Budgets have been cut dramatically and spending on both private finance initiatives for social housing and Building Schools for the Future has been shelved. An innovative method of continuing to regenerate is the use of Local Asset Backed Vehicles.
The LABV is a long-term joint venture between the public and private sector. The basic concept is that the joint venture company is a 50/50 profit share. From the public sector's perspective, the attraction is that its consideration within the joint venture is land or assets. The valuation of these is matched by the private sector's equity contribution. In the current financial circumstances, this is an attractive model. The public sector gets to regenerate significant areas of land. Other than possible remediation costs,prior to transferring land to the joint venture, the local authority is not contributing money. Ultimately, the redeveloped assets will be sold at a profit or create an income stream for both parties.
The LABV can be set up in a way that enables strategic, coherent redevelopment of a substantial area over a 20'year timescale. This contrasts with piecemeal, one'off joint ventures where development occurs without consideration of the long-term strategic aims of an area.
Where the LABV is undertaking a significant one'off project, identifying the appropriate form of construction contract is straightforward. However, where a long term framework is being contemplated, the framework agreement needs to be structured carefully to protect the LABV's long term aims and at the same time to allow flexibility to enable a range of projects to be undertaken within the framework.
Key issues can be developed with the tenderers during competitive dialogue. The local authority will set its baseline position in the tender documents. If tenderers seek to amend the documentation, the local authority will consider the risk balance posed by the amendments and ascertain if the private sector is prepared to share risk and be innovative in finding solutions which have the potential to enhance profit.
The key construction issues at both framework and construction level are:-
- call'off and audit of costs;
- contractor exclusivity;
- key performance indicators;
- incentives;
- form of contract.
Call'off and audit mechanism
The local authority needs to ensure that profit for the joint venture is maximised. Commonly, the private sector party in the joint venture will be a consortium including a construction company. The construction framework will be typically between the joint venture and the consortium's construction arm. The consortium will require exclusivity for a substantial period of the framework. This arrangement enables the private sector to obtain profit through the framework's supply chain as well as at joint venture level. To ensure that fair value is obtained by the joint venture, the framework needs a robust call'off mechanism. Prior to entering into a contract, the joint venture will need to provide a specification and site information for pricing. Following pricing, the joint venture will retain the right to review the contractor's costs on an open book basis. Once the price has been agreed, a contract can be issued.
Contractor exclusivity
The private sector will want to secure a workstream for its construction arm. There is a potential advantage to the work being kept "in'house". The contractor may be motivated to agree a reasonable level of overhead and profit. However, there is the possibility that lack of competition may make prices less keen. The solution is provide a period of exclusivity which can be reviewed at the joint venture's option at the end of each exclusivity period. The right of renewal of exclusivity can be linked to satisfactory performance against a range of key performance indicators. If thresholds are not achieved, the joint venture is entitled not to renew.
Key performance indicators
Ensuring continued good performance of a contractor is at the heart of the framework. Unless a contractor becomes insolvent, it is unlikely that individual contracts will be terminated. Whilst key performance indicators can be used as an incentive at contract level, they are unlikely to have any deterrent. Site'based key performance indicators tend to work best when assessed at completion of a project. If there has been poor performance, by the time of completion the joint venture will be unwilling to terminate the contract as it will lose the benefit of the contractor's obligation to repair defects.
In those circumstances, the joint venture is faced with a contractor who is performing unacceptably and will have to continue to place work with a contractor whose performance is unimpressive. It is important to agree a robust set of key performance indicators which are appropriate for the type of work. A failure to attain the threshold on individual contracts on a number of occasions must lead to the right to terminate. Failure can also be used as along stop entitling the joint venture not to renew an exclusive arrangement. In setting the KPI thresholds and termination rights, a balance has to be struck between creating a hair trigger termination event and a threshold which means that in practice, the framework can never be terminated. Ideally the termination right should be based on a failure to pass key performance indicator thresholds on a small number of contracts which have been completed in any 12 month period.
Additional KPIs can be added to further the joint venture and local authority's overall aims. A set of softer KPIs dealing with local employment opportunities and other potential social and economic benefits can be included and assessed at regular intervals.
Form of contract and incentives
The LABVs have a significant housing element. This has led to substantial negotiations regarding the best form of contract to use within the framework. The local authority partners have been keen to utilise the NEC suite. This preference emanates from the NEC's approval by the OGC. Local authorities prefer to use NEC Option C so that there is a target cost and pain/gain share. If efficiencies are produced then the joint venture can share in the benefit. If contracts have cost overruns then those can be borne by the private sector.
In dialogue, the house builders have been less keen to use Option C. Two reasons are cited. The larger house builders have robust arrangements with their own supply chain. They have used their purchasing power to obtain keen prices from their sub-contractors and most of the value has been squeezed from the supply chain. Any gain share is at best limited.
The other factor is the house builder's business model. House builders engage a series of package contractors. The model is akin to construction management or management contracting. Option F of the NEC has been tabled as the preferred solution. Generally to retain flexibility of the frameworks, NEC Option A is used call off house building works and Option C is retained in the event that there are non'residential works or works which have a greater complexity and where innovation through the design process may lead to saving.
Where target costs are included, the private sector may suggest that in order to receive its full share, it must have performed successfully against the KPIs. If it fails to do so, the joint venture becomes entitled to the unearned element of the contractor's share.
By Nigel Blundell, Partner, Pinsent Masons LLP
Winner British Legal Awards 2010-11 – Law Firm Innovation
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