The procurement of the rolling stock for the Thameslink rail line is better known for its choice of supplier than its contractual structure. The successful bidder’s lead sponsor, Siemens, has less extensive UK rail manufacturing operations than the losing bidder, Bombardier. In the wake of its loss in June 2011, Bombardier made it clear that losing would affect its UK employment levels.

Cross London Trains Ltd

Status

Closed 26 June 2013

Size

£1.77 billion

Description

Procurement of 1,140 carriages for train line running north-south through London

Grantor

UK Department for Transport

Sponsors

Siemens Project Ventures (33.3%), 3i Infrastructure (33.3%) and the Innisfree PFI Secondary Fund 2 (33.3%)

Equity and sub-debt

£175 million

Debt

£1.36 billion 22-year commercial bank loan, 20-year European Investment Bank loan

Mandated lead arrangers

SMBC, BTMU, Lloyds, KfW IPEX

Lenders

Bank of China, Barclays, Bayerische, Commonwealth Bank of Australia, Crédit Agricole, CIC, DBJ, Deutsche, DZ Bank, HSH Nordbank, ING, Mizuho, Landesbank Hessen-Thüringen and SEB

Grantor legal adviser

Freshfields

Borrower legal adviser

Linklaters

Siemens legal adviser

Reed Smith

Lenders’ legal adviser

Clifford Chance

Franchisee legal adviser

Burges Salmon

But the procurement of the Thameslink line’s 1,140 carriages is also an attempt to work within the confines of the UK’s franchise system, which involves private operators holding short-term franchises to run different lines. This system is one of the reasons why the UK’s rolling stock fleet is so old. The profitable rolling stock companies that supply trains to franchisees have little incentive to invest if their counterparties hold short-term franchises for small parcels of the UK network.

The UK’s government stepped up to push forward the procurement of 57 trains for the InterCity Express programme’s western section. It was the direct counterparty on the design-build-finance-maintain contract for that £2.485 billion ($3.7 billion) deal. Thameslink’s financing involves government standing to one side of the process, though it features heavily in the financing.

Siemens Project Ventures, 3i Infrastructure and the Innisfree PFI Secondary Fund 2 each own a third of the project company for the contract, Cross London Trains. The £1.59 billion debt financing for the £1.77 billion project closed on 26 June, ten days after the formal award of the contract, and a short standstill period had elapsed.

SMBC, BTMU, Lloyds and KfW IPEX are lead arrangers of the £1.36 billion 22-year commercial bank financing, with KfW contributing £150 million. Another 14 lenders participated: Bank of China, Barclays, Bayerische, Commonwealth Bank of Australia, Crédit Agricole, CIC, DBJ, Deutsche, DZ Bank, HSH Nordbank, ING, Mizuho, Landesbank Hessen-Thüringen and SEB.

Rounding out the financing are a £225 million 20-year loan from the European Investment Bank and £175 billion in equity and sub-debt, split equally between the three sponsors. The A3-rated financing was originally pitched to banks at below 200bp over Libor, before coming to market late last year with starting pricing around 285bp, but is now thought to be nearer 250bp.

The Thameslink line runs north-south through London, and is in heavy demand both as a commuter line and to serve two of London’s airports – Luton and Gatwick. The Thameslink Programme involves extending the line to serve additional stations with longer trains. The bulk of the line’s rolling stock is over 15 years old, though some of its subleased trains are more modern.

The line’s current franchisee is First Capital Connect, a subsidiary of First Group, which won the franchise in 2005. The franchise was meant to end this year, but in the wake of the cancellation of the tender for the InterCity West Coast line the department has extended the franchise until September 2014. First Group, along with Abellio, Govia, MTR and Stagecoach, made the shortlist for the new franchise in March 2012.

UK-listed First Group was founded as a bus operator but now runs seven rail lines. It produced £6.9 billion in revenues in the year to March 2013, but has struggled to service its £2 billion in debt, and closed a £615 million rights issue in late June that was designed to repair its balance sheet. First Group has made maintaining an investment grade rating a priority: S&P puts its rating at BBB-, with a negative outlook, while Fitch rates it BBB-, with a stable outlook.

