The Use of Mini Perms in UK PFI Passing Fad or Here to Stay

8/2/2019 The Use of Mini Perms in UK PFI Passing Fad or Here to Stay

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GLOBAL INFRASTRUCTURE

The use ominipermsin UK PFI

Passing ad orhere to stay?

ADVISORY


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The use o miniperms in UK PFI

Listening to the banks and reading the project nance press, you

would think that mini-perms are the in-vogue funding technique

for PFI transactions, that traditional long-term debt is history and

that banks will only provide short-term lending. This paper considers

whether mini-perms will become the norm for funding UK PFI

projects and, if so, what does it mean for public sector authorities

and private sector bidders in the PFI market?

In order to arrive at the answer to this

question, it is helpul to look at:

The background to why miniperms

have emerged

What is it that is orcing banks to

push this particular debt product?

The eatures o the miniperm

Is it hard, is it sot? What does that

actually mean?

How miniperms are applied in UK

PFI transactions

What does it mean or authorities?

Are they orced to accept the

greater risks? How does it aect

VFM and aordability?

What does it mean or sponsors,

project risk and pricing o bids?

What alternatives exist?

Is there a better solution or

UK PFI?

2009 KPMG LLP, a UK limited liabil ity partnership, is a subsidiar y o KPMG Europe LLP and a member rm o the KPMG network o independent memberrms aliated with KPMG International, a Swiss cooperative. All rights reserved


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Background




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Mini-perms are not being promoted by banks because of credit issues

with UK PFI assets. Indeed, the credit quality of PFI projects is as

strong as ever and arguably more so given the credit enhancements

we are seeing on recent deals like Manchester Waste and M25.

Mini-perms are being promoted by banks in the UK PFI market

because of i) concerns over long-term liquidity; ii) banks inability

to underwrite and syndicate deals, with the resultant dependence on

clubs for funding; and iii) a certain degree of opportunism among

those banks still in the market.

Liquidity

The real concern or banks is uncertainty

over liquidity their ability to attract

deposits and access the interbank

market at rates that match their lending

commitments.

Typically, banks lend to projects on

the basis o a foating interest rate(threemonth or sixmonth LIBOR)

plus a margin. The LIBOR rate is re-

set (every three months or six months)

by reerence to a screen rate, which

is supposed to refect the market cost

at which banks have been able to und

themselves or attract matching (three-

month or sixmonth) deposits in the

interbank market traditionally a very

smooth, transparent and ecient

marketplace. And the margin simply

represents the banks prot.

ProjectCo will usually swap its foating

rate liability into a xed rate in order to

hedge its exposure to interest rates

which would otherwise move every

three or six months. But the underlying

loan remains linked to LIBOR.This is

the issue because all o a sudden in

todays dysunctional market, banks

are nding that the LIBOR screen rate

bears no resemblance to reality: either

they cannot access the interbank

market or are having to pay a massive

premium (o 200300bps over the

screen rate) to do so. In this context,

lending or periods o up to 30 years

on a mismatched basis doesnt look

very clever hence the move to

shorter tenors.

Not all banks are aected in the same

way, o course and the liquidity

constraints are less o an issue or

banks with strong credit ratings orwith access to a retail sterling deposit

base such that they are less reliant on

the interbank market. Hence, we are

still seeing the UK clearing banks and

some overseas banks with UK deposits

[NAB via Clydesdale and Yorkshire Bank;

and Bank o Ireland via the Post Oce

deposit base] willing to lend long term.

The lowest common

denominator o a club

Another reason miniperms have

become prevalent, particularly in larger

projects, is because o the demise o

the syndication market which means

all deals are being done on a club basis.

With banks only prepared to lend

and hold amounts o 3050 million,

it requires a number o banks to club

together to und most PFI projects.

In this situation the lowest common

denominator tends to prevail so i one

or two banks in a group o eight require

a miniperm, all the banks get it.

