Guide 98/71

PFI case studies

Contents

Executive summary

Small-scale provision of a student residence service

Falmouth College of Arts and Sanctuary Housing Association

Relocation of Portsmouth Business School

University of Portsmouth

The Winter Gardens project

Bournemouth University

Use of a soft market test

Acronyms and abbreviations

Executive summary

1. This guide presents four case studies of recent Private Finance Initiative (PFI) projects undertaken in the higher education sector. PFI is a method of procurement which seeks to achieve best value for money by focusing on the delivery of a service, rather than the provision of an asset. All the projects described in these case studies were supported by the HEFCE under the terms of its pathfinder initiative.

2. The case studies will be of interest to people in higher education institutions who are considering the use of PFI as a procurement method, and those who are already involved in PFI projects. Only one of the projects resulted in the successful negotiation of a contract with a private sector supplier, but all the case studies provide useful lessons for future projects.

Falmouth College of Arts

3. The first case study describes the experience of Falmouth College of Arts, in negotiating a successful contract to provide 156 units of student residential accommodation. This detailed study contains its own separate executive summary. The project was not originally conceived as a PFI application, but adopted PFI principles during the contract negotiations. The use of PFI was particularly valuable in transferring to the private sector the risks associated with a development on a difficult site, and its design, construction, financing and operation. As a result, the college gained the advantages of sharing the project risk with a strong private sector partner. The case study demonstrates that the benefits of PFI need not be confined to large projects.

University of Portsmouth

4. The University of Portsmouth explored PFI as a procurement route for new premises for its business school. The second case study describes the way the project was presented to the private sector to allow maximum flexibility to exploit the development opportunities on various sites. It explains how the university had to reflect its changing requirements in preparing an invitation to negotiate, and outlines the development of a comparator against which to evaluate bids from the private sector. The project attracted three bids from the private sector. The university made considerable efforts to reconcile the bids with its comparator, but eventually had to accept that none of them came close enough to represent better value for money.

Bournemouth University

5. The third case study will be of particular interest to institutions considering PFI procurement associated with lottery funding. Bournemouth University's Winter Gardens project was intended to develop a media arts complex from an existing concert hall owned by Bournemouth Borough Council. The case study addresses the problems of joint sponsorship, and describes how the project team had to develop an approach which reconciled the requirements of a PFI competition with the process of bidding for a lottery grant.

6. The project was always dependent on Arts Council Lottery Board support for its viability. Once it became clear that development funding would not be awarded the project negotiations were brought to a close. However, valuable lessons have been learnt about the interaction of lottery bids with PFI. The National Lottery Division of the Department of Culture, Media and Sport has since published an advisory note for lottery distributors. Institutions contemplating this procurement route should contact the relevant lottery distributor for advice.

Soft market testing

7. Soft market testing is a technique which can be applied early in the PFI process. It provides a structured way of exploring whether the private sector is likely to be interested in the opportunities that a project presents. The fourth case study describes how a higher education institution used soft market testing to inform a decision on whether to explore PFI in more detail. In this instance, the response from the private sector did not favour a PFI approach. However, the case is presented as an example of good practice. Proper use of a soft market test provided useful strategic guidance without involving the considerable effort and expense of a full PFI competition.

Small-scale provision of a student residence service

Falmouth College of Arts and Sanctuary Housing Association

Executive summary

1. The project described in this case study is the provision of 156 self-catering en-suite residential units, within a purpose-built complex of 11 three-storey blocks in Falmouth town centre. The development is funded, designed, constructed, and will be operated for the next 25 years, by the successful bidder as private partner, Sanctuary Housing Association (SHA). With no other residential accommodation and a growing UK and international student population, securing this facility was a strategic gain to Falmouth College of Arts (FCA).

2. All the accommodation will be available to FCA for 52 weeks per year, for student use during term time and for conferences, summer schools and business events during vacation periods. FCA, directly contracted to SHA for the entire provision, will issue licences to students and other occupants and collect all rents.

3. Although this project started and reached tendering stage in a rather conventional vein, the college sought to embrace guidance from both the Private Finance Panel and the HEFCE on exploring innovative procurement routes that would reduce the inherent risks of the project. For this reason it was selected as a pathfinder project in 1996 and, following lengthy negotiations and testing of the scope for realistic risk transfer, it has demonstrated that the principles of PFI can be applied to a small-scale scheme.

4. In recognising that the higher education sector has employed a number of beneficial arrangements in residences procurement over recent years, the following summary of project achievements concentrates on what is unique, novel or innovative about FCA's agreement and circumstances.

Unique risks relating to the development site

5. With no site in the college's possession and a scarcity of commercially viable sites close to the town, the main campus bidders had a difficult hurdle to overcome before even considering their development proposals. The procurement route pursued and delivered an ideally located site, but one that had serious ground works problems and onerous planning conditions for SHA to satisfy. With these and other circumstances conspiring against the scheme, the site risks were exceptional, although they were identified and costed accordingly.

Financial feasibility despite small scale

6. Pre-determined payments to Sanctuary Housing Association with effect from 1999-2000 will enable FCA to provide value for money accommodation to students. Centrally located for both the college and the town centre, students will benefit from spacious, en-suite rooms and all the advantages of professionally managed accommodation. An affordable weekly charge has been achieved despite the small scale of the scheme and the college lacking a site of its own for development, a drawback that has added considerably to the overall capital costs.

Link between provision of the facilities management and of the building

7. The terms of the overall agreement are such that the supply of the facilities management and that of the building are inextricably linked. As a ‘design build finance operate' (DBFO) project, the capital phase is linked to the operational phase and all risks relating to the design, construction, financing and operation are borne by the operator over the 25-year term.

Minimising occupancy risk

8. Since FCA will underwrite the full charge of the service to SHA and bear the cost of empty rooms, it is concerned about ensuring that facilities management performance is such that the facility is attractive to students. In tackling risks relating to the performance the agreement has broken new ground:

a. More than 50 aspects of facilities management performance will be assessed under the terms of the agreement. Failure to deliver the agreed standards will result in penalties which threaten up to 15 per cent of SHA's debt financing costs and all its operating costs.

b. Ultimately, if SHA persistently fails to perform, FCA will at any stage during the 25 years have the option to acquire the freehold site and building at 85 per cent of the outstanding debt charge (see paragraphs 80-82 below for further details). Alternatively it can replace SHA as the operator at terms disadvantageous to SHA. SHA can accept these risks because of its long-term commitment to housing management, and confidence in its ability to deliver high quality housing management.

Alternative use

9. In the event of under-demand, reversion of occupancy risk to SHA is a realistic option because of the convenient ‘off campus' location of the residences, design features (11 discrete and self-contained houses), and SHA's core business of social housing. There are provisions within the agreement for the reversion of up to 30 per cent of the units to SHA if student demand slumps, and there is replacement demand from social housing tenants. An alternative arrangement in such circumstances will be for FCA to let some of the units directly to non-FCA students who want accommodation in the centre of town.

Exploring benefits of partnering a national housing association

10. The project demonstrated that SHA could not only provide housing management and development expertise, but also that it appreciated price inelasticity and therefore cost control. Its strong credit rating could attract highly competitive funding terms. Thanks to SHA's efforts and experience, a £400,000 grant from English Partnerships was obtained for the scheme.

Summer letting potential using SHA's facilities management team

11. Term-time occupation of the residence operation is intended to cover pre-determined payments to SHA, while income from summer letting covers marginal costs in relation to additional facilities in vacation periods and related indirect costs. The college has chosen to bear the risks and rewards of summer occupation because it can best maximise the potential through complementing use with the existing college catering and conference facilities.

Background to the project

Sanctuary Housing Association (SHA)

12. Sanctuary Housing Association is the fourth largest housing association in the UK with a management portfolio of over 27,000 units. It has 40 offices across the country employing in excess of 1,000 staff and with an annual turnover of more than £80 million.

13. The 1988 Housing Act introduced private finance to the world of housing associations, and encouraged organisations like SHA to supplement their public grant allocations with private funds from banks and building societies. This gave SHA and other housing associations the opportunity to adopt a far wider role in providing housing, beyond that of traditional general family housing.

14. Since 1988 SHA has successfully built over 10,000 new properties across the country, borrowing £300 million from UK and US sources in the process. This new commercial regime has allowed SHA to consider initiatives such as student housing.

15. The reasons for SHA's initial interest in the project were as follows:

a. Efficiencies in housing management could be achieved through economies of scale (SHA already managed 1,400 units in Cornwall).

b. SHA was geared to respond to such opportunities with established in-house development teams in the South West.

c. Housing management is SHA's core activity and one of its strongest features.

d. One of SHA's key objectives is to scan for new business opportunities.

Any commitment would, however, be subject to full assessment of the risks and return.

Falmouth College of Arts (FCA)

16. Falmouth College of Arts is a successful higher education institution (HEI) specialising in art, design and communication media. Located on the south coast of Cornwall, the majority of its 1,500 students are recruited nationally and an increasing number of international students are coming to Falmouth to pursue their studies (10 per cent of the college's income is from international recruitment).

17. Since 1994 FCA has been aware of the need for student residences. In an increasingly competitive sector it is essential to be able to offer good quality, affordable and appealing accommodation in order to enhance the attractiveness of the college to potential students. Although previously it had approximately 35 units in an old residence, there was very little experience of how to develop or professionally manage a modern hall of residence.

18. Private landlords in the town generally reacted well to the rising demand for accommodation which accompanied the college's 50 per cent growth in numbers over recent years. Although the college bears no occupancy or financial risk with private sector letting, there were concerns that standards were inconsistent and that many first-year students and their parents would be more comfortable with institutionally controlled accommodation. There were also fears that private landlords could pull out of the market if more attractive opportunities arose or might fail to respond to further growth in the future.

19. In essence, the risk of relying completely on the private sector outweighed that of development and therefore this requirement became a priority within the college's estate strategy in 1995. The governors remained cautious throughout the evaluation period and were anxious to ensure that any commitment to residences would not threaten the financial stability of the college's core business.

