OGC GUIDANCE ON CERTAIN FINANCING ISSUES IN PFI CONTRACTS

Transcription

1 OGC GUIDANCE ON CERTAIN FINANCING ISSUES IN PFI CONTRACTS Introduction In PFI projects, responsibility for raising finance clearly rests with the private sector Contractor. However, the terms on which finance is available are of key concern to an Authority because of the impact they have on value for money. The proposed financial structure, the risk appetite of financiers and their rights enjoyed under the PFI Contract are all matters which can affect value for money just as much as the underlying cost of finance itself. Accordingly, Authorities and their advisers will need to address a range of financing issues as part of their bidder appraisal processes and subsequent negotiations with the private sector. The Guidance To assist departments and other public authorities deal with some of these complex issues, Partnerships UK has prepared, for the OGC, the following guidance on three important aspects of financing: Section 1: Ensuring Competition in the Financing of Contracts Section 2: Using the Capital Markets for Finance Section 3: The Use of Internal Rates of Return in PFI Projects This guidance complements the OGC Guidance on Standardisation of PFI Contracts, and the definitions and abbreviations used in this guidance are the same as those in the standardisation guidance. The first section, on ensuring competition in the financing of contracts, takes account of the National Audit Office Report, Innovation in PFI Financing: the Treasury Building Project, published 9 November Further chapters on additional topics may be added in the future. Private Finance Unit Office of Government Commerce 31 st July

2 1 ENSURING COMPETITION IN THE FINANCING OF CONTRACTS 1.1 Introduction If capital costs make a large contribution to Unitary Payment levels, Contractors should be required when bidding for projects to provide documentary evidence that they can obtain funding commitments from financial institutions if they intend to arrange debt from third parties (rather than from internal corporate finance resources) Such commitments are usually provided through support letters 1, incorporating a term sheet agreed by the Contractor with its financiers, which provides a detailed summary of the basis and terms on which finance will be provided. While a term sheet does not normally create a legal commitment on the part of the financial institution, there should be no deviation from these terms unless significant changes in the base assumptions for the financing take place The purpose of this procedure is to ensure that the necessary third party finance will in fact be available when the Contract is signed, on the terms and conditions envisaged. However, this approach alone may not necessarily offer the Authority best value for money. Although there is a natural incentive on bidders to reduce their costs of capital (including through holding their own funding competitions for the appointment of financiers as part of their bid preparation), there will be cases where additional action can be taken by the Authority to enhance value for money One such action is requiring a preferred bidder to run a funding competition. There are two fundamental reasons why funding competitions may achieve better value for money: Lenders are likely to offer more competitive terms to a Preferred Bidder; and Lenders are less likely to raise issues on the Contract if faced with competition from other institutions willing to offer the Contractor finance for the Project While these reasons will always exist, it would be wrong for Authorities to conclude that holding a funding competition is right for every project. An Authority and its advisers need to consider the particular circumstances of each 1 See Section 33 (Commitment Letters) of the OGC Guidance on Standardisation of PFI Contracts. 2

3 procurement, the nature of the project, the particular market and the status of the competition to determine whether a funding competition is likely to offer value for money. In particular the Authority should consider: the suitability of the project (see 1.2 below); the extra risks and costs involved in conducting a funding competition (see 1.3 below); the procedure for carrying out the competition (see 1.4 below); and how the risks and benefits that arise from a funding competition should be calculated and shared between the Authority and the Contractor (see 1.5 below) In certain circumstances it will be possible for the Authority to determine at the outset of a procurement whether requiring a Preferred Bidder to run a funding competition is likely to be beneficial. Where this is the case, it is recommended that Authorities signal their intention to require the Preferred Bidder to conduct a funding competition in the ITN documentation Where it is not possible for the Authority to determine whether a funding competition is likely to prove value for money in advance of the competition, Authorities may choose to reserve the right to require the Preferred Bidder to conduct a funding competition. Where Authorities do reserve this right, it and its financial advisers can then keep the situation under review as the procurement progresses and assess whether they need to exercise the reserved right It would be unreasonable however, for the Authority to conclude, solely on the evidence presented in the different bids submitted in response to the ITN, that a Preferred Bidder should conduct a funding competition Conversely, it would be reasonable for an Authority to exercise its right to require the Preferred Bidder to conduct a funding competition where the Preferred Bidder s financiers seek to materially amend the terms of the Preferred Bid or, through passage of time, financiers commitments lapse and need to be renegotiated By reserving such rights in the ITN, there is an immediate incentive on the bidders preferred financiers to offer competitive pricing and reduce the number of amendments it requests to be made to the Contract. In many cases where Authorities choose to reserve the right, the very fact that such a right exists will be sufficient to ensure that good value from financing is achieved In cases where a funding competition is merited, the competition can be applied to Senior Debt and to any third party subordinated or mezzanine debt. 3

