G LO B A L I N F R AST R U C T U R E

The use of mini-perms in UK PFI

Passing fad or here to stay?

A DV I S O RY

 The use of mini-perms in UK PFI

Introduction

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

The use of mini-perms in UK PFI 

Listening to the banks and reading the project finance 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 helpful to look at: The background to why mini-perms have emerged What is it that is forcing banks to push this particular debt product? The features of the mini-perm Is it hard, is it soft? What does that
actually mean?

How mini-perms are applied in UK PFI transactions What does it mean for authorities? Are they forced to accept the
greater risks? How does it affect
VFM and affordability? What does it mean for sponsors, project risk and pricing of bids?

What alternatives exist? Is there a better solution for UK PFI?

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

 The use of mini-perms in UK PFI

Background

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

The use of mini-perms in UK PFI 

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 for banks is uncertainty over liquidity their ability to attract deposits and access the inter-bank market at rates that match their lending commitments. Typically, banks lend to projects on the basis of a floating interest rate (three-month or six-month LIBOR) plus a margin. The LIBOR rate is re set (every three months or six months) by reference to a screen rate, which is supposed to reflect the market cost at which banks have been able to fund themselves or attract matching (three month or six-month) deposits in the inter-bank market traditionally a very smooth, transparent and efficient marketplace. And the margin simply represents the banks profit. ProjectCo will usually swap its floating rate liability into a fixed 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 of a sudden in todays dysfunctional market, banks are finding that the LIBOR screen rate bears no resemblance to reality: either they cannot access the inter-bank market or are having to pay a massive
Inter-bank Market 6M LIBOR Bank 6M LIBOR + M 6M LIBOR Swap Bank Project Co Fixed Rate

premium (of 200-300bps over the screen rate) to do so. In this context, lending for periods of up to 30 years on a mismatched basis doesnt look very clever hence the move to shorter tenors. Not all banks are affected in the same way, of course and the liquidity constraints are less of an issue for banks with strong credit ratings or with access to a retail sterling deposit base such that they are less reliant on the inter-bank 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 of Ireland via the Post Office deposit base] willing to lend long term.

projects, is because of the demise of the syndication market which means all deals are being done on a club basis. With banks only prepared to lend and hold amounts of 30-50 million, it requires a number of banks to club together to fund most PFI projects. In this situation the lowest common denominator tends to prevail so if one or two banks in a group of eight require a mini-perm, all the banks get it.

Opportunistic behaviour
As many sponsors and advisers will have observed, there is a certain amount of opportunism in the banking community there is much less competition and, as a result, banks are demanding mini-perms because they can.

The lowest common denominator of a club

Another reason mini-perms have become prevalent, particularly in larger

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

 The use of mini-perms in UK PFI

What is a mini-perm?
In simple terms, mini-perms can be broken down into two products Hard and Soft.

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

The use of mini-perms in UK PFI 

Hard
In the hard mini-perm, the bank loan has a short legal maturity (five or seven years) at which point: The bulk of the loan is still outstanding The sponsors face an event of default if it is not refinanced This could lead to a termination of the concession or PFI contract It is an Armageddon situation and arguably more suited to an infrastructure 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 of default rather than try to guess what the market interest margin might be seven years after financial close, hard mini-perms 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 forced refinancing raises

a couple of major issues: i) hedging: do you put a short-term swap in place and take the risk on interest rates at the time of the forced refinancing, or do you put a long-term swap in place and make an assumption about the profile of the debt that you hope to be able to put in place at the time of the forced refinancing?; ii) affordability: what assumption does the authority make about margins, underlying interest rates, tenor and amortisation profile (assuming it takes the risk on all these) that will apply to the debt at the time of the forced refinancing and, therefore, what budget approval does it require?

First, a margin ratchet: incremental step-ups of 25-50bps at certain dates, which make the cost of borrowing more expensive in the event the loan isnt refinanced. Second, a cash sweep: this triggers at a certain date, after which some or all free cash flow 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 of free cash flow is swept for prepayment in year 5 and increases to 100 percent in years 8 or 10. But the effect is the same the loan is fully repaid several years short of its legal maturity and the shareholders suffer a long period of zero distributions. A good incentive to refinance if ever there was one!

