This thesis has been submitted in fulfilment of the requirements for a postgraduate degree (e.g. PhD, MPhil, DClinPsychol) at the University of Edinburgh. Please note the following terms and conditions of use: • This work is protected by copyright and other intellectual property rights, which are retained by the thesis author, unless otherwise stated. • A copy can be downloaded for personal non-commercial research or study, without prior permission or charge. • This thesis cannot be reproduced or quoted extensively from without first obtaining permission in writing from the author. • The content must not be changed in any way or sold commercially in any format or medium without the formal permission of the author. • When referring to this work, full bibliographic details including the author, title, awarding institution and date of the thesis must be given. A fair return for risk? An examination of structure, competition and profitability in the market for private finance in the National Health Service By Mark Hellowell This thesis is submitted in fulfilment of the degree of Doctor of Philosophy, University of Edinburgh Global Public Health Unit Social Policy School of Social and Political Science University of Edinburgh i Title: A fair return for risk? An examination of structure, competition and profitability in the market for private finance in the National Health Service. Abstract Since 1993, the Private Finance Initiative (PFI) has been the dominant form of large-scale infrastructure procurement used by National Health Service (NHS) organisations in the United Kingdom. As of April 2011, 123 PFI projects for new hospital facilities had been agreed between NHS organisations and private sector consortia, representing privately financed investment of £15.9 billion (in 2010 prices), and a projected long-term cost to the NHS of £70.5 billion. Eight additional hospital PFI schemes were being procured or prepared for tender as of April 2011, with an estimated capital investment value of £2 billion. Despite the financial significance of PFI projects to the NHS, the literature has not assessed whether, or the extent to which, the returns expected by investors are excessive. This gap in the evidence base is highly problematic. The presence of excess returns to investors will have an impact on the cost efficiency and affordability of PFI projects, and consequently the financial sustainability of the NHS organisations that pay for them. This thesis evaluates the returns that investors in NHS-commissioned PFI projects expect to earn with reference to the scale of risk being borne by these investors, and explores the sources of the identified excess via an examination of the structure and competitiveness of the PFI financing markets. ii The study therefore comprises two substantial empirical components. The first draws on the financial models of 11 NHS PFI projects to describe and evaluate the return to investors. Cost of capital benchmarks, constructed on the basis of the Capital Asset Pricing Model, are used as comparators to assess the Internal Rate of Return (IRR) for the 11 projects, and as discount rates to calculate Benefit-Cost Ratios. Both measures agree on the presence of significant excess returns for investors on each project – with large “spreads” between the IRRs and the corresponding cost of capital benchmarks, and high Benefit-Cost Ratio scores. The second empirical component provides an analysis of the structure and competitiveness of the market for private finance. Two indicators of this market’s structure – concentration and entry/exit rates – in addition to the dynamics of the procurement process are the focus of measurement and evaluation. It is demonstrated that: (a) the market for private finance in this sector is an oligopoly, (b) market share is highly concentrated when assessed against UK regulatory standards, and (c) churn and market penetration rates are extremely low. Constraints on the competitiveness of the market are identified as: (i) the low number of bidders; and (ii) the extensive period of non-competitive bidding in the final phase of the procurement process, in which the output specifications of projects are materially altered. The thesis concludes that recent reforms to the procurement process have been ineffective, and the problems underpinning a lack of competitive pressure in procurement may be insuperable, given the inherent complexity of this form of investment and the need to secure external financing. For the NHS, this source of cost inefficiency implies substantial opportunity costs (i.e. foregone opportunities for additional capital investment) and excess costs (i.e. a higher than necessary burden on the revenue budget). A stronger regulatory iii regime, incorporating regulation of the profitability of PFI projects for investors, is required to minimise the threat posed by this policy to the financial sustainability of the NHS. iv v Acknowledgements This thesis would not have been possible without the support and guidance of a number of colleagues and other individuals whose contribution I would like to acknowledge. First and foremost, I would like to thank my supervisor Jeff Collin, who has contributed hugely to my personal and professional development while providing the support and encouragement I needed to complete the thesis at the same time as working as a full-time lecturer. I would also like to thank my second supervisor Iain Hardie, now a lecturer in politics but previously a banker, for his crucial insights into financial practice. My colleague Sarah Hill has been a tremendous source of support and advice, and this has been especially invaluable in the last two years of researching and writing. Former colleagues Allyson Pollock and David Price were also influential sources of guidance in the early phases of planning this research study. Outside the University of Edinburgh, a number of people have provided specialist expertise without which a multi-disciplinary project of this type could not have been undertaken. In particular, I would like to acknowledge the contribution of Robin Milne, formerly of the Department of Economics at the University of Glasgow, who acted as co-supervisor in the early years of the PhD before retiring in 2009. His expertise on the applicability on competition theory to the NHS context was invaluable in framing the current project. Two academics at the University of Boccóni, Milan - Veronica Vecchi, lecturer in health care management and Stefano Gatti, professor of finance - worked with me on papers which apply the techniques of financial theory and practice to evaluate public private partnerships, and I would like to acknowledge the contribution of their work in shaping parts of the study. vi I would like to thank my mother, Barbara, who provided extraordinary support with family and other commitments at critical periods in the data collection and writing processes. Finally, I would like to thank my partner, Alice, for exceptional patience and constant support throughout the project. This thesis is devoted to our three children, George, Carys and Jack. Mark Hellowell University of Edinburgh 27th August 2012 vii List of acronyms and abbreviations BAFO Best and Final Offer. The final stage of bidding prior to the selection of a preferred bidder. BAFO bids contain detailed responses to the output specification and prices. BCR Benefit-Cost Ratio. A measure of an investor’s expected return. The ratio of the present value of the revenue cash-flows to the present value of the initial investment. CAPM The Capital Asset Pricing Model. A method of measuring the opportunity cost of capital for an equity investor. CR Concentration ratio. A measurement of the concentration of market share among an industry’s largest firms. DBFO Design, Build, Finance and Operate. A technical term for the project finance model as used within the PFI programme in the United Kingdom (see ‘PFI’ below). DSCR Debt Service Cover Ratio. The ratio of the cash-flows from the project against scheduled debt service. FBC Full Business Case. A document drafted by public authorities in order to secure the support of ministers for a proposed PFI project prior to signing contracts with a preferred bidder. FCFBE Free Cash Flow to Blended Equity. The cash available per period after payment of all operational costs and after making scheduled payments of debt interest and principal. FCFP Free Cash Flow to the Project. The cash available per period after payment of all operational costs but before making scheduled payments of debt interest and principal. ERP Equity Risk Premium. The minimum amount of money by which the expected return on an investment must exceed the return on a risk-free asset in order to attract investment. EMRP The average return on the market portfolio of risky assets over a defined period. IRR Internal rate of return. The rate of return on an investment calculated as the discount rate that brings the present value of a stream of projected cash-flows to zero. ITN Invitation to Negotiate. An invitation to bid in a public procurement. HI Herfindahl Index. A measure of the market share of firms in relation to the industry as a whole. Used as an indicator of the amount of competition between firms in a market. NHS National Health Service. The shared name of three of the four publicly financed health care systems of the United Kingdom. viii LIBOR The London inter-bank offered rate. A floating interest rate that is used by banks and other financial institutions to price a large number of assets. NAO The National Audit Office. The supreme audit institution of the United Kingdom. NPC Net Present Cost. The NPV (see below) of the whole-contract cost of the PFI to the public authority. NPV Net Present Value. The discounted present value of a stream of future cash-flows, offsetting benefits against costs. OFT Office of Fair Trading. The supreme competition regulator in the United Kingdom.