4 Before requiring the Preferred Bidder to embark on a funding competition, Authorities should note that funding competitions impose significant additional responsibilities on their own project management teams as well as their advisers. Accordingly, it is essential that project management teams and advisers are appropriately qualified if they are to take on this extra role. Equally, if the process is to be successful, it is also very important that the Preferred Bidder and its advisers can each demonstrate an understanding of the requirements of funding competitions Authorities considering requiring the Preferred Bidder to run a funding competition should take appropriate advice (including legal advice) on the requirements to be put on the Preferred Bidder in terms of how it runs the competition. This advice should enable the Authority to be satisfied that running a competition will maximise value for money and that any legal requirements are taken into account Authorities should note that where they simply reserve the right to require a funding competition, they should still normally require bidders to submit all the information relating to finance that would be required at ITN and BAFO stages on the assumption that a funding competition will not be required. This will usually be necessary to apply full and proper award criteria If an Authority decides at the start of the procurement process that, due to particular circumstances of the Project, it requires the Preferred Bidder to run a funding competition, which may then lead to bidders not being required to submit all of the usual information relating to finance as part of its ITN or BAFO bids, then appropriate advice must be sought by the Authority on how to structure the procurement so as to achieve value for money and apply suitable award criteria Should an Authority decide to require the project to run a funding competition, it is recommended that they discuss that intent with their respective devolved executive, sponsoring department, Private Finance Unit or OGC. 1.2 SUITABILITY OF PROJECTS FOR FUNDING COMPETITIONS Projects where a funding competition may be suitable and where such suitability can be determined in advance include: larger projects that involve a significant amount of capital investment to be made by the Contractor; 4

5 more novel projects, including those based on market risks, where financiers may each adopt a markedly different approach and so offer greater choice to borrowers, rather than presenting a consensus market view; or projects where there are likely to be very few bidders Funding competitions may also be suitable where: the Preferred Bidder s selected financiers are requesting changes to be made to the Contract despite the fact that the project is based on a high degree of standardisation of terms and structure, and a low level of innovation or complexity; or a significant gap in time arises between appointment of the Preferred Bidder and financial close (e.g. because of the planning process) which can lead to the deal drifting away from finest market terms Due to the risks and costs involved in funding competitions, their use should be the exception, rather than the rule. In particular, an Authority should not normally seek to utilise a funding competition on complex transactions nor should they use funding competitions solely as a means of addressing affordability. Authorities should seek advice from their relevant Departments and/or Departmental Private Finance Units where such benefits are sought Major projects may not be suitable for funding competitions if each financier, or group of financiers, is required to offer full underwriting for the total finance required because there may be insufficient capacity in the financial markets for several underwritings to be completed at the same time on competitive terms. Nonetheless, worthwhile funding competitions may still be run in such circumstances by the Preferred Bidder inviting several financiers to underwrite a portion of the total finance required where more offers than are required are received. 1.3 RISKS AND COSTS Whilst funding competitions should bring benefits, they are not without the following risks and costs: a lack of market interest in the funding competition, perhaps more so where the decision is taken to exclude financing from the competition until after the Preferred Bidder has been selected; 2 A funding competition would only be considered in these circumstances if the Authority has decided that recompeting the project is not feasible. 5

6 bids turn out to be less competitive than they might have been or the final bids may not be acceptable to the Authority e.g. for affordability reasons and as a result the project may be cancelled; the Authority may incur higher financial advisory fees because of the additional work and responsibility that will be required from its financial advisers; and bidders that reduce financial advisory costs prior to submitting bids by using banks as both advisers and arrangers of the finance may be discouraged from doing so, and so may have to include extra costs in their bids The risk of lack of market interest or of bids received in the funding competition being less competitive than those originally offered as part of the Preferred Bidder s bid are remote in that if financiers were originally willing to support the Preferred Bidder, then they should still be willing to provide finance at a later stage. If not, the likelihood is that something has subsequently arisen which would have invalidated the support of the Preferred Bidder s original financiers in any event. To the extent that a funding competition is known prior to Preferred Bidder being selected, the willingness of banks to carry out detailed due diligence in the project prior to Preferred Bidder may be reduced depending upon the terms of their appointment. This could lead to the project documentation negotiated with the bidders needing revision prior to finance becoming available. This risk is higher in innovative/complex projects If run well, the competition could reduce the time taken to reach financial close by cutting out extended triangular negotiations between the Authority, the Contractor and pre-appointed financiers during the period between appointment of Preferred Bidder and financial close, so saving all parties costs. However, the Authority runs the risk of removing the incentives upon the bidder to get the best terms from their banking group, and end up in direct negotiations with the bidding banks. 1.4 HOW TO RUN A FUNDING COMPETITION Any type of financial institution should be able to bid in a funding competition. However, for ease of administration and to ensure commitment on the part of prospective financiers, a pre-qualification procedure may be introduced. The total number of pre-qualified financiers may be limited to say 4-6 financiers or groups of financiers (each being a bank or other financial institution) where each is bidding on the basis of a fully underwritten offer for the total finance required 6

