2  General principles

The general principles assumed by this appendix are set out below.  

The general principle in relation to the exercise, or not, of the lease option is that the market value risk lies with the Contractor - the Authority simply has the choice of whether to leave that risk with the Contractor (by not exercising the lease purchase option) or crystallising that risk at the point of expiry or early termination by purchasing the lease(s) at market value.

There is no requirement to include overage in the contract.  However, overage is a common feature of these contracts and likely to offer value for money. The guidance is therefore written on the assumption that an overage clause is in place, so that if the market value of the lease(s) at the Expiry Date is above that assumed in the base case financial model the excess is split between the Authority and the Contractor on an agreed percentage basis.  Where the Contractor retains the lease(s) it will pay the Authority's share of any overage to the Authority; and where the Authority purchases the lease(s) the Authority's share of any overage will be deducted from the price paid by the Authority.  Normally this would apply at the Expiry Date but it should also apply on early termination and this appendix suggests, with the concept of "Authority's Residual Value Overage Share", a way in which this should normally be done.

It is worth noting that the value of Dwellings, which are (in broad terms) reserved for use as general needs affordable rental, is not volatile in the same way that open market valuations are.  The value is a function of rental income, costs, and discount rates.  Of these, the one with probably the greatest potential to introduce volatility to valuations - rental income - is currently subject to regulation which limits such potential.

The amount of debt secured on the residual value at the Expiry Date will depend on lenders' attitudes to residual value risk.  In terms of the suitable drafting provided here, the definition of "Residual Value Sum" and related definitions (which govern overage arrangements) and the definition of "Lender RV Element" (which relates to elements of compensation payable in relation to senior debt) therefore operate independently.  

In the following descriptions of compensation on termination amounts, no reference is made to non-finance related elements of compensation such as costs of redundancies etc., which all follow SoPC.  Also, for ease of comprehension this appendix sometimes describe elements of compensation on termination as payable to equity or lenders - in reality all compensation is payable to the Contractor and it is a matter for the detail of financing agreements, sub-contracts, etc, in terms of how precisely the total compensation sum is split between the various parties.

Certain points are not explained in detail in the following narrative, which should be read alongside the drafting in the main body of the Guidance.  In particular, please see the drafting for the detail of (i) the mechanism which should apply to allow the Authority to pay compensation in instalments and (ii) the mechanisms which apply to ensure that the compensation calculations work whether the project is in construction or has moved to the operational phase (one difference between the two often being that during construction the Contractor is operating under a building licence and as the project moves into the operational phase a lease or series of leases is granted by the Authority).

(a)  Expiry (No lease option exercised)

Upon expiry, should the Authority not wish to exercise its option, the Contractor will retain the residual value risk and be exposed to the risk of the value of the lease(s) not being capable of repaying the tranche of debt that was used to fund the residual value sum.

The Contractor will pay any overage to the Authority.

(b)  Expiry (Lease option exercised)

Upon expiry, should the Authority wish to exercise its option, the Authority will pay to the Contractor the market value of the lease(s).  If the market value is above the residual value sum and an overage arrangement is in place, the Authority's share of overage is deducted from the payment otherwise due to the Contractor.  The Contractor takes the risk of the amount being paid to the Contractor being less than the sum owed to the lenders.

(c)  Early termination on Contractor default - retender

As the New Contractor will require the lease(s) to carry on with the project, the Authority will acquire control of the lease(s) and then either procure the assignment of the existing one(s) to the New Contractor or grant new lease(s) to the New Contractor.  Authorities will need to take tax advice on the most appropriate structure here and in any other case where it wishes to take back the lease(s).  

Compensation will be assessed according to normal SoPC principles with tenderers knowing they will have the benefit of the lease(s), subject to any overage arrangements that might have been agreed at the outset.

(d)  Early termination on Contractor default - no retender (No lease option exercised)

Compensation will be assessed on the usual SoPC basis valuing the cash flows, including rectification costs.  In addition the Contractor will retain the lease(s) and therefore will take the residual value risk.  

The Contractor will retain the residual interest and should therefore be exposed to the risk of the then current market value not being capable of repaying any particular tranche of debt.  However, the Authority should be entitled to its overage share (if overage has been agreed).  This is justifiable on the basis that Contractor default should not deprive the Authority of this share.

There is the potential for double counting, insofar as if the Contractor is paid the value of project cash flows (net of rectification costs etc) and also retains the lease(s), the cash flows include rental income and certain costs relating to the lease(s), for the time from (early) termination to the Expiry Date and the Contractor has this already through its ownership of the leases themselves.  The approach taken in drafting to avoid this is to remove this double counting from the cash payment by obtaining a valuation of a hypothetical lease(s) which expire(s) at the Expiry Date, and deducting this value from the cash payment.  Therefore in this scenario the Contractor will retain the lease(s) granted and be paid the value of the project cash flows (unitary charge plus rental income less all costs) less the value of a hypothetical lease with a term only from termination until the Expiry Date - as the cash flows associated with such a lease should not be reflected in the cash payment given that the Contractor retains the actual lease(s) - less the Authority's overage share.

When calculating the overage, an adjustment to reflect the fact that the Termination Date occurs before the Expiry Date will be necessary.  This will be dependent on the precise terms of the overage but the drafting assumes that x% of any surplus of market value over £y at the Expiry Date was to have been paid to the Authority and that on early termination x% need not be changed but £y should be adjusted for inflation, i.e. expressed in "today's money" by discounting back to the Termination Date at an agreed rate.

