Securing a Better Deal From Investors in Public Infrastructure Projects

Abstract

The return on capital is a major contributor to the cost of design, build, finance and operate (DBFO) contracts, under which public infrastructure is financed and delivered by private companies. The article presents a method for evaluating the rates of return targeted by bidders and applies this to 10 contracts commissioned by the UK National Health Service. The presence of significant excess returns is identified in each case. We argue that, if the rate of return projected by an investor exceeds a benchmark cost of capital, derived using standard capital budgeting techniques, then a reduction in the fee to be paid by the public authority is justified.

Key words:

• design-build-finance-operate
• public infrastructure
• project finance
• hospitals
• internal rate of return

Notes

1 Under a typical DBFO, various tasks relating to the development and operation of public infrastructure are contracted out as a single package to a ‘special purpose vehicle’ (SPV), which is owned by private investors. The SPV manages the construction of the required infrastructure and thereafter administers maintenance functions and any other services included in the deal, receiving a periodic fee from the public authority in return.

2 Formally, the expected value of a given parameter is the ex ante mean of all possible ex post values of that parameter, weighted by probability. This approach to risk analysis, which follows Markowitz (1952), is based on the principle that such factors are uncertain, and this uncertainty can be modelled in terms of a probability distribution which summarizes an investor's degree of belief about the likelihood of possible outcomes. This distribution is often based on the past historical performance of investments with the same characteristics, modified to reflect the investors' knowledge of the current project or market conditions. On the basis of this probability distribution, the mean value or expected value of costs, revenues and returns can be measured. The risk of the investment is reflected in the variance, or dispersion, of the values modelled about their mean value.

3 These can give rise to different results. For example, in a seminal study, Fama and French (2002) examine the EMRP using (a) the average historical dividend yield plus average capital gain, (b) the average dividend yield plus the average rate of growth in dividends and (c) the average dividend yield plus the average rate of growth in earnings – and found an EMRP above commercial bonds of 7.7%, 2.7% and 4.5%, respectively, for 1951–2000.

4 In effect, reversing the process in which the sectoral Asset Betas were derived from the observable Equity Betas, thus: Equity Beta=Asset Beta × 1 + (1 − tax rate) × the amount of debt/the amount of equity.

5 The effect of the Blume adjustment is to reduce the difference between the Beta and the market average (i.e. 1). Blume (1971) found that adjusting estimated Equity Betas toward unity improved their ability to forecast subsequent period stock returns. The most widely held explanation for this is that unusually low or high Betas are subject to measurement error. Blume adjustment is standard in the calculation of Equity Betas by regulators in respect of UK, US and Australian utilities in determining the appropriate rate of return to investors and is recommended in the most prominent corporate finance textbooks (e.g. Brealey et al. 2010). Blume-adjusted Betas are available from most commercial databases, such as Bloomberg and the London Business School Risk Management Service. The formula is Blume-adjusted Equity Beta=(0.67)×βOLS + (0.33)×1.

6 We assume here that the source of debt will be the banking sector. Since the withdrawal of the capital markets in 2008 (Hellowell 2010), banks are likely to be dominant source of debt for DBFOs for the foreseeable future.

7 The WACC calculated with the gearing level at financial close (typically circa 90/10) will under-estimate the average WACC over the project's life. The WACC increases as the proportion of equity in the finding grows.

8 This is the average of daily swap rates recorded in the database of FT.com for the year the project signed.