The Allenby/Connaught Ministry of Defence (MoD) accommodation project has had a winding path to financial close since the MoD first issued an invitation to negotiate (ITN) on 31 July 2002. It was worth the wait: the £1.8 billion debt raised in the capital markets is the largest UK PFI transaction to close since the Tubelines refinancing in the summer of 2004. The deal could also signal the resurgence of monoline-wrapped paper in the UK PFI market.

Now branded the Aspire Defence project, the scheme is a 35-year DBFM concession featuring a large construction programme over the first 8.5 years across four garrisons. The project is ambitious in scope but not in technical difficulty: the project company will be responsible for constructing 393 buildings, demolishing 439, refurbishing 146 and managing 1,510 others. Most of the accommodation blocks are prefabricated modular en-suite units and should pose few difficulties to seasoned PFI operators Carillion and KBR.

The project company, Aspire Defence Limited was awarded the contract in the summer of 2003. The Aspire consortium originally comprised Mowlem (50%), KBR (45%) and HSBC Infrastructure Fund II (5%), but Carillion came in with its takeover of Mowlem.

The concession agreements are largely based on Standard Form 3 (SOPC 3), but there are deviations on the normal UK PFI template. One of the most notable contractual arrangements is the use of flexible pricing for construction work. Rather than use the traditional fixed-price turnkey build and design contract, the MoD considered that, given the scale and scope of the construction, a blended approach between fixed-costing and works 'whose scope has yet to be decided' would best achieve value for money.

Contracting obligations are split into three categories: firm, fixed and competed works. The firm works represent 39% of the nominal price of the construction work, £481 million, and are pre-determined as a fixed-price contract at financial close. Fixed works represent 28% of the nominal price, £343 million – works under this category have their scope fixed, and the price in real terms, with the MoD either liable for changes in price due to inflation or changes in the law or with the option for reducing the scope of the work. The third category, competed works represent 33% of the nominal price and the exact scope of the works has yet to be determined. The price for competed work will be determined by benchmarking or competition and may be reduced in scope.

Given the flexible nature of the contractual arrangements and the 92% gearing, lenders will take comfort from the higher than market-average coverage ratios of 1.32x minimum and 1.39x average, and according to the lenders' advisers EC Harris, the relatively benign unitary payment regime.

The unitary payment by the MoD is based on the availability of units of space (SSC) and the market-tested service charge (MTSC), and does not depend directly on the completion of assets. Deductions are made when units of space (functional groups of assets) are unavailable or delays are incurred. The penalty fees are weighted so that there is a 100% liability for functional groups that relate to an incoming military unit whereas there is only 50% liability for a unit relocating within, or between, the four garrisons. EC Harris regards the payment mechanism and performance-monitoring regime as cumbersome.

The financing comprises a mirrored set of A and B series bonds with an underlying rating of BBB- (S&P-rated) and wrapped to AAA by Ambac and MBIA respectively. Each series consists of £724 million fixed-rate paper, plus £115 million authority variation bonds and £37.5 million rescue variation bonds, all due 2040.

The bonds priced the week beginning 27 March at 56bp over the 4.25% 2032 Gilt. Both tranches were heavily oversubscribed, with the Ambac tranche 2.2 times covered, and the MBIA piece 1.75 times. Around 50 accounts from the UK fixed rate investor base participated, with tickets ranging from £5 million to £50 million-plus.

With the monoline fees thought to be at an aggressive sub-25bp, the issue highlights the clear cost advantage of a capital financing versus bank debt on large deals. The all-in cost to the borrower on the deal is likely to be below 80bp (56bp + ~25bp) over Gilts – at the current 25-year swap spreads this is equivalent to 55bp over Libor, a level that might find limited support in the bank market for a transaction with a final maturity of 2040.

The bond lead managers, HSBC and Citigroup were named when HSBC won the funding competition in December 2003, with Citigroup, as financial adviser, given the pre-emptive right to match the best bid.

All UK PFI projects over £50 million are now expected to consider the benefits of undergoing a separate funding competition after the announcement of the preferred bidder. Whilst vanilla deals are always likely to find backing, sponsors may find it more difficult to get bank backing for bespoke or complex deals. It is unclear what level of bank support sponsors can obtain before the funding competition, which potentially leaves bidders vulnerable if market appetite changes.

The effects of negative carry on large paper issues and inflexibility are countered to some extent on Aspire Defence by a subordinated shareholder-financed tranche of £119.9 million injected in the project from two to seven years after financial close (backed by letters of credit from HSBC and Citibank). Also a £75 million pre-contract activities letter enabled the sponsors to push ahead with design and planning before financial close.

The chief mitigant to the effects of negative carry is Aspire's use of GICS (guaranteed investment contracts) whereby the borrower deposits cash with a suitably rated financial institution (s) with a specified drawdown schedule for a fixed rate of return.

Despite Standard & Poor's opining that the MoD benefits "from excellent credit quality that does not constrain the underlying project rating", the unitary payments are sculpted to lower levels in the initial years because of MoD budgetary constraints. Given the financial mire that several NHS funds are currently finding themselves in, it will be interesting to see if the ratings agencies take a similar stance on the forthcoming St Bart's issuance.

Aspire Defence Finance PLC
Status: Closed 6 April 2006
Sponsors: Carillion (originally Mowlem) 50%; Kellogg Brown & Root 45%; HSBC Infrastructure Fund II (5%)
Financial adviser to sponsor: Citigroup
Lead managers: Citigroup; HSBC
Monolines: Ambac; MBIA
Legal counsel to sponsor: Cameron McKenna
Legal counsel to lenders: Clifford Chance
Legal counsel to the MoD: Freshfields
Lender technical adviser: EC Harris
EPC: Carillion; KBR
Main sub-contractors: Lex Transfleet; Sodexho; MUJV