7 or (in the case of a major project) 3 an underwritten position in the total finance requirement The funding competition will take place after the Authority and the Contractor have negotiated the Contract. The Contractor should also by then have agreed other significant project contracts (e.g. construction contract, operation and maintenance contract, etc.). Thus the overall structure of the project apart from the financing is fixed A Financing Information Memorandum ( FIM ) on the project is prepared. The primary responsibility for this task should lie with the Contractor and its advisers, but the Authority should have the right to verify its final contents, with advice as necessary from its own financial advisers. A FIM s contents may include: an overview of the project and its general background; the structure of the project company, its ownership, organisation and management; details of any shareholder agreements relating to the project company or the project; financial and other information on the Contractor and other major project parties, including their experience in similar projects, and the nature of their involvement in and any support for the current project; technical description of the construction and operation of the project; summary of the Contract and other significant project contracts; project costs and financing plan; risk analysis; financial analysis, including the base case and sensitivity analyses. Financiers may be provided with the financial model, or print-outs of its output; and a detailed term sheet for the financing Thus the FIM provides a synopsis of the structure of the project and the whole due diligence process. As part of this due diligence, the Contractor should appoint legal and technical advisers to act on behalf of the prospective financiers these advisers should be conversant with the requirements of financiers to PFI projects and should make representations during the negotiations of the Contract between the Preferred Bidder and the Authority. Once the Contract has been 3 See Section above. 7

8 finalised between the Preferred Bidder and the Authority, the financiers advisers should review the project information and documentation, and produce due diligence reports which are included in the information package for financiers. At this stage these advisers have only a shadow client (i.e. the competing financiers). However, once the financiers are appointed these advisers come under their direct control If the Authority elects to require the Preferred Bidder to run a funding competition, the Authority should work with its advisers to determine the aspects of the financing which it should require the Preferred Bidder to open up to competition. Any aspect of the financing that will have an impact on the calculation of the Unitary Payment or the Net Present Value of the Contract could be competed for by prospective financiers. Examples include: capital structure margins, fees and premiums; reserve requirements repayment structures; and hedging arrangements (including interest rate swaps and fixed rate deposits) Financiers should be required to accept all the terms proposed or raise any exceptions they may have with the term sheet, the Contract or other project contracts (e.g. specifically in relation to issues referred to in Section See Section 33 (Commitment Letters) of the OGC Guidance on Standardisation of PFI Contracts). Bid requirements should be sufficiently flexible to allow for innovative financing proposals that give best value for money The Authority should have the right to attend meetings with financiers and to be kept informed on progress. It may be asked to assist in making presentations on the project to prospective financiers, but all parties should clearly understand that the ultimate responsibility for both the information package and any such presentations lies with the Contractor The final decision to choose a particular financier also lies with the Contractor, but this choice should be ratified by the Authority. 4 See Section 2.11 (Fixed Deposit/Guaranteed Investment Contracts) below. 8

9 1.5 CALCULATION AND DIVISION OF BENEFITS The financial benefit (or cost) of the result of a funding competition, by comparison with the funding assumptions included in the Preferred Bidder s bid, should be agreed between the Authority and the Contractor based on calibrated financial models. To the extent that the Authority is taking all the risk on the process, it should rightly take all of the benefit of the funding competition. But the Authority should also consider the Value for Money of requiring the Contractor to commit to a cap on the financing costs (i.e. guaranteed maximum margins). If such a model is used the Contractor should be entitled to share in the benefits of the funding competition with the Authority The actual costs of advisers organising the competition (i.e. financial, legal and technical advisers) should be borne by those instructing the advisers, and other out-of-pocket costs should be borne by the Preferred Bidder and included in the bid costs. 1.6 REFINANCING COMPETITIONS In circumstances where the Authority has rights or otherwise expects to share in the benefits of a refinancing 5, similar principles will apply and a competition for the provision of an underwritten refinancing is most likely to yield best value for money and so should always be considered by the Authority as an option. 1.7 CONCLUSION Many sectors of the PFI market are now mature and consequently, for the majority of projects, the benefits achieved from and the frequency of conducting funding competitions, will be quite low. However, by reserving the right to require the Preferred Bidder to run a funding competition, the Authority can ensure that the financing package that supports the Preferred Bidder s solution is highly competitive The particular features of some projects may indicate to the Authority that a funding competition would, in fact, deliver value for money. In such cases, the Authority should be signalling in its ITN documentation that it will require the Preferred Bidder to conduct a funding competition Equally, to guard against and largely anticipate circumstances in which, having appointed a Preferred Bidder, it is clear that a funding competition would deliver value for money, rights to require such a competition may need to be included in 5 See Section 35 (Refinancing) of the OGC Guidance on Standardisation of PFI Contracts. 9

