Refinancing PFI Project Vehicles 2

United Kingdom

Nancy Eller discusses some of the issues that may arise when refinancing a PFI project after completion of the construction phase

As the Government's Private Finance Initiative has been operating for the last seven years or so, a large number of PFI projects have now reached the stage where the project debt is or shortly will be, in a position to be refinanced. The risk base of a project changes when the construction phase has been successfully completed and the project company has been providing the services under the project agreement without difficulty for a year or so, thereby evidencing a proven track record and steady income stream. The reduced risk post-completion can amongst other things be translated into lower financing costs for the project company, which can increase returns to the project company's shareholders.

Benefits of refinancing

Although there are many reasons to refinance, the typical benefits sought are:

  • to increase on-going shareholder returns, in other words, the project's internal rate of return (IRR), and as part of this, provide payment of an immediate cash shareholder premium; and
  • to remove or relax restrictions imposed on the project company or the project sponsors by commercial banks in their facility documentation.

Many of the restrictions are sought to be removed or relaxed primarily with the first objective in mind. For example, decreasing the required debt service reserve from six months to three months frees-up cash in the project and reducing the distribution lock-up criteria facilitates its distribution out of the project. Other restrictions sought to be relaxed, such as information and reporting requirements or limits on the project company's ability to make decisions without the banks' prior consent, are designed to simplify the day-to-day operations of the project company.

Types of refinancings

Refinancing in its broadest sense is any change in the level of principal or interest payments or the repayment profile. The choice for most project companies looking to refinance is whether the project company will:

  • remain with its existing bank group, but merely change the interest rate margin, amortisation profile and other relevant terms of its existing documents;
  • enter into new facilities to repay the existing facilities, with a new set of banks on new terms (either with new commercial banks or institutions, such as the European Investment Bank, which can offer long term fixed rate funding); or
  • issue a bond, either "wrapped" (that is, supported by financial guarantee insurance issued by a monoline insurer) or "unwrapped".

Achieving the benefits of a refinancing

Regardless of which method of refinancing the project company chooses, the key benefits are likely to be achieved by some or all of the following:

  • Decreasing the interest rate: cheaper funding has an obvious impact on reducing project costs and so increasing shareholder returns
  • Extending maturity/term of facilities: as debt is repaid more slowly, more cashflow can be directed to pay shareholders' returns earlier than anticipated, which directly impacts their IRR
  • Increasing the size of facilities: increasing the size of the facilities will enable the project company to pay the shareholders an up-front dividend and/or repay shareholder sub-ordinated debt, assuming that the economics of the project support a more highly geared project
  • Releasing monies held in contingency reserve accounts: such as the Debt Service Reserve Account: as less surplus cash needs to be locked-up in the project, the additional cash can be released to the shareholders (or released earlier than expected in the base case)
  • Lowering distribution lock-up financial cover ratios: this facilitates the payment of distributions to shareholders
  • Removing or relaxing other restrictive covenants: (as mentioned above).

Main issues that arise when refinancing

Public sector involvement
One of the issues to address early in the process is whether the refinancing can be implemented without the need to first obtain public sector consent.

To put the issue in context, it is useful to summarise what the Treasury Taskforce Guidance on the Standardisation of PFI Contracts, published in July 1999, says about project companies looking to refinance in circumstances where the project is doing well (i.e., it is not a rescue situation). First, the Guidance recommends that the issue be addressed explicitly in the Invitation to Negotiate and the project documentation so that the public sector and the project company (and its shareholders) know, when they bid for and sign a concession, the parameters under which a refinancing can be done without the public sector's consent and how much, if any, of the "refinancing gain" must be shared with the public sector.