Opportunistic behaviour

As many sponsors and advisers will

have observed, there is a certain

amount o opportunism in the banking

community there is much less

competition and, as a result, banks

are demanding miniperms because

they can.


Inter-bank

MarketBank Project Co

Swap

Bank

6M LIBOR 6M LIBOR + M

6MLIBOR

FixedRate


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What is a miniperm?


In simple terms, mini-perms can be broken down into

two products Hard and Soft.



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Hard

In the hard miniperm, the bank loan

has a short legal maturity (ve or seven

years) at which point:

The bulk o the loan is stilloutstanding

The sponsors ace an event o deault

i it is not renanced

This could lead to a termination o

the concession or PFI contract

It is an Armageddon situation

and arguably more suited to an

inrastructure acquisition than a

PFI concession.

But it does give the banks a very strong

hand with which to renegotiate the loan

terms at the point o deault rather

than try to guess what the market

interest margin might be seven years

ater nancial close, hard miniperms

give them the opportunity to apply

whatever margin (gearing, cover ratios

and other covenants) are applicable at

the time. To date, however, it has not

been considered let alone adopted in

UK PFI projects which is a good thing,because the orced renancing raises

a couple o major issues: i) hedging: do

you put a shortterm swap in place and

take the risk on interest rates at the

time o the orced renancing, or do

you put a longterm swap in place and

make an assumption about the prole

o the debt that you hope to be able to

put in place at the time o the orced

renancing?; ii) aordability: what

assumption does the authority make

about margins, underlying interest

rates, tenor and amortisation prole

(assuming it takes the risk on all these)

that will apply to the debt at the time o

the orced renancing and, thereore,

what budget approval does it require?

Sot

The sot miniperm has been used in

UK PFI and continues to be promoted

by banks on a number o projects

travelling through procurement.

Importantly, in this case the legal

maturity o the bank loan remains

long term (say, 26 years or a 28year

concession) but two eatures o the sot

miniperm encourage or incentivise the

sponsors to renance the loan by an

earlier date.

First, a margin ratchet: incremental

stepups o 2550bps at certain

dates, which make the cost o

borrowing more expensive in the

event the loan isnt renanced.

Second, a cash sweep: this triggers

at a certain date, ater which some

or all ree cash fow is used to

prepay the debt outstanding rather

than being directed to shareholder

distributions. Sometimes the cash

sweep is structured so that, say,

50 percent o ree cash fow is

swept or prepayment in year 5 and

increases to 100 percent in years 8

or 10. But the eect is the same

the loan is ully repaid several years

short o its legal maturity and the

shareholders suer a long period o

zero distributions. A good incentive

to renance i ever there was one!



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Senior Debt Closing Balance and Capital Repayments

300,000

250,000

200,000

150,000

100,000

50,000

(20,000)

(18,000)

(12,000)

(8,000)

(4,000)

-1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

0

Year

0


300,000

250,000

200,000

150,000

100,000

50,000

0

Year -1 0 1 2 3 4 5 6 7

(20,000)

(18,000)

(12,000)

(8,000)

(4,000)

0

8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

For illustrative purposes only

The graph above represents the senior

debt prole or a UK PFI waste project,

where the debt was structured with

margin ratchets applying in year 7, 10

and 18, and a 50 percent cash sweep

in year 7 climbing to 100 percent cash

sweep in year 10. The top graph shows

the traditional sculpted annuity prole

with a 26 year tenor or a 28year

(3 + 25) concession.The impact o the

miniperm cash sweep can be seen in

the graph above where the eect o

mandatory prepayments shortens the

base case debt tenor to 17 years. In

act, the requirement o the banks on

this project was that the cashswept

debt maturity must always be under

20 years even in the severe downside

scenarios that were tested as part

o the banks sensitivity analysis.