Lenders on the 20-year financing cannot be assured that First will retain the franchise, or that its replacement would have a higher credit quality. Crucial to their comfort is a 20-year undertaking from the UK’s secretary of state for transport that any new franchisee would need to sign a lease contract for the Thameslink trains on substantially the same terms as the initial lease.

Precedents exist for the replacement of failing franchisees, even as a last resort with government, in extreme circumstances. The current operator of the East Coast line is Directly Operated Railways, a government-owned entity, after National Express abandoned that franchise in 2009.

The department also had to help the sponsors mitigate funding risk. The European Investment Bank (EIB) was willing to support the deal with a larger loan than originally envisaged, but both the EIB and Moody’s, which eventually rated the deal A3, had to be satisfied that the withdrawal of a bank from the lending group would not create a funding gap that would sink the entire contract.

The scenario is not purely hypothetical. New South Wales had to restructure the Reliance Rail rolling stock PPP after one of the monoline insurers that had wrapped that project’s debt became insolvent. Banks might have been able to stop draws under their financing documentation, though the sponsors disagreed. The dispute coincided with delays to the delivery of the trains, and required the state to promise to buy out the sponsors’ equity to ensure that the deal was fully funded.

On Thameslink there are several lines of defence in the event that a lender pulls out of funding on its 22-year commitment. Firstly, the sponsors’, and then the other lenders’, funding commitments would be accelerated, and the sponsors would try and find an additional or existing lender willing to step up, though this lender would need to have a rating of at least A3 (Moody’s), the same level as the average of the existing group. If a gap remains the UK government can step in either with grant funding or with a debt commitment on the same terms as the existing lenders. If it decides not to do so, then the deal would be restructured to accommodate as many trains as could be delivered using the available funding, with a new financial model.

But these backstops all assume that Siemens would not be willing to step up, and Siemens, as train supplier, has provided considerable support to the financing, particularly with respect to termination. Siemens promises to make good the 5% deduction that is payable if the trains do not meet service standards, and to make whole lenders in the event of a termination during the manufacturing period.

In the event of a termination during operations because the performance of the trains is below specified levels, the scale of support from Siemens is lower, though it would be enough to keep the lenders whole while they procure a new set of trains, with the residual value of the existing units used to pay down lenders once the new trains are in service.

Siemens had originally hoped that the extent of its support for the rolling stock contract would allow the debt to price a little closer to its corporate levels, but the complex regulatory backdrop and the tenor of the bank debt meant that pricing ended up closer to the market norms for highly-leveraged UK PFI deals.

Siemens is also building the depots for the new trains at Three Bridges and Hornsea outside the scope of the rolling stock contract, and leasing the depots to the project company. Siemens Bank is providing the debt for the depot, which is essentially Siemens corporate risk.

The financing for the Thameslink programme demonstrates that, at least on paper, it is possible to procure new rolling stock within the framework of the franchise system. But the franchise system itself is looking far from healthy. The refranchising of both the East Coast and West Coast main lines, not to mention Thameslink, is delayed, and even the negotiations of extensions to existing franchises have been protracted.

While both of the UK’s main political parties broadly support the franchise system, because both have been involved in its development, they differ as to how much of a role government can have in operating franchises. With a general election looming in 2015, the present Conservative-led administration will need to move fast on re-franchising, not to mention making a decision on how the East Coast portion of the InterCity Express rolling stock programme will be financed.

Meanwhile, Siemens has withdrawn from the bidding for the UK’s other main London-focused rail procurement – Crossrail – saying that a bumper crop of new orders means that it would not have the resources to carry out Crossrail on top of its existing order book. Hitachi, the winner of the InterCity Express west contract, Spain’s CAF and Bombardier remain in contention for Crossrail. But the department and London’s mayor have already agreed that the £1 billion Crossrail order will be procured directly, to assure an in-service date of 2017.