A long-running saga finally ended on 27 April when the UK's health flagship Barts & London Hospitals PFI reached financial close. After the difficult approval process, the financing demonstrated that large PFI banks are squeezing out more traditional investors from the RPI-linked market for such assets.

The Capital Hospitals PLC issue comprised £1.027 billion ($1.94 billion) of 40-year bonds, including £265 million of variation bonds, wrapped from an underlying BBB-/Baa3 (S&P/Moody's) to AAA by FSA and Ambac. The EIB is lending a further £250 million of senior debt in the form of a 35-year index-linked wrapped loan to the project, sponsored by a Skanska/Innisfree-led consortium. The deal also features £86 million of subordinated debt and £20 million of mezzanine.

Managers Deutsche and Morgan Stanley began the roadshow on 5 April and bookbuilding began after the Easter break. It started slowly, but a pick-up of interest towards the end squeezed out most of the pension funds and insurance companies, which ended up with as little as 10% to 20% of the paper.

Two healthcare deals from 2005 had already shown that traditional investors were being challenged by asset swappers – banks snapping up index-linked bonds and swapping them for Libor-plus assets. The £197.8 million Newcastle and £320 million Nottinghamshire wrapped hospital deals both saw single buyers take the whole issue.

Both these deals were much smaller than Barts. Nevertheless, there were banks that offered to snap up the entire Capital Hospitals issue: The concession awarder – the Barts and The London NHS Trust – decided that an open and transparent bookbuilding process would be the best way of ensuring that value for money is proved to the National Audit Office.

The increase in demand for long-dated inflation-linked assets from new market entrants was evidenced by the bonds pricing at 51.5bp over RPI gilts – exceeding the mid-50s expectations of Deutsche and Morgan Stanley.

The project entails modernising two of the UK's oldest hospitals – St Bartholemew's and the Royal London – under a 42-year DBFO concession. Skanska and Innisfree partnered up, as they have done on a number of important hospital PFI deals, and won the concession, first tendered in February 2002, in the autumn of 2003.

There followed a number of political challenges, including design issues that delayed the granting of planning permission. The final setback came in December last year when the Ministry of Health suspended the project pending a review, complaining of the project's escalating costs.

There was media speculation at the time that the government might drop the project, but given the effect on market confidence of canceling such a high-profile deal, that outcome was unlikely. Barts finally got a green light from the Treasury in March after it made some changes to lower the initial annual unitary payment from £114.2 million to £96.6 million.

The project, as initially conceived, involves the construction of two new buildings and the refurbishment of existing hospital buildings, which currently hold 990 beds. Under the revised plans, two floors of the new buildings won't be fitted and the old buildings won't be refurbished unless east London's population grows at the forecast rate. The variation bonds will be used to finance this work if it is required.

Barts has an unusually long construction period of 10 years, during which it is highly reliant on one build contractor, Skanska. This risk is mitigated by Swedish constructor's experience of doing UK hospital PFIs, and the S&P report also praises the project for being well costed with contingencies built in. Average and minimum annual DSCR is 1.21x.

The high liquidity of the market for RPI-linked PFI bonds is largely down to liquidity across the board in the banking sector and the confidence banks have in PFI assets. But it is also exacerbated by the lack of recent issues. In particular, delays to hospital projects such as Barts have caused a bottleneck to build up.

This is good news for upcoming issues like the £559 Birmingham scheme, featuring a wrap from FGIC, which will hit the market in June. With traditional investors largely missing out on the Capital Hospitals notes and looking to fill up their portfolios, bookrunners RBS and HSBC will be hoping to match Barts on pricing.

This situation is a reversal of usual conditions in a market where supply has traditionally exceeded demand. In September 2003, the same Skanska/Innisfree consortium had to close the £446.5 million South Derbyshire Acute Hospitals PFI in the fixed-rate bond market because, in a year of exceptional activity, they could not find enough takers for the index-linked bonds.

The Treasury is currently working on publishing guidance on the use of index-linked bonds in the PFI sector, with RBC advising them in the review. The concern is that though the initial coupon is lower than with fixed-rate bonds, index-linked bonds could prove too costly if inflation spirals in the future.

Some have speculated that this may lead to the introduction of caps in their use, but this seems unlikely in the health sector where NHS Trusts' revenue streams are linked to inflation.

Capital Hospitals PLC
Status: Closed 27 April
Description: Wrapped RPI-linked bond issue EIB loan for the DBFO of St Bartholemew's and Royal London Hospital
Debt: £1.28 billion
Sponsors: Skanska, Innisfree
Lead managers: Deutsche Bank, Morgan Stanley
Monolines: Ambac, MBIA
Financial advisers to the borrower: Investec Bank
Financial adviser to the concession awarder: PwC
Borrower legal: Clifford Chance
Lender legal: Ashurst
Concession awarder legal: Allen & Overy