Is PFI money for old rope?
In recent years the British state has increasingly been funding its infrastructure projects, in particular when building new hospitals, roads and schools, by using the Private Finance Initiative (PFI).
Under the PFI, private-sector firms pay for the construction and the state then pays them over an extended period of time both for the construction and any ongoing management that the project requires.
The PFI is considered by some commentators to be an expensive way of concealing the true cost of these projects by turning them into a hire purchase contract. Many PFI contracts are thought to provide poor value for money; this was highlighted last December when the Treasury was told that under the terms of an existing PFI contract it would cost £900 to buy a Christmas tree.
So if the contractors are doing nicely from the PFI, can investors get a piece of the PFI action?
Profit from PFI
In many instances firms which win PFI contracts end up selling some or all of their interest to outside investors. Private investors are thus able to indirectly profit from the PFI by investing in the few specialist funds which buy these PFI investments.
The secure nature of the income generated by PFI contracts, together with their fairly predictable returns, means that PFI funds' share prices should be less volatile than the market.
One such fund is the HSBC Infrastructure Company (LSE: HICL) whose shares pay a dividend of just under 5.5%. Investors who are concerned about share price volatility should note that the price of these shares haven't changed all that much; they spent 2010 trading in a very narrow range between 112p and 121p.
You can find more information about the company and its investments in this article from September. This time I'm going to look in more detail at the risks presented by the PFI.
Money for old rope?
As the Treasury's Christmas tree has shown, it's clear that some PFI contracts provide poor value for the taxpayer.
Given the pressure on the public finances it's not inconceivable that the government may try to wriggle out of its contractual obligations.
Funny money accounting?
The accounting treatment of PFI liabilities is controversial and it can be argued that the PFI has been used first and foremost because it enables governments to hide their debts because they can keep PFI liabilities off the national budget sheet.
But there's a strong counter-argument that because some PFI liabilities are future expenditure they shouldn't be treated as debt. If you think that doing so is a form of accounting trickery, ask yourself why doesn't Tesco (LSE: TSCO) or any other FTSE 100 company put next year's staff salaries on its balance sheet? After all, these salaries are liabilities which must be met.
In theory because the PFI payments will be funded from future taxes they can be treated as being very similar to mortgage interest payments (which we don't count as liabilities). But it is a very contentious topic, particularly when it comes to capital costs.
If the PFI is so good, how could you buy the contracts?
Another concern is that if the PFI contracts are so profitable why are the contractors selling some of them to investment funds? Why wouldn't they keep them instead?
A major reason for selling is that many PFI contractors aren't in the business of maintaining buildings or providing other services, nor do they want to keep their capital tied up in these projects. So they stick to what they're good at, finish the construction and then sell the contract to a third party.
This isn't an unusual practice; the hotel trade is another sector where new projects are built by one firm, then sold to a second firm on completion before being operated by a third firm. Most of the major hotel chains, like Hilton International and Marriott, don't own very many of their hotels; they stick to running the hotel whilst others own the building.
Escalating costs -- but what about robots
Concerns have been raised about the lack of transparency shown by most PFI contracts. Unfortunately that's one of the problems with business, sometimes it can be quite opaque and you have to take things on trust. It happens in all sectors. For example, does any investor really understand the full ins and outs of BAE Systems' (LSE: BA) arms contract with Saudi Arabia?
Some investors also worry that since the running costs of most PFI contracts are linked to the retail prices index (RPI), rather than national average earnings, their profitability will decline over time as wage increases should exceed changes in the RPI.
There are two counter-arguments to this, one which comes from mainstream economics and a second which may seem like science-fiction (I can assure you that it isn't).
Firstly, unit labour costs will continue to be driven down by future technological improvements; after all that's been happening for the past three hundred years so there's every reason to expect this to continue. So wages could increase at a faster rate than the RPI but the cost per unit of output will increase by less than the RPI because fewer staff will be needed to do the same amount of work.
The second reason is that developments in artificial intelligence and robotics in the next two decades are likely to completely transform the workforce, especially for unskilled and low-skilled jobs. And robots don't form trade unions, go on strike or demand pay increases!
Good for income, less so for capital growth
HSBC Infrastructure Company isn't the sort of share I'd hold, largely because I'm much more interested in capital growth and am very relaxed when it comes to volatile share prices. But many investors are looking for what it offers.
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