1.5.1 An Authority may opt to take its share of the Refinancing Gain either as a cash lump sum at the time of the Refinancing and/or by a reduced Unitary Charge. Alternatively, an Authority may opt, having discussed the matter with its sponsoring department or Private Finance Unit, to receive its share of a Refinancing Gain through an increased scope of services.11
1.5.2 As discussed above, the Refinancing Gain is not necessarily an amount of cash which is available immediately after the Refinancing, and the Authority should not expect to get its share any faster than the investors in the Contractor. This means that no more than 50% of each projected increase in Distributions12 should be paid to the Authority, which therefore determines the maximum speed with which the Authority's share of the Refinancing Gain can be paid.
(a) Lump-sum option
If the Refinancing involves raising a significant amount of new Senior Debt, and thus prepayment of shareholder subordinated debt, this is likely to lead to a large initial Distribution equal to the amount of new debt which is being raised, followed by reduced Distributions for the remaining term of the Contract caused by the increase in Senior Debt service. In such a case the Authority may opt to take its share of the Refinancing Gain out of this first Distribution. The Authority is entitled to take up to 50% of the first Distribution as the lump-sum payment.
If payment of the Authority's share cannot be fully satisfied out its share of up to 50% of the first Distribution, payment of the balance should be made by reductions in the Unitary Charge, as otherwise the Authority would be taking a long-term credit risk on the performance of the Contractor.
(b) Unitary Charge reduction option
If new debt is not being raised, the benefit of the Refinancing-e.g. from an extension of the debt maturity or a reduction in the interest rate-generally accrues over a longer period and it is generally more appropriate to take out the Authority's share of the Refinancing Gain over the remaining term of the Contract as a reduction in the Unitary Charge.13
If payment is not being made out of the first Distribution as discussed in (a), under most circumstances a reduction to the Unitary Charge spread evenly over the remaining term of the Contract is the most straightforward approach, although a faster reduction schedule could be agreed, within the limit of 50% of projected Distribution increases set out above. The requirements of the Refinancing itself-e.g. for debt cover ratios-should also be taken into account in considering the schedule of payments to the Authority.
Payment of the Refinancing Gain by way of a reduction in the Unitary Charge gives the Contractor a further tax benefit-i.e. its corporation tax bill goes down because its income goes down-which has not been taken into account in the calculations set out above. A further iterative calculation should therefore be included in the post-refinancing financial model to ensure that the calculations are performed on a post-tax basis consistent with the use of a post-tax discount rate.14
Once calculated at the time of the Refinancing, any lump-sum payment or reduction in the Unitary Charge should not be contingent on the performance of the Contractor. If this were not the case the Authority would in effect become an equity investor in the project, without any of the controls or protections which normally accrue to an equity investor.
The Authority is also entitled to payment of interest where its share of the Refinancing Gain is not being paid immediately after the Refinancing date. As the Refinancing Gain was calculated by discounting at the base case Equity IRR it might be thought that the same rate should be used to accrue interest on any deferred payment of the Refinancing Gain. However this does not reflect the fact that the Authority has a fixed claim for a lump-sum payment, or the Unitary Charge reduction is already committed, and therefore the Authority is less at risk than the Contractor. Therefore a lower interest rate-e.g. similar to that for Senior Debt, based on the gilt or swap rate for the average life of the period of reduction in Unitary Charges, plus x%-should be used for this purpose. This interest rate should also be included in the calculations of the reduced Unitary Charge amounts, to produce a level schedule of reductions.
(c) Whether to choose Lump Sum or Unitary Charge Reduction?
It should be noted that the Unitary Charge reduction option may be less attractive to an Authority than a lump-sum payment where a lump sum is available because:
• It will tend to produce a lower Refinancing Gain, as reductions in the Unitary Charge will reduce debt cover ratios, and hence reduce the amount of new debt that can be raised. This means that the lump sum may be more attractive even where the interest rate on Unitary Charge deferral is above the public-sector discount rate.
• The interest rate earned on deferring payment via a Unitary Charge reduction is lower than the discount rate used to calculate the lump sum.
• The Contractor will probably pay out to its shareholders the portion of the lump sum which would have been paid to the Authority, thus in effect allowing them to borrow this sum from the Authority and pay it back via lower distributions as a result of the reduced Unitary Charges.
• It leaves the Authority at risk that later cash-flow problems prevent payment of its share of the Refinancing Gain.
Balanced against this is the fact that a Unitary Charge reduction should lead to the Contractor becoming less highly geared through a refinancing than would otherwise have been the case, if the refinancing had been predicated solely on lump sum payments, where a lower gearing may be something favoured by the Authority. There may also be budgetary issues which lead to an Authority favouring a Unitary Charge reduction over a lump sum payment.
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8 Usually six-monthly.
9 i.e. the base case post-tax nominal equity IRR (cf. Section 34.5.2 of SoPC4).
10 It might be thought that, rather than discounting the two Distributions streams to their respective NPVs and then calculating the difference, it would be simpler just to divide the differences as they occur, and pay half to the Contractor and half to the Authority. However, as discussed in footnote 7, refinancings may, e.g., produce an initial positive cash gain, followed by decreases in Distributions. In such cases if this simple division method were used, it would mean that the Authority would receive an initial cash sum significantly larger than 50% of the Refinancing Gain, and then have to make increased Unitary Charge payments in future. In effect the Authority would be borrowing surplus cash from the investors and paying it back-at the Contractor's cost of debt-through the higher Unitary Charges, which is clearly inappropriate.
11 Subject to suitable value for money tests and the application of any relevant procurement procedures.
12 Subject to the payment of any "catch-up" sum to meet the Threshold Equity IRR (cf. Section 1.4 above).
13 Cf. Section 1.5(c) below
14 Cf. Section 34.5.2 SoPC4.