20. Being located in a spectacular seaside location, and with the potential to host conferences and other events as well as summer schools, a residence could serve a useful purpose during the summer vacation period.

21. This was the context for the first stage of procurement.

22. The college's objectives were as follows:

a. Minimise FCA's financial input and risk in the development and operation of halls of residence. This meant procuring the units at a cost and with a specification which would be attractive to students over a 25-year period, without relying extensively upon income from out-of-term lettings.

b. Minimise the college's management input. With a modest estates infrastructure and a small management team it was important that the college diverted as few resources as possible from its core education activity.

c. Off balance sheet accounting treatment. An off balance sheet accounting treatment would give the college more flexibility to borrow for future academic initiatives. The HEFCE's Financial Memorandum requires HEIs to obtain approval for borrowing where the annual debt servicing cost exceeds 4 per cent of the institution's turnover. An agreement not satisfying conditions for off balance sheet treatment (under financial reporting standards SSAP21, ‘Accounting for leases', and FRS5, ‘Reporting the substance of transactions') would constitute a long-term liability in accounting terms and be recognised as borrowing by the HEFCE and potential lenders. Although in theory a self-financing scheme should be discounted where risk assessment is under consideration, it was recognised that no liability on the balance sheet would simplify future fundraising ventures.

d. Location of site. The college felt it was imperative to identify a site which could accommodate at least 150 units, was close to the town's amenities and was within one mile of the main campus.

Procurement process – negotiating the purchase

Site identification problems

23. In 1994 the college commenced a site search in Falmouth in an attempt to identify all options and to establish if, realistically, its fourth objective could be achieved. Ideally, it wished to identify the preferred site and then select a developer to provide the accommodation on that site. The scarcity of sites appeared to be the biggest obstacle to the college in making any progress.

24. When a professional site search conducted by the college foundered, it was decided to allow potential bidders, all of whom were likely to have associations with local property agents, to identify suitable options. This decision was taken somewhat reluctantly, because of the danger of competing bidders driving prices upwards.

25. Having observed some progressive residential schemes in the sector and undertaken preliminary value for money tests, the college embarked upon a design, build, finance, operate scheme (DBFO), as a means of delivering its objectives.

Professional team

26. With an upward battle on its hands, the college was intent upon having experienced project managers on board to draw up tender documents, assess bids and contribute to the contract documentation, particularly for the building output specification. Grimley was selected because of its knowledge of and track record with the college, and its recent experience with the University of Greenwich at Avery Hill.

27. The college faced a dilemma in respect of professional advisers: it wanted the best but had to balance the cost against the benefit to a relatively small scheme. Because of all the risks involved (complications, site difficulties, and so on) the prospect of having to write off costs, as abortive fees, could never be totally ignored.

28. A Cornish firm of solicitors Hancock & Lawrence, in preference to a City firm, was selected to undertake the legal work. This appointment proved to be most appropriate and effective.

29. Coopers & Lybrand and the college's VAT consultant, Mr Ian Jarvis, provided accounting and VAT advice respectively, but effectively the project managers, legal advisers and officers of the college conducted FCA negotiations. All involved learnt a lot about PFI ‘on the job' with the help of the Private Finance Panel, the Department for Education and Employment's (DfEE) Private Finance Division and the HEFCE's Private Finance Unit.

30. Details of FCA's advisers along with those of SHA can be found in Annex A.

Selection of preferred bidder

31. At the first stage of the DBFO procurement process, a preliminary enquiry document was prepared by the college in conjunction with Grimley as project managers. This document set out, in performance terms, the key requirements of the facility.

32. The private partner would be required to:

• acquire a suitable site (as explained above)
• arrange all necessary finance within the parameters of a pre-determined rent
• obtain all necessary consents and permissions
• design the facility (to the performance criteria set out in the document)
• construct the facility
• operate, manage and maintain the facility for 25 years (again, to performance requirements set out in the document).
  

33. A critical factor to be established at this stage was whether an advertisement in the Official Journal of the European Communities (OJEC) was required. Because the scale of the scheme and the value of the concession fell below the threshold under the EU public procurement regulations, no advertisement was necessary at that time.

34. The market for potential private partners was explored and the following consortia identified:

• housing association/contractor
• funder/contractor/facilities manager
• contractor/facilities manager.
  

35. The bids were evaluated against the following criteria:

• suitability of site:
  • location
  • planning feasibility
  • acquisition timescale
• design and construction capability
• financial:
  • site costs
  • construction costs
  • facilities management costs
  • equivalent weekly cost/rent
  • funding
  • covenant strength
• facilities management response to:
  • facilities management performance specification
  • building life cycle cost.

36. The successful private partner or preferred partner at the time, was Sanctuary Housing Association (SHA). The key factors for choosing SHA were:

a. Identification of a site in the required location that was judged to be potentially the best in terms of the feasibility of acquisition in the required timescale, alternative use, and the likelihood of appropriate planning consent.

b. This project coincided with SHA's own strategy to diversify investment into areas other than social housing, and as a consequence it was able to offer a keen financial package within the given parameters. Since the 1988 Housing Act, SHA had been allowed to raise private funding and, with this more commercial regime, was free to consider other initiatives as part of a wider brief.

c. SHA possessed an existing knowledge of residential accommodation and presented an appropriate construction design and specification.

d. SHA, as the fourth largest housing association in the UK with 40 offices nationwide, had the experience in the facilities management of residential accommodation and had an established infrastructure in the South West to deliver it.

e. In appraising all the options available to the college SHA's proposal clearly provided the best solution in value for money terms.

HEFCE pathfinder status

37. In late 1995, as the momentum behind PFI was growing, the HEFCE recognised the need to support institutions that were embarking on PFI projects, because progress within the sector would depend upon models of success and failure. It also recognised that the substantial time input from both the professional team and officers in institutions would reflect the relatively untested nature of PFI within the higher education (HE) sector.

38. As a selected Pathfinder project, FCA and its professional team had access to the expertise of the Private Finance Panel Executive (PFPE) (latterly replaced by the Treasury PFI Taskforce), the DfEE's Private Finance Division and the HEFCE's Private Finance Unit. FCA also received a 50 per cent contribution to the costs of professional advice.

39. Having pathfinder status was critical to the success of the scheme because it focused attention on risk transfer and the structure of the agreement, and it raised the profile of the project. This latter point was a real advantage in rescuing the deal with SHA at one stage in negotiations, and in driving the project ahead within the institution.

40. At the same time it must be accepted that before achieving this pathfinder status, PFI had not been a recognised feature of the scheme. SHA was therefore being drawn into terms not identified at the tender stage, a factor which undoubtedly prolonged and complicated subsequent negotiations.

Milestones through negotiation stage

Establishing fundability of the project

41. In spring 1996, SHA reassessed the major risks being proposed within the FCA contract and in particular the newly introduced emphasis upon PFI. SHA was concerned about the fundability of the scheme on account of the projected income streams, uncertainty about capital costs, and the small scale of the scheme.

42. Further discussions with the alternative consortia were not attractive to FCA, primarily because of their respective proposed sites and/or their ability to compete with SHA on price and quality. Stronger alternative consortia would have strengthened FCA's negotiating position but, because of all the constraints, wider advertising of the opportunity at the selection stage might not have yielded any benefits.

43. SHA concluded, after some discussions with FCA and the PFPE, that the scheme could be progressed if the association provided funding for the project initially out of its general funding reserves, and sought third party funding only when SHA had other projects to add to the FCA scheme to constitute a fundable proposal to lenders.

44. Any further advancement of the project was subject to SHA completing a satisfactory due diligence test at FCA, and ascertaining the strength of FCA's covenant. This was completed satisfactorily in April 1996.

Planning consent

45. SHA's and FCA's preferred site was located in the town centre and comprised a disused garage site and an adjoining listed former police station which had been derelict for 20 years. Local planners were determined that any consent given for the development would involve a renovation of the 19th century police station building, although the planning application made by SHA only included the garage site and some land at the back of the police station site.

46. As a result the local planning authority imposed a section 106 condition requiring the developer (SHA) to have completed the works on the police station site before commencing construction of the residences. To most private partners this demand would have been an insurmountable hurdle. However, because of its status, SHA secured funding for 12 social housing units in the police station and was in a position to comply with the section 106 terms.

47. The application, which departed from the district wide local plan, attracted much local opposition but was granted in June 1996.

Agreement of the legal structure

48. Agreement on the legal structure was problematic. SHA wished to have a lease element within the overall contract through which the capital charges passed, and a separate charge for facilities management under the service element of the agreement. This condition, it believed, would ensure fundability of the agreement. In contrast FCA wanted a single charge for the provision of the overall service. Details of the final agreement reached are given in paragraphs 59-86 below.

VAT

49. VAT law zero-rates buildings used for student residential accommodation and disregards vacation lettings (under an unpublished concession) as long as the institution itself, rather than a subsidiary or associated body, supplies the lettings. This constraint not only made it imperative that FCA and not its subsidiary company contracted with SHA but also that vacation lettings were operated by the college and not by SHA.

50. Establishing that the total supply of the service would be exempt from VAT, as opposed to just charges relating to the provision of the building, demanded advance clearance from Her Majesty's Customs and Excise. This clearance, as well as agreeing VAT consultants' advice on the contract structure, added to delays in completion.

English Partnerships

51. From an early stage in the project it was evident that the topography of the chosen site and extensive ground-works were going to add to the capital costs and possibly render the scheme financially unfeasible. Because the site had been derelict for some time, was located in a European Objective 5b area, and fulfilled other specific criteria, SHA was in a position to apply for ‘gap funding' of £400,000 from English Partnerships.

52. This was critical and, largely due to time taken in obtaining the approval of the grant, the completion of the agreement was postponed from September 1998 to July 1999.