A point to note here is that the eect

o a miniperm will depend on the

type o project.The example used

here was a waste project with a air

degree o merchant exposure and,

thereore, reasonably high base case

cover ratios. On the other hand, a

standard accommodation project with

cover ratios at c. 1.20x would generate

considerably less ree cash in the base

case and, thereore, the eect o the

miniperm cash sweep would be less

pronounced in terms o shortening the

debt maturity.



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How are miniperms being applied in UK PFI?



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The use o miniperms in UK PFI 0


300,000

250,000

200,000

150,000

100,000

50,000

0Year

(4,000)

(8,000)

(12,000)

(16,000)

(20,000)

-1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 280


300,000

250,000

200,000

150,000

100,000

50,000

0

(4,000)

(8,000)

(12,000)

(16,000)

(20,000)

0

Year -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

Subordinated Debt Closing Balance and Capital Repayments

120,000

100,000

80,000

60,000

40,000

20,000

0

(7,000)

(6,000)

(5,000)

(4,000)

(3,000)

(2,000)

(1,000)

-1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

0

Year

Subordinated Debt Closing Balance and Capital Repayments

120,000

100,000

80,000

60,000

40,000

20,000

0

(7,000)

(6,000)

(5,000)

(4,000)

(3,000)

(2,000)

(1,000)

-1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28Year

0

Dividends Profle

(16,000)

(14,000)

(12,000)

(10,000)

(8,000)

(6,000)

(4,000)

(2,000)

-1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28Year

Dividends Profle

(16,000)

(14,000)

(12,000)

(10,000)

(8,000)

(6,000)

(4,000)

(2,000)

-1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28Year




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Another point o interest is how to

hedge interest rate risk when you do

not know what your loan amortisation

is going to look like and you riskending up overhedged i and when

the cash sweep applies. Prudence

would suggest that it is best to swap

the original prole at nancial close

so as to lock in the longterm interest

rate and provide the authority with

certainty, retain the benet o the

underlying swap within any subsequent

renancing (subject to an amount o

reproling at the time) and unwind any

overhedged position i renancing is

not achieved and the cash sweep kicks

in. This fexibility would need to be

addressed upront and accommodated

within the nancing documentation.

It may well emerge that bidders play

a tactical game in relation to the risks

associated with miniperm structures

in order to give themselves a bidding

advantage. For example, a bidder

who is prepared to absorb the risk

o the margin ratchet as well as the

cash sweep might present a more

compelling and aordable oer to the

authority compared to the bidder who

wants to share the risk even though

equity returns would be urther diluted

in the event that the sponsors cannot

renance at or below the preratchet

margin level. It is not such a radical

suggestion, as the IRR impact is not

perhaps as signicant as you might

think.The graphical analysis shown

top right was conducted on a liveproject, showing that the cash sweep

impact is a 0.9 percent reduction in

postSPV, postshareholder blended

IRR but absorbing the margin ratchet

impact only reduces it by a urther 0.2

percent. I you are able to view your

project returns on a holistic basis,

including prots on subcontracts, this

might be a commercial position you are

comortable in oering the authority

i you think the presentational impactexceeds the physical risk.

Beore scaring too many sponsors into

believing that the market will absorb

these risks, it is worth returning to

the question o whether ManchesterWaste and the M25 have changed the

marketplace or whether, in act, they

prove the exception to the rule.

The lower graph below is an

approximate illustration o the

upcoming pipeline o UK PFI deals

by size. For example, i you look

at the 100+ PFI deals currently in

procurement (many o which are stalled

at preerred bidder stage), there are

very ew indeed in the >250 millioncategory.The vast majority o preerred

bidder and pipeline deals alls into the

smallersize categories where there

is still sucient longterm unding

available rom the nonminipermbanks: most BSF, Streetlighting, Social

Housing, Blue Light and Prison deals

all into this category and these are the

sectors where most o action is.

It is only the odd deence deal (like

SARH), road maintenance (like

Sheeld and Birmingham) and waste

deal that will exceed 250 million in

size. And even then, the case or using

miniperm debt is uncertain when you

consider the alternatives available.

