The launch of the £1.03 billion financing for the Metronet consortium's operational takeover of nine of London's underground lines heralds the first major tapping of the bond market by the UK rail infrastructure companies (infracos). It also marks financial completion of one of the most contentious transactions in the UK's longstanding privatisation programme ? the transfer of operational responsibility for the running of London's subway from government-owned London Underground to privately-held consortia.

The decision was first made to part-privatise the capital's underground system four years ago and the financial close for the two infracos is a major milestone. Each deal is is unique, as are the risks that they incorporate. The nature of the business means that investors are buying into deals that involve a high degree of transitional risk as the running of the underground system moves from public to private hands. But is the Metronet deal it a blueprint for future financing ? and therefore could it herald a new market in UK PPP rail bond finance?

Metronet is the second tube consortium to arrange financing ? Tubelines closed its deal on December 31 last year (see www.projectfinancemagazine.com, February 2003 issue). The Metronet consortium includes WS Atkins, Balfour Beatty, Bombardier, Thames Water and Seeboard. The financing is being arranged through two vehicles: Metronet Rail BCV ? which will run the Bakerloo, Central and Victoria lines ? and Metronet SSL which will run the sub-surface lines ? District, Circle, Metropolitan, Hammersmith and City and East London.

The Tubelines consortium is made up of Amey, Bechtel and Jarvis. The Tubelines deal incorporated £1.8 billion senior debt which was split into £630 million uncovered, £600 million wrapped (by Ambac), £200 million standby, £96 million liquidity facilities and a £300 million EIB loan ? but did not involve bond finance. The two financings are, however, the culmination of years of political wrangling and both incorporate a feature that will be at the core of all UK tube financings for the foreseeable future ? a 95% letter of comfort from the UK government.

The Tubelines deal was wrapped by a single monoline ? Ambac ? but this latest Metronet financing involves two guarantors with Ambac and FSA underwriting £515 million apiece. This level of cover has been necessary to achieve a deal which finally realises the potential of rail industry cash flows in the bond market. It is not a securitisation ? the true sale of the assets involved is not permitted ? but the structure does make use of rail receivables flowing from government grants to the issuer.

?This transaction is more a structured project financing than conventional ABS,? explains Jeffrey Rubinoff, partner at Freshfields Bruckhaus Deringer in London. Freshfields advised London Underground for both the Tubelines and Metronet deals. The eventual structure of both deals is a reflection not just of the mechanics of the market but also the political wrestling match that the refinancing of London Underground became. The levels of comfort that investors required were clearly affected by this in the first two infraco financings but may ease off as the market matures.

Can the market take more risk?

The decision by Tubelines to fund in the loan rather than the bond market may be more of a question of timing than anything else. ?The logistics of tying a bond issue to a commercial closing were too tight,? says Rubinoff. The Tubelines deal will, however, be refinanced in the bond market by arranger Goldman Sachs (although no definitive decision has been made). This will also need careful timing if investor appetite is not to be overstretched.

Tubelines involved HBoS, Mizuho, WestLB and SG as mandated lead arrangers with a further arranger group of ABN Amro, Bayerische Landesbank, BES, Bank of Ireland, Credit Agricole, Depfa Bank, Dexia, Dresdner Kleiwort Wasserstein and Hypovereinsbank. The Metronet deal is lead managed by Deutsche Bank, Royal Bank of Scotland and UBS Warburg. It is just part of Metronet's £8.5 billion budget to undertake running of its tube lines for the first seven and a half years of its 30-year concession. Other funding in addition to the bond issue and £1.1 billion in bank loans involves £600 million from EIB and £70 million investment apiece from consortium members.

With the infracos now coming to the market for funding, what are the main concerns for investors? The part-privatisation of the London Underground has been hugely controversial and these companies will oversee the transfer of operational control of the system away from the public sector via a series of contracts that are untested. ?The evaluation of the deal [Metronet] focused on what could happen to affect cashflow and what would happen in the event that the deal went wrong,? explains Rubinoff.

In the first instance, comfort should be derived from the substantial grant funding that TfL receives from the UK government. The UK Department for Transport sets the level of grant payment that it will make in order to enable TfL to meet its obligations under the Lonedon Underground PPP. It is expected that a full 50% of TfL's revenue will be in the form of Department for Transport grants. But that still leaves cash flow risk on the remaining 50%. This is where the 95% comfort letter from the Secretary of State for Transport comes in. The comfort letter is clearly not legally binding, but it states that in the event that London Underground was unable to meet its financial obligations it is untenable that the Secretary of State would not consider whether it was appropriate to adjust the TfL grant or that s/he would stand by and do nothing.

