Feature / This year's model

For years, PFI was the only game in town when it came to funding NHS capital development. But with PFI now replaced by PF2 how are trusts approaching the financing of new buildings? Seamus Ward reports

There are several ways of funding a new hospital, and North Tees and Hartlepool NHS Foundation Trust appears to have tried every one of them. In many ways, the trust’s tale is a study in perseverance as it tried to finance a 558-bed acute hospital at a time when capital is severely constrained. It has been faced with the collapse of available public funding, a Treasury review of the private finance initiative and issues in bringing innovative funding models into the NHS. Yet it is hoping to take a big step forward in the next two months.

The North Tees scheme is one of five hospitals currently in the Department of Health private finance initiative pipeline. It’s a far cry from the heyday of PFI between 1997 and 2010 when more than 100 hospitals were built or approved under the initiative.

North Bristol NHS Trust’s £430m Southmead Hospital, a part of which is due to open next year with full opening a year later, was one of the last health PFIs approved. After such a concentrated period of construction, it was always likely the PFI pipeline would slow. But, as with capital development everywhere, the global economic crisis has had a significant impact on the schemes coming forward.

The North Tees and Hartlepool scheme was one of those affected. Director of finance and information Lynne Hodgson explains that initially the new hospital, which will consolidate its two sites onto one, was to be funded through public dividend capital. But this plan was scuppered as the government revised budgets in response to the economic crisis. The trust looked at PFI, but then all schemes were put on hold as the Treasury reviewed the use of the initiative across the public sector.

‘It was taking some time, so we talked to the Department and, as we are a foundation, we have a little bit more freedom,’ says Ms Hodgson.

The trust held exploratory talks with pension funds, hoping they would provide the finance. ‘But as we went through the first stage of dialogue with the pension funds, it became apparent there was a problem with risk transfer,’ she says.

Under traditional PFI, the interest rate on the loan that funds the scheme is set higher to account for the transfer of risk out of the public sector. So, if there is a fault and a theatre cannot be used, for example, the unitary payment to the private sector partner will be reduced. But the pension funds were not able to accept such risk. With risk remaining with the trust, the scheme would not have passed the Treasury value for money test.

North Tees had hit a dead end, but then the Treasury launched PF2, the revised version of PFI. Ms Hodgson says: ‘We talked to the Department and the Treasury about PF2 and we worked through the scenarios to see what value we could get under PF2. We have come up with a revised outline business case and a long-term financial model.’

PF2 template

PF2 differs from its predecessor in a number of ways. In general terms, it resembles the Lift (local improvement finance trust) model used to develop new primary care facilities. PF2 was announced in chancellor George Osborne’s autumn statement last year following a review of PFI. All PFIs in development were halted while the year-long review took place.

Soft facilities management services, such as cleaning and catering, will be excluded from PF2. The inclusion of these services in PFI has long been one of the main planks of union opposition to the initiative. The taxpayer will also be a minority equity investor in PF2 projects, while equity will make up a greater proportion of the private financing. Mr Osborne also said there would be an 18-month time limit for agreeing deals, after which time the offer of the public sector equity could be withdrawn.

North Tees has proposed a £272m capital scheme, with £93m coming from public dividend capital (PDC), a small amount of government equity and the balance (about £170m) from private sources.

Ms Hodgson says the PDC element is important because, although it will attract a 3.5% capital charge, as with all PDC, it helps make the scheme affordable at a time when tariff is being deflated year-on-year.

The trust is hopeful the Department will approve its OBC and commit to providing the PDC later this year.

None of the five hospital schemes in the pipeline could be described as a traditional PFI. As well as North Tees and Hartlepool, there are projects at The Royal Liverpool and Broadgreen University Hospitals NHS Trust, Papworth Hospital NHS Foundation Trust, the Royal National Orthopaedic Hospital (RNOH) NHS Trust and Sandwell and West Birmingham Hospitals NHS Trust.

The Department confirms that the use of PFI for new builds is all but finished. ‘The NHS will complete a small number of schemes that began their procurements before the Treasury’s 2011 review of PFI and issue of the PF2 model,’ a spokeswoman says. ‘There are three altogether – Royal Liverpool, Papworth and RNOH. It is likely that some characteristics of the new PF2 will nevertheless be incorporated in these schemes’ contracts. All new schemes that are not public-capital funded, will be delivered under PF2.’

The Department is considering three major schemes with a total value of £766m that are not privately financed, including the £420m redevelopment at Brighton and Sussex University Hospitals NHS Trust.

The Department says it is likely that the North Tees and Sandwell projects will be PF2 schemes. The West Midlands trust’s planned new Midland Metropolitan Hospital is seen as a pilot for PF2 in health, having been highlighted in the chancellor’s autumn statement as a prime candidate for the initiative. Though details remain sketchy, the trust is developing its outline business case for the project.

Further information may emerge later this year, but with several Department and Treasury assessments to pass, together with the procurement and construction phases to negotiate, it could be five or six years before it opens its doors.

The £429m Liverpool scheme and £165m Papworth schemes have innovative funding structures. The Liverpool scheme, which will build a 664-bed, single-rooms-only hospital, is the most advanced. It is hoped its final business case will be approved and reach financial close by the end of the year.

The scheme will be funded from a number of sources, including £118m of the trust’s money; £94m in public dividend capital from the Department; and £128m via a PFI. It is expected a further £89m will come from the European Investment Bank (EIB, the European Union bank), meaning three-quarters of the funding of the scheme will come from public sources.