Soft
The soft mini-perm has been used in UK PFI and continues to be promoted by banks on a number of projects travelling through procurement. Importantly, in this case the legal maturity of the bank loan remains long term (say, 26 years for a 28-year concession) but two features of the soft mini-perm encourage or incentivise the sponsors to refinance the loan by an earlier date.

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

 The use of mini-perms in UK PFI

Senior Debt Closing Balance and Capital Repayments 300,000 250,000 200,000 150,000 (8,000) 100,000 50,000 0 Year -1 0 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 (4,000) (20,000)

(18,000) (12,000)

Senior Debt Closing Balance and Capital Repayments 300,000 250,000 200,000 150,000 (8,000) 100,000 50,000 0 Year -1 0 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 (4,000) (20,000)

(18,000) (12,000)

For illustrative purposes only

The graph above represents the senior debt profile for 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 profile with a 26 year tenor for a 28-year (3 + 25) concession. The impact of the mini-perm cash sweep can be seen in the graph above where the effect of

mandatory prepayments shortens the base case debt tenor to 17 years. In fact, the requirement of the banks on this project was that the cash-swept debt maturity must always be under 20 years even in the severe downside scenarios that were tested as part of the banks sensitivity analysis. A point to note here is that the effect of a mini-perm will depend on the type of project. The example used here was a waste project with a fair

degree of merchant exposure and, therefore, 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 free cash in the base case and, therefore, the effect of the mini-perm cash sweep would be less pronounced in terms of shortening the debt maturity.

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

The use of mini-perms in UK PFI 

How are mini-perms being applied in UK PFI?

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

 The use of mini-perms in UK PFI

Well, first, only three PFI deals have closed using a soft mini-perm structure. So it is early days in the mini-perm era. But one of the key issues which is of interest to public sector authorities and sponsors alike is: who takes the ratchet and refinancing risk?

It will take a while before Treasury guidance appears on this subject but emerging practice is that, in the event a refinancing does not occur, the public sector pays for the margin ratchets (which are priced into the base case model) and the sponsors take the impact of deferred distributions and lower IRRs resulting from the cash sweep. Because the ratchets are priced in the base case, miniperms will certainly test authorities affordability constraints and could force the de-scoping of projects or the use of authority capital contributions to mitigate affordability issues. It seems that the public sector is demanding a greater share of any future refinancing gain (up to 90 percent) as a quid pro quo for the affordability impact, but it is unclear whether bidders will be pricing in the additional risk to them.

One thing is clear financial investors will be less willing to accept the prospect of reduced equity returns in the SPV than, perhaps, corporate sponsors who are able to take a more holistic view of returns within a project. This is illustrated in the series of graphs overleaf, which show the traditional profile of senior debt, equity and subordinated debt returns on the left-hand side and the mini-perm, cash swept profiles on the right-hand side. The graphs on the right-hand side show how the senior debt repayment is accelerated and the subordinated debt service and dividends are put on ice as free cash flow is directed towards senior debt prepayment until the senior debt is fully repaid when all cash flow is redirected to shareholders in the latter years. For financial investors such as the infrastructure funds banking on a steady yield, the barren years during the cash sweep period will be hard to stomach.

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

The use of mini-perms in UK PFI 0

Senior Debt Closing Balance and Capital Repayments

300,000 250,000 200,000 (12,000) 150,000 100,000 50,000 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 (8,000) 100,000 (4,000) 50,000
0

Senior Debt Closing Balance and Capital Repayments

(20,000) 300,000 250,000 200,000 (12,000) 150,000 (8,000) (20,000)

(16,000)

(16,000)

(4,000)

0 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 (3,000) 40,000 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

(7,000) (6,000) (5,000) 80,000 (4,000) 60,000 40,000 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

120,000 100,000

(7,000) (6,000) (5,000) (4,000) (3,000) (2,000) (1,000)

0

(2,000) (1,000)
0

Dividends Profile
(16,000) (14,000) (12,000) (10,000) (8,000) (6,000) (4,000) (2,000) (16,000) (14,000) (12,000) (10,000) (8,000) (6,000) (4,000) (2,000)
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 Year -1 0 1 2 3 4 5 6 7

