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Unwanted partners Should contractors leave financing to the bankers and stop investing their scarce reserves in Private Finance Initiative projects?

Last week Channel Tunnel Rail Link consortium London & Continental Railways underlined its unique approach to the Private Finance Initiative.

By announcing preferred bidders for its first two major construction contracts, LCR confirmed a project structure which excludes contractors from the client side of the operation, relegating them to the role of subcontractors with no financial stake.

LCR is the first major PFI consortium to set itself up as a client with no contractor shareholders. As such it hopes to avoid the conflicts of interest which dogged the early stages of the Channel Tunnel project leading to the establishment of Eurotunnel as client and operator by contractor TML.

LCR is no longer unique, however. Last week it emerged that PPM, the consortium chosen for the Department of Social Security's £4bn PRIME property estate redevelopment concession, had become contractor free, with the departure of Amec just before the concession was signed (News 15 January).

Amec's decision to withdraw from PPM - a consortium of property developers and facilities managers led by merchant bank Goldman Sachs - throws doubt on the need for contractors to invest often scarce financial resources in PFI consortia.

Traditionally contractors have put equity into PFI consortia so that they can pick up the construction contracts. Banks and other investors are usually unwilling to put up more than 90% of a project finance package. They expect consortia members to put in the rest as high risk equity as a sign of commitment.

Equity ranks behind bank loans or bonds in the queue for repayment so if a project runs into serious financial trouble, contractors and other consortium members face the biggest risk of losing their money.

Contractors tend to invest money in PFI consortia because they want the workload. This is as true for the first privately financed prisons, hospitals and roads as it was for earlier private finance projects like the Channel Tunnel, the Second Severn Crossing and the Queen Elizabeth II Bridge at Dartford.

Whether this continues to be the case is open to question, now that the PFI has started to produce a stream of projects.

City financiers are becoming more confident about putting money into PFI schemes and specially established investment funds such as Innisfree and BZW Private Equity have begun to invest - often alongside contractors - relieving some of the financial pressure on them to put money in.

It is perhaps not surprising that as a result contractors are being seen by some in the financial community as unwanted equity players who should stick to the business of building and leave investing money up to them.

'Contractors are not only not necessary but as a general rule should not be there,' says KPMG partner and head of corporate finance Tim Stone. He predicts that as the PFI matures, the role of contractor as investor will shrink.

'If you are putting a consortium together, you have got to think about where your competitive advantage is and how to get the best price,' says Coopers & Lybrand partner Simon Roberts. He believes that contractors winning work on the back of their investment in a PFI consortium may not necessarily offer their fellow shareholders the best value for money construction contract.

This is because their reward for investing in the consortium is a construction contract whose only exposure to competition is the DBFO procurement process.

Poor value for money could be a particular problem on building projects where the construction element is small and relatively simple, compared to the facilities management work.

There is speculation that this may have been one of the issues at the centre of Amec's withdrawal from PRIME.

For PRIME the problem could have been that there was no new build element. At £4bn, PRIME is one of the largest PFI projects, most of the money for which will go on facilities management contracts worth around £85M a year and repair and refurbishment work worth £41M a year.

Amec is not known as a FM contractor and may have struggled to convince the other members of PPM that it could offer the best value for money FM and refurbishment deal.

Significantly, Amec and FM contractor Building & Property Group this week signed the private finance concession to design build finance and operate a £160M new office building for the DSS in Newcastle.

Unlike PRIME this is a new build project with a clear construction element. It will be interesting to see when Amec decides to cash in its stake once the building stage is over.

Part of the problem for contractors is that few if any are really investing in projects for a long term financial return. Most have scant financial resources and cannot afford to spread them between more than a few projects at a time.

Consequently most can be expected to cash in their equity as soon as construction work is over. If they are lucky they will make a profit on their stake at this stage, as investors are likely to pay a premium to invest in a project which has passed from the high risk construction phase to lower risk operation.

Some in the construction sector fear that if contractors are only involved in projects for the short term they will pay more attention to keeping construction costs down than to whole life costing.

This could lead to tension in consortia formed by contractors and facilities management companies because the FM company would be pushing for higher construction cost, lower maintenance building.

Facilities management and construction services groups like Jarvis have started to exploit this problem by bidding alone and offering a combined FM and contracting service.

Jarvis is currently investing equity in and building the new Colfox School in Dorset on this basis although even it admits that it could look to recycle its equity within a few years of the end of the construction phase.

Despite the drawbacks, there are still some advantages in contractors becoming investors in certain types of PFI projects. 'It does help on roads to a degree,' says KPMG's Stone. 'But it depends to what extent serious money is being put at risk.'

Contractors maintain that as most DBFO roads have a high up-front capital cost, it is imperative on them to get involved in consortia from the beginning if they are to put in a competitive bid. It is no surprise that the consortia involved with these projects all have at least one contractor on board as equity investors.

Competition for roads is intense at the best of times , given the shortage of work in this sector. As a result it is unlikely that DBFO contractors will be getting away with comfortable margins just because they are part of a winning consortium.

'Contractors understand very well that they are bidding against their competitors through the PFI process,' says Mike Mercer-Deadman, general manager of UK Highways, in which Laing and Tarmac are shareholders.

Coopers & Lybrand's Roberts says that contractors could help some consortia bidding for

high-tech building projects with a substantial plant and equipment content. On these projects there is a role for an early contractor involvement because there is a close link between construction and operating

costs.

The Construction Confederation made a plea in its recent Budget submission, that contractors' role in PFI projects not be downgraded. Whatever the government thinks of this request, it is likely to be a lot less important than the attitudes of prospective partners, particularly funders and operators, and the objectives of the individual builders, who - rightly or wrongly - are likely to be focused on short term profit.

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