The NHS estate – what are the opportunities for private investors?

 New accounting standards that came into force for the NHS last year have made it even more difficult for trusts to pursue much needed capital investment. Stan Campbell (partner) and Dean Parrett (legal director) at DAC Beachcroft LLP explore the historic difficulties and the potential solutions

The need for investment into the NHS estate is well documented. The Naylor Review, published in 2017, estimated the cost of making the NHS estate in England fit for purpose at around £10bn. It also identified a backlog of maintenance work that needed to be carried out, requiring a further £5.7bn.

This combined estimated figure of around £15.7bn is now out of date. With rising energy costs, growing demand for healthcare services, increased staffing costs, high inflation and the need to upgrade and modernise aging infrastructure, the cost of making the NHS estate fit for purpose is likely to have increased significantly.

The role of private investors

One of Sir Robert Naylor’s key recommendations was that a third of the funding required to satisfy the need for additional investment into NHS estates should come from private sources. This, however, has yet to transpire. The NHS estate is a complex and diverse system with many different types of buildings, facilities, and infrastructure, which has made it difficult for private investors to identify investment opportunities and assess the risks involved.

Increased investment in the NHS estate as part of the government’s plans for health and social care reform is long overdue. Many who work in the industry argue investment in the NHS estate should be a priority in order to improve patient care, support staff and create a more sustainable and efficient health system. While the government has yet to release detailed information on how much it expects to spend on the NHS estate during the current financial year, it says it is committed to investment, with plans to spend £3.7bn on capital projects in 2021/22; this is part of a wider commitment to invest £33.9bn over the next five years. It is too early to tell if these targets have been met, but it is evident that this investment is aimed at improving the quality of healthcare facilities, reducing waiting times and ensuring the NHS can meet the needs of patients now and in the future. Of course, as is always the case, such spending plans are subject to change.

It is fair to say, the cost of running the NHS estate is significant (NHS Digital data confirms it cost £11.1bn in 2021/22). And the funding gap is clear to see.

The impact of PFI

Much of the investment in the NHS estate was previously secured via private finance initiatives (PFI), first introduced in 1992 by John Major’s Conservative government. The PFI model involves private companies providing funding for the construction, refurbishment and maintenance of NHS facilities in exchange for a long-term contract to deliver services. The private companies receive regular payments from the NHS over the duration of the contract, typically 25-30 years. This allows private investors to generate a return on their investment while also delivering vital healthcare services to the population.

Some of these contracts will not expire until 2050, and according to UK government and HM Treasury data, payments under operational PFI contracts in the health sector will cost more than £2bn, or around 2% of the NHS budget. This figure is set to rise, peaking at around £2.5bn in 2030. While the upfront capital from private sources allowed infrastructure to be developed, the contractual burdens associated with PFI led to widespread criticism that it has led to higher costs for the NHS and reduced control over the management of healthcare facilities; this ultimately led to the withdrawal of PFI as a funding option.

Then-Chancellor Philip Hammond launched a government review of infrastructure finance after abolishing the use of PFI, but a hole has been left in its place, and the UK lags behind the Organisation for Economic Co-operation and Development (OECD) average in capital spend on healthcare. Required capital investment into NHS infrastructure is unlikely to be achieved if this remains unaddressed.

One attempt to raise private capital for infrastructure projects was the Regional Health Infrastructure Companies (RHIC) scheme (conceived by Community Health Partnerships as Project Phoenix) which aimed to fundraise in a similar manner to the Local Improvement Finance Trust (LIFT) initiative, but for larger projects (though smaller than those previously agreed using PFI). While the scheme was scrapped before it took off, a primary benefit was its intention to account for costs on an off-balance sheet basis, meaning projects would not be included in the NHS’ capital spending limits. That model would not work under recent accounting changes.

Enter IFRS 16

IFRS 16 came into force for NHS bodies on 1 April 2022. The accounting standard has made capital investment in NHS estate more difficult because it has changed the way leases are accounted for in NHS financial statements. Previously, leases were classified as either operating leases or finance leases, with the former not impacting the Capital Departmental Expenditure Limits (CDEL) budget. However, under IFRS 16, all leases are now accounted for on the balance sheet as capital, which means signing up for a lease – even, for example, for a photocopier – will now count as a charge against CDEL. This change has restricted the cash that trusts can invest in buildings and equipment, as the full value of the lease now counts towards the CDEL, even though it is a non-cash transaction.

In practical terms, this means that signing up to a ten-year lease, for instance, with £100,000 annual rent payment, would now account for £1m of a trust’s charge against its CDEL. While CDEL limits have been adjusted upwards for leases pre-existing 1 April 2022, what was previously treated as a revenue lease will now consume a chunk of CDEL for new leases going forward.

IFRS 16 recognises this as a £1m charge against CDEL and £1m is being paid to a landlord, whereas in cash terms it is a £100,000 transaction, per annum, over ten years. The argument is that the IFRS 16 calculation should therefore constitute a non-cash transaction, yet at present it counts in full towards CDEL, restricting the actual cash trusts can invest in buildings and equipment. And, of course, the consequence of IFRS 16 may be much bigger when you consider higher rents and longer leases.

This has made it more difficult for NHS trusts to find alternative sources of funding for capital investment, as they are constrained by CDEL limits.

There is no doubt this has been a headache for some NHS organisations, which have had to grapple with a new CDEL framework, the arrival of IFRS 16 and ICS changes – whereby CDEL is calculated at individual provider trust level, largely based on historic depreciation levels, but managed and consolidated across the system.

These recent changes have left trusts searching for alternative solutions to find capital funding sources not constrained by CDEL, with potential solutions including land or building disposals and charitable sources. Previous routes such as an income strip – where a trust builds the infrastructure it needs and sells a lease back via a fund, thereby turning it into a revenue lease – have been ruled out by the IFRS 16 accounting change. It is possible for NHS trusts to be innovative in how they seek investment in order not to be constrained by CDEL. However, this involves early engagement with and co-operation of private sector partners and possibly third-party funders.

Of course, CDEL is in place for good reason, and public spending cannot go uncapped. But in a post-PFI landscape, where new LIFT schemes are in short supply, there appears to be no magic fix for this infrastructure funding challenge.

Government intervention

One solution to the lack of capital for the NHS estate could be the creation of a government-backed structure that would encourage private investment in healthcare infrastructure. There are an increasing number of investors interested in ‘doing well by doing good’ by investing in the UK’s health and social care infrastructure, and with the strong covenant strength of the NHS, such a structure could provide the necessary reassurance to encourage private investment.

However, at present, it remains unclear whether the government will create a replacement for PFI or establish an alternative avenue for private investment. With the cost of running the NHS estate set to rise, it is crucial that a solution is found soon to ensure the NHS can continue to provide high-quality care to patients whilst tackling the post-pandemic backlogs. The recent changes to CDEL and IFRS 16 have only made funding the NHS estate more challenging, and from conversations with our clients we know some NHS bodies and their finance teams would welcome a more simplified route to infrastructure funding.

All eyes are therefore on the Secretary of State for Health and Social Care and HM Treasury. The New Hospital Programme aside, key questions remain: how will estates be funded going forward? Will there be a replacement for PFI? Will an alternative avenue for private investment be created? Will investment be purely taxpayer-funded? Only time will tell.