The interest rate on the debt of PFI/PPP Project Companies is, in almost all circumstances, fixed on financial close, either through the issue of a long dated bond or through the purchase of an interest rate swap where the project has been financed using variable rate bank debt.
Interest income in PFI/PPP Project Companies mainly represents the interest receivable on finance debtor balances. John Laing accounting policy is to set the finance debtor interest rate for the term of the project agreement at or soon after financial close. This rate is normally higher than the cost of senior debt, up to a maximum of 300 basis points (‘bps’) above the long-term gilt rate.
The comparatives for 2003 include interest on non-recourse bridging finance that was arranged in respect of the deferred consideration from the sale of Laing Homes. The last instalment of the deferred consideration was received on 31 December 2003.
Interest on Corporate debt was charged at 175 bps above LIBOR prior to arranging new debt facilities in December 2004, from which date the margin reduced to 100 bps. Debt issue costs of £1.2 million brought forward in respect of the cancelled facilities have been written off in 2004 and debt issue costs of £0.9 million on the new facilities have been capitalised. The Group has operated with net deposit balances throughout 2004 such that the primary interest rate exposure is to changes in deposit rates. Use of facilities has been largely restricted to the issue of letters of credit in support of forward funding commitments on PFI/PPP projects. These are charged at the relevant debt margin, i.e. 175 bps until December 2004 and 100 bps thereafter.

TAXATION

The Group’s tax charge for 2004 was £13.7 million, representing an effective tax rate of 55% (2003 charge of £13.3 million – effective rate of 63%). The high effective rate is attributable to the fact that for many PFI/PPP Project Companies no tax deduction is available for the cost of buildings and civil engineering works, other than for the plant element. Since these assets revert to public ownership at the end of the project term for little or no payment, the profit and loss account suffers a full depreciation charge over the life of the project that exceeds the capital allowances, thus causing a high effective tax rate. Where this is likely to occur, the high tax rate is fully reflected in our financial appraisal ahead of commitment to invest in the project and our required return is calculated after allowing for the high level of taxes to be paid. In addition, releases of insurance reserves relating to the disposed construction business are taxable while compensating increases to the retained construction liability provision are not eligible for tax deduction because the related trade has ceased.

TAXATION ANALYSIS

Pension and other post retirement liabilities accounting

The Group adopted FRS 17 (‘Retirement Benefits’) in 2003, ahead of the mandatory implementation period. This has resulted in a net deficit of £135.0 million (2003 – £93.7 million) being recognised in the Group balance sheet. The value of the deficit is highly dependent upon some critical assumptions and is likely to vary significantly from year to year. An increase of £41.2 million to the net pension deficit in 2004 includes £38.5 million increase in the value of scheme assets but the present value of liabilities has increased by £102.2 million due to a changed assumption for long-term future inflation rates from 2.28% to 2.75% and from a reduction in the AA rated corporate bond yield from 5.5% to 5.3%, this being the stipulated discount rate applied to calculate the net present value of future liabilities. Comment on the funding implications of the deficit is given in the cash flow section at the end of this review and the assumptions are set out in greater detail in note 5 to the accounts.
The pension deficit has been calculated using the Institute and Faculty of Actuaries’ current mortality tables for life expectancy. These are due to be updated in the first half of 2005 and it is expected that the revised tables will show increased longevity. The pension fund liabilities are therefore likely to increase.
With effect from April 2005, new legislation will oblige the Group to pay a levy to the Pension Protection Fund. This is expected to amount to approximately £130,000 in the first year and double that amount in the second year. Thereafter the levy will be calculated on a risk weighted basis, which remains to be determined.

CAPITAL STRUCTURE, RESOURCES AND COMMITMENTS

There has been no significant change to the capital structure of the Group. However, during 2004 the holders of warrants, which were issued at the time of the Group’s refinancing in September 2001, have exercised their right to subscribe for 6.1 million shares at a subscription price of £1 per share. There are no outstanding warrants in issue.
The Group’s corporate funding requirement is to support its investment in special purpose PFI/PPP Project Companies, to finance the costs of bidding and asset management and, from time to time, to finance acquisitions. Typically, the total of shareholder equity and loans in PFI/PPP Project Companies represents between 5% and 15% of the total funding required, with the balance of the project finance being secured by either bank debt or a capital bond issue. The lenders/investors in project finance have no recourse to the Group in the event of default by the Project Company.
On financial close the Group commits to provide equity and loan funding to PFI/PPP Project Companies. However, in many instances the funding is not drawn down until construction of the project assets has been completed. In these circumstances it is usual for the Group to procure letters of credit to secure the funding commitment. These letters of credit are issued, by the Group’s bankers, out of general corporate debt facilities. Due to the very long lead times associated with bidding for PFI/PPP projects, it is possible to project the likely forward funding commitments with a high degree of confidence once the Group has secured preferred bidder status. The Group’s borrowing and letter of credit requirements can therefore be predicted well ahead of final commitment to investments and it is the Board’s strategy to ensure that financial resources are in place to meet both actual and likely investment commitments.

