PFI secondary markets: due diligence

Due diligence is a sensitive area for all parties and sometimes there can be a mismatch of thought between the seller, who may prefer there to be minimum due diligence, and the purchaser who is likely to want to undertake more detailed due diligence. Balanced with this is the level of warranty protection that a purchaser will require. Both purchaser and seller need to understand that greater due diligence will mean less warranties whereas less due diligence may mean the converse.

The level of due diligence undertaken may be affected by the identity of the purchaser and their level of sophistication:

Third party purchasers: it is unrealistic for any seller to expect a third party purchaser to do no due diligence whatsoever and such an approach is likely to result in a request for the provision of a greater number of warranties or indemnity protection.

Operator shareholder: an operator shareholder is unlikely to require much due diligence as it will be running the project on a daily basis, assuming it is in the operating phase. The operator will, however, wish to undertake certain due diligence on the construction aspects of the project, in particular, ascertaining the period and level of cover for latent defects and will also require some basic warranty protection.

Financial investor shareholder: although a shareholder, a financial investor is likely to maintain that it does not know what is occurring on a daily basis in respect of the project and will therefore require further due diligence, although it is arguable that having received board packs and attended board meetings such shareholder should have reasonable knowledge of the project.

Ultimately, the level of due diligence undertaken and warranties provided will depend on the strength of the bargaining position of both seller and purchaser.

Commercial approach

It is important for prospective purchasers to take a commercial approach to due diligence and bear in mind that several law firms (acting on behalf of the investors, the authority and the lenders) will have previously reviewed the project documents at financial close; the target company is likely to be a special purpose vehicle that has done nothing other than undertake the PFI project; and, if the project is in the operating phase, construction risk will be reduced.

Due diligence can be as complicated or straightforward as a purchaser wants to make it. Purchasers should consider using due diligence questionnaires tailored to PFI secondary market transactions and not a regular M&A questionnaire as the latter will raise very few questions that will be relevant for such a transaction. As the PFI secondary market becomes more sophisticated and competition increases, the use of such questionnaires will be key to enable prospective purchasers to quickly prioritise due diligence issues, particularly if time is limited for carrying out due diligence before submitting a bid.

Specific due diligence issues

Some key areas, which are by no means exhaustive, that should be reviewed in the project documents are set out below:

Due diligence – financial close

• Pass through to sub-contractors – has there been full pass through of risks to the sub-contractors? If not, the risks left with the project company ("Projco") need to be identified.
• Termination/compensation on termination – termination thresholds in the project agreement and the sub-contracts should be reviewed to assess the opportunity for Projco to take remedial action before the project agreement is terminated.
• Payment mechanism – identify if there are exclusive remedies and what the Authority's remedy is for non-performance.
• Insurance – what happens on uninsurability and what are the circumstances when Projco may have to meet additional costs?
• Refinancing – are there any restrictions on changing the finance documents without Authority consent? Are there refinancing gain share provisions?
• Pre-emption – are there such provisions and how do they operate?
• Drag/tag along provisions – when may these be triggered? Could a prospective purchaser end up acquiring more shares than originally anticipated?

Due diligence – post financial close

• Breach of project documents – has this occurred? In particular, has there been a breach of the finance documents and has this led to a distribution lock up?
• Will the scheduled opening date be met? – is the project on time or are there delays and what is causing them? If there is a delay, is Projco entitled to relief?
• Have liquidated damages ("LADs") been claimed? – have any LADs been claimed and if so, how much has been claimed, and how close to the cap is this amount?
• Contract price deductions – have there been any deductions and if so, why have there been deductions?
• Litigation – are there any disputes between the sub-contractors, Projco or the Authority? If so, what are they about and how are they affecting the project?
• Variations – have there been any and what are they?

If there is a risk of pre-emption rights being exercised by a non-selling shareholder this needs to be addressed early on in the transaction process as it may affect a purchaser's decision to incur time and costs in undertaking due diligence. Waivers of pre-emption should be sought or, alternatively, a seller could offer to pay a 'break fee' (covering the reasonable due diligence costs of the purchaser) to a prospective purchaser should a shareholder actually pre-empt. If a break fee is to be offered, this should be included in the heads of terms. However, both purchaser and seller should ensure that the break fee provision is properly drafted as there is a risk that it could amount to unlawful financial assistance under the Companies Act 1985, which can lead to criminal liability on the part of those giving the financial assistance and can make the transaction void.

One of the most important areas of due diligence will be in relation to events occurring post financial close. Due diligence on post-financial close matters will indicate the likelihood of a purchaser's equity investment losing value and a purchaser and its team will therefore need to know what questions to ask and why. For example, is the project running smoothly or is it in trouble, could it be behind schedule and near its cap on LADs, or worse, could it be heading towards termination? A few such issues to consider are listed in the table.

Interpreting due diligence

Having carried out due diligence, the skill for any purchaser and its advisors will be to interpret the information.

If due diligence has revealed nothing untoward, a purchaser can proceed to exchange/completion of contracts. However, where issues do arise, a purchaser must consider what this information means in the context of its proposed investment. Where issues do arise there are a range of options available to a purchaser:

• to do nothing since the risk existed at financial close and the purchase price reflects this;
• to obtain an indemnity;
• to defer part of the consideration. This is preferable to an indemnity if the risk is more likely to occur if a limited partnership is the seller since once there is a distribution to its limited partners, recoverability under a warranty or indemnity will be nearly impossible;
• to seek a price reduction if none of the above are appropriate; or
• to abort as a final option.

Conclusion

Competition in the PFI secondary market will only increase with time and as a result PFI secondary market transactions will become more sophisticated: timetables will be truncated so there will be less time to undertake due diligence, and 'seller's packs' (including an information memorandum) will become more common, particularly as this approach may avoid the need for break fees. However, purchasers should understand that this process is unlikely to result in greater warranty protection. It is important therefore that when undertaking due diligence tailored prioritised questionnaires are used and that a purchaser's team is sufficiently experienced to understand and identify the real risks in a project and how they can be managed: this could be the difference between winning and losing a bid for a purchaser.

For more information please contact Sandra Rafferty on +44 (0)20 7367 2804 or at [email protected].