The Guidance suggests that there should be no public sector consent requirement to a project company refinancing unless doing so would materially and adversely affect the ability of the project company to perform its obligations under the project agreement. One scenario which the Guidance indicates could result in this is the project company incurring additional debt to an "overly aggressive level of gearing". It further suggests that, contrary to what is fast becoming market practice, requiring project companies to share the refinancing upside with the public sector is likely to be appropriate only in limited circumstances. In part this is because as the PFI market has become more competitive, bidders are increasingly building into their price the refinancing benefit and therefore the public sector may be seeking a double benefit and furthermore that the upside is the shareholders' reward for taking the risk of the downside, which is not similarly shared with the public sector. However, the Guidance neatly side-steps this position by stating nonetheless that the public sector may request a share of the upside if it believes that a refinancing would result in "significantly enhanced profits over and above the proper reward for good project performance".

Many projects closed prior to publication of the Treasury Taskforce Guidance do not explicitly address the project company's right to refinance and whether it has to first obtain public sector consent. However, the issue is usually addressed indirectly by restrictions on amending the financing documents. Because the public sector pays compensation to the project company in certain circumstances upon early termination of the project agreement by reference in part to the level of the project company's bank debt or lender liabilities, amendments to the terms of the financing agreements (including new terms as a result of a refinancing) might result in the amended or new financing ceasing to benefit from the termination compensation arrangements, unless approved by the public sector.

In such circumstances if the banks agree to amend the terms of their facilities with or provide new facilities to the project company without first obtaining public sector consent, the banks would be left in the uncertain position as to whether the level of termination compensation payable might be prejudiced. In this situation, the project company and its banks often decide that the most prudent way to proceed is to approach the public sector directly and if required share a percentage of the upside as the price for securing its consent and eliminating this uncertainty. The terms of any sharing of the upside would be negotiated on a deal by deal basis but it has ranged from about 10-50%.

Some issues arising from termination of the existing Financing Agreements
Commercial banks provide their facilities to the project company on a floating rate basis and then usually require the project company to enter into a long term swap to hedge interest rate exposure. Depending on interest rate movements, terminating this swap early can result in substantial breakage costs for the project company. However, it may be possible to keep an existing swap in place to hedge the new facilities notwithstanding a refinancing of the debt to which it originally related subject to appropriate intercreditor arrangements between the new financiers and the swap counterparty.

For the same reason, it would be unusual to refinance a bond or a long term fixed rate loan as the make whole price or prepayment penalties would absorb a significant proportion of the benefits of the refinancing.

The existing finance documents must also be reviewed to determine what requirements have to be satisfied in order to prepay the existing facilities, since the existing financing arrangements will have been negotiated on the basis that the debt will be outstanding for, typically, anywhere from 18-25 years. These might include paying the existing banks a prepayment premium.

Lack of Distributable Profits
If one of the goals of the refinancing is to realise an up-front shareholder premium, then the shareholders must address how this cash is paid from the project company or otherwise received by the shareholders. If the shareholder contribution to the project has been quasi-equity in the form of subordinated debt then this may be prepaid. However, if there is insufficient subordinated debt to support the envisaged payment, then the monies may need to be paid as a dividend or special distribution, or come from another source such as new investors willing to pay a premium to existing shareholders for a stake in the project.

Under the Companies Act 1985, a company can make distributions only to the extent that it has distributable reserves. Therefore, if the proposed refinancing is to occur shortly after completion of construction has occurred, as the project company will only have generated revenues since the commencement of services, it may not have sufficient profit or reserves to support the distribution that the shareholders are looking to receive. In this circumstance the shareholders may need to devise a corporate structure that will facilitate these payments.

Timing
One question that needs to be considered when deciding to refinance is whether doing so "now" is better than "later". A project is unlikely to be refinanced more than once (unless difficulties arise) and therefore, before investing the considerable amount of time, money and resources (unless there is merely a limited restructuring of the existing facilities) on a refinancing, a decision should be taken as to whether waiting until later in the operations phase has commensurate benefits. One consideration is if any shareholders are looking to exit the deal and whether this would allow a refinancing to be taken in tandem with a recapitalisation or other change to the corporate structure of the project. If the preferred route is a bond, market appetite for bonds (and whether they are wrapped or unwrapped) has to be gauged.

For further information please contact Nancy at [email protected] or on +44 20 7367 3412.