Equity

Return (%)

12.2%

11.3% pa

Base Case Cash Sweep

11.1% pa

Cash Sweep & Margin

No. o

Projects

50-100 100-150 150-200 200-250 > 250 Deal Size

(M)




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Miniperm alternatives




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Even the larger PFI deals will not need to resort to mini-permstructures if they can take advantage of alternative funding sourcesthat already exist or could be introduced with minimal interaction.

EIB

There is an obvious role or the EIB in

lling the longterm unding gap and

thereby mitigating the move to mini

perms. It is pleasing, thereore, to see

the EIB begin to step up to the plate

with large chunks o longterm cash.

The M80 DBFO road project in Scotland

is a good example, where the EIB lent

more than 50 percent o the debt, in the

process allowing the project to close

with 290 million o traditional long

term debt (and at competitive pricing).

Even more recently, the involvement

o EIB unding helped the Enniskillen

Hospital project close with 270 million

o longterm project debt.The EIB will

not be able to help out all projects, not

least because o its own resource and

policy constraints, and its involvement

in Manchester Waste and M25 did not

avoid the need or a miniperm so

urther alternatives will be required toeradicate the miniperm beast or ever.

TIFU

TheTreasury Inrastructure Funding Unit

is already showing an appetite to break

away rom its initial mandate (as lender

o last resort to projects that cannot

otherwise attract commercial banks

such as Manchester Waste) by taking

a more proactive role in helping project

sponsors to ditch the outlying and

more unreasonable members o bank

clubs so as to keep the overall unding

terms more competitive without

having to indulge the lowest common

denominator every time. Assuming

this new approach does not all oul o

state aid issues, it will certainly help

to get deals done more quickly, more

aordably and without resorting to mini

perm structures. It only requires the

TIFU to fex its muscles in this manner

once or twice or the market to sit up,

take notice and maybe change its ways.

Authority capital contributions

While authority colending is rowned

on by HMT, authorities can still play

a positive role in terms o reducing

a projects unding requirement by

introducing capital contributions to

the construction costs o a project.

The mechanism is reasonably tried and

tested, does not require the authority

to take on excessive construction riskand is one o the most eective ways

o solving aordability constraints.

All the above miniperm alternatives

are here and now. But there are

additional initiatives which could

be introduced to really open up the

banking market. With a small tweak

to the system, HMT could ree up

resources within existing longterm

lenders and, moreover, welcome

additional longterm lenders back intothe market thereby improving the lie

o authorities, sponsors, banks and tax

payers alike. These adjustments might

include:

Competitive dialogue and

preerred bidder debt unding

competitions

At present, a number o authorities

running procurement exercises under

competitive dialogue ask each bidder

at ISDS to submit bids which are

ully unded, i.e. have the support o

sucient banks to secure the whole

debt unding requirement. In the

current market, many bidders play sae

by signing up more than the required

number o banks in order to provide a

level o redundancy in the event that

one o its banks has a change o heart

during the process. For a 200 million

project with our bidders submitting

ISDS bids, this is quite a challenge or

the market to deliver unless sponsorsare content or their bank group to

support more than one bidder which

in itsel tends to undermine the value

o the support because sponsors are

reluctant to share the ull details o their

bid with banks that are talking to their

competitors. Equally, it is more likely

to orce sponsors to accept miniperm

structures while there are sucient

banks in the market to lend 200 million

on a traditional longterm basis, there

are not sucient banks to do it our



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times over so some i not all bidders

will need to satisy the shorttenor

members o their supporting

bank group.

It would benet the market enormously

i this constraint could be lited, getting

the best rom the (whole) market via

an open unding competition once the

preerred bidder has been selected

and reeing up banks to concentrate

on getting preerred bidder dealsclosed rather than attending endless

meetings so that bidders can satisy

procurement requirements. Provided

each bidder has the structuring, due

diligence support and commitment o at

least one sensible longterm bank, the

authority and its nancial adviser should

be able to get comortable that the debt

unding or the bid is deliverable in a

preerred bidder unding competition.

