comparables – by doing sales and leasebacks.

Such transactions, if structured in a way that falls in line with the amendment to FRS 5 – would take them off balance sheet and increase the return to shareholders’ funds, that is, to use the US term, increase EVA (economic value added). This kind of transaction could also be applied to public PFIs to take them off balance sheet and out of FRS 5.

Certainly our experience at Crosher James with commercial sale and leasebacks for specialist factories, research centres, pipelines, laboratories and infrastructure has shown us that auditors would not treat them as an operating lease, if an amortising rent was simply added to by a facilities management charge. They have been applying the FRS amendment for years.

In order to create an opportunity lease, we have had to create substantially variable rents on the realty component of the transaction. This transfers to the acquirer a true project risk.

This has been achieved by recognising that realty assets have within them a variety of slices of value. Each of these slices can be valued separately and, if necessary, sold to different investors. For example, all realty can be divided into at least the following slices or floors of value: the current passing rent; the rent review formulae; the tax reliefs (such as capital allowances), and the reversionary value.

Using this technique we have introduced equity investors into transactions to ‘buy’ the rent review formulae. These deals have been based on market comparables elsewhere, movements in share price, or through output volumes, for instance. Indeed, the transactions will work with any form of bet that can be sold into financial or other markets.

Equity investors can also be attracted to acquire the pregnant tax reliefs that are present within projects. Furthermore, the various reversionary values that could be present in the manufacturing equipment or buildings can also be sold at the beginning of projects.

You will appreciate that the injection of equity into these variables will result in the lowering of the realty cost. As a result, the starting rent can be reduced to quite low levels. Indeed, it can be reduced to levels that transfer the project risk most definitely to the operator or landlord under the accounting standards.

These corporate PFIs – ‘sale and leasebacks’ in old speak – can also be structured, giving the tenant almost total control of the building and the ability to alter it almost at will. This ‘tenant control’ has proved very important to corporate users who have often had bad experience of traditional institutional sale and leasebacks where landlords have been very difficult over alterations – alterations that are essential to most dynamic businesses.

Happily, with the type of commercial PFI we are talking of here, which is covenant-based, alterations to properties are unrestricted.

So what can be learned from the commercial sector and applied to public PFIs? In reality, there would be no problem gearing the rent on schools or hospitals to appropriate variables – provided, of course, that these variables, when packaged into an investor format, are in a form that can be sold. If this were done, the starting unitary charge could be reduced to quite a low level.

I have heard, however, from a couple of public-sector sources that the realty portion of a unitary charge cannot be variable because of existing law. I have not been able to verify this. If correct, all the government needs to do to break out of the FRS corner is to permit it. To have a variable rent on a school is, in reality, little different to renting a Whitehall office block from a property company with market-based reviews.

Jimmy James is chairman of Crosher James Capital Ventures Ltd.

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