Following the sale of Laing Homes in 2002, the Group has been able to finance its investment programme wholly out of equity and retained profits. Since the Group has no significant working capital requirement, the Group has operated with net funds on deposit and has not drawn significant amounts of bank debt. However the corporate debt facilities have been utilised for the issue of letters of credit, as described above.
The Group has a wholly owned captive insurance company that maintains cash backed reserves for claims relating to the previously owned construction businesses.
At 31 December this asset backing stood at £17.3 million.
In addition, the Group is required to maintain cash backing for other contingent liabilities amounting to £2.5 million. These amounts are not available for general corporate use.
The Group holds a controlling interest in a number of PFI/PPP Project Companies which are accounted for as subsidiaries. The project finance provided to these subsidiaries is included within bank debt in the Group balance sheet but the lenders have no recourse to the Group in the event of Project Company default.

ANALYSIS OF FINANCIAL RESOURCES

The financial resources available are principally earmarked for the funding of future equity and loan commitments on PFI/PPP projects. At 31 December 2004, the potential equity and loan requirements on preferred bids and the short-list is estimated at £137 million (2003 – £98 million).
The syndicated facilities as at 31 December 2004 reach maturity on 31 March 2010 and the bilateral facilities and overdraft are set to mature between October and December 2005.
Within the £39.5 million of letters of credit drawn, £33.4 million is in support of forward investment commitments (2003 – £56.5 million) and £6.1 million is to counter-indemnify performance bonds (2003 – £16.6 million).

TREASURY POLICIES
Foreign Currency

The Group has a relatively small balance sheet exposure to foreign currency fluctuations and the Board has endorsed a policy of remaining unhedged throughout 2004. However, with the Group’s increasing activity in mainland Europe, the Board has agreed that future foreign currency investments having a sterling equivalent value in excess of £5.0 million should be hedged. The Group seeks to cover significant transactional exposures arising from receipts and payments in foreign currencies, where appropriate and cost effective.

Interest Rates

The Group is not a significant borrower at the corporate level and does not, therefore, seek to hedge exposure to interest rate movements. However, there are significant levels of non-recourse borrowing within the PFI/PPP Project Companies in which the Group invests. In almost all circumstances the financing agreements of the Project Companies require the debt to be on a fixed interest rate basis or, where variable rate debt has been arranged, to be swapped to fixed rate for the full value and term of the loan.

Debt Facilities

The Group treasury function seeks to ensure that the Group has access to funds and committed bank facilities that cover, as a minimum, the forward investment commitments on both signed PFI/PPP projects and the potential commitments estimated in respect of projects where the Group has been confirmed as preferred or sole bidder. Detailed medium-term cash flow forecasts are prepared and reviewed on a regular basis. The corporate debt facilities contain financial covenants that set minimum interest cover, minimum adjusted tangible net worth and maximum levels of gearing. The current cash flow forecasts indicate that the Group will comply with these covenants for the foreseeable future.

CASH FLOWS

An analysis of the cash flows for 2004 is shown below. This shows the cash flows affecting the recourse funds of the Group separately from the cash flows affecting the consolidated non-recourse funds.

CASH FLOW SUMMARY 2004

The running yield derived from the PFI/PPP portfolio, (dividends, interest and loan repayments) amounted to £18.2 million (2003 – £15.7 million) and was in line with expectations, thereby underlining the predictability of cash flows from the portfolio. Presentation of future cash flow forecasts associated with the existing portfolio of PFI/PPP projects is set out on pages 34 and 35.
The Group has an existing agreement with the Trustees of The John Laing Pension Fund to provide additional contributions of £4.0 million per annum towards funding of the pension deficit. Due to recent adverse movement in actuarial assumptions we are in renewed discussion with the Trustees, which is likely to result in an increase in these additional contributions. The Group intends to fully fund the deficit over a period of 20 years and the additional contribution is likely to vary over this period. However, the Group has committed to increase the additional contribution to £6.0 million in 2005, and subject to review regularly thereafter. In order to progressively remove the Pension Fund, and hence the Group, from volatility to the value of equities, the Trustees have agreed on a strategy to shift the balance from approximately 50% currently invested in equities to 40% by the end of 2005 and to a fully non-equity investment portfolio over the next 25 years. This strategy has been agreed following consultation between the Trustees and the Group and reflects the advice of the actuaries to the Trustees and the independent actuaries to the Group.

A J H Ewer
Group Finance Director
21 March 2005