Timetable

53. The project timetable is shown in Table 1.

Table 1 Summary of project timetable

Overall service agreement

FCA's intent

54. The essence of the agreement is the college's purchase of a service (the provision of 156 serviced residential units) over a 25-year period, where the risks of providing the service are borne by SHA. This is in return for a pre-determined annual service charge payable by FCA, to the extent that payments will be subject to penalties if specified standards are not delivered.

Contractual structure

55. Annex B illustrates the contract structure.

56. The building agreement deals predominantly with the construction phase, including the ‘mock-up' of a room and communal area. It obliges SHA to acquire the site and construct the building to a required standard by a specified date. Provided that this is delivered to the college in accordance with the agreed building output specifications, and certified by a jointly appointed independent surveyor, the principal agreement obliges FCA and SHA to enter the lease and service agreement.

57. The principal agreement contains provisions on the calculation of service charges, the college's step-in rights, and termination arrangements, as well as a lease.

58. The lease contains details of the demise, the service agreement with respective charges, and the facilities management output specification (see payment mechanism in paragraphs 74-76 below).

Key elements

Duration of the agreement

59. The principal agreement will cover the period of 25 years from the construction completion date, due to be 1 July 1999.

60. In the event of late delivery of the service, SHA will be responsible for compensating the college for all losses in income over the summer period. If delays extend beyond September 1999 it will also be responsible for procuring, at its own expense, suitable alternative accommodation for all students who have reserved accommodation.

61. At the end of the 25-year term the college will have an option to purchase the freehold of the site and building at 65 per cent of market value or to renegotiate renewal of the agreement.

Building performance specification

62. The original enquiry document specified the accommodation requirements in broad terms. These were refined following a number of visits to other new HE residential developments. The project managers spent considerable time with SHA and the contractors ensuring that there was full appreciation of the necessary robustness of design for student usage. There needs to be a genuine understanding by SHA of the likely use to which student housing will be put in order to avoid potential arguments during the operational period regarding ‘use' and ‘abuse'.

63. The building performance specification needs to be read carefully in conjunction with SHA's projections of life-cycle costs, not only for principal elements of fabric structure and services but also in terms of fixtures, fittings and equipment which tend to bear the brunt of wear and tear.

64. Energy is another sensitive area of cost in use and it is an issue which needed to be carefully addressed in order to find favour with the hard-pressed student. Inevitably, heating systems with low initial costs tend to have high running costs. The specification requires that a reasonable amount of electricity is included within the rent. SHA is required to demonstrate, both initially through an energy model and subsequently through physical tests, that this can be achieved.

65. Finally, the requirement for a mock-up has proved invaluable to demonstrate in what is relatively compact space that fixtures and fittings, equipment and general construction styles all co-ordinate satisfactorily. The contractor, designer, operator and end user all have extremely important contributions to make here to ensure that a functional, cost-effective (net present cost) solution is achieved.

Facilities management output specification

66. The output specification sets out the overall aims and objectives of the operational phase of this project, in providing a standard and quality of service that will:

• ensure the health and safety of residents
• be perceived by residents as a ‘quality' service
• enhance the appeal of the accommodation to residents
• maintain the structure and fabric of the buildings
• seek to continually improve standards and quality of service.
  

67. These overall aims and objectives are applied to each of the key service areas (that is, general management, security, reactive maintenance, long-term maintenance, cleaning, energy management, and so on). Flowing from these, the specification defines the required standards of quality expected for each of the service area functions.

68. Details are provided for the method by which the operator will implement the services, (such as management structure, resources, cleaning schedules, maintenance plans, and so on). These details form the basis of the quality management system and will be the benchmark by which the performance of the service provided is measured.

69. The document has drawn on the experience of the college in operating student accommodation, together with the knowledge of its advisers working on several similar schemes. In addition, input from SHA has been provided based on its experience as providers of social housing.

Performance audit

70. The performance audit aims to maintain the defined standards of service, and accurately identify the cause and quantity of any inadequacies in the service provided. This enables SHA to address any specific problems, and allows the college to measure and control effective performance levels and penalise sub-standard performance.

71. The college and SHA will jointly carry out an audit of the facilities management service one month before the service payment date (three per year) to record and agree the assessment.

72. A performance rating system (scoring from 0 to 5) will be applied to approximately 50 audit criteria. A satisfactory performance percentage (SPP) will be used to assess and compare satisfactory performance. The SPP will be calculated by dividing the actual total score by the achievable total score for satisfactory performance (taken to be a score of 4 for each criterion).

73. The full-term service fee will be allocated by the college where the SPP is between 100 per cent and 90 per cent. The percentage shortfall below 90 per cent will be deducted from the term's service fee and the term's rent payable under the lease to SHA and will not be recoverable.

Payment mechanism

74. From an early stage in negotiations a weekly charge per student had been agreed upon. FCA felt it was a realistic level in relation to the student market, while SHA fully accepted the inelasticity of student rents and the need to contain costs. These annual charges gave FCA the right to occupy for 52 weeks per year, with indexation determined by the escalator described below.

75. In paragraph 48 above, reference is made to how charges were to be made within the agreement. In essence FCA wanted as much of the payment to SHA to be subject to performance, and therefore within the service agreement, while SHA sought to have all the financing charges treated as rent within the lease, which would be outside the performance measurement regime. Approximately one-third of the overall charge relates directly to management and two-thirds relate to financing costs.

76. After negotiation it was agreed that, of the debt financing costs, all within the lease, 15 per cent would be subject to performance measurement, in addition to all the facilities management charges contained within the service agreement. Because actual financing costs were not available at the time, certain assumptions were agreed to calculate notional costs for inclusion within the agreement. Details of this are set out in Annex C. Payments to SHA will be termly in December, March and May.

Payment escalator

77. The annual charges are indexed in line with the rolling three-year averages in changes to the retail price index. To protect FCA against high rises in charges at times of high inflation, which may not coincide with increases in residential rent indexes, a cap of 4.5 per cent and a collar of 1.5 per cent were agreed in respect of the debt financing charges.

Funding the scheme

78. One of SHA's greatest concerns was that the project could be funded competitively albeit at some stage in the future as referred to in paragraphs 41-44. The key issues that potential funders had focused on were as follows:

a. The size of the project demanded it be incorporated into a portfolio covering other projects.

b. Valuation of the future revenue income streams from the project to SHA in relation to debt financing costs.

c. In addition to relying upon the covenant strength of SHA, funders would need to be comfortable with FCA's financial strength. In order to pre-empt the views of funders SHA conducted its own due diligence review of FCA.

d. Financial modelling is completed using prudent assumptions. SHA's experience in borrowing private funds was particularly advantageous in this area, fully recognising the needs of funders.

79. As referred to in paragraph 51 above, English Partnerships provided gap funding of £400,000 to the project. This was critical to financial feasibility.

Protections and remedies for the college

80. Both parties are entering the agreement for the long term and wish to build a relationship of trust. Performance measurement and step-in provisions are, however, essential to ensure that the quality of service remains high throughout the agreement, especially in the later stages of the 25-year term.

81. Firstly, poor performance as measured by the audit will result in penalties, and payments from FCA to SHA will be reduced.

82. Secondly, persistent default leading to material breach of the service will trigger FCA's step-in rights. The two options are as follows:

a. Purchase the freehold of the site and buildings at 85 per cent of the outstanding debt.

b. Retain the lease with SHA, with payments reduced to 85 per cent of the original lease cost, and bring in a new provider.

Alternative uses

83. By virtue of the central location of the site, the design of the blocks and SHA's core business, alternative use options have been explored and provisions contained in the agreement. This would reduce FCA's volume risk in the unlikely event of under-demand. Reversion of up to 30 per cent of the occupancy risk to SHA is provided for, subject to replacement demand from social housing tenants. While any adaptation costs would be borne by FCA, its future financial commitment in respect of the 30 per cent of units would be limited to the differential between payments due from FCA and those receivable by SHA as housing benefit or directly from tenants.

84. In the event of under-demand by FCA students, other students and some staff would be offered accommodation by FCA. As there is an identified shortfall in supply of single person accommodation in Falmouth, it is highly unlikely that this development will become empty in the foreseeable future.

Accounting treatment

85. As mentioned in paragraph 22 above, FCA was seeking an off balance sheet accounting treatment for the agreement, but advice from its auditors indicates that it is doubtful whether this will be achieved. Unlike many public sector projects, this was never critical, but desirable in the context of future project funding. The decision on the treatment will be reviewed before preparation of FCA's financial statements in 1999, when the agreement will first need to be recognised.

86. An analysis of the arguments surrounding the accounting treatment is given in Annex D.

Risks transferred and value for money

87. In applying PFI principles to this project, every effort has been made to locate risk with the party best placed to manage it. Table 2 illustrates how the risks have been allocated.

Table 2 Allocation of risk

Lessons learnt by FCA

88. Unless there is potential for lucrative out-of-term lettings and the private partner is prepared to exploit it, the return from a student residential scheme, similar to FCA's, is not significant. As a result the incentive for the private partner to accept substantial risk is limited.

89. The location of the site in the centre of Falmouth had a strong bearing on the agreement in respect of alternative uses and assignment of risk.

90. Resolving the perceived conflict between the philosophy of PFI and the rigidity of ‘tried and tested' legal principles took some time.

90. The advantages of working with SHA (and probably other housing associations) are numerous and include: expertise in housing development and management; fund-raising expertise and a strong covenant; charitable objectives; and the compatibility of culture which inspires confidence and trust between the two parties.

91. Obviously the success of the project can only be judged when the residences are fully operational.

92. The potential for delays in finalising agreements is considerable. Despite efforts by all, progress was determined by the pace of the slowest contributor, and deadlines slipped on a number of occasions. Absolute determination to achieve a solution was necessary to overcome the numerous obstacles.

93. The quality of the input from advisers, PFPE, the DfEE's Private Finance Division and the HEFCE's Private Finance Unit was critical to the nature of the final agreement. A huge effort was necessary up-front to minimise risk in the future.

