The first monoline wrapped bond issue for a UK schools PFI project has closed. The construction of up to 24 schools has allowed North Lanarkshire Council in Scotland to take advantage of the debt capital markets with the economies of scale afforded by a large portfolio project.

The 32-year concession involves the construction of at least 21, but up to 24, new schools in North Lanarkshire. There are 15 sites in the first phase for 18 primary schools and three large secondary schools, including a public library and a cultural centre. A 50/50 joint venture between Balfour Beatty and Innisfree has established the concession.

Lead arranged by Royal Bank of Canada (RBC), the deal comprises £15.6 million in equity and £157.8 million in debt split between a bond and EIB loan. Special purpose vehicle Transform Schools (North Lanarkshire) Funding PLC issued £87.8 million ($158.9 million) of 2.343% LPI index-linked guaranteed secured bonds due in 2036 (including £15 million in variation bonds) on 8 June 2005. The EIB has also provided a £70 million LPI index-linked guaranteed secured loan due 2034. The loan and bonds are both wrapped to AAA by monoline insurer XL Capital.

The bonds are index linked to the Limited Price Index (LPI) and this mechanism provides a collar, so that if inflation rises above 5% per annum, the coupon is capped at 5% and if inflation falls below 0%, the coupon is floored at that level. This is particularly suitable in a deal like this because it protects North Lanarkshire Council and there is no cost to agreeing to the floor.

The floor of 0% is also attractive to the bond investors, as it makes the structure deflation resilient for the next 30 years. This is a convenient arrangement that suits those involved in both the public and the private parts of the partnership. Using LPI is unusual in bond deals and PFI, the only previous example being the De Havilland campus development project at the University of Hertfordshire.

The issue includes $15 million of variation bonds, which function exactly the same as all of the other bonds, but are held by the issuer and will be sold at a later date to fund a variation in the project. This is essentially a pre-documented tap issue and the variation envisaged is the funding of three further schools, taking the portfolio total from 21 to 24 schools. Construction is to start once certain planning and title issues have been resolved at the sites.

The book was oversubscribed and interest was received from traditional and non-traditional investors. RBC used this demand to achieve an issue spread of RPI gilts + 73 bp (including the cost of the collar).

The project contains the following by way of third-party support against construction risk: (i) withholding of any sums due but unpaid; (ii) an on-demand guarantee in the form of a retention bond of £4.14 million from Lloyds TSB; (iii) a parental performance guarantee from Balfour Beatty PLC; (iv) liquidated damages for delays; and (v) an adjudication bond of £4.5 million provided by BBVA.

Standard & Poor's (S&P) reports that this level of third party credit support is notably weaker than that seen in recent health PFI deals, although the strength and expertise of Balfour Beatty mitigates these concerns, it is felt that for future PFI transactions it is unlikely that the combination of a mid-tier constructor and this level of third party support would result in an investment-grade rating.

The total capital costs of the project are in the region of £138 million. Construction began under an advanced works contract in October 2004. Works are being carried out jointly by an unincorporated joint venture (JV) between Balfour Beatty Construction and Balfour Kilpatrick under a fixed price, date certain, turnkey contract. All construction risk has been passed to this JV. The first of the new sites are scheduled for delivery in January 2006, with the remainder expected by October 2008. All of the schools are new buildings and construction is considered low in complexity.

Haden Building Management Limited (the building management arm of Balfour Beatty) will provide all hard and certain limited soft FM services, such as cleaning (subcontracted back to North Lanarkshire), security, janitor services and reactive and preventative maintenance. At the commencement of full operations in October 2008, it is estimated that the FM contract is worth £3.5 million per annum in real terms. Both the obligations to provide these services and the obligations of the construction joint venture are guaranteed by a Balfour Beatty PLC performance guarantee.

The project has reportedly raised issues, since resolved, with the Roman Catholic Church in Scotland, over the plans for six of the sites to be shared by Roman Catholic and nondenominational primary schools. These schools will have their own names and separate teaching staff, but will be under the same roof and pupils will have to share PE facilities and an assembly hall. Many of the schools will also be built over the top of mine shafts, but naturally these concerns will be addressed prior to construction and the sponsor retains construction risk.

There is potential for similar schools deals in Scotland, including South Lanarkshire, Edinburgh and Aberdeen, as well as in England, where other local authorities are looking to replace enough schools to support a bond deal.

It remains to be seen whether it would be possible to complete a similar transaction to finance schools from different local authorities. Such an umbrella deal has been considered a step too far in the past for various reasons, not least the different politics across different local authorities. Batching projects have been successfully completed in health deals, in which a framework agreement has included more than one NHS trust, but such a deal has not yet been tried with a batch of schools.

Transform Schools (North Lanarkshire) Funding PLC
Status: Launch/Pricing Date 2 June 2005 and Payment 8 June 2005
Issue Size: £87.796 million 2.343% LPI Index-Linked Guaranteed Secured bonds (including £15 million variation bonds)
Maturity: 31 March 2036 
Debt: £70 million LPI Index-Linked Guaranteed Secured Loan due 2034
Location: North Lanarkshire, Scotland
Sole Lead Manager: Royal Bank of Canada
Coupon: 2.343% sa + UK RPI
Legal Counsel to the Lead Manager: McGrigors
Legal Counsel to the Issuer: Tods Murray
Bond Ratings (S&P/Moodys): AAA/Aaa
Project Shadow Rating (S&P): BBB
Issue Price: 100.003%