Thursday, 19 July 2007

The Death of Metronet

The collapse of Metronet and the attendant comment suggests it might be worth saying something about risks in equity and debt finance.

The classic model of a company is that it can raise money in two ways: by issueing shares, or by borrowing money. The best thing that can happen to a lender is that they get paid back: there is no upside to making a loan other than receiving your interest. Therefore lenders demand that they get paid before shareholders - if a company has funds, it must pay its creditors first, and only after that do shareholders receive a dividend. Moreover if a company cannot pay its debts, debt holders can typically seize the company and sell or liquidate it to get (some of) what they are owed.

In exchange for taking the risk that they might not receive anything, shareholders collectively own the company and so receive anything that is left after debt holders have been paid. This is sometimes called a residual interest: it is potentially high risk and high reward position, since if the company's earnings can't support its debt, they might get nothing; but if earnings are high, then there is a lot left for them after interest costs.

One key capitalist idea, then, is that shareholders take risk in exchange for potentially big rewards. If you don't like the idea that you might lose everything, don't buy equity.

Now consider a company in a long term PFI contract such as Metronet. The rewards are potentially very high, as the profits of someone like Amey indicate. But so are the risks, as we see with Metronet or the late and unlamented Railtrack. Is this a good deal for the tax payer?

There are two arguments for PFI: a specious one; and a sensible one. The specious one is that PFI gets infrastructure built without the government having to raise money. But that is just accounting trickery: the tax payer pays eventually, after all. A PFI contract is an ongoing liability just as a bond issued by the government to pay for maintaining the underground without a PFI contract would be.

A private firm doing government work will demand an extra return over and above what they think it will cost in order to pay their shareholders: they are right to do that as their shareholders are taking risk. So on average PFI contracts are more expensive than their fair cost. Are they still the best that is available? That depends on whether the PFI contractor can get the job done and make their profit for less than it would cost the government to do the job themselves. There is a natural assumption that private enterprise is more efficient than government - that may even be true - but is it so efficient it makes up for the extra profit shareholders demand?

Here's a view from the capital of London financing, Canary Wharf, to end.

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