Tube Lines was born amid a political firestorm four years ago when it won a 30-year, £20 billion (€30 billion) building and maintenance contract for three London Underground lines with the backing of central government against fierce opposition from the Mayor of London, the leftist Ken Livingstone, and his transport commissioner, former CIA agent turned transport expert Bob Kiley.
A joint venture between Ferrovial of Spain and Bechtel of the US, Tube Lines runs the Jubilee, Piccadilly and Northern lines, three of the busiest on the world’s oldest and largest metropolitan subway system. London Underground’s two other public-private partnerships (PPPs) were won by Metronet, which is backed by Balfour Beatty, WS Atkins and others. While Metronet has been criticised by both Parliament and London Underground for missing targets, Tube Lines’ performance has won support. For a shorthand check on this progress, read London Underground managing director Tim O’Toole’s annual reports over the last three years, which go from highly sceptical (“It remains to be seen whether the scope of improvements promised by the PPP will prove real or ephemeral”) to grudging appreciation (“There are indications that with the right focus from [infrastructure companies], the contracts can deliver the step change in asset condition that they set out to”).
Tube Lines’ finance director, Steve Hurrell, says the key to managing these highly complex projects has been marrying “change management” to detailed financial planning. In its first four years, the company has beaten most contract targets, which puts it on track to give shareholders a return significantly above the 19.9% life-of-project target, after the first seven-and-a-half-year review in 2010. This helps explain the private equity interest in the infrastructure sector this past year, such as Henderson Group’s aggressive bid for John Laing in November. But Hurrell—having watched the near financial collapse in 2005 of Jarvis, his former employer and a partner in Tube Lines before it sold its share to Ferrovial—points out that the sector’s risks, as well as its rewards, can be large.
You put a lot of emphasis on information systems and what you call “change tools” early on in your London Underground contract. Why was that?
There are three key tenets of the PPP contract: we need to be economic and efficient, follow good industry practice, and apply “whole life asset management” decisions. The latter encourages us to select the right balance between our capital programme and our maintenance activity to achieve the best performance.
But to do that, you need good quality data and information. When we first took over the company, not only had the infrastructure suffered from decades of underinvestment but also the fabric of the system that we inherited, particularly in terms of IT, had been neglected.
We set up a programme to invest around £30m to replace all of the key enterprise systems so they could support our whole life asset management requirements. One example of that: we now have one asset management system, whereas we inherited over 500 separate databases of information. Clearly, when you are in that situation, there is no common information and frankly it is difficult to make informed decisions.
You had problems with productivity and the workforce at the beginning. How did you overcome them?
We did have a challenge in terms of productivity, however I wouldn’t say we really had problems with the workforce. To deal with productivity, an example would be a project we carried out for the escalator fleet. When we first took over, to change a single escalator at one underground station took 26 weeks on average. Using various techniques, including Six Sigma, we are delivering that same type of work within eight weeks. That’s the practical use of “change tools” to bring about a substantial improvement to the customer experience.
It’s interesting to note that we did an opinion survey of our workforce fairly soon after we took control. We did a similar survey towards the end of last year and that showed a massive improvement across a whole range of areas in terms of the way that the people felt about working for Tube Lines. In fact, the independent company that did the survey said that it’s one of the largest positive changes they’ve experienced in a survey in such a short period of time. So, it’s fair to say that the majority of the workforce—and one can’t say absolutely everybody, because there are some people who would like to see the business return to the public sector—feel that working for Tube Lines is a more positive and motivating experience than working directly for the public sector.
How did politics affect the financing of the project?
There was a lot of opposition to the PPP rising up through Bob Kiley and the mayor. That didn’t help, obviously, and raising finance at the time was affected. The institutions looked at the risk profile brought about by the political landscape at the time and took a view about that in terms of their pricing.
We refinanced the business fairly soon after signing the contract in early 2004. That brought about a significant reduction in the cost of funding and that really demonstrates that the political climate and the challenge around PPP by that stage had significantly reduced. The issue is one that is discussed far less now.
