Authority Voluntary Termination (or default)
Summary of alternative SoPC provisions for compensating junior capital
SoPC §20.1.3.6 allows Contractors to choose from one of three possible compensation régimes for junior capital at the time of Contract signature, and therefore the effect of the refinancing on termination liabilities may be different depending on which option was originally chosen. This Annex considers how each option affects termination liabilities.
A Refinancing may affect both the compensation due to Senior Debt (as described elsewhere in this Application Note) and that due to junior capital (i.e. the combination of equity and subordinated debt which is generally subscribed by shareholders of the Contractor). As a general principle, an increase in compensation payable in respect of Senior Debt should be counter-balanced by an off-setting reduction in compensation payable in respect of junior capital. However, this assumption cannot be relied upon in every case and must, accordingly, be checked with greater care by suitable financial modelling for each period over the life of the Contract, whether the Contract is SoPC-compliant or not. An Authority will be concerned by the overall level of compensation payable upon termination, and so the aggregated and inter-active effects of all the components of compensation must be rigorously checked.
The effects of the three possible SoPC approaches to compensation of junior capital are summarised below: 12
- Junior capital compensation based on rate of return to termination date
In this case, the termination compensation for junior capital is calculated so as to give the investors their Base Case Equity IRR over the period up to the termination date. If the Refinancing results in accelerated distributions to investors, this should also enable them to achieve the Base Case Equity IRR more rapidly, and thus decrease the payment to be made on account of junior capital at the time of a later termination. If this projected decrease is equal to or greater than the increase in termination liabilities on the Senior Debt, there will no overall increase in termination liabilities on this account.
- Junior capital compensation based on market value
In this case, the termination compensation for junior capital is based on its market value at the time of termination. The equity element of this market value will generally be reduced after the Refinancing (on account of the increased debt burden of the Contractor). If this reduction is equal to or greater than the increase in termination liabilities on the Senior Debt, there will be no increase in total termination liabilities on this account.
- Junior capital compensation based on projected Base Case returns
In this case, the termination compensation for junior capital is calculated as the future returns (from the termination date forward) payable under the Base Case, discounted at the Base Case Equity IRR. SoPC cautions (SoPC §20.1.3.9 footnote 13) that "Care should be taken that if a refinancing has occurred…and the original equity and Junior Debt reduced, there is no double counting". In other words, the increase in Senior Debt termination compensation should be balanced by a decrease in the equity compensation. If this is so, there will be no overall increase in termination liabilities on this account.
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12 As discussed in §1.3.2, compensation payable on Senior Debt will involve breakage costs (e.g. in respect of interest rate hedging instruments, Spens clauses on bond issues or RPI swap instruments). Breakage costs may also arise as a result of the use of mezzanine finance. The aggregated impact of all of these, over a reasonable range of scenarios, must be taken into account before an overall conclusion can be reached as to whether termination liabilities in a given period over the Contract life remain unchanged, increase or decrease.