10 the ITN. Where such circumstances do arise and where the Authority lacks any rights to require the Preferred Bidder to conduct a funding competition, the Authority s ability to act on the results of its monitoring of the Preferred Bidder s financiers will be extremely limited. 10

11 2 USING THE CAPITAL MARKETS FOR FINANCE 2.1 WHY DO PFI BIDDERS USE THE CAPITAL MARKETS? The bond markets offer a source of long-dated debt and accordingly, it is now commonplace for many bidders to consider raising money in this market as an alternative to the banking sector, especially if the project concerned is so big that there is insufficient liquidity in the banking market to procure attractive margins. The principal driver for any bidder when assessing the benefits of bond over bank debt will be the comparison of cost of bond versus bank debt, and this will be a function, inter alia, of the level of swap spreads, credit spreads and cover ratio requirements in each market. That said, factors which a bidder may consider when deciding whether to finance a bid with a bond include: Debt requirement a minimum debt requirement of approximately 50m has historically been required to make bond finance attractive. The growth in the private placement markets now makes smaller projects down to 20m, and potentially below, possible. Maturity due primarily to the identity of the institutions that invest in bonds, bonds can sometimes provide much longer maturities than bank debt, e.g. 35 years in some cases. A longer maturity on the underlying debt may offer the Authority the best value for money and therefore be attractive to a bidder. Cost of prepayment - the terms and conditions of long-dated bonds include a make-whole provision in the event of a voluntary early repayment by the borrower. This is likely to make early redemption of the bonds expensive in comparison to an equivalent bank facility, and so it is generally assumed that bonds will not be refinanced. Flexibility - investors in bonds in the public market need to be able to sell the bonds as tradeable instruments and therefore expect a certain degree of uniformity in the bonds terms and conditions. Consequently, bond terms and conditions are sometimes perceived to be less flexible than those of bank debt. Wrapped vs. Unwrapped Bonds The majority of PFI bonds have benefited from monoline insurance of the project risks (a wrap ). In comparing the efficiency of a wrapped issue against unwrapped, the total cost of the wrapped debt including the insurance premium must be considered rather than the headline yields. 11

12 Comparing Bond vs. Bank Finance To ensure a fair comparison between bond and bank finance, the Authority should insist that the forecast interest rates used for both bank finance and deposit of bond proceeds are determined by reference to the projected cashflows, rather than on average term of finance. Issue Costs - many cost items will apply to both bank or bond finance. Additional cost of the roadshow items attributable only to bonds include rating agency fees as well as printing and the marketing cost (although frequently syndication costs on a bank deal will similarly be charged to the project company). The Contractor (and the Authority) should ensure that all up-front costs are estimated and included in the bid price so that an accurate comparison of the cost of bank versus bond can be made. 2.2 WHAT IS A BOND? A bond is a negotiable debt instrument that pays the bondholder a rate of interest in exchange for the bondholder paying the principal amount of the bond to the issuer on issuance. During or at the end of the term of the bond the issuer repays the principal amount of the bond according to the agreed repayment profile. Full repayment may be made on final maturity (a bullet bond ) or may be made according to an agreed amortisation schedule. Bonds come in various forms, including: and and Floating Rate i.e. interest rate varies with the rate of LIBOR and is reset at the beginning of each interest period; or Fixed Rate i.e. the interest rate is set on issuance and does not vary with any underlying interest rate; or Index-linked i.e. the principal amount of the bond escalates according to movements in a selected index, commonly the RPI (all items), Wrapped i.e. scheduled payments of principal and interest are guaranteed (in return for a fee) by a very creditworthy monoline insurer. As a result of the guarantee (or credit wrap ) the bonds are themselves rated AAA/Aaa, thus reducing the cost of borrowing; or Unwrapped i.e. there is no guarantor and the bonds rating is based on the project itself. The bond pricing will, in turn, be driven by the project s rating, Public i.e. the bonds are listed on an exchange and (usually) widely distributed; or 12

13 Private i.e. the bonds are distributed by way of a private placement. This will involve an offer to a very limited number of (occasionally sole) investors and may be unlisted. A private placement will usually require less disclosure than a public offering and is akin to a bank club deal. 2.3 HOW IS A BOND PRICED? All non-government bonds (corporate or project-related) are priced to offer investors a higher return than an investment in a comparable government obligation i.e. the Reference Gilt. The level of this additional return will be influenced by a number of inter-related factors, including, in the case of PFI bonds: maturity; interest rate basis; underlying project strengths/monoline guarantee 6 ; size of issue; competing supply of bonds from other issuers; and general market conditions The bond coupon is the aggregate of the yield on the Reference Gilt and the risk margin (or spread) appropriate for the project in light of prevailing market conditions. 2.4 HOW IS A BOND RATED? Almost all public bond issues are rated by one or more rating agencies 7. This rating provides investors with an indication of the underlying credit quality of a transaction and the borrower s ability to meet its debt service obligations. The use of external credit ratings provides transparency. When combined with the relative standardisation of bond terms and conditions it assists in the tradeability of bonds without reference to the original documentation. Bonds rated in the range of AAA/Aaa to BBB-/Baa3 are investment grade. Bonds rated in the BB or lower category are non-investment grade or high yield. (At the non- 6 7 A large element of the initial pricing and subsequent trading level of a bond is determined by its credit rating, assigned by one or more rating agencies (see Section 2.4 (How is a bond rated) below). See Section 2.5 (Private Placements) below for a discussion of how private placements are rated. 13