Acknowledgements

94. The valuable contribution to the project made by HEFCE, officers of the former Private Finance Panel Executive, in particular Natalie Norminton, and Simon Claridge from the DfEE's Private Finance Division, is acknowledged. Their support and the commitment of all advisers were critical to the agreement described in this case study.

95. While every effort has been made to achieve completeness and accuracy, no liability can be accepted for the accuracy or content of the information in this document nor for any errors, omissions or mis-statements. The provisions of the agreement are specific to this project and must not be considered in any way as a precedent for future agreement involving either Sanctuary Housing Association or Falmouth College of Arts.

96. This case study was produced by Niamh Lamond, Director of Finance of Falmouth College of Arts.

Annex A

Professional advisers to FCA and SHA

Falmouth College of Arts

Project managers
Paul Watson (Partner) and John Fahy (Senior Project Manager)
Grimley
10 Stratton Street
London W1X 6JR

Legal adviser
Stephen Branfield
Solicitor
Hancock and Lawrence
The Old Mansion House
Quay Street
Truro, Cornwall TR1 2HD

VAT adviser
Ian Jarvis
SWAT Ltd
Derriford Park
Plymouth, Devon

Accountancy adviser
Ian Carruthers
Senior Manager
PricewaterhouseCoopers
(formerly Coopers & Lybrand)
No. 1 Embankment Place
London WC2N 6NN

Sanctuary Housing Association

Legal adviser
Peter Keuls
Solicitor
Trowers & Hamlins
1st Floor, Portland House
Leverbrook Street
Exeter, Devon

VAT adviser
David Callan
PricewaterhouseCoopers
(formerly Price Waterhouse)
10 Bricket Road
St Albans
Herts AL1 3JX

Annex B

Contractual structure and main obligations

Structure of contracts between SHA and FCA

Contents of Agreements

Annex C

Calculation of the amounts payable under the lease and service agreement

1. While the overall service charge per year was agreed in the early stages of negotiation, the apportionment of the overall charge between the lease and the service agreement was a complex matter. This would determine the amount of charges subject to performance measurement (all the service charge and 15 per cent of the lease charge).

2. It was agreed that only debt financing charges would constitute the lease charge, with the balance equating to the service charge. As mentioned in paragraphs 78-79 of the main text, a funder, and therefore a funding rate, had not been identified at the time of the negotiations, nor was the capital cost of the development known precisely. For these reasons assumptions were made about both the capital cost and the borrowing rate and, on this basis, notional annuity repayments over 25 years were calculated. The net present value (NPV) of the cumulative lease payments being proposed by SHA could not exceed the NPV of the cumulative notional annuity payments.

3. The model described above to calculate the split in charges also served to identify the notional outstanding debt in any year, 85 per cent of which would be payable by FCA to acquire the freehold in the event of default by SHA.

4. Provision was made in the overall agreement to revise the model when actual funding rates and capital costs were confirmed.

Annex D

Accounting treatment - analysis of arguments

Considering the project under FRS 5 ‘Reporting the substance of transactions', FCA's auditors advised on balance sheet treatment and made the following observations.

The college's auditors believed that SSAP 21 ‘Accounting for leases' could be applied to this project because the lease agreement could be treated in isolation. Whether the lease satisfied the 90 per cent rule (as prescribed under SSAP21) or not was determined by the treatment of the 15 per cent of the lease charges which are subject to performance measurement. Again this involves subjectivity and the auditors believed that sufficient risk transfer to SHA could not be demonstrated. The result was that full lease costs were included as minimum lease payments and the 90 per cent rule was satisfied.

Relocation of Portsmouth Business School

University of Portsmouth

Introduction and project rationale

1. The University of Portsmouth currently operates on two campuses, the main Guildhall campus and Milton campus, which are two miles apart within the city. There are operational problems as well as significant disadvantages with regard to the delivery of an integrated curriculum, or even offering more flexible access to the curriculum in general, to undergraduates. Although these problems had been pressing for a number of years, it was generally felt that a management solution would be required rather than a relocation. In late 1995, however, a significant opportunity presented itself to the university to address this major estates issue.

2. Two important factors were identified which, in combination, were considered to give rise to a relocation opportunity which needed to be seriously addressed. On the one hand, changing planning policy guidelines with regard to out-of-town retailing suggested that in-town locations, such as the university's Milton campus, should be preferred locations for large scale retailing. Potentially, this change in national policy enhanced the disposal value of this part of the university's estate. Secondly, a major development site known as Gunwharf was released by the Ministry of Defence close to the university's main Guildhall campus, and became the focus for a bid supported by the Portsmouth Partnership (including both the University of Portsmouth and Portsmouth City Council) to the Millennium Commission for a Landmark Millennium project. That bid was successful, meaning that a site for a prestigious business school was available within 250 metres of the rest of the university.

3. The university then needed to determine how it might achieve a project which involved the most advantageous disposal of the Milton campus and moving the academic activities undertaken there (primarily the Portsmouth Business School) to the new location.

Initial advice to the university

Property considerations

4. The university had an ongoing relationship with a property practice offering strategic advice on to its property portfolio. It was clear that the project would require a high level of expertise in relation to property development which was not available within the university and, accordingly, the university's professional property advisers were involved at an early stage. Considerable discussion took place as to whether the two parts of the project (disposal and acquisition) should be linked directly in a composite property deal, or whether the university's interest might be better served by treating them as two separate transactions. On the advice of the university's property consultants, the latter approach was adopted.

5. The proposed new millennium project development at the Gunwharf site was envisaged from the outset as one very much integrated into a commercial development. At that stage it was seen as a centre for tourism on a large scale, focusing particularly on the regeneration of the frontage of Portsmouth Harbour. From the inception of the project, it was evident there would be a range of waterfront leisure facilities including bars, restaurants and associated leisure retailing. As the project took on more shape, it became clear that there would also be a considerable general retailing element in the scheme.

6. In considering the university's needs for academic facilities, it was therefore thought likely that there would be considerable opportunities for third party income if the university's business school were close to the new development within Gunwharf. In particular, the prospect of hotel developments, associated with university conference facilities particularly serving the needs of management education, was identified as an opportunity for a commercial partner. It was also felt that the presence of a large client base from the university would enhance the value of many of the trading outlets within the development.

Financial considerations

7. Since 1994, the university has incurred significant debt in order to complete an estates development programme to meet its most urgent estates needs. The university felt that its gearing situation needed to be closely monitored. Therefore it was unlikely that it would wish to enter into a significant additional debt in order to finance the proposed project, and an alternative financial arrangement would be attractive. The prospect of joint use of certain facilities was also seen as having possible financial returns to the university.

The PFI recommendation

8. Bringing together a project which had potential to generate third party income with the university's debt situation, it was recommended that a PFI approach be thoroughly tested.

9. Accepting this recommendation, the university placed an EU procurement notice in the Official Journal of the European Communities (OJEC) seeking interest in the provision of facilities for a business school close to or within its existing principal campus, the Guildhall campus. A more specific preferred location was not identified since the university was committed to giving full consideration to any proposal put to it by the commercial sector. The Gunwharf site was a possible option, but the university had no commercial agreement to use it, and so it had no special status.

10. Notwithstanding the particular opportunity identified at Gunwharf, any proposal which overcame the problem of split-campus operations was invited. This notice was placed in June 1996. At this stage, the Board of Governors was content that a PFI solution should be thoroughly tested, although such a solution would only be implemented if it could be demonstrated that it would deliver best value for money.

Appointment of consultants and project team

11. It was agreed at an early stage that a strong consultant team would be required to guide the university through the PFI process. In appointing legal and financial advisers to the project, the university invited presentations from major practices, with the requirement that each had demonstrable experience in PFI projects.

12. At that time, in early 1996, it would be fair to say that only a limited number of legal practices could reasonably claim a strong expertise in PFI matters. The choice of legal advisers was therefore probably more circumscribed than is now the case, with more PFI projects having been developed and completed. The value of experienced advisers was, however, acknowledged by the university, since it was well aware that the project to be undertaken was a complex one which would need the highest level of professional support. There was no doubt that each of the three advisers (legal, financial and property) was capable of carrying out a number of the tasks within the PFI procurement process. Identification of specific responsibility was therefore required. The division of tasks between each member of the consulting team was determined at the outset, together with a fee structure closely tied to task achievement. This was also a prerequisite of effective fee negotiation for the services of the professional advisers. The university's property advisers were appointed as overall project co-ordinators.

13. The project also required considerable internal support from the university. The lead officer was a member of the university's senior management team, and the heads of finance and estates and associated personnel were heavily involved in the technical specification of the project, as well as evaluation of bids at each stage. Early in the process it became evident that a full-time project officer was required to service the project, maintaining liaison with the consultant team as well as the bidding consortia. There is no doubt that a full-time project officer was vital to the co-ordination of the project, not only because of its complexity but also to be able to respond rapidly to queries from bidding consortia, thereby maintaining commercial credibility as a client.

Development of the invitation to negotiate (ITN)

14. The university set up a user group to develop the ITN for the project. In many ways, this paralleled its previous experience in successfully procuring conventional new building projects where end users had necessarily been fully involved in determining the brief for the building. It would be fair to say, however, that those in the university involved in this process were unfamiliar with the PFI approach as a long-term contract for the delivery of services, rather than for the provision of a physical structure. Developing an ITN was, therefore, a very different process from writing a conventional educational or technical brief for a building.

15. The task of the user group was to focus on the definition of services to be provided, rather than a hard and fast technical specification of floor space and associated services. This process did require an adjustment on the part of the end users, to move away from attempting to define specific space needs (for instance, a seminar room) to describing the activities which would be required to be carried out within the building. The object of this approach was to allow the PFI provider the maximum flexibility in producing the physical environment in which the activities might take place. For example, this exercise focused on the requirements for an individual staff study. Those with experience in the commercial property world were quick to point out that the actual amount of time spent by an individual member of staff in her or his study was very small given other needs of teaching, research, external contact and so on. Definition of teaching space included the facilities required and the time period over which it was needed, but not the actual room dimensions.