Papworth intends to build a new 310-bed hospital (virtually all single rooms) on the Cambridge Biomedical Campus. The trust says funding will come from a combination of private equity finance, debt funding – the details of which will be determined via a preferred bidder funding competition – and a capital contribution from the trust.

Other trusts, particularly foundations, are finding innovative and complex ways of funding their capital development. Cambridge University Hospitals NHS Foundation Trust, for example, is planning to build a new medical education centre, private hospital and hotel and conference centre – The Forum – on the same biomedical campus as the new Papworth hospital. 

Under the deal, the Cambridge University trust will retain the freehold on the land on which the development will be built. The trust and John Laing Investments will form a special-purpose vehicle that will lease the land to an institutional investor. The investor will then sub-let the individual components – Ramsay Healthcare UK for the hospital; the trust for the education centre; and IHG on a management contract for the hotel/conference centre. The trust says it will receive a share of the profits plus a ‘substantial’ annual payment.

Generating income from capital development schemes is one way of increasing affordability. Affordability is one of the questions hanging over many PFI deals, as demonstrated recently in south London and Peterborough. PFI schemes contributed to the South London Healthcare NHS Trust losing about £1m a week. The trust was dissolved in October and its hospitals and services distributed among three neighbouring trusts.

Earlier this year, a Monitor contingency planning team concluded that Peterborough and Stamford NHS Foundation Trust was not financially sustainable and its PFI contributed to an annual £40m financial gap. The team said the trust’s estate costs were 22% of turnover (£22m) more than the Department’s current 12.5% PFI approval threshold.

As well as receiving ongoing financial support from the Department, the trust is also looking at subletting some of its under-used estate. In February, the government set up a £1.5bn fund to subsidise PFI payments at seven trusts, including South London and Peterborough.

Many trusts insist PFI can be affordable. North Bristol says its new development will cost around 7% of turnover, for example.

Andy Hardy, chief executive of University Hospitals Coventry and Warwickshire NHS Trust, believes affordability can only be determined on a case-by-case basis. ‘I don't think there’s a black and white answer on the question of affordability. Some PFIs have been made affordable, some are not,’ he says.

Question marks

Mr Hardy, previously the trust’s director of finance, says there are question marks against the sign-off process for the PFIs that have proved unaffordable.

‘If you go back to the early PFIs, a few went through even though they didn't meet the golden rule of the unitary payment being less than 15% of revenue.’ The figure was later changed to 12.5%, but the principle remains.

His trust has a large PFI (£350m), which reached financial close in 2002. The unitary payment is approaching 15%. However, he insists the PFI is affordable, pointing out that the trust has not recorded a deficit since its PFI hospital opened in 2006.

‘Most PFI payments are index-linked, which is a real challenge. Each year, the cost goes up by the rate of RPI, but NHS funding has flattened. The unitary payment will rise as a proportion of your income. Even if you meet the golden rule when the deal is signed off, that’s not going to be the case in the future.’

The global economic crisis has reduced the availability of finance to restructure deals, but there are some, limited, opportunities to reduce fixed costs. ‘You can work with your providers. For example, we worked with our soft service provider ISS to drive a cost improvement programme, taking out more than £1m per annum. You can take money out, but the majority of your costs are fixed,’ says Mr Hardy.

But what of PF2 and the other schemes in the pipeline? Will they prove to be affordable? The Department insists PFI and PF2 schemes must demonstrate they are value for money. 

In the Liverpool scheme, the unitary payment made under the PFI element of the plan will be less than 6% of turnover (a payment of £20.5m a year). In 2010, the trust expected the payment to be around 8%, but this has come down with the help of the £94m from the Department.

Together with its own funds, this has made the trust’s ‘bullet payment’ larger (similar to putting a larger deposit on a mortgage), reducing the level of repayments.

The actual level of the unitary payment will not be determined until financial close and there will be additional costs of the other financing sources – the PDC dividend at 3.5% and it is unclear how much the EIB would expect in return for its investment. The annual cost of the PFI unitary payment and the PDC dividend is likely to be around £25m.

North Tees and Hartlepool’s Lynne Hodgson says: ‘Until we go to the market and get quotes, all we can do is estimate the investment companies will expect to be paid. We have worked with financial advisers to do this.’

The total cost of the scheme in relation to turnover will be in the range of 8% to 10%.

Papworth also insists its project is affordable, with a unitary payment ‘significantly below the 12.5% of turnover threshold’.

KPMG corporate finance partner Matthew Custance believes PF2 could be more expensive than PFI. A greater proportion of equity funding is expected in PF2 and the cost of equity may be higher than the cost of debt, which traditionally formed a larger proportion of PFI financing.

He says trusts may choose PDC, if available, or the rebadged Foundation Trust Financing Facility (now called the Independent Trust Financing Facility as its remit has extended to cover NHS trusts) over PF2.

He adds that the removal of soft services could be a mistake. ‘We did some research a couple of years ago on soft services delivered through PFI and we found they provided better value for money than those delivered by other means,’ he says.

Paradoxically, at a time when capital is constrained, trusts probably have access to more potential sources of finance than ever. However, it is likely affordability of privately funded elements of capital developments – legacy PFIs, hybrid schemes and PF2s – will remain an issue.

Next month we look at funding capital developments in other parts of the UK