Dividends Profile

Year -1

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

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

 The use of mini-perms in UK PFI

Another point of interest is how to hedge interest rate risk when you do not know what your loan amortisation is going to look like and you risk ending up over-hedged if and when the cash sweep applies. Prudence would suggest that it is best to swap the original profile at financial close so as to lock in the long-term interest rate and provide the authority with certainty, retain the benefit of the underlying swap within any subsequent refinancing (subject to an amount of re-profiling at the time) and unwind any over-hedged position if refinancing is not achieved and the cash sweep kicks in. This flexibility would need to be addressed upfront and accommodated within the financing documentation. It may well emerge that bidders play a tactical game in relation to the risks associated with mini-perm structures in order to give themselves a bidding advantage. For example, a bidder who is prepared to absorb the risk of the margin ratchet as well as the cash sweep might present a more compelling and affordable offer to the authority compared to the bidder who wants to share the risk even though equity returns would be further diluted in the event that the sponsors cannot refinance at or below the pre-ratchet margin level. It is not such a radical suggestion, as the IRR impact is not perhaps as significant as you might think. The graphical analysis shown top right was conducted on a live project, showing that the cash sweep impact is a 0.9 percent reduction in post-SPV, post-shareholder blended IRR but absorbing the margin ratchet impact only reduces it by a further 0.2 percent. If you are able to view your project returns on a holistic basis, including profits on sub-contracts, this might be a commercial position you are comfortable in offering the authority if you think the presentational impact exceeds the physical risk.

Before scaring too many sponsors into believing that the market will absorb these risks, it is worth returning to the question of whether Manchester Waste and the M25 have changed the marketplace or whether, in fact, they prove the exception to the rule. The lower graph below is an approximate illustration of the upcoming pipeline of UK PFI deals by size. For example, if you look at the 100+ PFI deals currently in procurement (many of which are stalled at preferred bidder stage), there are very few indeed in the >250 million category. The vast majority of preferred

bidder and pipeline deals falls into the smaller-size categories where there is still sufficient long-term funding available from the non-mini-perm banks: most BSF Streetlighting, Social , Housing, Blue Light and Prison deals fall into this category and these are the sectors where most of action is. It is only the odd defence deal (like SAR-H), road maintenance (like Sheffield and Birmingham) and waste deal that will exceed 250 million in size. And even then, the case for using mini-perm debt is uncertain when you consider the alternatives available.

Equity Return (%)

12.2% 11.3% pa 11.1% pa

Base Case No. of Projects

Cash Sweep

Cash Sweep & Margin

50-100
For illustrative purposes only

100-150

150-200

200-250

> 250

Deal Size (M)

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

The use of mini-perms in UK PFI 

Mini-perm alternatives

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

 The use of mini-perms in UK PFI

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

EIB
There is an obvious role for the EIB in filling the long-term funding gap and thereby mitigating the move to miniperms. It is pleasing, therefore, to see the EIB begin to step up to the plate with large chunks of long-term cash. The M80 DBFO road project in Scotland is a good example, where the EIB lent more than 50 percent of the debt, in the process allowing the project to close with 290 million of traditional longterm debt (and at competitive pricing). Even more recently, the involvement of EIB funding helped the Enniskillen Hospital project close with 270 million of long-term project debt. The EIB will not be able to help out all projects, not least because of its own resource and policy constraints, and its involvement in Manchester Waste and M25 did not avoid the need for a mini-perm so further alternatives will be required to eradicate the mini-perm beast for ever.

clubs so as to keep the overall funding terms more competitive without having to indulge the lowest common denominator every time. Assuming this new approach does not fall foul of state aid issues, it will certainly help to get deals done more quickly, more affordably and without resorting to miniperm structures. It only requires the TIFU to flex its muscles in this manner once or twice for the market to sit up, take notice and maybe change its ways.

of authorities, sponsors, banks and tax payers alike. These adjustments might include:

Competitive dialogue and preferred bidder debt funding competitions

At present, a number of authorities running procurement exercises under competitive dialogue ask each bidder at ISDS to submit bids which are fully funded, i.e. have the support of sufficient banks to secure the whole debt funding requirement. In the current market, many bidders play safe by signing up more than the required number of banks in order to provide a level of redundancy in the event that one of its banks has a change of heart during the process. For a 200 million project with four bidders submitting ISDS bids, this is quite a challenge for the market to deliver unless sponsors are content for their bank group to support more than one bidder which in itself tends to undermine the value of the support because sponsors are reluctant to share the full details of their bid with banks that are talking to their competitors. Equally, it is more likely to force sponsors to accept mini-perm structures while there are sufficient banks in the market to lend 200 million on a traditional long-term basis, there are not sufficient banks to do it four