All it requires is guidance rom HMT

on the evaluation o bids in the current

climate and, perhaps, a greater reliance

on quality over price when certain

authorities choose their nancial

advisers.

Authority risk share

It is instructive to look outside the UK

to see what other governments are

doing to retain the benet o longterm

lending or their inrastructure projects.

A good example is the approach taken

by the Belgian government to help

close the Liekenshoek Rail Tunnel

project in November 2008. In order

to overcome the interbank liquidity

issue that banks are aced with (i.e.,

the risk that interbank unding costs in

excess o the prevailing Euribor rate),

the Belgian government intervened

by capping the participating banks

exposure to Euribor premia, thereby

removing a key obstacle to longterm

lending. As a result the project was

nanced in the bank market with

626 million o traditional longterm

project nance debt.

Credit Guarantee Facility

Introduced in 2004 as a means o

shaving a ew basis points o the

cost o unding or PFI projects at the

peak o the market, the CGF involved

HMT providing the unding or PFI

projects guaranteed by commercialbanks, the EIB or, in those days, the

monoline insurers. A lot o eort went

into developing the product, standard

documentation was prepared and two

deals (Portsmouth Hospital and St

James Hospital) were closed, both with

commercial banks providing the credit

wrap. Then the scheme was abandoned

when it was discovered that projects

unded in this way appeared twice on

the governments balance sheet.

I ever there was a time to reintroduce

this product, the middle o a credit crisis

when banks are happy with the credit

quality o PFI projects but struggling

to access the interbank market or

unding and the government has

greater concerns than the presentation

o its accounts would seem like a good

time. It would have quite an impact

in terms o increasing the number o

banks active in the longterm end o

the project nance market. When swap

credit margins have increased rom a

low o 5bps p.a. to a mouthwatering

45bps p.a. on some recent deals,

the ability to tap xedrate unding

without a swap would also provide an

immediate saving to authorities and

taxpayers alike.



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Summary




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Two large (and one small) UK PFI projects have been nancedusing a mini-perm debt structure, but these projects cause afford-ability issues for the public sector and increased risk exposure for the

private sector. There are still a number of banks prepared to lend longterm. When combined with the alternative funding sources available,most PFI deals can still match their long-term assets with long-termfunding. HMT has an opportunity to further improve the climatefor traditional project nance and, thereby, to protect PFI frommini-perm mania.



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kpmg.co.uk

For urther inormation on the

content o this paper or any other

aspect o the project fnance market,

please contact:

Mike Harlow

Tel: +44 (0) 207 311 4227

Email: [email protected]

Jeremy Barker

Tel: +44 (0) 207 311 8156


Nick Greenwood

Tel: +44 (0) 207 694 3769


The inormation contained herein is o a general nature and is not intended to address the circumstances o any

particular individual or entity. Although we endeavour to provide accurate and timely inormation, there can be no

guarantee that such inormation is accurate as o the date it is received or that it will continue to be accurate in the

uture. No one should act on such inormation without appropriate proessional advice ater a thorough examination

o the particular situation.

2009 KPMG LLP, a UK limited liabili ty partnership,

is a subsidiary o KPMG Europe LLP and a member

rm o the KPMG network o independent member

rms aliated with KPMG International, a Swiss

cooperative. All rights reserved. Printed in the

United Kingdom.

KPMG and the KPMG logo are registered trademarkso KPMG International, a Swiss cooperative.

Designed and produced by KPMG LLP (UK)s

Design Services

Publication name: The use o miniperms in UK PFI

Publication number: RRD145467

Publication date: June 2009
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Documents

The Use of Mini Perms in UK PFI Passing Fad or Here to Stay