Sir John Bourn, head of the National Audit Office (NAO), told Parliament today that the Prison Service had secured £1 million of the expected £10.7 million increase in returns to shareholders of Fazakerley Prison Services Limited, following the refinancing of the Fazakerley prison contract let under the Private Finance Initiative (PFI). Further refinancings of PFI contracts are likely to occur, and the NAO’s report suggests a number of principles which should guide departments faced with similar refinancings.
The refinancing of this first PFI prison contract took place in November 1999. The contract had been let in December 1995 to Fazakerley Prison Services Ltd (FPSL), a project company formed by Group4 and Tarmac. Under the contract, FPSL is responsible for constructing the new prison and operating and maintaining it for 25 years. The refinancing followed the prison’s successful construction and first two years of operation. The benefits which the refinancing brings to shareholders can be seen as the reward for taking risks in managing this novel prison contract.
The PFI contract did not give the Prison Service a contractual right to share in the benefits of a refinancing. But the refinancing involves the Prison Service in increased risk, so the Prison Service sought compensation for accepting it. The increased risk arises because the refinancing increases the project’s bank borrowings, and in certain termination circumstances the Prison Service might have to pay off that debt. The contract did give the Prison Service a right to seek such compensation.
The Prison Service achieved its objective for this negotiation. The Service accepted compensation of £1 million, having rejected lower offers. The £1 million compensation was consistent with the Service’s estimate (adjusted for risk) of the extra payment which might arise. The actual payments could range between £8 million and £47 million with a low probability which the Prison Service assessed as no more than 10% in the worst case.
The Fazakerley refinancing has important lessons for departments because further refinancings are likely to occur. This is because banks are often prepared to offer better terms once the project is successfully developed and the perceived risks reduce. Refinancing opportunities apply especially to early PFI deals where better terms are now available in the developing PFI market.
The report recommends that departments should keep in mind a range of principles when developing PFI contracts and if they are faced with a refinancing. The key ones are:
- appropriate benefits should go to those bearing risks
- benefits from reducing costs in a developing market should be shared if they have not already been reflected in the contract price;
- it is reasonable for departments to seek compensation for any increased exposure to termination liabilities arising from a refinancing;
- substantial refinancing gains to the private sector may threaten the perceived value for money of the project;
- a refinancing should not jeopardise the stability and success of the long term contractual relationship between a consortium and a department; and
- if the private sector seeks to improve its returns by renegotiating parts of a PFI contract it is reasonable for departments to seek a share of refinancing benefits.
The report identified a number of other key learning points for future projects :
- Departments should give careful consideration to refinancing issues when planning PFI projects. They should address whether they should establish within the PFI contract the right for them to share in refinancing benefits.
- They should also unambiguously set out in their PFI contracts the circumstances in which they will be required to consent to part, or all, of a proposed refinancing.
- Given the complex issues which arise from refinancings it is essential that departments take early advice from experienced legal and financial advisers as the Prison Service did in connection with the Fazakerley prison refinancing.
- Where departments will be exposed to increased termination liabilities as a result of a proposed refinancing they should consider whether they wish to limit this risk.
- Where a department has given itself flexibility to negotiate over refinancing benefits it should give careful attention to preparing a robust but reasonable negotiating strategy.
- Departments should consider linking at least part of their advisers’ remuneration to the outcome of any negotiations to which the advisers contribute.