The rules on public procurement provide an important protection for all businesses, designed to ensure fair access to the market for public contracts. This space is a highly lucrative one as government contracts are estimated to account for around 12% of GDP.
In our experience, public contracts are an important source of revenue for PE backed enterprises, many of whom are engaged on public contracts. Indeed, government contracts may account for a significant part of their overall turnover. This is not to say, however, that the relationship between public procurement and private equity is an easy one. In our experience, the public procurement rules can impose significant obstacles to private equity firms winning and securing contracts.
There is a concern that the situation could deteriorate further. In June 2020, HM Government released an updated version of the “ Outsourcing Playbook”1, a guide to Central Government bodies on the correct approach to commissioning services from the private sector or bringing them in-house for delivery. The initiative was prompted largely by the collapse of Carillion in 2018. The updated version of this Government guidance, which will have a widespread influence on Government procurement, contains detailed guidance which risks excluding PE entities from participation in public tender processes.
Private equity and public procurement: a difficult relationship
The UK rules in public procurement are laid out in a number of statutory instruments, the most commonly encountered being the Public Contracts Regulations 2015. The rules mandate that public contract opportunities above a certain monetary value must be advertised in the Official Journal of the European Union and subject to a tender process.
It is incumbent on public bodies running the process to ensure that bidders are treated fairly and equally and not subject to discrimination (Regulation 18 of the PCRs). However, it is normal for buyers to apply set minimum financial and technical standing criteria in order to identify those bidders suitable for consideration (Regulation 58 of the PCRs). They may also use a points based assessment system linked to such criteria to shortlist a pre-set number of bidders who can participate (see Regulation 65 of the PCRs). Financial criteria often assess the strength of the balance sheet of the bidding entity. Purchasers have some discretion to set qualification thresholds as they see fit and to exclude tenderers who do not meet those standards. They may also shortlist a pre-set number of qualified tenderers, assessing them against qualification criteria and admitting those who score highest against those criteria.
In our experience, problems can arise for private equity backed companies at the selection stage. It is not uncommon for public buyers to fail to appreciate that they have a distinct form of funding (for example in the form of preference stock or loan notes issued by the bidding entity or its parent). Commonly, of course, that means that these businesses carry high levels of debt, but that this is owed to other companies in the group or another entity ultimately owned or controlled by the underlying investors.
That debt is not necessarily a risk to their financial health and it is wrong to conflate such debt with other forms of borrowing. Whereas a normal creditor has only an interest to recover its debt at the earliest opportunity (at whatever cost to the debtor), the commercial interests a preference shareholder / loan stock holder and the issuer are aligned to a far greater degree.
Because the private equity investor has an interest in seeing as great a return as possible on its capital, it is highly unlikely to seek a premature recovery of its investment if that prejudices the ability of the bidder to carry out its day-to-day contractual obligations. That would adversely affect the reputation of the PE group and, accordingly, the likely return which it would enjoy on its investments.
In a number of instances, we have intervened on behalf of clients to threaten litigation under the procurement rules where public bodies have failed to take these considerations into account and instead disqualified our clients. We have alleged that the public bodies have acted in a way which is irrational and fails to interpret correctly the financial data before them.
Implications of new guidance on financial standing
In seeking to dissuade public buyers from excluding our clients, we have often referred to guidance of the now defunct Office of Government Commerce (OGC). The OGC was responsible for setting significant parts of the Government's procurement policy and advice to public purchasers. This included a guidance note on financial evaluation, which included the following advice to public bodies in considering the debt carried by bidders:
“consider whether interest-bearing debt is inter-company or provided from an external source. Inter-company borrowings are less likely to pose the same level of risk as external borrowings”.
V2.0 of the Outsourcing Playbook and a supporting Guidance Note2 provide new advice on running a financial standing evaluation. They also take a slightly different approach to that of the OGC.
Firstly, whereas the OGC guidance cautioned against relying too mechanistically on pre-set formulae to determine financial health, the Playbook includes a significant reliance on such tools, particularly for larger contracts. The more critical the contract and the services provided under it, the more stringent the assessment will be (contracts are tiered into “gold”, “silver” and “bronze” for these purposes within the Playbook). Purchasers are advised to have recourse to a wide range of forward and backward looking financial data on individual bidders: such as credit agency reports, accounts. For contracts in the “gold” and “silver” tiers, bidders can expect to be submitted to a series of complex ratio tests, as set out in the Appendices to the financial evaluation and monitoring Guidance Note.
With regard to debt, the current Guidelines deviate from the previous common sense approach taken by the OGC. Metrics 3a, 3b and 43 are among the tests to be applied in relation to bidders for “gold” and “silver” tier contracts. Amongst other things, these require buyers to aggregate the “borrowings” the bidder has. For the purpose of these tests: “[b]orrowings should also include balances owed to other group members”. This misses the obvious point that a parent or sister company is far less likely to wind up its sibling than other creditors. The tests will be applied to generate a rating of “low risk”, “medium risk” and “high risk”.
Acquisitions of contract holders by PE houses
The problems of public procurement may arise not only when bidders are trying to win new work but also following a change of control with a new, incoming private equity owner. The public procurement rules provide that a where there is a change in ownership of a service provider, the contracts should be re-tendered if the provider would no longer satisfy the original qualification requirements (including financial requirements) which were set for bidders (see e.g. Regulation 72(1)(d) of the PCRs).
There could therefore be problems for the acquirer if, pursuant to the acquisition, the provider now has a more prominent debt profile meaning that it would not have satisfied the financial threshold requirements set out in the tender documents. For that reason, a private equity acquirer should consider whether any aspect of the corporate purchase could jeopardise the target's retention of the contract. That may lead it to reconsider the levels of debt it wishes for the target to carry, to engage with the public sector customer or in a worst case scenario, decide not to proceed with the purchase. There is a risk of the target losing one or more sources of revenue which the purchaser will have taken into account in agreeing a price with the vendor.
Because of the current economic uncertainty resulting from the COVID crisis, public buyers are likely to test more vigorously the financial health of businesses competing for contracts. The guidance on financial evaluations set out in the Outsourcing Playbook and its rather generalised approach to the treatment of debt could result in private equity backed firms being disadvantaged in the bidding process. The more cautious outlook could also lead to difficulties in newly acquired companies retaining public contracts if their post-acquisition debt profile is incompatible with the original requirements for financial standing.
PE houses should not be afraid to challenge adverse procurement decisions. The Outsourcing Playbook is only guidance and does not override the duty of public bodies to act rationally and to avoid unwarranted discrimination against bidders or incumbent suppliers. In our experience, even the threat of litigation can lead public bodies to reconsider exclusion decisions or take a fuller account of the financial information presented by bidders.
1 The package of guidance is available here: https://www.gov.uk/government/publications/the-outsourcing-playbook
3 See p.29, 32 and 44 of the Guidance Note.
Originally published by Charles Russell Speechlys, October 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.