The changing economic weather that the UK and wider world economy is bringing to our public sector clients is giving them plenty to think about around existing funding and financing arrangements. While many hope that these changes are temporary, the remainder of this year continues to look uncertain.
Rising to the inflation challenge
In February 2022, the retail price index (RPI) measure of annual inflation reached 8.2%. For many organisations, managing the impact of high inflation provides a requirement to have increased scrutiny on its funding and financing arrangements. While not all arrangements are based on RPI, the consumer prices index (CPI) was reported at 6.2% with an increasing trend set to remain for the short term – these indicators raising the prospect of challenges for all.
High inflation will affect transactions and vehicles around housing and commercial space delivery, Private Finance Initiative/Public Private Partnerships (PFI/PPP) arrangements, and other projects involving index-linked cashflows. All will need close inspection in the short term. Often arrangements lack flexibility in return for certainty so it makes sense to explore wider options where the impact is large.
Economists predict that high inflation is set to remain for the short term. Funding arrangements shouldn’t be viewed in isolation therefore but how they fit within the broader financial landscape. Organisations should consider and review:
How to meet all funding obligations
Increased inflation leads to increased costs, and for many public sector organisations this is likely to intensify financial pressure in its ability to meet all obligations. Organisations can expect sharpened focus on funding obligations including the reporting of financial covenants and headroom to continue satisfying these requirements.
Leasing transactions
Challenges are not just restricted to debt/loan financing. Many public sector organisations are engaged in lease transactions where annual lease rentals are subject to inflationary increases, which potentially leaves exposure for any elements that are not hedged. Many leases have caps on these inflationary increases, which certainly helps to mitigate this risk. But the compounding effect of these increases up to the cap means that a return to a lower inflationary environment would be welcomed sooner rather than later.
Understanding funding arrangements
Where is your money placed? And where has that investment come from? It’s fair to say that the public sector’s often complex arrangements have radically changed. More innovative methods are required to respond to financial pressures while the breadth of partners that public sector clients engage with is ever expanding.
‘Know your customer’ and anti-money laundering legislation continue to evolve. All parts of the business need to understand the impact of actions that don’t comply with the legislation. There is a clear need to understand each link of a transaction chain in order to protect your organisation’s reputation.
Three next steps to navigate uncertainty
There is a huge amount of activity for public sector organisations to contend with. To stay ahead of these and build resilience for the future, consider the following action points:
- review future funding arrangements to ensure they are value for money – and fit a sensible risk profile
- carry out scenario testing and financial modelling to understand the robustness of a project against key variables such as inflation, cost pressures, and changes in income
- assess partners to understand their wider background and risks beyond the financials.
Despite the uncertainty, there remains a large amount of capital to deploy and continued appetite from investors who see the public sector as a safe place to invest. With only minor hardening on pricing, organisations need to ensure that the uncertainty doesn’t bring a halt to assessing opportunities. But equally it’s important to be clear on the risks as well as the rewards, and to understand the trade-off between certainty and flexibility that different arrangements will bring.
To discuss this topic further, contact Wayne Butcher.
