REVIEW OF 2005

MARKET DEVELOPMENTS IN 2005
The year was strongly marked by trends in the financial markets which accelerated the emergence of infrastructure investment as a more distinct asset class. Pension funds and life companies have furthered this development by placing increased emphasis on matching assets to long-term liabilities. This trend in itself has both been reinforced by, and contributed to, the decline in long-term gilt and corporate bond rates. This development has been particularly pronounced in the UK (where the yield curve inverted from October 2005), but the demand for longer term investments – particularly that giving index-linked protection against inflation – has been evident in all major economies, leading to a substantial increase in long-term bond issuance by governments.
This financial and investment backdrop has in turn had a variety of consequences for both the primary and secondary markets that John Laing operates in.
Secondary market appetite for acquisition of interests in operational project assets has increased noticeably as liability matching, encouraged by tightening pension fund regulation in the UK and elsewhere, has led to a significant and continuing diversion of funds from equity investment into fixed-interest assets. This flow was estimated at £40 billion in the UK in the year to mid 2005 by the Investment Management Association, and in the context of the accompanying fall in corporate bond and gilt yields, appears to have triggered a concomitant search for alternatives capable of yielding similarly steady but more attractive returns. As a consequence, acquisition prices for regulated infrastructure assets rose markedly during 2005, driven by well funded secondary market intermediaries that either came into being during the year or conducted new fund-raisings. International institutional interest in UK infrastructure assets was noticeably strong.
This broad financial market environment also impacted on the debt structuring of major projects reaching financial close and those in competition. In particular the relative attraction of bond financing for project investments increased further by comparison with alternative bank debt solutions. Analytical evidence increasingly shows that PFI investments have a low correlation with non-infrastructure equities and corporate bonds, rendering exposure to the sector increasingly attractive as a portfolio diversifier. This in turn led to extremely keen competition for project bonds issued as part of infrastructure debt financing, whether for new projects or for acquisitions and refinancing of existing project investments.
While this backdrop has theoretically created more options for governments to access long-term funds at historically attractive rates of interest, the public policy focus continues to emphasise the value for money benefits inherent in the risk transfer achievable through PFI/PPP. This has been the key principle behind UK Government procurement of privately financed serviced assets underpinning public services for some time. While financial market developments have sharpened the competition between PFI and conventional procurement, and policy developments are leading to differential changes in the volume of new opportunities across various public service sectors, current policy plans suggest that more than 10% of Public Sector Net Investment will continue to be procured utilising private finance.
Outside the UK, strong growth in the number and value of PFI/PPP opportunities coming to the market was evident in a number of markets, with new PFI debt for projects reaching financial close totalling the equivalent of £5.7 billion as against £3.6 billion in the UK. Within Europe, the market for transport projects, particularly roads, was strong, but substantial growth was also evident in the social infrastructure sector with schools, hospitals and prisons projects coming to market in core EU markets such as Germany, Italy, Spain and France. In the accession states, roads projects continue to figure most prominently, although countries such as the Czech Republic and Hungary are now actively promoting accommodation projects.
The most striking primary market development of 2005 was the burgeoning of the USA roads pipeline which grew in scale as many states completed enabling legislation and substantial transactions were put to the market attracting significant international interest. These included privatisations with improvement obligations of existing assets (Chicago, Indiana), as well as programmes of primary development opportunities (Virginia, Texas). During the year it became clear that a tipping point had been reached whereby the traditional pattern of municipal-bond financing and conventional public sector procurement for roads will now be regularly evaluated against the privately financed alternative. Increasingly, state and city authorities will be looking to realise the latent value of operational infrastructure assets, especially existing toll roads. The extent to which this will lead on to other categories of transport infrastructure and local facilities being procured through mechanisms similar to PFI/PPP is as yet unclear. Such a broadening of primary demand is evident in Canada where pilot programmes are being either established or significantly expanded in a number of provinces including Ontario, British Columbia, Alberta and Quebec.
2005 was a General Election year in the UK and, as in 1997 and 2001, some slow down in key procurement processes was evident prior to the calling of the poll. While the election saw the return of a Government strongly committed to reinvestment in the asset base underpinning public service delivery (and all major parties campaigned in support of this objective), the post election period has seen significant policy reviews launched in major spending areas such as transport, education, local government spending and health.
In particular, all major PFI health projects have been subject to some delay as a variety of change initiatives and delivery innovations have impacted on the National Health Service as a whole. Furthermore, previously promoted schemes have been reviewed for affordability in the light of the changing role of acute, intermediate and primary care provision. Scheme review processes are generally leading to re-confirmation that projects already in procurement will proceed to implementation (often with marginally reduced scope), but the Government has indicated that the future acute hospitals PFI pipeline is likely to be of the order of £7-9 billion as opposed to a previously projected £12 billion. Offsetting this in England and Wales are initiatives in relation to expanding investment in primary care facilities through the LIFT programme, community hospitals, intermediate treatment centres and the supply of outsourced support services. In addition, while it is likely that acute hospital PFI schemes in England and Wales will tend to be of lower average size than in the past, and may be fewer in number, a growing number of health projects are evident in Scotland, Northern Ireland and in the EU outside the UK. Other sectors exhibiting significant growth in primary demand in the UK during 2005 included waste, social housing and regeneration.