14 investment grade level the cost of raising debt is significantly increased and such issues tend to be short to medium term.) The underlying credit strength of PFI projects is usually in the range of BBB- /Baa3 to BBB+/Baa1. Consequently, it has been a feature of most PFI bonds to date that they have been wrapped by a monoline insurer (which then allows the bonds to benefit from a AAA/Aaa rating), thereby providing a financial guarantee to the bondholders and offering a more affordable financing solution to the Contractor. However, it is a requirement of the monoline insurers that the bonds they wrap are at least BBB (this is known as the shadow rating which may not always be disclosed to investors) The rating process can be accommodated within a 4 to 6 week period. If properly handled, it should not add to the timetable to financial close. Assisted by the issuer s financial adviser, the monoline and the lead manager, the issuer will typically make an initial presentation to the agencies. This will be followed up by provision of the suite of project documentation for review by the rating analysts. Such documentation should be in relatively final form in the sense that most risk issues must have been addressed in order to minimise the time taken. This avoids the need for the analysts to review multiple drafts if this occurs it can add to the timetable The issuer will maintain a dialogue with the relevant analysts within the rating agencies, answering any questions which may arise (with input from financial, technical or legal advisers as appropriate). While the rating will not be formally assigned until the date the bonds are issued, informal confirmation that the bonds will achieve an investment grade rating (and the rating level) will be required by the monoline (for its underwriting committee) and by the lead manager prior to the marketing of the bonds. Such informal confirmation is usually only conditional upon the agencies receipt of legal opinions. 2.5 Private Placements The term private placement is applied to any bond issue which is relatively restricted in size and where distribution is very narrow (maybe two to three investors). A pure private placement is like a club deal with one or two investors, is unlisted, is not guaranteed/wrapped and may be unrated externally. Since private placements are usually unlisted, the information provided to investors does not have to comply with the relevant listing authority s disclosure rules for the listing particulars. The investor is responsible for forming his own view as to the merits of the investment However the term private placement may also be used to refer to any issue where distribution is narrow and the bonds in question may in fact be listed and/or rated and/or monoline guaranteed. In such a case the documentation may 14

15 be identical, or very similar, to a public bond offering or it may more closely resemble loan documentation The role of the lead manager in a private placement can also vary. In a true bilateral arrangement, the issuer will negotiate directly with the investor(s) without any involvement of a lead manager. In such circumstances the investor(s) would typically structure the transaction and receive an upfront fee payable on close which compensates for the time/resources devoted to the negotiation process. However in some private placements a lead manager may be involved to actually carry out the structuring of the deal with the investor brought in only at a very late stage. In such circumstances the upfront fee (or the bulk of it) would be paid to the lead manager. Alternatively the lead manager and the investor(s) may agree to share the structuring/negotiation process Institutions purchasing bonds on a private placement basis may adopt one of three approaches to the pricing: Provide the issuer with pricing based upon a LIBOR-plus return so that the ultimate pricing will be influenced by movements in swap rates (as occurs in a swapped bank deal). Provide the issuer with pricing based on a fixed rate for a limited period, where the investor absorbs for this time period any underlying market movements (in either the Gilt yield or the appropriate credit spread). Pricing is indicated but left open until the transaction is ready to proceed to close and is determined in the light of market conditions at the time. Whatever the details of the structure of the private placement, because the issue size will tend to be small, and the distribution of the bonds narrow there may be some small pricing premium compared to a larger public offering A refinement of the private placement product has recently developed in the PFI sector. A small number of institutional investors now offer bespoke products designed to compete with alternative sources of finance. It is important in assessing the competing sources of finance that the Authority informs itself of the characteristics of the funding on offer and its deliverability. The Authority s financial adviser will then be able to evaluate the financing support associated with the bid The choice of funding source will to some extent be driven by the size of the issue. Should the sum to be raised exceed 75 million, and the bond market is chosen over the bank route, the issue will almost certainly be public. Private placements are possible between 50 and 75 million, as are public issues. At below 50 million a bond transaction will almost certainly be structured as a private placement. 15