16. The ITN was therefore the product of considerable discussion and analysis of the activities of the Portsmouth Business School. The primary lesson to be learned from this process was undoubtedly that a good ITN, giving flexibility to the commercial sector while ensuring that the end users' needs are met, takes considerable time to develop.

The EU procurement process and location issues

17. The university situation was made more complicated by delays in the disposal of the land by the Ministry of Defence at Gunwharf for the millennium project. The decision by the Ministry of Defence was delayed for several months before a developer was finally chosen as the preferred and single developer of the site. Prior to this decision being taken, the university had attempted to acquire an interest in a parcel of land within the development area in order that it might make that land available to a PFI provider. The Ministry of Defence rejected that approach and insisted that the site should be assigned to a single developer. At that stage, therefore, it was clear the university's original intention in terms of location was called into question. Unless the selected developer chose to respond to the university's EU advertisement, it was unlikely that it could achieve its original relocation aim. Fortunately, the OJEC advertisement had deliberately set the location parameters with sufficient flexibility to draw in a range of other sites.

18. Following initial responses to the EU advertisement, information days were organised, inviting respondents to discuss the project with the university. A number of consortia emerged from this process, three of which were invited after interview selection to make proposals to the university in order to arrive at a final short-list of bidding consortia.

19. Evaluation criteria for selecting the consortia focused primarily on the need for a consortium to demonstrate an understanding of the PFI process, and the degree to which consortia appeared to be capable of delivering the financial benefits of the PFI process to the university through generating third party income. The importance of a strong all-round team was also recognised, especially since facilities management expertise was identified as being vital to successful service delivery. Architect-led or developer-led consortia tended to give less confidence when a long-term service contract was at the heart of the proposal.

Other strategic property issues

20. To safeguard its negotiating position, the university had already taken the precaution of identifying a development site in its own ownership, which could be used for the business school if the Gunwharf location could not be secured. In the event, the chosen developer at Gunwharf did not respond to the EU advertisement seeking a PFI provider. Instead, a number of other potential providers did come forward, focusing either on the university's own site, or on other vacant sites close to the main campus.

21. In the final analysis, the three selected consortia emerged with credible proposals, two of which focused on the university's site and a third on a vacant piece of land adjacent to other university property. Both sites were suitable in terms of meeting the strategic aims of the project.

Progress of the invitation to negotiate (ITN)

22. The process of issuing an ITN was lengthened by the need to undertake a degree of academic restructuring within the university, which reduced the overall size of the project. In essence, a department which was at the Milton campus, which it was originally intended to relocate along with the Portsmouth Business School, was integrated into another part of the university. To some degree this changed the scale of the facilities required. It was also evident that the original ITN led to an interpretation of need for space in excess of that anticipated by the university. It was decided, therefore, to withdraw the original ITN and to re-issue it. This inserted a two-month period into the procurement process. There can be no doubt that this was a frustrating experience for the chosen consortia. On the other hand, client needs do change from time to time and may cause a revision to a client brief for a conventionally procured project. In risk terms, it certainly could be argued that the risk to the client as a self-developer was very much being transferred to the private sector, since significant changes in the brief during the design process for a conventionally procured building would have incurred direct costs to the client.

23. The revised ITN was issued in February 1997, and resulted in considerable variation in interpretation by the three consortia, since the requirements when translated into space needs varied widely. These variations stemmed from differing net to gross ratios, as well as different approaches to the provision of specific services.

The comparator

24. The university developed a comparator drawing on its experience of procuring buildings through a more conventional route. It was then adjusted for risk in order to make a realistic comparison with the PFI proposals.

25. Advice on risk adjustment was provided by the university's financial advisers, giving rise to an interesting exchange of views as to the risks a self-developer actually incurs. The university's own experience in terms of closely managed projects had been that project delivery of five major capital projects in the previous six years had all been within budget, with only one significant project delay. Nonetheless, risk adjustment relating to both project delivery and more general development risk identified above was agreed to be necessary, and the comparator fully reflected this. The costs of the comparator in terms of capital and revenue costs were based on quantity surveyors' advice for current capital build costs and the university's own experience of operating similar buildings.

Bid submissions

26. The submissions by the three consortia varied considerably from the comparator. Detailed discussion took place with the providers in extensive feedback sessions in an attempt to identify the source of the variances. Over-generous interpretations of requirements and misunderstandings of risk transfer were seen as the most significant reasons. In the case of risk transfer, the consortia had at times made cost provision for a level of non-performance of all facilities since, in the event of service failure, payments would not be made by the university. However, the university was willing to be rather more flexible in this area, permitting non-performance in certain areas for limited periods of time since, within the context of a university, short-term provision might be made for substitute facilities or services. For example, if the heating were to fail for three days in a university teaching block, it would be relatively easy to overcome the problem either by temporary heating or re-timetabling. In other public sector institutions, such as an NHS hospital, it would be unlikely that such flexibility in risk acceptance would be acceptable.

27. Further clarification was therefore given to each of the consortia on these and other issues, and best and final offers were invited. It might have been possible at that stage to have come to a decision that the PFI bids were so far away from the comparator that a further invitation to the consortia was unlikely to yield a positive result. Nonetheless, it was felt that still further areas of necessary clarification had been identified and risk transfer issues needed to be more fully discussed. It was considered probable that at least one consortium would have come sufficiently close to the comparator to allow negotiations to take place to achieve a final deal.

28. Analysing all three proposals, it was also evident that at least one consortium was proposing operating costs which were finely tuned and highly competitive, but the project was too high on capital costs. A second consortium's proposal was satisfactory in terms of capital costs, but was the most expensive by some distance in terms of running costs. It was thought necessary therefore to give all three consortia opportunity to explain their costings in more detail and to give further consideration to all aspects of their bids.

29. In the event, once best and final offers had been received, the gap which remained between those offers and the comparator was deemed to be too wide for any real possibility of it being bridged through further negotiation. The Board of Governors decided therefore that the PFI process should be aborted and that an alternative procurement route should be investigated.

Timetable of the PFI process

30. The timetable for the process had been an extended one, probably more so than that for a conventionally procured building project. A summary of the timetable is shown in Table 1.

Table 1 Summary timetable

Conclusions and reflections

31. There is no doubt that at the inception of the project, the PFI appeared to offer real advantages to the university. The university was willing to be innovative and work in partnership with a PFI provider, particularly to generate third party income, in the belief that by doing so its own costs would be reduced. The proposals made to the university were, in general, not particularly innovative with regard to the generation of third party income. However, such opportunities will always be determined, and possibly limited, by the chosen site for the development. The development of the ITN, setting out the service specifications for a project, is a complex and demanding task. Flexibility on the part of the client in terms of permitting the private sector to deliver a service in an innovative way can undoubtedly lead to novel solutions.

32. The issue of risk transfer will always figure prominently in public/private sector partnerships. In the case of a major educational institution, many risks to its continuing operation are probably not identified, if only because its business is rarely interrupted unless there is a significant breakdown in services. This is particularly true of a university with a wide range of other premises which can be used flexibly in order to accommodate a particular problem. Other public sector institutions such as schools or hospitals may have less flexibility, with the consequential need to quantify risk in a much more rigorous manner. The private sector may, however, choose to provide for a greater level of risk for non-performance than is actually necessary, leading to an inflation in costs.

33. The selection of consultants and the identification of the tasks to be carried out by each element within the consultant team are essential tasks over which considerable care must be taken.

34. The outcome of this process was a disappointment for the university and the bidding consortia. However, in the last analysis it was evident that private sector proposals for this particular project did not represent best value for money and it was on these grounds that the decision was taken to abort the PFI process.

Acknowledgement

35. This case study was produced by Dr Michael Bateman, Pro-Vice-Chancellor of the University of Portsmouth.

The Winter Gardens project

Bournemouth University

The project

1. The purpose of the scheme was to create a major international performance centre for digital arts at the Winter Gardens in Bournemouth. While this purpose remained constant, the process by which it was achieved was amended over time so that the project became the first to seek to use both Arts Council lottery funding and PFI.

2. The project had its genesis in the coincidence of needs of the university and Bournemouth Borough Council (BBC). After a period of rapid expansion the university was seeking additional accommodation. In particular it was seeking to improve the facilities available to its School of Media Arts and Communication. This school had been a strong performer in the recent Research Assessment Exercise, had a strong national reputation in its field and a growing international reputation. Its current facilities were felt to be inadequate to support its medium-term development proposals.

3. BBC was the owner of the Winter Gardens concert hall in the centre of Bournemouth. The present building was built in 1937 as an exhibition centre and indoor bowling green. In 1946 it was converted into an 1,800-seat concert hall with further alterations being made in 1954. In recent years the building has deteriorated and the frequency of its use reduced, especially since the Bournemouth Symphony Orchestra relocated to the new Arts Centre in adjoining Poole. BBC therefore had to maintain an ageing building in a prime town centre site, being constrained from taking more drastic measures by a very vocal local group of Friends of the Winter Gardens.

4. The proposal from the university in mid-1995 for the refurbishment and extension of the concert hall into a media arts complex, with capital funding provided by the Arts Council Lottery Board (ACLB), was therefore viewed by most officers and many councillors of BBC as an expedient solution to an intractable problem.

The changing process

5. The original process outlined to the university board in July 1995 envisaged the university taking a long lease (at least 99 years) of the relevant freehold property from BBC for a peppercorn rent. The university would be responsible for producing a business plan to demonstrate the viability of the proposal, not only to the university board but also to the ACLB, in order to procure capital funding. In other words, all the risks of the venture would be borne by the university.

6. By January 1996 a business plan for the new complex had been produced with the assistance of specialist consultants (Arts Business Ltd). While noting a number of potential dangers in the proposals which would need addressing at a later stage, the university board agreed in January 1996 that an application to the ACLB should be made for a feasibility grant. This was subsequently awarded in May 1996.