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THE COMPETITIVE ENVIRONMENT
The financial trends discussed above have had a variety of impacts on the competitive environment in which John Laing operates.
Broad institutional interest in the infrastructure sector has not only reinforced liquidity in the secondary market (and increased the number of secondary market participants) but has also led to new alliances and approaches to bidding for primary opportunities in PFI/PPP sectors and the related infrastructure market. These have included investment banks acting directly as sponsors procuring construction and service subcontracts; contractors forming co-investment partnerships with investment banks (some pooling existing project investments and sponsoring new bids, others for new bids alone); and primary funds drawing on institutional, local authority and other pension fund interest in investing in assets under construction.
These developments reflect the fact that access to a steady supply of operational project assets is the major constraining factor for intermediaries seeking to meet the extended institutional appetite for investment in such assets. Under the impact of these influences, pricing for project equity interests traded in the secondary market has continued to advance with lower discount rates being applied to future secured cash flows and a tendency for purchasers to be more willing to place value on the potential for future refinancing, project optimisation and benefits which arise during projects lifecycles.
This competitive environment is having some impact on hurdle rates for project equity investments, but these are uneven between sectors and markets. Public authorities, including the UK Treasury, have observed that the development of the secondary market should have the effect of reducing the base case returns required by equity investors in the primary market. However it should be noted that equity returns are not the key driver of value for money from the public sector perspective, given the highly leveraged nature of project structures, and that returns will be related to the degree of operational stage risk that is retained by equity sponsors. Where lower risk, project models are put to the market in known sectors, competition is likely to lead to a “commoditisation effect” and a lowering of projected equity returns. However, barriers to entry continue to exist in relation to large projects, projects in new sectors and project models that require management of new risks. Set against the broader context of growing government demand in an internationalising market, and application of private financing in new sectors, there is no evidence of a substantial and general reduction in equity return expectations.
While significant barriers to entry exist in many sectors, competition is likely to be at its most intense where government authorities articulate and adequately resource a programme of procurement of substantial size embracing numbers of projects over a protracted period. On this basis, the UK’s Building Schools For The Future Programme, covering England and Wales, has attracted many bidding groups. Equally the corporate approach of devolved authorities in Scotland and Northern Ireland has led to substantial market interest because the need for PFI/PPP procurement has been set within a broader context of public sector investment planning. Conversely, where large projects are inadequately resourced from a procurement perspective, or are subject to repeated delays and uncertain national backing, market interest will be repelled. This differential effect is now evident at an international scale and national, regional and city governments seeking to utilise private finance to accelerate infrastructure investment are increasingly subject to pressures to render themselves competitive, particularly where very substantial programmes are envisaged that require implementation and financial resources only available to major consortia and leading companies.

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BROAD INSTITUTIONAL INTEREST IN THE INFRASTRUCTURE SECTOR HAS NOT ONLY REINFORCED LIQUIDITY IN THE SECONDARY MARKET (AND INCREASED THE NUMBER OF SECONDARY MARKET PARTICIPANTS)
HAS ALSO LED TO NEW ALLIANCES AND APPROACHES TO BIDDING FOR PRIMARY OPPORTUNITIES IN PFI/PPP SECTORS AND THE RELATED INFRASTRUCTURE MARKET

operates Chiltern Railways through a 100% subsidiary (M40 Trains) under a long-term franchise. Laing Rail delivers enhancement projects for Chiltern Railways and is a leader in practical application of project finance techniques in the rail environment. Its subsidiary, Laing Rail Projects Limited, delivers third party enhancement projects and also specialist rail consultancy services.
After a prolonged period of relatively smooth growth in patronage sustained by excellent operational performance, Chiltern Railways had an exceptionally difficult year, with seven weeks of major disruption caused by the collapse of third party building works at Gerrards Cross resulting in great inconvenience to the travelling public. Laing Rail is confident it will obtain full compensation for both the 2005 and longer term revenue and cost impacts of this event under the relevant legal agreements. Subsequent to re-opening a reliable service was swiftly restored.

Other key initiatives for Laing Rail in 2005 included: