In an illiquid lending climate – particularly one where the biggest project lender, RBS, has been bought by the state and publicly announced, if not enacted, its exit from project finance lending – the UK transport project market has been surprisingly buoyant.

Fears at the beginning of 2009 that long-term headline grabbing deals like the M25 would have trouble getting banked proved unfounded. As did RBS' exit from project lending – the bank has since started a new UK PFI lending unit with the blessing of the UK government.

Furthermore, the UK government's new UK PFI debt, the Treasury Infrastructure Finance Unit (TIFU), which is designed to bolster deals with debt at commercial bank rates should liquidity for key deals not be found in the commercial banking sector, has yet to be used for a transport project. Even the M25, with its £956 million ($1.57 billion) debt volume and 27-year tenor (average tenor 22.5 years), banked without TIFU lending.

Although there have been few transport deals closed this year – Stepps-to-Haggs, the M25 and Carlisle Northern Development Route – the volume is symptomatic of a mature market where toll road concessions are almost non-existent, apart from Macquarie's M6, and the majority of airport, rail and tubeline assets have already been privately financed or privatized over the past 10 years.

Consequently, the market is looking better than expected at the start of 2009 when many of the UK banks were in meltdown, foreign project lenders, many of which were also financially sick, were pulling back from the market nursing very low margin PFI/PPP portfolios built during the liquidity boom, and long-term tenor debt had become project financing non grata.

Although a number of lenders have fled the UK, many are still comfortable with PPP deals where margins have risen again to an acceptable level after years of bank under-pricing to gain market share. For example the non-UK lead arrangers line-up on the M25 includes SMBC, WestLB, BBVA, Dexia, Societe Generale, Calyon, Natixis, BayernLB, Helaba, KfW, NAB and BTMU. And syndication of the debt, still underway, is expected to have significant uptake among second-tier European lenders.

M25 proves the doubters wrong

In effect the M25 proved that there was still a bank market for well-structured projects in the UK at a time when counterparty risk was a huge concern to all potential lenders – banks were concerned about the creditworthiness of other banks, hedging counterparties, insurers and bond providers. The documentation had to minimize these counterparty risks in addition to the normal project issues.

Most commercial banks initially took the view that the M25 would require 90-95% direct government backing as featured in the London Underground concessions – Metronet and Tubelines. However, the DfT was keen to avoid such a liability, particularly given the fallout from the Metronet default. The DfT staunchly argued for keeping a long-term deal and a 60% floor on termination liabilities. Both the tenor and non-SOCP4 termination conditions, under which in default the project is retendered, were sufficiently stringent to scare five banks away from the deal (although some withdrew due to internal capital constraints).

In return, and given the concerns over counterparty risk, banks demanded concessions over project risks. The initial package proposed a debt equity ratio of 92/8 with a loan life cover ratio of around 1.2x. The negotiations took the structure a long way from those beginnings: At close the project was levered 85/15 and with an ADSCR of 1.4x and a LLCR of 1.5x. The generous ratios helped the banks expedite their due diligence of the 30-year concession agreement and performance grid for the availability payments.

The conservative cover ratios were achieved by the increase in equity, but also by increasing the availability fees. The DfT and Highways Agency were keen to avoid paying more in availability payments while boosting the sponsors' rate of return, so the structuring featured a novel rebate mechanism whereby excess cash is diverted back to the procurer before being distributed to shareholders.

As well as improved ratios, banks also moved for cash sweeps to bring down the average tenor.
The sponsors – Skanska (40%), Balfour Beatty (40%), WS Atkins (10%), Egis Projects (10%) – are injecting £200 million of equity, which is a mixture of upfront equity plus pro rata letters of credit from corporate relationship banks. As late as January a £200 million equity bridge was to be bundled with the project financing, but was dropped due to concerns about its impact on the liquidity for the senior tranche.

Debt pricing

The final deal – which includes a £200 million EIB direct loan, a £215 million EIB guaranteed loan and a £710 million 27-year commercial tranche – priced at 250bp until year seven and then steps up to 300bp, and then 350bp at year 11. Two cash sweeps are included to reduce the average tenor to 22.5 years and make the deal more attractive to lenders. A 50% sweep will take place at year eight and a full sweep is scheduled at year 20.

Given the reluctance of banks to place long-dated swaps, the inflation and interest rate swap fees were relatively high at 45bp and 35bp respectively. The swaps were shared among 15 of the 16 commercial banks, after pre-hedging from Lloyds, HSBC and Barclays Capital.

Although the pricing increase on M25 appears aggressive at year 11, the reality is that UK PPP debt for lesser assets is already demanding 300bp. And the deal is removed from the trend in other European transport markets towards miniperms (now called maxiperms depending on tenor). The maxiperms appear to be long tenor but force refinancings around years 7-10 via aggressive cash sweeps and margin step-ups. Hence they leave sponsors with significant refinancing risk.

The other UK roads financed this year also feature long-term facilities. Although debt pricing (190-210bp) was agreed on the £360 million Stepps-to-Hagg M80 32.5 year concession in 2008, and is therefore not reflective of market rates and explains why it struggled to close, the project still featured a 32-year debt tenor.

The same is true of the £176 million Carlisle Northern development Route (CNDR), which financed with a 28 year tenor. Like the M80, Carlisle Northern – sponsored by Balfour Beatty – was a long time in the making.

Cumbria County Council shortlisted Connect CNDR, comprising Sir Robert McAlpine and Vinci Investments, for the scheme in 2004. But in 2005 it had to resubmit its plan to both the Department for Transport (DfT) and the Treasury after all three contenders came in with bids significantly higher than the council's first estimate of £77.8 million. The deal was further delayed when the credit crunch forced Dexia out of the financing and the sponsor had to find new bankers.

The final deal was backed by £158 million of PFI credits and debt financed by Barclays, SMBC and National Australia Bank. The £87 million 28-year debt comprises three tranches: a £74.3 million senior loan, a 32.2 million change in law facility and a £10.8 million equity bridge. Margin is 275bp over Libor rising in stages to 300bp over the life of the loan – pricing that puts the margin increases on the M25 into perspective.

Asset pricing and future deals

The biggest impact of the liquidity crunch on UK transport has been on asset pricing. For example, Macquarie Infrastructure Group (MIG) has seen the equity valuation of its M6 toll road cut by two-thirds since December – from £600 million to £206 million – and four-fifths since its £1 billion valuation over a year ago.

Macquarie Airports has also taken an asset price pinch on its Bristol Airport concession where the value of its stake has dropped to £149 million from £168 million six months ago. And Ferrovial's BAA is similarly struggling to raise anything other than a loss on the forced sale of its Gatwick airport concession.

Arguably the decline in asset pricing is not purely symptomatic of the lack of global liquidity. Prices had spiralled up in the race for assets and the ratings agencies were sending out warnings in 2007 that the market was overheating.

As the market has cooled, and both debt and asset pricing have got back to more realistic levels, lending and sponsor appetite are likely to be flexible but relatively conservative in the coming period.

Further headline grabbing projects are underway. The EIB has given the go-ahead for its biggest loan to date into UK transport – £1 billion for the £16 billion Crossrail project. PricewaterhouseCoopers and HSBC are financial advisors on rolling stock PPP deals for Thameslink and Agility Trains respectively.

And most recently, Birmingham City Council appointed Amey/PwC as preferred bidder for its £2.7 billion highways maintenance and management PFI contract. With an approved capital value of £588 million, the project will be the largest UK local government PFI to date outside London. The £350 million investment in the initial five-year stage of the project will be debt-financed and construction is due to begin by April 2010.