7. In March 1996 a representative of the HEFCE visited the university and suggested that the project could usefully be developed as a PFI project. Pathfinder status could be (and later was) awarded to the scheme by the HEFCE under its initiative for encouraging PFI projects in higher education. The immediate advantage that the additional £50,000 of pathfinder funds gave to the university was to enable it to appoint legal and financial advisers to the scheme without calling upon the feasibility grant monies from the ACLB; these were largely directed towards the project architects. The reports of the independent advisers would also give the university board additional external objective views on the financial status of the project.

8. Legal and financial advisers (Beachcroft Stanleys and KPMG) were appointed in the late summer of 1996, a year after the university board had first been advised of the project and four months after the award of the feasibility grant from the ACLB. In that year the process had turned into a joint PFI/National Lottery funded arrangement, and the implications of this unique approach began to be worked out in practice.

9. One further major change was to occur in March 1997 when BBC formally became joint sponsors of the project with the university.

The rationale for using PFI

10. In 1996 there appeared to be a strong desire to see an increase in the level of private sector involvement in National Lottery projects. The PFI process had been developed as the main procurement tool for the public and quasi-public sector. The objectives of PFI and the ACLB were in many instances quite compatible: both wanted to see projects that were sustainable in the long term; and both wished to preside over projects that were well managed in the design and construction stage, and that transferred the responsibility for cost overruns to the private sector. The university, in conjunction with officers of the Private Finance Panel Executive (PFPE), sought to construct a process that effectively harmonised the ACLB's bidding procedure with the PFI procurement procedure.

11. The university was aware that it did not have the expertise required to run a concert hall and the other commercial activities envisaged for the new centre, as it would have had to do under the original simple proposals outlined above. The PFI process, it was recognised, could provide it with the means to enter into a partnership with a company expert in the management of such a venture. The PFI process seeks to place the risks inherent in each phase and area of a project with the party best able to manage the risks. This enables a sustainable project to be developed which achieves value for money.

Problems with joint PFI/National Lottery funding

12. The grant application rules of the ACLB required a bidder seeking capital funds to submit a detailed business plan which indicated that the project was sustainable, together with an outline design for the building. Unfortunately, the university did not have all the information regarding the business plan and was not in a position to develop it easily. Given that the private sector partner (PSP) in a successful PFI project would have the ultimate responsibility for managing the project, logically the PSP should provide this information.

13. However, deriving the information would require the potential PSPs to undertake a significant amount of work, which they would be unlikely to do given that the project would not be sustainable without a lottery grant.

14. In other words, the university could not meet the requirements of the ACLB's bidding process until it had negotiated with private sector partners. They in their turn would not be prepared to invest in the project until they had the assurance that lottery funds would be available - and such assurance would not be forthcoming until the bid application was made!

The proposed solution

15. After much discussion with the PFPE and the ACLB, a hybrid PFI scheme was developed to overcome these problems. Under this arrangement the PFI procurement process was split into two phases:

• phase 1 was designed to take the project from initial competition for PSPs through to full submission for lottery grant
• phase 2 would proceed after the award of the grant (which made the project financially viable) to the detailed evaluation of bids and the selection of a preferred PSP.
  

16. Phase 1 would proceed to a selection of short-listed bidders as in any PFI contract, following the usual placing of an advertisement in the Official Journal of the European Communities (OJEC) and preparation of an information memorandum (IM) to issue to respondents. The IM would contain information on the university, the project and its requirements, and set out criteria that must be addressed by the respondents. Bidders would be asked to describe the consortium with which they would develop and run the project.

17. Respondents would be short-listed and the successful ones issued with a phase 1 invitation to negotiate (ITN). This document would cover the detail necessary to make a full application for lottery grant. Its requirements would not be so onerous as to discourage the PSP from proceeding, while at the same time ensuring that sufficient work was undertaken both in design and in developing the business plan to meet the ACLB's requirements.

18. The university would then submit the proposals to the ACLB who would judge whether the applications (in their totality) could be awarded lottery support.

19. If the grant were awarded, phase 2 of the process would begin. A phase 2 ITN would be issued. The short-listed PSPs would have a greater commitment to the project knowing that the ACLB support made it financially viable. The phase 2 ITN would describe the output specifications to be met by the private sector, and would require proposals on payment mechanisms and detail the level of risk transfers, together with draft contract terms and heads of agreement.

20. An important feature of the hybrid scheme was the need to co-operate closely with the ACLB in the drafting of all documentation, so that the views and requirements of the Arts Council could be reflected in the documentation from the outset. This would ensure that the bidders worked towards an application that would be acceptable to the ACLB.

The project architects

21. In the summer of 1995, before the project had assumed its PFI characteristics, an OJEC advertisement was placed identifying the project and seeking interest from prospective architectural practices. A short-list of four was compiled, and a committee of representatives from the university and BBC selected Michael Hopkins and Partners (MHP) to progress the proposal. These architects have an international reputation and particular expertise in the areas covered by the project. In the context of a project seeking significant funds from the ACLB, a large factor in determining MHP's selection was their known acceptability to the Arts Council: the Arts Council had worked with MHP before and held them in high regard.

22. The prior appointment of an architect by a project sponsor is clearly not within the spirit of the established PFI rubric. This posed a potential dilemma to the university given MHP's known acceptability to the ACLB.

23. The architects made it clear that they were unable to operate a system of Chinese walls within their practice should they find themselves advising more than one PSP. After much discussion between the university and its advisers, it was agreed that MHP's prior appointment as architects should not prejudice the PFI status of the project so long as all potential private partners were made aware of the appointment and certain ground rules were established in advance.

24. The IM therefore advised prospective partners that it was a condition of selection that MHP provided design services. It went on to make the point that while standard PFI projects involve a significant cost to the PSP for survey, architectural and other services, the opportunity existed for them to use all the work carried out already by the appointed architects.

25. The phase 1 ITN document elaborated the process further: it acknowledged the legitimate concern of PSPs that insistence on the use of MHP design services might create the theoretical risk of leakage of commercially sensitive information between bids. It noted that a process had been devised whereby commercially sensitive detailed design work would be undertaken relatively late in the tendering process, and quite possibly after the stage when the preferred PSP had been identified.

26. Thus in the preparation of responses to the phase 1 ITN, all enquiries from PSPs on architectural matters were to be referred to the university's design and construction advisers (F C Denley King and Partners). A written response to these enquiries would then be made as soon as the appropriate information or answer had been established. In addition, joint meetings with representatives of F C Denley King and MHP could be made by prior appointment.

27. However, while the phase 1 ITN noted that the concerns of potential PSPs over the commercial sensitivity of design work would be further safeguarded in phase 2 (possibly with a deferral of detailed design work), it was acknowledged that the precise mechanisms would depend upon:

• the actual outcome of phase 1
• the outcome of the application to the Arts Council for development study funding
• the number of PSPs moving forward to phase 2.
  

28. In other words, the prior appointment of architects to the project led to practical problems with the operation of the normal PFI process. While the problems were acknowledged, their solution inevitably was deferred in the interests of progressing the scheme to the point where an application for funding to the ACLB could be made. In the event, these problems remained unresolved when funding for the scheme was refused by the ACLB.

29. The reactions of the PSPs to these arrangements, at least up to the point where they had provided responses to the phase 1 ITN, were mixed. They appreciated the reasons for specifying MHP but they were understandably concerned over the locus of responsibility for buildings liability claims and for life-cycle costing of the operation of the completed building. These issues would need to be addressed in the contractual documentation if the scheme progressed to phase 2 ITN.

Joint sponsorship

30. BBC formally became joint sponsors of the PFI Winter Gardens project in March 1997. There were two principal reasons for this change of status from prospective landlord to joint sponsor:

a. Political. Feasibility funding had been awarded to the university in May 1996 and it was therefore clear to the council that serious proposals were being worked up to develop a very sensitive piece of freehold property in the centre of the town. Furthermore, the receipt of feasibility funds increased the probability of receiving substantial capital funds after the feasibility stage had been completed (at that point there was only a two-stage application process to the ACLB). In the circumstances BBC could not be seen to have no control over the transformation of a major public asset.

b. Legal. The university's legal advisers were of the opinion that the university would be acting ultra vires if it operated all the proposed new arts complex. The powers of the university are set out in section 124 of the Education Reform Act 1988. The university has the power to provide higher and further education and carry out research, together with anything which it deems to be ‘necessary or expedient for the purpose of or in connection with the exercise of that power'. The advisers felt that operating a concert hall and other facilities for the general public did not fall within section 124. However, if the university and BBC acted in concert it was considered that their joint powers were sufficient.

31. The change of status by BBC was welcomed by the university. The formal joint sponsorship was seen as a means of strengthening the burgeoning relationship between the university and ‘the town', which was appropriate as the town would be a major beneficiary of the new centre.

32. BBC was therefore formally designated as co-sponsor of the project on the OJEC notice (despatched on 2 June 1997), on the IM, and on the phase 1 ITN document (issued on 8 August 1997).

33. No formal memorandum of understanding or similar agreement was entered into by the university and BBC. By the beginning of March 1997, senior officers of the council were attending the weekly meetings of the university's Winter Gardens executive group and were sharing information on the project.

34. In practice this meant that officers of the council were attending meetings with the university's financial and legal advisers. KPMG and Beachcroft Stanleys had been appointed by the university to advise it on the Winter Gardens project. Their fees were being met in part from pathfinder funds supplied to the university by the HEFCE. University staff members of the Winter Gardens executive group were bound to heed the advice of their own advisers. Occasionally council officers disagreed with this advice but on all occasions an amicable solution was found. However, had the scheme progressed, the status of the advisers vis-à-vis each sponsor and the scheme as a whole would have needed reviewing. This was because both the university board and the town council, as legally independent bodies with their own constituency responsibilities, would need separate assurance on the economic viability and legality of the scheme.

