The refinancing of private finance initiative projects has become an important area of interest to all those involved in the sector. Refinancing can provide an opportunity for the private sector parties who have invested in the project to significantly increase their returns, although there are now requirements for these refinancing benefits to be shared with the public sector.

This is a complex area and it is worth, therefore, explaining the background to how refinancing opportunities arise, and summarising the key issues that public authorities should address when faced with refinancing proposals from the private sector.

As the risk in a PFI project diminishes, for example when a building is up and running and the service is being delivered, it is often possible for the private sector project company to negotiate improved financing terms with the lenders. These, in turn, can generate financial gains over the life of the project for the shareholders of the project company.

Lenders can offer better financing terms in a number of ways. First, they might give the PFI project company longer to repay its loan. This will put the project company in the position of being able to pay increased dividends each year to its shareholders, because pressure to pay off the loan has decreased.

Second, lenders are often prepared to reduce the interest rate they are charging the project company to reflect the reduced risks. And some PFI projects also benefit from the fact that interest rates are generally lower today than they were in the mid-to-late 1990s when early PFI deals were entered into.

Third, once the service is in operation the lenders may be prepared to allow the contractors or other private sector investors to withdraw part, or even nearly all, of their original cash investment in the project, but continue to draw the same level of dividends. The lenders may also be prepared to increase the amount of debt in the project company, creating surplus funds which can be used to accelerate the payment of benefits to shareholders.

Under each of these three scenarios, diminished risk in the project results in lower finance costs and hence higher rates of return for the private sector shareholders over the life of the project.

Awareness of the refinancing of PFI projects was raised when the National Audit Office (NAO) published in June 2000 a report on the first major PFI refinancing, the Fazakerley PFI prison project. As a result there were concerns on the public sector side about the effect that refinancings might have on the perceived value for money of PFI projects.

In the Fazakerley prison project the rate of return to the private sector consortium’s shareholders increased from 16 to 39 per cent following the refinancing. The Commons public accounts committee (PAC) saw this as a windfall gain and asked the Office of Government Commerce (OGC) to introduce new guidance aimed at sharing refinancing gains between the public and private sectors.

In the early days of PFI, departments had not been encouraged to seek a share of refinancing gains. In part, this reflected the Treasury’s desire to encourage the development of the PFI market and its recognition that similar deals overseas did not then usually have contractual arrangements to share refinancing gains.

In the light of emerging experience and the concerns raised by the NAO and PAC, the OGC and the Treasury introduced new refinancing arrangements, following discussions with the private sector. In July 2002 new guidance stated that all future contracts would include clauses to give departments the right to approve refinancings and to share the gains 50/50 with the private sector.

A new voluntary code, agreed to by both the public and private sector sides, was launched in October 2002. Under the code the public sector will generally receive 30 per cent of the refinancing gains of early deals, many of which contained no explicit arrangement to share refinancing gains.

For the new arrangements to work in practice, there needs to be increased understanding of refinancing issues. Public sector officials must gain a deeper understanding so that they are fully equipped to operate the new arrangements effectively. And, on the private sector side, contractors have to appreciate the public sector’s need to be accountable for value for money throughout the life of a PFI project.

There is also a need for a good information flow from the private sector about intended and completed refinancings. The new guidance required the private sector to seek departments’ approval for all refinancings where the sharing of gains would be applicable.

It is also important for the public sector to monitor the extent to which these new arrangements succeed in genuinely improving the value for money of PFI deals. This will involve taking account of any effect that the new arrangements to share refinancing gains may have on the pricing of deals.

And particular care needs to be taken before agreeing to any refinancing proposals which involve increased level of private sector debt, increased public sector termination liabilities, or longer contract periods.

Most of these issues were raised in our Refinancing Update report published in 2002. As part of our current PFI work we are commencing an examination of how the new refinancing arrangements are working out, now that they have been operating for over two years. Other new NAO reports, for example our report on progress on the Dartford and Gravesham PFI contract, will report on refinancings which have been completed on individual projects.

In addition, the Treasury, which took over responsibility for PFI policy from the OGC, has a refinancing taskforce available to advise public sector officials on issues arising from the Treasury refinancing guidance.

Given the complexities involved in refinancing, being aware of the relevant issues, and taking appropriate advice, is an essential prerequisite for any public sector official faced with a future PFI refinancing.