Authority capital contributions

While authority co-lending is frowned on by HMT, authorities can still play a positive role in terms of reducing a projects funding requirement by introducing capital contributions to the construction costs of a project. The mechanism is reasonably tried and tested, does not require the authority to take on excessive construction risk and is one of the most effective ways of solving affordability constraints. All the above mini-perm 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 free up resources within existing long-term lenders and, moreover, welcome additional long-term lenders back into the market thereby improving the life

TIFU
The Treasury Infrastructure Funding Unit is already showing an appetite to break away from its initial mandate (as lender of 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 of bank

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

The use of mini-perms in UK PFI 

times over so some if not all bidders will need to satisfy the short-tenor members of their supporting bank group. It would benefit the market enormously if this constraint could be lifted, getting the best from the (whole) market via an open funding competition once the preferred bidder has been selected and freeing up banks to concentrate on getting preferred bidder deals closed rather than attending endless meetings so that bidders can satisfy procurement requirements. Provided each bidder has the structuring, due diligence support and commitment of at least one sensible long-term bank, the authority and its financial adviser should be able to get comfortable that the debt funding for the bid is deliverable in a preferred bidder funding competition. All it requires is guidance from HMT on the evaluation of bids in the current climate and, perhaps, a greater reliance on quality over price when certain authorities choose their financial advisers.

by the Belgian government to help close the Liefkenshoek Rail Tunnel project in November 2008. In order to overcome the inter-bank liquidity issue that banks are faced with (i.e., the risk that inter-bank funding costs in excess of the prevailing Euribor rate), the Belgian government intervened by capping the participating banks exposure to Euribor premia, thereby removing a key obstacle to long-term lending. As a result the project was financed in the bank market with 626 million of traditional long-term project finance debt.

Credit Guarantee Facility

Introduced in 2004 as a means of shaving a few basis points off the cost of funding for PFI projects at the peak of the market, the CGF involved HMT providing the funding for PFI projects guaranteed by commercial banks, the EIB or, in those days, the monoline insurers. A lot of effort 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 funded in this way appeared twice on the governments balance sheet.

If ever there was a time to re-introduce this product, the middle of a credit crisis when banks are happy with the credit quality of PFI projects but struggling to access the inter-bank market for funding and the government has greater concerns than the presentation of its accounts would seem like a good time. It would have quite an impact in terms of increasing the number of banks active in the long-term end of the project finance market. When swap credit margins have increased from a low of 5bps p.a. to a mouth-watering 45bps p.a. on some recent deals, the ability to tap fixed-rate funding without a swap would also provide an immediate saving to authorities and taxpayers alike.

Authority risk share

It is instructive to look outside the UK to see what other governments are doing to retain the benefit of long-term lending for their infrastructure projects. A good example is the approach taken

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

 The use of mini-perms in UK PFI

Summary

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

The use of mini-perms in UK PFI 

Two large (and one small) UK PFI projects have been financed using a mini-perm debt structure, but these projects cause affordability issues for the public sector and increased risk exposure for the private sector. There are still a number of banks prepared to lend long term. When combined with the alternative funding sources available, most PFI deals can still match their long-term assets with long-term funding. HMT has an opportunity to further improve the climate for traditional project finance and, thereby, to protect PFI from mini-perm mania.

2009 KPMG LLP a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member , firms affiliated with KPMG International, a Swiss cooperative. All rights reserved

kpmg.co.uk

For further information on the content of this paper or any other aspect of the project finance market, please contact: Mike Harlow Tel: +44 (0) 207 311 4227 Email: mike.harlow@kpmg.co.uk Jeremy Barker Tel: +44 (0) 207 311 8156 Email: jeremy.barker@kpmg.co.uk Nick Greenwood Tel: +44 (0) 207 694 3769 Email: nick.greenwood@kpmg.co.uk

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

2009 KPMG LLP a UK limited liability partnership, , is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Printed in the United Kingdom. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Designed and produced by KPMG LLP (UK)s Design Services Publication name: The use of mini-perms in UK PFI Publication number: RRD-145467 Publication date: June 2009