Private sector partners

35. Although the project had the outward form of a ‘traditional' PFI scheme, potential PSPs were faced with an unusual task. Because of the requirements of the ACLB bidding process and the hybrid PFI process developed to deal with them, outlined above, they were being asked to assume a quasi-partner role with the project sponsors. They were not presented with an ITN that included a quite detailed output specification and draft legal heads of terms. Instead they were being asked to assist in working up proposals, using the expertise of the various consortium members, on the assumptions that certain resources and income streams would be provided by each of the sponsors, and that they would suggest further income-generating proposals that could be incorporated into the scheme.

36. It was necessary to make this approach clear to potential PSPs from the beginning. The IM spoke of inviting the PSP ‘to develop business plan proposals which will maximise the opportunities for public and educational use'. The phase 1 ITN document invited PSPS ‘to demonstrate how they can use their expertise to add value to the proposals over and above the work already undertaken to date by the joint sponsors during the feasibility stage. As such the ability of the PSPs' proposals to support the joint sponsors' application for further funding is essential'. The phase 1 ITN contained details of the work undertaken to date in developing the Winter Gardens scheme by the joint sponsors, including some estimates of capital and revenue budgets. In particular it provided details relating to the design and construction of the scheme, including indicative costs. PSPs were ‘encouraged to consider how these designs could be enhanced and where opportunities exist for generating additional value' over and above the minimum output specification requirements of the joint sponsors. These requirements were set out in the document and had to be incorporated into any proposals developed by the PSPs.

37. Seven formal responses were received to the IM. These were short-listed to four consortia, the members of which were all firms of national or international reputation. Formal and informal meetings were held with each of the four prospective PSPs, at which they began to come to terms with the role that was expected of them. The advantage of the two-stage ITN process was emphasised by the sponsors: it should mean that the risk exposure of the PSPs would be limited since all that was being required in response to the phase 1 ITN were indicative proposals that would satisfy the ACLB's bidding procedure.

38. Prospective PSPs were encouraged to survey the site and consider how it could be extended by the acquisition of additional freehold property not under the ownership of the BBC, in a way that improved the income potential of the whole scheme.

39. The submissions in response to the phase 1 ITN by two of the four short-listed PSPs failed to comply with that document's requirements. They therefore had to be ruled out of further discussions. The quality of the responses of the remaining two PSPs, however, demonstrated that a process in this form was viable. To be viable, it required the willing engagement of the PSP with the project sponsors in a spirit of entrepreneurial co-operation. There was a need for the PSP to absorb the ethos and spirit of the proposed scheme while adding elements to ensure its financial viability.

40. In other words, because of the necessary lack of precision in specifying the output specification on the ITN, the sponsors were requiring prospective PSPs to contribute to the process of defining the project. In doing so the PSPs had to look beyond the straightforward generation of developer's and construction profits and a straightforward facilities maintenance agreement. The fact that at least two prospective PSPs were willing to embrace this approach indicates that it is feasible.

The Arts Council Lottery Board (ACLB)

41. There were three principal difficulties in practice experienced by the university in dealing with the ACLB:

• changes in the ACLB's grant awarding process
• changes in the amount of grant available
• their acceptance of the PFI process.
  

Changes in the grant-awarding process

42. When the university originally applied (in its sole name) to the ACLB for a feasibility grant in 1995, the ACLB operated a two-stage grant application process. Successful completion of the feasibility study stage led to consideration of the awarding of a full grant to the project. It was with this model in mind that the university, in conjunction with the PFPE, developed the hybrid PFI process outlined above. The splitting of the ITN process into two phases was designed to enable the input of the prospective PSPs to be incorporated within the bid for full grant funding.

43. In late July 1997 the ACLB reviewed their procedures for granting major capital awards and announced new guidelines for applications. The new procedures broke the process into three phases rather than two. These were:

• feasibility award (now a maximum of £50,000)
• development study award (on average £500,000 to £700,000)
• grant of capital funds.
  

44. The sponsors had early indication that these changes were to be made and were able to amend the drafting of the IM accordingly. This document was sent out after 10 July 1997 upon receipt of expressions of interest to the OJEC notice.

45. The university had been working closely with senior executives of the ACLB in the development of this scheme. These executives advised the university and BBC to apply for the development study award. It meant in practice that the result of work done in the original feasibility award stage had to be tailored to some extent to comply with the requirements of bidding for the new development study award.

Changes in the amount of grant available

46. An essential feature of the hybrid PFI scheme, as noted above, was the need for the sponsors to liaise closely with the ACLB at each stage of the scheme's development, especially with regard to the wording of documents such as the IM and the ITN. Integral to these discussions had been an indication from the ACLB as to the probable level of funding that they would be prepared to contribute to the scheme. Accordingly the phase 1 ITN document, issued in August 1997, included the statement that ‘both sponsors are looking to access a substantial Arts Council lottery grant (of up to £25 million) to partially fund the project'. A grant of this magnitude was being factored into discussions on building designs with the architects and there was no indication from the ACLB that the sponsors' expectations in this regard were unreasonable.

47. However, in November 1997 the ACLB unexpectedly announced that capital grants for projects would be limited to a maximum of £15 million. By this stage the university had already submitted its application for development study funding (on 16 October 1997) based on a grant considerably in excess of that new limit.

Acceptance of the PFI process

48. Once the potential advantages of the PFI process had been outlined in March 1996, there was a period of approximately six months in which the university's appointed project director engaged in discussions with both the ACLB and the PFPE. Even in the short period of its existence, the PFI process appeared to have assumed its own orthodoxy. Although for a number of reasons the initiative had not been conspicuously successful in delivering completed projects, there appeared to be – at least from the university's perception – a reluctance to adapt procedures in order to accommodate the lottery as a source of public funding.

49. Similarly, the ACLB were aware of the potential advantages of combining the long-term operational perspective of the PFI process with the single bullet payment of capital project funding which had been their traditional modus operandi.

50. However, with the particular assistance of a seconded member of the PFPE's staff, the development of the hybrid scheme described above was generally regarded as an innovative method of combining public funding from the lottery with private finance and, as such, was welcomed by the ACLB.

51. The sponsors were invited to make a presentation to the ACLB in December 1997 at which the main interest of the board was in the process rather than the particular merits of the Winter Gardens scheme.

The timetable

52. The university board approved the application to the ACLB for feasibility funding in January 1996. In March 1996, under the advice of the HEFCE, the university began to explore the possibilities of applying PFI principles to the scheme. In turn this led to prolonged discussions between the university, the PFPE and the ACLB from which the innovative hybrid PFI scheme was developed. In the autumn of 1996 the legal and professional advisers to the scheme were appointed, and detailed discussions on the progression of the project started.

53. In the meantime, following the award of feasibility funding in May 1996, the architects had begun to develop plans for the refurbished concert hall and additional academic buildings on the Winter Gardens site. They were compelled to work within stringent planning guidelines set by BBC, which was subsequently to become co-sponsor of the project.

54. In parallel with this work by the architects, other site survey analysis work and acoustic analysis of the existing concert hall was carried out.

55. The completed plans were lodged with BBC in January 1997 so that they could be inspected by the public prior to their consideration by the planning committee and, subsequently, the full council in March 1997. Outline planning permission was granted, subject to certain conditions. The sponsors considered that it was necessary to be able to inform prospective PSPs that planning permission had been given for the project - at least in outline – before any public announcement was made. Had planning permission been refused the timetable for the project would necessarily have been extended.

56. Once planning permission had been received and BBC had become joint sponsors (to ensure the university was not exceeding its powers) it was possible to draft the necessary documentation. Thereafter, once the OJEC notice had been placed and prospective PSPS were involved, it became necessary to specify a detailed timetable within the IM and the phase 1 ITN. The projected timetable was as illustrated in Table 1. From the despatch of the OJEC notice on 2 June 1997, this timetable was adhered to until submission of the application for the development study award on 16 October 1997.

Table 1 Projected timetable for the Winter Gardens project

Project management

57. As described above, the project moved from being under the total control of the university and therefore resourced from the university's limited budget. These resources were augmented by Pathfinder funding from the HEFCE which contributed towards the costs of the legal and financial advisers, after which the resources of BBC became available when it became joint sponsors of the project in March 1997.

58. In March 1996 the university board appointed the deputy vice-chancellor, who was to take early retirement in September 1996, to act as project director. Formerly responsible for the finance and resourcing of the university, he had extensive experience in managing large budgets and building projects. He retained the post as project director after his retirement as deputy vice-chancellor.

59. The project director formed an executive committee to oversee the project. In the first instance this was composed entirely of university staff, with the exception of the university's adviser on design and construction matters. University staff co-opted onto the executive committee included heads of accounting services, estates, strategic planning and the head of the academic School of Media Arts and Communication. In October 1996 the project director's successor, the pro vice-chancellor responsible for finance and corporate development, joined the committee.

60. Each committee member had designated responsibilities for various aspects of the project:

• head of accounting services – liaison with legal and professional advisers
• head of estates – liaison with architects
• head of strategic planning – liaison with BBC and other local groups in the town with an interest in the Winter Gardens
• head of School of Media Arts and Communication – liaison with arts related bodies and technology providers
• pro vice-chancellor – liaison with the office of the vice-chancellor and the board.
  

61. The university board established a sub-committee of its Finance and Resources Committee to oversee the Winter Gardens project.

62. Membership of the executive committee expanded to include senior officers of BBC when it became joint sponsors of the project. Principal members of the committee were the director of development services, and the director of leisure and tourism.

63. On average the committee met weekly for at least two hours. The legal and professional advisers and the architects had a standing invitation to attend. Occasionally committee members met in the London premises of the advisers.

