In this case, SoPC links the compensation payable by the Authority in part to the level of Senior Debt (SoPC §20.1 & §20.5), and therefore the Authority will have to conduct a VfM analysis before agreeing to any increases in these termination liabilities. This is the most complex termination scenario which the Authority will have to consider in reviewing the effect of a Refinancing.
The starting-point should always be the principle of there being no increase in termination liabilities. These liabilities have to be considered as a whole, taking into account both the payment made on account of Senior Debt, and that made on account of junior capital (i.e. the combination of equity and subordinated debt).7 Thus an increase in termination liabilities relating to Senior Debt may be counterbalanced by a decrease in liabilities relating to junior capital. However, the proper assessment of this requires detailed financial modelling for each period over the Contract life and proper account to be taken of all the breakage costs incurred as a result of a Refinancing (see below). SoPC offers three formulæ applying to junior capital compensation, from which the Contractor can make an initial choice (cf. SoPC §20.1.3.6) at the time of Contract signature. Annex 1 to this Application Note gives a brief summary of the possible scenarios which result from these choices.
It follows from this counterbalancing effect that a Refinancing involving increases in levels of Senior Debt may be arranged without increases in the total termination liabilities for the Authority, potentially even up to the limit of maximum acceptable Senior Debt. If, nonethe-less, a Refinancing proposal does involve an increase in total termination liabilities, the Contractor making the proposal should be required to offer a choice of Refinancings to the Authority: one involving increased total termination liabilities and one not. Only in this way will it be possible for an Authority to assess fully the VfM benefit of agreeing to these increased liabilities as required by SoPC (SoPC §35.3.1.6). Importantly, this is not only a quantitative exercise but is likely to require qualitative analysis by the Authority.
If an increase in termination liabilities needs to be considered, it is important that the Authority has a clear understanding of what these increases actually are. There are two points to bear in mind here:
- Profile of termination liabilities
Termination liabilities vary (generally decreasing) over the life of the Contract. Hence for an Authority to apply the principle of there being no increase in termina-tion liabilities relative to the situation prior to a Refinancing, requires a time-dependent profile of termination liabilities extending over many years to be calcu-lated and compared with the original profile (i.e. pre-Refinancing) calculated using the Base Case financial model.
- Breakage costs
Breakage costs on Senior Debt may be incurred if a Senior Debt facility (whether bank or bond) is repaid early (that is pre-paid in the case of a bank loan or redeemed in the case of a bond)-such costs would be added to the Authority's termination li-abilities. In the case of a bank loan carrying a fixed rate of interest these are referred to as swap-breakage costs (cf. SoPC §32.2.1) and in the case of a bond they are re-ferred to as Spens costs (cf. Office for Government Commerce's "Guidance on Certain Financing Issues in PFI Contracts" (July 2002), §2: "Using The Capital Mar-kets For Finance", §2.12).
In many cases, Spens costs will be greater than swap-breakage costs for a given Senior Debt amount, so a bond issue will involve greater termination liabilities for an Authority and thus greater costs in terms of lost flexibility (see below).
Moreover, if long-term interest rates have gone up since the financing was originally put in place, this should result in a breakage profit on a swap-which will reduce termination liabilities-rather than a swap-breakage cost. This may not be the case under a bond with a Spens clause. Thus the possibility of both higher and lower long-term interest rates at the time of termination (and a variety of different termination dates) need to be taken into account in assessing likely termination costs where a Re-financing takes the form of a switch from a bank loan to a bond financing.
A further element of breakage-cost risk is introduced if the funders make use of an RPI swap (to hedge against changes in inflation). Again the breakage costs on such a swap would have to be evaluated in a variety of inflation scenarios.
Since the Authority is concerned about aggregate termination liabilities in respect of the Contractor's finances (i.e. the combination of compensation due to Senior Debt and that due to junior capital and not just Senior Debt), it follows that investors in junior capital can elect to pledge their share of compensation to Senior Lenders to secure either more Senior Debt, or to cover incremental increases in termination liabilities arising from changed profiles of termination liabilities and/or changed breakage costs, without affecting the Authority's overall liability. If, nonetheless, the Contractor is proposing a Refinancing which increases the Authority's aggregate termination liabilities, then these additional costs must be weighed against the benefits of an increased Refinancing Gain made possible through these increased liabilities.
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7 Some projects may also include mezzanine capital which will have its own compensation régime which needs also to be taken into account in the assessment of aggregate termination liabilities.