Secondary market? It’s first for profits

You know one of the most interesting things about the UK secondary market for Private Finance Initiative (PFI) equity stakes? Nobody really knows how big it is or how much profit it has generated ever since trading in PFI stakes began in earnest in the early 2000s.

The reason for that is quite simple: “The Treasury has not previously required disclosure of sales proceeds,” as the National Audit Office highlighted in a May 2012 report titled Equity investment in privately financed projects.

And if the government isn’t asking, then the private sector has very little incentive to provide that sort of commercially sensitive information. But here’s what we do know: if the 100 stake sales detailed in the NAO’s May report are anything to go by, the UK secondary market appears to be generating a healthy profit.

How healthy? Non-smoking, teetotaling, five-a-day type of healthy. The figures speak for themselves: 48 transactions covering the sale of equity and subordinated debt stakes in 100 projects worth £388 million (€477 million; $618 million) between October 2003 and September 2011 generated £811 million.

That’s £423 million in profit, or a 47.8 percent profit margin, using a rudimentary calculation that only takes into account the value of the equity and subordinated debt sold versus the final sale price.

Dexter Whitfield, a professor at the University of Adelaide and director of the European Services Strategy Unit (ESSU), an organisation that monitors public-private partnerships (PPPs), submitted a written statement to the UK Parliament reaching much the same conclusion.

Drawing on the ESSU’s proprietary database, Whitfield told MPs that 63 transactions covering the sale of just over £1 billion of stakes in 154 PFI projects generated close to £518 million in profit between 2003 and 2010 – an average profit margin of 50.6 percent. Whitfield did not describe his sources other than to say they were “reliable sources”.

Not surprisingly, he argues that the UK PFI equity market is actually much larger than the above sample.

According to the Australian professor, 622 PFI stakes worth £3.88 billion changed hands between 1998 and 2010. While he doesn’t provide exact profit figures for this larger number of deals, he extrapolates that if we apply the 50.6 percent profit margin from his smaller sample of 154 stake sales, then the PFI secondary market as a whole will have generated over £2 billion in profits during the above 12-year time period.

Based on its analysis of 100 stakes sold between 2003 and 2011, the NAO concluded the typical secondary market deal achieved an exit return for the seller of between 15 percent and 30 percent. Some deals generated impressively high returns of between 40 percent and 60 percent while others barely registered on the radar, with returns to sellers of 5 percent to 10 percent.

For that privilege, buyers – usually infrastructure funds on behalf of institutional investors – get access to a de-risked portfolio generating long-term average returns in the high single digits. Sellers, on the other hand, get to recycle equity and net a solid, medium-term return for taking on construction risk.

A virtuous circle for all investors involved, but one that is facing two potentially significant obstacles: an ever-diminishing pipeline of deals in the medium term, as the primary PFI market dries up; and an increased level of government scrutiny that threatens the sort of profits made to date.

Tick-tock

To clarify, there is no immediate threat to deal flow in the UK PFI secondary market and, provided the new government’s re-tooled PFI gains momentum via a consistent pipeline, there may never be a shortage of deals in this space.

Perhaps the best indicator of the health of the secondary market is found in the latest fundraising statistics. In early October, Dalmore Capital, a London-based fund manager, reached a £130 million first close on a new UK-focused secondary fund with commitments from five investors, including UK corporate and local authority pension funds and international institutions.

As if to prove that investor confidence in the new vehicle was not unwarranted, the fund immediately spent £89.5 million acquiring a 49.9 percent stake in two investment vehicles holding 19 PFI assets. It’s also encouraging to note that the team behind Dalmore is made up of veterans from I2, which was once the UK’s largest PFI secondary fund before it was sold to Barclays Private Equity in 2009 for £558.6 million.

Many of the space’s well-established players have also been tapping the market successfully since the beginning of the year, in a sign that investors are comfortable with the pipeline visibility highlighted by general partners.

Two of the sector’s most recognisable names – HICL Infrastructure Company, the UK’s first listed infrastructure fund, and International Public Partnerships – raised £250 million and £200 million respectively this year.

Even a relative newcomer like London-based Gravis Capital Partners, which dabbles in the UK subordinated debt market, has managed to raise £155 million so far this year. More importantly, the secondary market is also showing it has enough breadth to allow players to approach it from different angles.

UK fund manager Foresight Group recorded the largest venture capital trust (VCT) fundraising in the 2011/2012 tax year with its tax-friendly, £33 million Infrastructure VCT Shares vehicle, which targets investments in the secondary PFI market and wider infrastructure projects.

Richard Thompson, senior investment manager at Foresight, is bullish on the UK secondary market, deeming it “very robust and increasingly competitive as investors pile into infrastructure on the back of sluggish returns in fixed income”.

But Thompson is also aware that, without a healthy primary market, the secondary market will eventually dry up. “The current pipeline for secondary PFIs is healthy and supports our current investment programme. However, unless the government ends the hiatus in PFI deal flow soon there will be a gap in the future secondary pipeline,” he warns.

Asked if he is confident the government’s re-tooled PFI framework will be enough to kick-start the primary market, Thompson sums up what is going through the minds of many other investors: “Only if it is backed up with a robust, visible pipeline.”

Party’s over

Despite the difficulties in estimating the size and profits generated by the UK secondary market, parts of the government appear to have already decided that the market is big and profitable enough to merit some changes in its functioning.

One of the most commonly mentioned changes – proposed by parliamentary bodies like the Public Accounts Committee (PAC) – would see investors share in the profits of future equity sales with public authorities.

In fact, some of the newer PFI contracts already stipulate this measure. The recently awarded £1.2 billion Isle of Wight roads maintenance PFI has a clause stipulating that the island government is entitled to get a part of the profits derived from future equity sales.

It will not be very surprising if a re-tooled PFI framework addresses this issue across the board.

Then there’s the more contentious issue of taxation; namely, how trading in PFI shares means that many of the owners of these projects are now located in tax havens, like Jersey or Guernsey.

Needless to say, this shift doesn’t sit nicely with many in Parliament. Margaret Hodge, the Labour chairwoman of the PAC, accused investors last year of “milking the PFI system for profit”. Stella Creasy, also a Labour member, argued that “there is tax out there that the British taxpayer is owed and the Treasury is doing nothing to get it back”.

All these criticisms, warranted or unwarranted, combined with a potential future drought in the pipeline, seem to point in one direction: the UK secondary market of the future is unlikely to look like today’s. In fact, while still attractive, its golden age might have already passed.