16 2.6 Public bond issues There is a general misconception within the PFI market that public bond issues are incredibly complex and time consuming. That said, in order to successfully launch a public bond into the capital markets, several protocols (in terms of procedure) and rules (generally the requirements of the UK Listing Authority 8 ) need to be followed. Consequently, if each party s expectations are to be managed as best as possible, it will be necessary for each party to have an appreciation and understanding of how the timetable for the launch of the bond fits together and what will be required of each of the parties involved in order for that timetable to be met. Whilst it is important to ensure that the Authority s financial adviser has an understanding of the bond market, the lead manager of the bond issue should (quite reasonably) be responsible for de-mystifying the process for the better understanding of both the Contactor and the Authority The lead manager (also known as bookrunner or underwriter) will be responsible for the overall co-ordination and management of the bond issue (including the listing of the bonds with the UK Listing Authority 9 and their admittance to the Official List of the Stock Exchange) and the related timetable 10. As part of its role the lead manager will prepare and negotiate the bond issue documentation and in particular, the Offering Circular 11 for the bonds. Once the documentation approaches finalisation, the lead manager will co-ordinate the marketing roadshow to be given to prospective bondholders and, most importantly, set a realistic price at which he thinks the bond will sell. The signing of the subscription (or underwriting) agreement follows roadshow, pricing and launch. Upon signature of the subscription agreement, the lead manager is contractually obliged to subscribe for the bonds at the issue price, should investors fail to do so Many of the above will require a qualitative judgement to be made by the lead manager who will wish to be allowed to exercise professional judgement on the handling of a number of inter-related tasks. Since there will be a significant interplay between the commercial negotiations for the project, the pricing of the bond, the appetite of investors and the roadshow and launch timetable, the lead manager will need to be closely aware of the state of the project as a whole, even in wrapped transactions where the monoline insurer is the principal risk-taker. An Authority should seek independent professional advice when considering such matters The rules governing the listing of a bond on the London Stock Exchange are set out in the Purple Book. All PFI bonds to date have been listed in London, rather than the alternative, Luxembourg. A typical timetable for the public launch of a bond is set out at the end of this Section. See Section 2.7 (The Offering Circular) below. 16

17 2.7 The Offering Circular The Offering Circular is the primary selling document for a public bond issue. It sets out the information upon which investors will base their decision whether or not to subscribe for the bond. The contents of the document must meet the requirements of the Listing Authority s Listing Particulars and, more generally, set out any information that the issuer of the bonds believes is material to any potential bondholders decision to invest 12. The Offering Circular also sets out the bond terms and conditions The Offering Circular is the issuer s document and it must take prime responsibility for the information disclosed in it (other than those sections provided entirely by third parties e.g. information provided by the monoline insurer or by the lead manager). Nevertheless, it is the job of the lead manager to satisfy itself that the proper due diligence has been carried out and that the Offering Circular fairly describes the project and the risks associated with it, so as to allow investors to make an informed investment decision. While it is the document by which the bonds are sold, it is a factual document which focuses more on risk disclosure than selling highlights Meeting listing particular requirements will involve the lead manager (who usually acts as listing agent) and its legal advisers in a series of communications with the Listing Authority in order to reach agreement as to the disclosure appropriate to the type of issue. The Listing Authority will treat each new issue as just that, subjecting the draft Offering Circular to scrutiny even if a monoline has wrapped a comparable offering in the previous month. Obtaining sign-off involves a number of readers at the Listing Authority and may involve several drafts of the Offering Circular being submitted before agreement is reached. Accordingly, the first draft of the Offering Circular should be as complete as possible before the Listing process is commenced. 2.8 Listing Requirements The contents of the Offering Circular will be heavily influenced by the requirements of the relevant Listing Authority. It is entirely appropriate for the Offering Circular to be reviewed by the Authority and its lawyers, but comments ought to be minimal as the document is designed to allow issuer and lead manager to discharge their legal obligation in relation to appropriate disclosure and due diligence respectively. 12 This general requirement is set down in the Companies Act

18 2.8.2 Listing rules generally require significant contractual documents to be put on display for a period of 14 days from the date of the Offering Circular. This is usually done by making a complete set of documentation 13 available for any actual or potential investor or member of the public to read at specified offices (photocopying or removal of documents is not permitted) Where concerns of a national security nature are raised by the listing requirements, this issue should be brought to the attention of the Listing Authority early in the process so that the appropriate derogation can be requested. However, Authorities should note that derogations are only granted in very compelling circumstances. 2.9 Pre-marketing and pricing The lead manager will usually sound out its investor base some time before a new issue launch and there will usually be a roadshow which will involve formal presentations and a series of individual meetings ( one on ones ), normally in London, Edinburgh and Glasgow. The size and length of the roadshow will depend upon the size of the bond issue. The aim of this marketing exercise is to bring to investors attention the prospective bond launch and to highlight the salient features. The formal investment decision by the investor, however, must be made on the contents of the Offering Circular At the roadshow, in advance of it or shortly after, the lead manager will distribute a Preliminary Offering Circular, also known as the Red Herring or Red to prospective investors. This document should be essentially complete but for the exact issue size, pricing, repayment schedule and other information derived from the final run of the financial model on the day of bond launch The bond issue will be priced at a margin over the Reference Gilt. The applicable margin will be finalised as a result of the investor feedback derived from the roadshow although the lead manager should provide to both the issuer and the Authority a realistic estimate of the margin before and during the roadshow. This should be a fairly reliable guide to the ultimate pricing, but there may be slippage where the issue size is very large or the market is unreceptive or volatile. The lead manager should seek to contain pricing at its tightest, consistent with deriving sufficient demand from the market for the bonds in question. Management of the book, i.e. the demand from individual investors at a given margin over Gilt, is the responsibility of the syndicate desk of the lead 13 This would typically include the Financial Model. If the Authority does not wish the model or any other sensitive documentation (e.g. due to security issues) to go on display, then this should be raised at the earliest point so as to give the lead manager and the issuer sufficient time to discuss the issue with the relevant Listing Authority. In circumstances where the Listing Authority regards such documents as material and therefore requires them to go on public display, the Authority may request that the bond be listed on another (more amenable) stock exchange. 18