Non-binding though it is, the government letter of comfort is crucial to raising money for the infracos. The reasons for this centre on both the debacle of Railtrack and the brazen hostility of TfL towards the PPP scheme during the long planning process. The spectre of Railtrack hangs heavy over the UK rail sector. ?We spent a great deal of time during the roadshow explaining why this deal [Metronet] is nothing like Railtrack or British Energy,? explains Michael Redican, director in the project finance department at Deutsche Bank in London, which co-underwrote the Metronet bonds. ?This company operates within a defined framework with contracts in place defining how it gets paid,? he says. ?That is very different from Railtrack's situation.? Redican makes a clear distinction between the risk associated with Metronet and the securitisation market. ?This is project-type risk which looks to the underlying contracts in the deal,? he says. ?It is not like a whole business securitisation.? Other industry professionals decribe the deal as ?hybrid PFI? but some caution that the supply chain contracts are not PFI standard as there is not the complete transfer of risk going down the chain. The infraco financings also have hallmarks of utility finance as in the event that a dispute arises between London Underground and an infraco independent arbitration will be provided by a statutory arbiter appointed by the Secretary of State for Transport.

Creating investor comfort

Railtrack they may not be, but infraco financings have had negative publicity of their own to contend with. Much of this has been the result of the high-profile opposition of Mayor Ken Livingstone to the scheme. Having made several legal attempts to stop the process, Livingstone eventually conceded that the scheme could go ahead in February this year but only after the government agreed to allow TfL to retain 2002's unspent grant (around £200 million).

The attitudes of the Mayor and his transport commissioner Bob Kiley remain a concern and seem to have contributed to the addition of a comprehensive standstill agreement to the structure. ?The concerns that led to the standstill agreement are unique to this deal,? explains Jeffrey Rubinoff at Freshfields. ?The standstill was not part of the original deal but was necessary to make everyone comfortable in light of various uncertainties exacerbated by the attitude of the Mayor, Ken Livingstone.?

The standstill agreement, or put option, requires London Underground to purchase the outstanding senior debt where senior lenders could accelerate the debt or where a mandatory sale notice has been served. ?This provides significant control to senior lenders and, as a result, mitigates against default risk,? notes Jonathan Manley, sector analyst at Standard and Poor's in London. Inclusion of this feature gives investors reassurance that structures are in place to prevent the infraco being placed in administration.

Given the untested nature of the infracos it was clear that significant comfort was going to be necessary to ease investor concerns ? even through the bonds are being wrapped to triple-A. For this reason London Underground itself is underpinning 95% of the debt by means of a legally binding guarantee.

The residual risk to the monolines from the contracts breaks down into payment risk and default risk and recovery,? notes Redican at Deutsche Bank. ?It is clear that there will be a higher level of recovery (95%) due to the contractual obligations of London Underground.? This guarantee is key to investor acceptance of the risk. London Underground will shortly become a subsidiary of Transport For London ? an entity that carries a double-A rating from Standard and Poor's. As such this binding guarantee, while being written by a TfL subsidiary and therefore linked to government funding via the Department for Transport grants, is essentially equivalent to a guarantee from a corporate entity with a double-A rating. Not surpringly, more was needed and the government stepped into the breach with its letter of comfort. ?The 95% comfort letter was key to this deal,? says Rubinoff. ?It was required by the funders. TfL clearly does not share the same rating as the UK government.?

But it is not the creditworthiness of Tfl that is uppermost in most investors minds, it is the enormous task that the infracos have signed up to. Rating agency Moody's describes this as a ?significant change management task, moving an organisation from a maintainer of an asset base with many life-expired assets and a maintenance back-log to a quality project manager of challenging construction projects and a maintainer of an asset base on a whole life cost basis? ? or, put more succinctly, trying to make a silk purse out of a sow's ear. The contractual framework under which this monumental task is to be achieved is extremely complex, meaning that that something will inevitably go wrong.

The real test of this Metronet issue, and any further bond issues from this infraco or Tubelines, will be how it stands up to the operational difficulties that undoubtedly lie ahead. The recent rail crash at Chancery Lane on the Central Line is an extremely timely reminder of the magnitude of the task that lies ahead. The crash was caused by malfunctioning equipment and has seen the tube line out of action for over two months necessitating compensation to be paid to passengers. This is a graphic illustration of the unpredictable and untested nature of the risks in this operation. The fact that the two main rating agencies do not even agree on the underlying rating for the Metronet bonds demonstrates the uncharted territory into which these deals are moving. Standard and Poor's gave the deal a preliminary BBB+ rating while Moodys gave the bonds an underlying rating of Baa3. Of significance is that S&P rates Transport for London while Moody's does not.

The enthusiastic take-up of the Metronet bond issue by the market vindicates the exhaustive structuring that has gone into the deal to mitigate operational risk. Both the Metronet entities sold their £350 million fixed rate tranches at 73 basis points over comparable gilts and their £165 million index-linked tranches at 80 basis points over gilts. All four tranches mature in 2032 and have a weighted average life of 22.2 years. ?Despite the high complexity of the deal the pricing of the fixed rate tranches for both Metronet transactions came in from initial price talk of 85bp over gilts due to strong demand,? notes one analyst at Dresdner Kleinwort Wasserstein. The two $510 million syndicated loan facilities run to 2011 and were oversubscribed.