TL,DR
Variations are often forgotten about, and can be complex
Contract clauses can be vague and left to interpretation
Transaction models were not designed to be “varied” and we would recommend building a “fit for purpose” model with dedicated variation coding and analysis tools
Having a simple and easy to interpret model can help the negotiations
Variations
Variations (or Cost Changes) in PPP contracts are the great contradiction – often forgotten about and consigned to the dusty annexes of the Project Agreement with the assumption they won’t be causing major debate. But, from what we have seen, when the trigger event occurs, they can have a major impact on a project.
Since 2012, Amberside Advisors has worked on major variations, valued at several million Pounds, and this article seeks to explain what variations are, why they are complex, and what can be done to mitigate the potential risks.
1. What are they?
At its core, a Variation (and some Benchmarking and Change in Law) in a PPP is a simple concept: Since Financial Close, when all stakeholders signed up to the project and were happy with the risk and return allocations, something has changed. At that point, we need to collectively take account of that change and adjust the numbers to leave all parties in a fair and commercially-neutral position. One way to think about it is to think, what if this was known at financial close, how would it impact the Unitary Charge?
For example, a healthcare PPP might have an additional wing built or the scope of FM services expanded. The Authority might want to reallocate responsibility for services from the Public side to Private side or vice versa – and this is expected to expand as Net Zero comes to the fore.
For a ‘simple’ variation where the operating costs of an SPV are increasing or decreasing, it’s often an assumption that the project just needs a Unitary Charge adjustment of the same quantum (“£1 in equals £1 out”). However, there are a number of factors that can prevent this from being that simple.
2. Why are they not easy?
Complexity A: Where do we start from?
In theory, PFI clauses were standardised under SoPC4 and similar, but this doesn’t prevent grey areas remaining. While all parties understand the need to keep the commercial risk/return allocations equal to the Financial Close position (often to leave parties in a “No better no worse” position), that itself raises a number of questions:
How is the variation process solved?
Which model should be used to make the adjustments and calculate the UC adjustments? Is it the FC model, is it a pre-existing variation model, a Refinancing model or a version of the Operational model?
How do we measure “No better no worse”?
IRR, real or nominal?
Senior Debt Cover Ratios, minimum or average?
Should we make adjustments to the base model to incorporate
Actual inflation to date?
Tax or Accounting legislative changes (e.g. rates and mechanisms)?
Updated forecast for inflation/interest receivable on cash?
Complexity B: Where do we go next?
Once a proper understanding of the starting position, and metrics to use, are both agreed, the process to actually solve the Unitary Charge adjustment should then be straightforward – or not?
Disregarding the profit-smoothing impact of Financial Asset/Debtor Accounting, ideally if the Variation were just related to FM costs, which inflate at the same rate as UC, then the result should broadly be “£1 in, £1 out”.
A number of cost types can bring additional complexity:
Are your cost changes inflated with the same mechanism as your UC? Many PPPs have “partially” inflated UC, or costs that increase contractually at RPI+1%. Both of these mean that your base UC number will not be the same as the base cost change number.
Are your cost changes related to lifecycle or a variable profile? Solving a flat base UC number to compensate for a profile that varies over time will inevitably lead to a returns profile, or senior ratio profile, changing from the FC position. How do we deal with that?
On a recent Variation mandate, Amberside Advisors encountered this issue where a number of costs inflated at different rates to the UC. It transpired that on average:
Each £1 of RPI+1 related cost required ~£1.15 of UC adjustment
Each £1 of lifecycle related cost required ~£1.30 of UC adjustment
By dedicating a section of our report to the mathematical explanation for this, we were able to provide comfort to both the Public and Private sector parties that the results were representative and aligned commercially with the risk allocation of the project.
3. Should I be worried?
Conceptually, variation clauses are there to protect both parties and prevent an event post-Financial Close from shifting the project away from its intended position. The issues often arise from multiple variations building up and having been dealt with at the time with a “close enough” mindset by applying a change to UC matching the cost basis as a pseudo-passthrough – until someone opens up the Appendix and realises what should have actually happened.
If not given proper consideration, Variations can bring a multitude of headaches, sunk time and advisor costs. But with due consideration, the process can and should be smooth and maintain the balance that was envisioned at project outset. Also, we understand from our clients that having a simple model with dedicated variations functionality, helps with negotiations as all parties can be taken on the journey of explaining of how you get from A to B.
Amberside Advisors has worked through a wide variety of Variation situations, clauses, documentation (both good and bad!), and the modelling and commercial implications. If you manage projects that have had Variations, or might have them in future, and would like to discuss please do not hesitate to reach out. Our aim is always to make your task of managing the projects as easy as possible. Variations are one area where our experience and skills can provide comfort for the historic Variations and devise a solution to future-proof against the Variations to come.
If you have any questions, or would like to discuss anything mentioned above, please get in touch with Alan Samuels or Rob Caroline.