19 manager. The aim of the syndicate desk ought to be to generate more demand than is on offer to the market so as to sharpen pricing. This will particularly be the case for larger deals Once pricing is agreed between the lead manager, the issuer and the Authority, it is desirable to move as quickly as possible to launch. If there is a long gap between roadshow and launch, investor interest may dissipate (e.g. because of competing supply from other bonds, the securitisation market or the corporate sector), leading to a higher margin on launch than was apparently obtainable at the end of the roadshow. An Authority should seek suitable independent financial advice when considering such matters Bond launch Bond launch should be a fairly mechanistic process, which nevertheless needs to be managed professionally. Launch will usually take place on a date and at a time which has been advised to or pre-agreed with investors and the Authority. Except where the market is volatile, or there has been a delay in launch, the lead manager should be confident of pricing/demand from the investor base. The Financial Model must be run so as to factor in the bond pricing (a function of issue price, Reference Gilt yield and spread over Gilt) and to factor in the fixed deposit rate obtainable on the declining balance of bond proceeds during the construction period 14. Once the lead manager has confirmed issue size, repayment profile, issue price and coupon, the details are publicised via Reuters and Bloomberg, and the bond is launched Fixed Deposit/Guaranteed Investment Contracts The bond proceeds are received in a lump sum by the Contractor at financial close, and must be deposited with a bank, or banks, until required. The rate of interest earned on these deposits will, almost certainly, be different to the interest rate on the bond, and this potential mismatch is usually hedged. (Please note, however, that these arrangements should be tailored to the project in question. The outcome will to some extent be influenced by the degree of flexibility required by the issuer/construction sub-contractor over the bond proceeds expenditure profile.) Set out below is a two-stage approach to the hedge First, an agreement may be reached with a bank (or banks) to deposit the money in accordance with a predetermined schedule of repayments to broadly match the contractor s payment obligations under its construction contract for the construction of the relevant asset. This deposit arrangement will be referenced 14 See Section 2.11 (Fixed Deposit/Guaranteed Investment Contracts) below. 19

20 to a floating rate of interest, reset periodically by reference to LIBOR. The bank(s) will undertake to pay a specified margin below LIBOR for the duration of the deposit arrangement and may also consent to a degree of flexibility in the timing and the amounts of the individual deposit repayments. This undertaking to commit to a specified margin relative to LIBOR over a number of years is sometimes known as a Guaranteed Investment Contract or GIC Although the GIC may in fact be left as floating rate, where the project is to be funded by way of a fixed rate bond the issuer will typically address the mismatch between the floating rate of interest on the deposit and the fixed cost of the bonds. This is normally corrected by procuring an interest rate swap to match the deposit profile, in order to convert the floating deposit rate into a fixed rate If the bond issue is index-linked, there is a further risk that the coupon cost on the bonds during the construction period will be higher than anticipated should inflation be higher than base case during this period. This risk can be hedged by identifying that portion of the bond proceeds which will be used to pay the coupon during construction, and linking the return on that element of the deposit to RPI, with the balance of the bond proceeds being fixed Any such swap may be obtained by a competitive tender amongst the banks that take the deposits. The cash deposit can provide collateral against the potential credit exposure under the swap. Such contractual rights of set-off may not work perfectly in the case of insolvency of the issuer and the swap counterparty may also wish to be secured to a limited extent by way of fixed charge. The actual security arrangements for the swap will vary from project to project Locking-in the rate of interest on the bond proceeds in this way is intended to shield the project company from fluctuations in LIBOR rates which, in respect of the substantial sums concerned, could be significant over a 3 or 5 year construction period. Arguably without such a hedge, cover ratios would have to be higher to mitigate this risk The Authority should note the following: The two stage arrangements described above provide transparency. The separation of deposit and swap allows for competitive rates to be procured. The swap will be documented by way of a modified ISDA Master Agreement so that the terms will be based on a standard form document. By its nature, the hedging of the bond proceeds will take place at a late stage in the project timetable. The swap counterparty will require credit approval for its exposure under the swap; and any issues surrounding set off/security will also have to be resolved. While it is in the Authority s interest to ensure that competitive rates are achieved, this will have to be 20

