How $17 Billion of High-Risk Financing Undid Britain’s Hospitals
(Bloomberg) -- Ian Swithenbank describes himself as “old school.” A former coal-mine electrician who started work at 15, he’s instinctively suspicious when something appears too good to be true.
It was this mindset that he took into meetings of a National Health Service governing board he was on in 2000, when it had to decide whether to build a new hospital in Hexham in northeast England.
The existing facility was a collection of single-story temporary buildings dating back to World War II. And the government was offering an apparently miraculous source of finance: A private company would build and service the hospital and the organization that managed it would pay the money back out of hospital revenue. The financing, originated by Bank of Scotland, would be off the government’s books.
Swithenbank was hardly an expert at high finance. But his sense of caution, along with that of others on the board, helped rescue the future hospital from financial disaster: They voted provisions that allowed the funding terms to be canceled at a manageable cost.
Without the special financing, Hexham General Hospital “would have just remained a collection of wooden huts,” Swithenbank said. “But I’m always dubious about doing something that can’t be undone.”
At least 125 other hospitals in the U.K. weren’t so prudent. They are now suffering under a 13 billion-pound ($17 billion) mountain of debt and must pay about 2 billion pounds a year to service it, about half of that to banks and other senior lenders. The contracts will cost the National Health Service, which oversees English hospitals through decentralized boards known as trusts, an estimated 81 billion pounds by the time they run out. And many hospitals are prevented from refinancing because the terms – especially those related to complex interest-rate provisions -- can only be changed at an impossible price.
The solution that looked so appealing two decades ago is now crippling Britain’s already-strapped NHS, sucking up money that otherwise could be used for nurses’ salaries, equipment purchases, beds and medicine. At least 2 percent of the NHS budget goes to paying for these projects, as emergency-room patients wait in long lines and hospitals struggle to pay for staff and the latest cancer treatments.
Since its founding 70 years ago today, the free-to-use NHS has been a touchstone of U.K. society and is regularly rated by Britons as one of their country’s greatest achievements. It was even a centerpiece of the London 2012 Olympics opening ceremony and is supported with near-religious fervor.
But the NHS is floundering, and it’s not just about funding cuts. About 50,000 positions in a workforce of 1.7 million went unfilled last year, according to the Nuffield Trust, a heath-care think tank; about 10,000 workers from other countries quit after the Brexit vote because of concerns about their immigration status.
Ironically, one of the reasons voters were persuaded to back divorce from the European Union was because campaigners promised a 350-million-pound-per-week windfall for the NHS as a result of money not being paid to the bloc. Prime Minister Theresa May said last month that those savings would help pay for the 20 billion pounds a year she proposed to bolster the NHS by 2023.
A spokesman for the Department of Health and NHS England declined to comment.
In all, public-private partnerships, sometimes called private finance initiatives or PFI, have received some 60 billion pounds in contracts from the U.K. since rule changes made them possible in 1989. There are now 716 operating partnerships; future costs could reach almost 200 billion pounds into the 2040s, according to the U.K.’s National Audit office.
The deals have been highly lucrative, bringing in an estimated 831 million pounds in pre-tax investor profit from 2011 to 2015, according to a study from the Center for Health and the Public Interest, a consumer advocacy group in London. Investors’ risk is low, since the government’s payments are guaranteed. Yet a 2012 survey of 77 NHS projects from 1997-2011 showed that most had higher rates of return than expected, with some reaching 20 percent.
Investment companies that provided the funds, including Semperian PPP Investment Partners, Innisfree Ltd., Aberdeen Asset Management Plc and HICL Infrastructure Co., along with dozens of others, are essentially profiting on money that could instead have been spent on patient care. The companies either declined to comment or didn’t respond to requests for comment.
“Hospitals are struggling to provide decent services because their PFI contracts are binding over many years and the payments are sky-high,” said Christina McAnea, assistant general secretary of the Unison labor union. Her group is campaigning to have the deals brought under public control so the cash can be better used.
But there’s a catch to that approach.
When Hexham bought its way out of its financing deal, 24 million pounds of the 114-million-pound cost was to break interest-rate swaps. The rest went to compensate shareholders and unsecured loan holders and pay the debt principal.
At the hospital in Pembury, about 300 miles to the south, it would cost as much as 43 million pounds just to buy out the swaps used in the financing to construct a 512-bed hospital seven years ago. Every year, before it pays for any treatments, the Maidstone and Tunbridge Wells NHS Trust, which runs the hospital, pays about 22 million pounds to service debt on the 225-million-pound facility, according to accounts.
They are caught up in the complexities of interest-rate swaps. Borrowers use swaps to secure stable interest rates on their debt, which can help reduce borrowing costs. They work well when interest rates go up. When they go down -- as they did in dramatic fashion in late 2007 before starting to rise again some eight years later -- the borrower may have to post collateral, and the swaps become more expensive to break, which can make refinancing extremely costly.