How did the financing change after the politics settled down?
Crudely speaking, we had raised £2 billion through a bank syndicate, some of which was [European Investment Bank] money. That’s how we started. What we moved to is 100% bond financing when we refinanced in 2004 and we have different classes of bonds depending on the level of security that we have from the contract. Our A and B bonds are essentially categorised as quasi-government with a 20% risk weighting. The A notes are placed with [Deutsche Pfandbriefbank] and the B notes are a combination of [Deutsche Pfandbriefbank] and other bondholders. Those are fully fixed out for 27 years. We then have C and D notes which are fixed but move to floating in 2010. The equity component has remained constant at £135m.
What has been the key to winning over the mayor?
Tube Lines has been able to deliver in terms of our major projects, including a very complicated project last Christmas that increased capacity on the Jubilee Line by 17%. The Piccadilly Line was probably one of the worst lines on the underground—we’ve brought about a 60% improvement in its performance since we first took over the PPP. That again shows change tools and improvement, but equally our flexibility around investment. Very early on we took a decision, which hadn’t been considered at the time of the bid, to invest £20m to improve parts of the train fleet on the Piccadilly line and that has brought about a tremendous improvement in the overall performance.
For your equity investors, how do the base and incentive profit targets work?
There is a calculated base return. But one of the fundamental drivers of PPP is that we keep any costs that are reduced as additional profit. But then as we go through the review every seven-and-a-half years, the public sector gets the benefit of that for the balance of the contract.
So, there is an incentive for us to drive down our costs through efficiency, which is something that the private sector is good at, which gets passed along as a long-term benefit to the public sector. For example, we priced based on the norms at the time of our tender for, say, 300 metres of track to be laid within a weekend “possession,” as we call it. We’re now securing something in the order of 1,000 metres and therefore we keep the cost improvement that this brings until we get to the first review period. The price will then be based on us achieving 1,000 metres in that time period with the cost improvement falling to the public sector.
What has been the running return for equity investors so far; can you put a number on it?
I’d prefer not to. We cannot rely on what has happened in the first four years as a proxy for how we might deliver in the remaining three-and-a-half. The return for shareholders is a cash return based on their initial investment. There are limitations on the dividends they can take out of the business until the eighth year. So, that does have quite a fundamental impact in terms of discounted cash flows on the level of return over the 30 years.
The issue is how much cash they will get out in year eight based on the profit generated in the first seven-and-a-half years. We don’t know what is going to happen in the next three-and-a-half years, but I can say that because of our efficiency and because of the change and improvement that we’ve managed to secure over the first four, we feel positive about the level of return.
Do you think the improving returns for public-private infrastructure projects are behind the private equity interest in the sector?
There is no guarantee that PPP companies will always deliver and beat their anticipated returns. We have a successful model in the way that the shareholders participate in the business through an incentive mechanism, through bringing their core skills to bear in delivery of both the capital works programme and the maintenance. That’s not necessarily true of every PFI or PPP contract. We’re perhaps demonstrating the attraction of some of these infrastructure funds for the delivery of whole life asset management that can make the difference if you get it right.
The UK, which started PFI and PPP, has more than a decade of experience of these projects. What are some of the lessons learned?
There is still a degree of frustration—for something that is as well developed as it is, there still seems to be a tendency on the part of both the clients and the contractors to want to finesse the contracts. That obviously changes the risk profile and that has to be explained to the institutions and the banks that make the investments. We’ve come a long way in a relatively short period in the UK but just trying to gain that stability would help.
The other thing, which is a fairly obvious and inevitable consequence, is that as PFI developed as a cornerstone of contracting for the UK, it started to attract more entrants and then the price started to become yet again the one determining factor in the assessment process; in other words, a significant reduction in margins. At Jarvis, one of the issues responsible for its downfall was clearly that it took on too big a portfolio. But you can’t draw too many comparisons with Tube Lines. You don’t quite get the pressures that Jarvis got coming through to this model.