21 2.12 Spens weighed against the additional complications and adverse impact on timetable which could arise if the swap competition is very wide. It is possible to combine both stages in one document the GIC. If this is the case the Authority may wish to ensure that the relevant documentation is as clear and unambiguous as possible. Where the issuer has entered into a swap in respect of the bond proceeds (or has effectively achieved the same thing through the GIC), the documentation should provide clearly for the outcome should the swap be broken (for example if the project were to terminate for any reason during the construction phase). Any breakage costs incurred as a result of breaking the deposit arrangement will typically be included in the definition of Senior Debt for the purposes of compensation on termination. These arrangements will be entered into at the same time or shortly after bond launch and should then become part of the base case financial model for the purposes of setting the Unitary Charge The bond markets function on a high degree of standardisation in terms and conditions, and transparency in the credit rating of the bond 15. Terms and conditions in the long-term sterling market for all borrowers (corporate as well as project-related) typically contain make-whole provisions in the event of early repayment or acceleration of the bonds (the Spens formula). In the UK longterm sterling market, the Spens formula has historically operated so as to ensure that on an early redemption of the bonds, the bondholders are broadly paid an amount equal to the higher of the outstanding principal on the bond and the foregone coupon on the bonds, discounted at a rate equal to the coupon on a Treasury Gilt of comparable maturity to the bond. This level of compensation is set to allow the bondholder to attain the same cashflows by reinvesting in risk free gilts The operation of the Spens formula is not mutual in the way that swap breakage costs can be seen as mutual because the markets are different. Although the swap breakage is agreed to be included in the definition of Senior Debt for the purposes of compensation on termination for all heads of termination (except termination for Contractor Default which pays no regard to 15 If flexibility is an important criteria for the Authority, the contingent liabilities inherent in the Spens clause should be taken into account in the Authority s overall assessment of value for money. Although a bond solution may be the most affordable for the Authority it is also very likely to be less flexible in terms of ability to vary, refinance or combine it with financings on other projects, and the Authority should consider the extent to which retention of such flexibility generally offers better value for money. 21

22 the Senior Debt amount), the swap loss will be paid by the Authority whereas any swap profit will be paid back by the swap counterparty to the project company (thus reducing the amount of compensation payable by the Authority to the Contractor). In the case of the Spens formula there is no such concept of breakage profit or loss. Instead, if interest rates have risen since the bonds were launched, the Spens formula effectively gives the bondholder a windfall (as the bondholder can reinvest at the higher interest rate). If interest rates have fallen, the formula will protect the investors yield over Gilt for the remaining life of the bond issue The Spens feature of long-dated sterling bonds may therefore be seen to be a cost to the Authority; however it is now market practice for the Spens element to only be paid by the Authority as part of the definition of Senior Debt for the purposes of paying compensation in respect of termination for Authority Default and Voluntary Termination by the Authority. In the case of termination for Force Majeure or Corrupt Gifts, the Authority should only pay the par value of the bonds outstanding (plus any accrued and unpaid interest) Although Spens is only payable by the Authority to the Contractor in limited circumstances (i.e. Authority Default and Authority Voluntary Termination), the Authority should recognise the significance of this contingent liability when assessing bidders funding solutions, especially if the prospect of the Authority exercising its right to voluntarily terminate the Project is reasonably foreseeable 17. To maximise flexibility to the Authority, bidders proposing a bond finance solution should be asked to obtain indicative pricing from their financial advisers for placing bonds which pay the typical Spens amount on early redemption for Authority Default and Voluntary Termination, and a placement which pays Spens at a level more akin to that paid on long-term bonds in continental Europe and the United States (which is broadly the foregone coupon on the bonds discounted at a rate equal to the coupon on a Gilt of comparable maturity plus a spread). To the extent that indicative pricing is different for each solution, the Authority should consider the Value for Money to it of paying the higher coupon for the reduced contingent liability. It is by no means certain that an Authority will have to pay a higher coupon on the bonds in order to have a lower contingent liability on termination, as pricing of bonds is due as much to marketing, competition and prevailing market conditions as it is financial theory This applies for both public and private bond issues. In some projects (e.g. light rail schemes) the prospect of voluntary termination may be reasonably foreseeable, especially if the Authority s medium to long term strategy will require an extension of the system or service that is so substantial that the Authority will be prevented by the procurement rules from relying on the change mechanism (see Section 12.3 (Authority Changes) of the OGC Guidance on Standardisation of PFI Contracts). Accordingly, an Authority may have no option but to terminate the Contract. 22