EPIC: Risk removal

On 17 November 2004 Depfa broke new ground with financial close on the first synthetic securitisation backed by loans to PFI projects. Lead managed by Merrill Lynch International, the £391.7 million ($738 million) partially funded synthetic was launched under the name Essential Public Infrastructure Capital (EPIC).

The issue was not about funding. The deal is designed to transfer risk to third parties and was motivated by regulatory capital adequacy objectives ? effectively reducing the amount of regulatory capital that Depfa needs to set aside against its loan book, so allowing it to improve the return on capital of its infrastructure financing. Consequently, the debt remains on Depfa's balance sheet while the credit risk is transferred through credit default swaps (CDS) via intermediary KfW.

Epic is a partially funded solution ? £31.75 million of funded notes were issued. A fully funded solution ? credit linked notes (CLNs) against amounts payable to Depfa in the event of a loan loss ? achieved the 0% capital weighting that Depfa was looking for but was too expensive to create any excess spread.

Instead, the majority of the deal is an unfunded synthetic collateralised loan obligation (CLO) and the funded portion is purely in place to give KfW cash collateral to meet investors' obligations in the lower rated tranches of the deal.

The role of KfW, or rather its 0% risk weighting, was integral to the deal's economics, allowing Depfa all the risk weighting benefits of a fully funded solution but at minimal cost. And the EPIC structure resembles the German agency's Promise and Provide securitisations ? indeed the same documentation was used.

KfW interposes itself in these financings by setting up a credit default swap with the originating bank. KfW then purchases credit protection by entering into credit default swaps with institutional investors. The advantage is that KfW is Triple-A rated, and can get the best CDS execution prices because of its strength as a swap counterparty. The loans remain on the balance sheet of the originating bank, and because KfW has a zero risk weighting as swap counterparty, the bank does not need to set aside regulatory capital to cover counterparty risk.

However, the underlying portfolio on EPIC has a very different credit profile to a typical KfW-sponsored CLO, with a low default record and high recovery rate. This is because PFI loans are typically extended to SPVs and are secured on a long-term concession from a public sector body, which will repay the construction cost in the form of a service charge over the life of the concession. If the holder of the concession goes bankrupt or fails to perform adequately, it can be replaced without causing a default on the PFI loan.

The pool reference in Depfa's deal is also relatively small ? 24 loans in all ? and thus has high concentration by typical CLO standards. The five largest loans make up 40% of the portfolio and only one has a public rating. And Moody's could not get comfortable with anything other than the super senior tranche of the deal.

Nevertheless, Standard & Poor's (S&P) estimated the average credit quality at triple-B and the projects are well diversified by sector, comprising offices, courts hospitals, prisons, schools, roads and rail. The concessions have average lives of 30 years and average debt maturities of 28 years. Nearly all have completed the construction phase, considered the riskiest part of most PFI contracts.

The £355.7 million unfunded super senior tranche, sold as CDS, was rated Triple-A by S&P and Moody's and sold to a single investor ? the monoline insurer Ambac. The supporting subordinated tranches, totalling £32.05 million and rated from Triple-A to Double-B, were cash tranches sold to investors as floating CLNs.

The deal achieves the regulatory capital relief that Depfa set out to get ? despite the fact that Depfa retains the first loss piece on EPIC and, given the synthetic nature of the deal, the loans remain on Depfa's balance sheet and it will continue to administer and service them.

The deal also creates an additional way for other institutional investors and banks to gain exposure to the UK infrastructure market and it is likely that other major PFI lenders will follow Depfa's lead in due course.

Depfa is already planning a much bigger deal next time round, in a repeat of the KfW structure, next year or early 2006. EPIC has gone a long way to proving that synthetics are an ideal solution for PFI loan books: PFI loans often have onerous restrictions on the transfer of security, making true sales too complicated to ever catch on. The fact that EPIC was restricted to UK PFI loans means the next challenge will be to apply the structure across a pan-European PFI portfolio or in an alternative European jurisdiction.

EPIC
Status: Closed 17 November 2004
Description: Synthetic securitisation of PFI loan portfolio
Originator: Depfa
Arranger: Merrill Lynch
Credit default swap intermediary: KfW
Legal counsel to Depfa: Clifford Chance; A&L Goodbody
Legal counsel to Merrill Lynch and KfW: Linklaters