The Cost of Public Healthcare Private Financing

In a typical hospital developed under a PFI (Private Finance Initiative) scheme, a private special purpose vehicle (SPV) manages and finances the design and build of a new facility. The financing of the initial capital expenditure (i.e. the capital required to pay start up transaction costs, buy land and construct the facility) is provided by a combination of equity from SPV sponsors (accounting for about 10% of the total investment at the point that contracts are signed) and senior debt from banks or bondholders, according to a project financing approach. On completion of construction, the SPV is responsible for maintaining the facility and running a suite of support service functions such as catering, cleaning and laundry, while clinical care remains the responsibility of the National Health Service (NHS) commissioner. In return for the capital investment by the SPV, along with its management of the construction process and the provision of buildings maintenance and ancillary services, the NHS pays a periodic "unitary charge" to the SPV, which is typically indexed by some ratio to the Retail Price Index (RPI).

The PFI is perceived by major PFI practitioners as a relatively low-risk investment for equity investors, being backed by government support (through the payment of the unitary charge, which is demand risk free), with a stable long-term yield and with many of the major risks shifted from investors to construction and facilities management subcontractors. Unlike other areas of project finance, PFI has very limited exposure to market risks and projects are structured so as to be highly robust to a wide range of potentially severe adverse events.

In an analysis of 77 PFI projects with a total capital value of £ 7.3 billion, signed between 1997 and 2011 by British National Healthcare Service organisations (Does the Private Sector Receive an Excessive Return from Investments in Health Care Infrastructure Projects? Evidence from the UK, forthcoming in Health Policy, doi: 10.1016/j.healthpol.2012.12.010), Veronica Vecchi (SDA Bocconi), Stefano Gatti (Department of Finance) and Mark Hellowell (University of Edinburgh) strikingly find that PFI sponsors extract a significantly higher return than their cost of capital. In their sample the average difference between the sponsors' Weighted Average Cost of Capital (WACC) and the PFI blended equity Internal Rate of Return (IRR) is 9.27%. The shareholders analysed are also involved in other PFI projects contracted by NHS organisations and across the programme as a whole the mean equity IRR is 15.11%.

Had financing for the 77 projects been available at the sponsors' WACC rather than the equity IRR, the unitary charges on each of the 77 projects would now be significantly lower. This is an extremely important issue since the costs faced by NHS organisations with operational PFI schemes have been shown to be a major contributor to financial difficulties for the NHS organisations involved. This has, in turn, often damaged the capacity of NHS organisations to meet population health care requirements.

A second way to view excess returns is in terms of foregone opportunities for investment. To the extent that capital investment is likely to increase the efficiency of the health system (and given the inappropriate profile of the current NHS estate, this appears to be a reasonable assumption), then the lost opportunities for additional investment have a negative impact on financial sustainability.

The article concludes saying that by consolidating the government purchasing function, standardising forecasted rates of return on an appropriate basis, and ensuring that actual returns converge to the acceptable level throughout the contract, policy-makers can eliminate the problem of excess returns on the (increasingly prominent) equity element of a project's capital investment. This is likely to yield significant financial benefits for individual public authorities involved. Conversely, given that equity is set to play a much greater role in project financing under PF2, the new approach to PFI introduced by HM Treasury in December 2012, in which gearing is to be lowered, the absence of such measures will lead to a major increase in the WACC for projects, and thus a much higher final cost for publicly funded hospitals and health care systems. In an era of tight fiscal constraints, such avoidable expenses should not be tolerated.