64. It was this group that, on an iterative basis, developed the output specifications outlined in the phase 1 ITN document. The iterative process took into account factors such as:

• the estimated capital costs of the preliminary designs from the architects
• draft revenue streams from income sources under the control of the sponsors
• the opinions of the ACLB and of Southern Arts
• the tenor of local opinion, derived partly from open meetings with the public and partly from BBC councillors
• the overriding need (as far as university staff were concerned) to satisfy the ‘due diligence' requirements of the university board
• the HEFCE's requirements as to proper use of public funds and value for money.
  

65. As noted above, it was not the intention of the phase 1 ITN to specify output specifications to the prospective PSPs in detail. However, indicative output specifications were stated covering the following areas:

• concert hall and main auditorium
• public spaces and performance environment
• IT and media technology
• exhibition installation
• School of Media Arts and Communication (incorporating a National Centre for Computer Animation)
• education, research, learning and arts access
• residential accommodation
• regional film theatre
• car parking
• virtual reality theatre
• commercial broadcasting studios
• archives
• cybercafé and other catering services
• retailing
• teleconferencing facilities.
  

66. A sub-set of the executive committee was convened to evaluate the responses of those companies submitting proposals in response to the IM. This comprised the project director, the head of accounting services, the university's adviser on design and construction, and BBC's director of development services. A scoring spreadsheet had been designed by KPMG so that a numerical score could be deduced to rank respondents.

67. The prospective PSPs were essentially self-selecting after the phase 1 ITN submissions, given that the responses of two were technically incomplete. The remaining two were invited to give a full presentation of their proposals to a joint meeting of the Winter Gardens executive, the Winter Gardens sub-committee of the university board, councillors and other officers of BBC, and other senior staff of the university. At this stage it was the intention to retain both prospective PSPs in order to maintain a competitive climate in the phase 2 ITN stage.

Outcome

68. The application for development study funding was submitted to the ACLB on 16 October 1997. This date was critical in that the ACLB had undertaken to give a ‘fast track response' if the application was received by that date. The response was promised by the end of January 1998.

69. In the meantime the sponsors were invited to give an oral presentation to the ACLB in December 1997. As noted above, this concentrated upon the PFI process and its interaction with the lottery application process rather than the merits of the proposed international performance centre for digital arts.

70. In February 1998 the sponsors were told that the ACLB had decided not to award further funds to the project.

Learning the lessons

71. Although the project was ultimately stillborn in that funding for the development study award was refused by the ACLB, it was successful in establishing the prototype of a process which combined ACLB funding with PFI. The hybrid PFI process developed, with its two-stage ITN process linked to the ACLB's bidding structure, is a model that could be used elsewhere. The combination of public and private financing in this way gives the ACLB assurance of the long-term economic sustainability of the projects in which it agrees to invest; and the financial support of the ACLB reduces the risk exposure of private sector companies as they contemplate investing time and money in public and quasi-public sector projects.

72. The project was innovative not only in its approach to the ACLB and PFI but in the nature of the proposed performance centre. Much of what was proposed for the centre was at the leading edge of current technology. This not only limited the number of potential PSPs who were able to cope with these demands but also had the disadvantage that the sponsors could not refer PSPs – and especially the funders within their consortia – to an existing comparator. Funders in particular are usually more relaxed about a project if they can obtain statistics of the performance of a comparable scheme.

73. The quality of the responses by two consortia PSPs to the phase 1 ITN indicated that requiring them to act as quasi-partners to the project sponsors was a viable approach in such a complicated and innovative project.

74. The two-stage ITN approach had the advantage of expediting the project in its early stages but also contained the danger of deferring difficult decisions. The status and loyalties of the architects and the legal and professional advisers were a case in point. Had the project progressed to the next stage their roles would have needed careful definition in order to establish clear lines of accountability vis-à-vis the advisers, the sponsors and the PSPs.

75. Applicants to the ACLB, or other lottery boards, have no control over their decisions. If they decide to change their grant awarding process, or restrict the level of grants, this can lead to radical changes in proposals or, potentially, abandoning the whole project.

76. Sponsors need to be realistic about the amount of time that projects of this size and complexity will consume for senior members of their organisations.

Acknowledgement

77. This case study was produced by Rob Allan, Head of Accounting Services at Bournemouth University.

Use of a soft market test

Background

1. A particular higher education institution (HEI) was faced with the problem of a disused building forming part of its estate. The building was listed Grade II, with a floor area of about 3,000 m2. It occupied a focal point on a secondary campus and the surrounding land was all used by the HEI, so selling the building would be difficult. Unused for six years before the HEI bought the land, the building represented a continuing drain on resources to prevent further deterioration.

Options

2. The HEI identified a number of options for dealing with the problem:

a. Continue with the status quo, accepting a continuous drain on resources to keep the building in a safe state.

b. Refurbish the building as academic and teaching accommodation.

c. Refurbish the building as a conference centre.

d. Demolish the building, and replace it with purpose-built academic and teaching accommodation.

e. Demolish the building and replace it with a purpose-built conference centre.

f. Sell the building.

3. A qualitative assessment favoured the conference centre options. A purpose-built facility would be preferred, were it not for the planning constraints which were likely to make it difficult to achieve any option involving demolition. An economic appraisal similarly favoured the conference centre solutions, as the only options to generate a positive net present value. However, the appraisal also indicated that the conference centre options were both particularly sensitive to a fall in income, most of which would be derived from residential conferences.

Risks and rewards

4. Projections of conference income indicated that a project which incorporated funding and operating a conference centre would generate a surplus. However, in taking on such a project the HEI would also have to manage a number of key risks:

a. Construction costs. Substantial risks are inherent in refurbishing a building of this nature, which could increase costs, delay the project, or both. Cost escalation or a delay would increase the financing costs, and a delay would also affect the income stream.

b. Availability. The HEI would have to manage the building for the life of the project, accepting the risks associated with maintaining the building at an appropriate standard within the predicted life-cycle costs.

c. Demand. The viability of the project is highly dependent on the HEI's ability to attract sufficient conference business to meet the income predictions. Any prospective funder would require the income stream to be underwritten in some way.

d. Service costs. Use as a conference centre implies maintaining an appropriate standard of service, and the HEI would have to manage the associated costs over the life of the project.

e. Performance. A consistent standard of service delivery and management would be key to the long-term success of the project.

PFI potential

5. The HEI recognised that all these risks might be transferred to the private sector, under the Private Finance Initiative (PFI). However, the viability of using this method of procurement would depend on the private sector's appetite for risk, and the price which would be charged. The HEI applied to the HEFCE for Pathfinder funding to support PFI procurement, and the HEFCE agreed to contribute to the cost of professional advisers to carry out an initial soft market test.

Recruiting advisers

6. Five firms of advisers were invited to submit a tender to undertake the following tasks:

• to define the HEI's requirements in output-based terms, to a sufficient level of detail to produce a briefing document
• to use this briefing document to conduct a soft market test, to establish the level of interest in the market for a project of this kind
• to advise how the project should be structured.
  

7. Three of the firms responded, and two were invited to interview on the basis of their response. The successful candidates were engaged to undertake the work for a fixed price.

Conducting the soft market test

8. The advisers produced a briefing document which was agreed with the HEI. It provided:

a. An introduction to the project. This included the supporting rationale, and a description of the opportunities for the private sector. As well as the development and operation of a conference centre, these included:

• wider facilities management across all or part of the HEI's estate
• the possibility of a joint venture company
• other opportunities which might be mutually beneficial to the HEI and the private sector.
  

b. A description of the HEI. This included:

• history
• strategy
• financial performance
• academic activities
• student numbers
• its management and staff
• the estate.
  

c. The investment opportunity. This emphasised:

• the location of the HEI in an area short of dedicated residential conference facilities
• the increasing demand for such facilities
• the availability of the site and building
• the underlying low risk income from the HEI's own demand for the facilities
• the HEI's expertise in its existing conference business.
  

9. The advisers used their experience and contacts to identify a long list of private sector companies who might be interested in the project as funders, constructors or operators. This was supplemented with the HEI's local knowledge. The private sector companies were invited to respond by:

• expressing the level and nature of their interest in the project
• explaining how the project could be made more attractive to private sector investment
• describing the broad commercial terms under which they might be prepared to invest in the project
• giving details of any other similar projects in which they were or had been involved, whether procured using PFI or by other means.
  

The response

10. Three categories of private sector interest showed a positive response:

a. The construction sector was prepared to take construction and availability risks, by funding, designing, building and operating the facility, on the basis of a fixed annual charge. However, it was likely that the price for bearing the construction and availability risks would absorb all the HEI's predicted operating surplus.

b. A few facilities management operators were prepared to take on services such as cleaning, catering and laundry, at rates roughly comparable to the HEI's own, and in doing so they would take on the associated cost and performance risks.

c. There was only a very limited response from the few specialist conference centre operators. Although they were prepared to take on the design, build and operate functions, this was only on the basis that the HEI would underwrite a substantial proportion of the projected income. They were also unwilling to fund the investment themselves or find a funder, and would rely on the HEI to find funding for the project.

Outcome

11. In the light of this somewhat disappointing response, the HEI resolved to revisit its strategy for dealing with the building, because it was clear that to pursue a conference centre option would still involve it bearing considerable risk in an area which did not represent core business. Since then, a leading conference centre operator has confirmed the viability of the project and wishes to become involved in a partnering approach, though not through PFI. The conference centre option remains the HEI's preferred solution for dealing with the building.

12. However, the exercise of conducting a soft market test was valuable. It enabled the HEI to review the potential for PFI with a relatively small amount of in-house effort, and at low cost. The alternative investigation method would have been to initiate a full PFI procurement through an advertisement in the Official Journal of the European Communities (OJEC). This would have involved developing a full output specification, preparing a risk register, and drawing up a draft contract. The cost of advisers and the management resources committed by the HEI would both have been much greater. In the circumstances, it is likely that all this effort would have been wasted, and the failure to attract a private sector bidder would have damaged the credibility of the HEI, making it more difficult to initiate PFI procurement in the future.

Acronyms and abbreviations