North Lanarkshire: A transformation

The wrapped Transform Schools deal marked the first time a public bond issue was used to finance an education PFI project in the UK. This was an important watershed, coming as England prepares to embark on a new wave of schools projects through the Building Schools for the Future (BSF) programme.

The sponsors, Balfour Beatty and Innisfree, were able tap the capital markets because of the deal's large size: the project includes up to 24 mostly newbuild schools in North Lanarkshire, Scotland, under a 32-year concession. This allowed them to exploit the economies of scale afforded to a larger portfolio project.

Transform Schools raised £142.8 million ($249.9 million) of debt, including a £72.8 million public issue lead arranged by Royal Bank of Canada (RBC) and a £70 million loan from the European Investment Bank. XL Capital wrapped both tranches, giving the deal an AAA/Aaa rating from Standard & Poor's and Moody's. There was also £15.6 million put into the project through equity, fronted equally by Balfour Beatty and Innisfree.

Aside from including the first public bond issue for a grouped schools project, the project is also notable for being linked to the Limited Price Index. This is similar to the Retail Price Index, but the coupon is capped at 5% if inflation is above that level. There is also a 0% floor if inflation falls below that. The unitary payments to be made by North Lanarkshire Council are linked to debt repayments, so the collar offers the local authority protection against high inflation.

The issue priced at 73bp over RPI gilts with a 2.343% coupon. The bonds' length is 30 years and 10 months.

Although the noteholders are protected against deflation by the collar, the bonds are still priced higher than other UK wrapped PFI bonds of 2005. This has been attributed to the greater liquidity available in the RPI swap market, where arbitrage investors have been able to hedge bonds and get a fixed-rate return. Nevertheless, the book was oversubscribed, and this allowed Transform Schools to obtain a better price than had been expected. Overall, the council estimates the issue has saved it between £500,000 and £800,000 per year on the unitary charge it pays to the sponsor.

The portfolio initially includes 21 schools, but this is likely to be extended to 24 by the council once certain planning and title issues have been resolved at the site. There are £15 million in variation bonds included in the deal, which are to be issued at a later date to finance this likely extension of the project. In the event of any difficulties arising in selling these bonds, the local authority will act as funder of last resort.

The financing structure is typically aggressive for a UK schools PFI deal. The debt equity split is 90:10, while base-case DSCR averages 1.20x with a 1.19x minimum. There are lock-ups on dividend distributions at 1.125x.

The project's shadow rating just scraped investment grade at BBB-. S&P also assigned the project a recovery rating of two, meaning that in the event of a default, 80% to 100% of the principal can be recovered.

One weakness highlighted in the S&P report was a lack of project liquidity to cover unexpected deviations in cost. BBVA is providing a £4.5 million surety bond, which is set at approximately 3% of the construction costs at financial close, and 20% of costs outstanding at the end of two years. This bond, which is subject to adjudication, provides funding in the event of cost overruns or delays during construction. However, the S&P report takes the view that "No surety bond can be considered equivalent to cash reserves, letters of credit, or similarly liquid instruments." Moreover, the report also points out that the bond is smaller, as a proportion of construction costs, than in recent health PFI deals.

Other measures in place providing third-party support for the project include: the withholding of any sums due but unpaid; an on-demand £4.14 million guarantee bond from Lloyds TSB; and liquidity damages to be paid by Balfour Beatty to the SPV to compensate for lost availability payments in the event of delays in delivering the schools.

There is also a performance guarantee (though not a financial one) in place from Balfour Beatty. This last measure is crucial in securing the project an investment grade rating, as the company is one of the UK's leading PFI contractors, with considerable experience in building schools. At the time of the project's rating, Balfour Beatty had closed 15 PFI projects and built 143 schools. This expertise was enough to convince the agencies that the lack of project liquidity and low cover ratios needn't overly handicap the deal.

Although there have been no more schools PFI project bonds to date, several are expected to be issued this year from projects in Scotland, including one in neighbouring South Lanarkshire.

It is south of Hadrian's Wall, however, that the ramifications of the Transform Schools project will be most widely felt. The BSF programme aims to rebuild every secondary school in England over a period of 15 years. Crucially, the tenders are grouping together all the work that needs to be done in each county, making for much larger projects – for instance, the second project to reach preferred bidder, a £400 million scheme in Bradford, entails work on 29 schools. The BSF scheme is still in its infancy, but when it takes off, so might schools PFI bonds.

Transform Schools (North Lanarkshire) Funding PLC
Status: Launch/Pricing Date 2 June 2005 and Payment 8 June 2005
Issue Size: £72.296 million 2.343% LPI Index-Linked Guaranteed Secured bonds maturity: 31 March 2036
Debt: £70 million LPI Index-Linked Guaranteed Secured EIB Loan due 2034
Location: North Lanarkshire, Scotland
Sole lead manager: Royal Bank of Canada
Financial adviser to the issuer: HSBC
Legal counsel to the lead manager: McGrigors
Legal counsel to the issuer: Tods Murray