The same kind of financing deals have burdened U.S. cities and schools, including Harvard University, with billions of dollars in costs. The same is true for towns across France and Italy. Harvard, the oldest and richest U.S. college, paid more than $1 billion in exit fees to unwind its agreements. U.S. states and municipalities have paid at least $9 billion to exit toxic interest rate swaps.
The financing company for the Pembury hospital makes a roughly 14 percent rate of return on its investment in the project, according to Veronica Vecchi, a professor at the SDA Bocconi School of Management in Milan who studies public-private partnerships. That translates into a profit of almost 1 million pounds in 2016 and 1.1 million pounds the year earlier, according to filings. In turn, that company, called a special-purpose vehicle, paid some 17 million pounds in interest to Bank of Scotland, the lender, in 2016 and 2017.
Contracts that provide such high returns “are expensive and unaffordable” for the public sector, said Vecchi, who says public-private partnerships should be structured more affordably. “We should ask ourselves whether the investment of building the hospitals is efficient or not.”
Bank of Scotland, which was acquired by Lloyds Bank in 2009, confirmed that it still holds the debt on the project and declined to comment further.
Howard Davies, chairman of Royal Bank of Scotland Group Plc, which has also financed such projects, called private financing a “fraud” on a BBC panel show earlier this year, saying it was designed to shift costs away from the government even if the ultimate cost to the taxpayer was higher. Royal Bank of Scotland didn’t respond to requests for comment.
The Maidstone and Tunbridge Wells trust isn’t currently considering redoing its contract but refinancing remains a possibility, said spokeswoman Hannah Alland. The trust is working with NHS Improvement, which oversees the hospital trusts, and the Department of Health & Social Care to get maximum value out of its contract, she said.
In using this type of financing, the NHS entered a realm in which it had very little experience and no way to foresee the consequences, said Kenneth Clarke, a former U.K. chancellor of the exchequer who championed the projects. In his 1996 budget statement he announced that such deals “will play an increasingly important role in providing new healthcare facilities.”
Now, he says that government health officials were unprepared for the complexity of the negotiations they were about to enter.
“The NHS and the Department of Health were innocents abroad when negotiating procurement contracts,” said Clarke, who was health secretary under then-Prime Minister Margaret Thatcher in the late 1980s. Officials and lawmakers “were slightly naive and they didn't have the skills in negotiating with the private sector contractors with whom they were dealing,” he said.
Tony Blair’s Labour government, elected in 1997, followed Clarke’s lead and expanded the program. Blair himself officially opened Hexham’s new hospital in 2004. While May’s government hasn’t abandoned public-private financing, ministers have devised a new version. Called PF2, it’s intended to remove some of the risk.
“We have set the bar for value for money in public-private partnerships very high, and we will continue to do so,” Chancellor of the Exchequer Philip Hammond told lawmakers earlier this year. Only six private finance deals have been signed since 2012, the Treasury said in a statement.
John McDonnell, economy spokesman for the opposition Labour Party, says if his party wins power it wants to nationalize the special purpose vehicles that carry out the financing contracts and is exploring how to take over the contracts and exit the swaps.
“They were never going to be a good deal, but I don’t blame those at a local level who entered into them because they were told this was the only way they’d get the resources,” he said. “We're exploring all the options and trying to look at where they're hitting hardest and health is one of the worst areas.”
Northumbria Healthcare NHS Foundation Trust, which runs Hexham, reckons it’s freed up more than 3 million pounds a year for patient care since buying its way out of the contract in 2014. That’s the equivalent of operating a fully staffed 28-bed ward, according to Swithenbank, and patients are benefiting.
“They’ve been champion,” said Stephen Anderson, 52, from nearby Haltwhistle, on his way to an appointment at the hospital. “For me it's been great.”
Still, hundreds of existing private construction projects continue to be financed with swaps. Nick Stoop, founder of Warwick Risk Management, said he’s working on about a dozen cases in which clinics and doctors’ offices are trying to exit swaps on projects that have become unaffordable.
The bigger they are, the harder it is, especially for larger entities such as Tunbridge Wells. The trust is among the U.K.’s 75 biggest public-private construction partnerships that used swaps, according to a 2015 government analysis. Courts have been unsympathetic toward larger customers, considering them to be “sophisticated” borrowers that should have been familiar with the risks of swaps.
Swithenbank says he has no regrets about using the complex financing, pointing out that without it the hospital couldn’t have been built. Though the trust still owes money to the county council, which lent the money to get out of the financing deal, the interest is lower and the terms are simpler.
“This is high finance, interest-rate swaps, this is a world that very few people have any experience of,” Swithenbank said. “One of the problems is the private sector is money-driven. Sometimes the public sector can look rather vulnerable.”
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