For the inflation rate assumption, the principle is to reflect nominal movements in the value of social housing assets.  Typically a figure drawn from a broad measure of historic inflation such as RPI (whilst reflecting the expectations of bidders and funders as reflected in the financial close model) will be appropriate.  Authorities should recognise that the value of social housing assets is primarily driven by assumptions about future rental income and associated costs rather than being linked to sales values for market housing, with social rents being regulated by government.  Authorities may wish to invite bidders to bid the inflation assumption.  The same figure would be used where an inflation assumption is required elsewhere in these clauses - see section (f) below and, in terms of drafting, the definitions of "Discounted Residual Value Sum" and "Lender RV Element".

(e)  Early termination on Contractor default - no retender (Lease option exercised)

In this case, there is no reason why the Authority should not have the ability to take back the lease(s).  Compensation will be assessed on the usual SoPC basis valuing the cash flows, including rectification costs, but in addition the Authority should pay to the Contractor the lower of (a) a figure based on the residual value sum assumed in the bid (which is described as the "Contractor Default Residual Value Sum" in the drafting) and (b) a figure based on the market value of the lease(s) at the time of termination.  

The underlying commercial principle in relation to residual value risk is that the Contractor takes the residual value risk and therefore the Authority pays market value where it acquires the lease(s).  However, in a context where the Contractor has defaulted before the Expiry Date there is the potential for the Contractor to take advantage of market timing and therefore the Authority's exposure should be "capped" in some way.  Payment of the lower amount of the two figures is therefore considered appropriate although the Authority needs to exercise the lease option to take advantage of this.  (It has been assumed that Authority overage will only start above the bid residual value therefore there is no need for any reference to overage given the "lower of" formulation.)

As above in (d), there is the potential for double counting in respect of rental income and associated costs if the Contractor is paid based on project cash flows (including unitary charge and rental income and all costs from the Termination Date until the Expiry Date) plus lease values (reflecting rental income and some costs from termination until the term of the leases).  Taking each of the two limbs of the "lower of" formulation above in turn: the approach taken in respect of the Contractor Default Residual Value Sum is to define that figure as the residual value figure included in the bid model discounted back to the time of termination at the Termination Date Discount Rate (which is based on the project IRR) - by doing this the Authority is effectively only paying compensation in respect of the residual value at the Expiry Date; the approach taken in respect of the market value is to obtain a valuation which excludes cash flows from the time of termination until the Expiry Date thus explicitly removing the double counting.

(f)  Early termination on Authority default/voluntary termination - (No lease option exercised)

The provision, in the case of Authority instigated early termination of explicit compensation in respect of senior debt (including break costs), and a separate equity payment, means that the element of debt compensation which is for debt which was supposed to be underpinned by the residual value should be disaggregated where the lease(s) are left with the Contractor.  

Therefore, compensation in respect of senior debt will be calculated in accordance with SoPC save that an amount reflecting the amount of debt secured on the residual value will be deducted.  This amount shall be the "Lender RV Element" which will use the figure in the finance documents for the debt scheduled to be outstanding at the Expiry Date, discounted back to the time of termination using an inflation-only rate.45

SoPC contains three possible options in respect of compensation to equity in this circumstance: recovery of base case IRR, market value and base case return for the remaining period (see SoPC section 21.1.3.6).  In non-HRA housing projects base case return for the remaining period is the most suitable option to adopt.  Equity compensation will be based on the present value of the cash flows to/from equity set out in the base case financial model (i.e. dividends and sub-debt cash flows including interest in most cases), using the base case equity IRR as the discount rate to discount each cash flow back to the Termination Date.  

In relation to the drafting provided for compensation to equity therefore, it is suggested that the "base case return option" from SoPC will normally be used.  There are some complexities in interpreting this for a non-HRA housing PFI project in this termination scenario, which are reflected in the drafting, as follows:

•  the Contractor will, following termination, continue to receive income from rental and the residual value where the lease option is not exercised.  This covers part of the return to equity insofar as the base case model includes these property-related cash flows.  Therefore it is important when determining compensation to equity from the base case financial model to exclude part of the return which is in effect being paid separately.

•  the recommended approach to making this adjustment is to apply a multiplier to the present value calculated from the base case equity returns: if the NPV of all base case equity returns is £x the compensation to equity should be only a proportion of £x.  This should be determined during the competitive phase of the procurement and quantified in the contract (the drafting leaves square brackets for a percentage figure but this could be expanded).  Authorities should consider (a) whether to state this figure or the calculation methodology behind it early in the procurement process or to ask bidders to bid this figure or a combination of the two and (b) how to draft, e.g. whether to use a single figure throughout the Contract Term or have a table of different multipliers for each year of the Contract, or something in between.

•  the underlying purpose of the multiplier is to eliminate from compensation to equity any payment of future profits which are already represented in the retention of the lease(s).  Care will have to be taken that the multiplier is appropriate regardless of when termination occurs including during construction, early in operations or late in operations.  The determination of the multiplier is specific to each project but two approaches which may help Authorities' analysis of this issue are (i) to consider the overall split of project revenue in the base case over the life of the project, e.g. if the unitary charge is £12 and total income over the Contract Term (unitary charge, rental and other income and residual value sales proceeds) is £20, the multiplier might be set at 12/20 = 60%; and (ii) to consider the overall project value (e.g. a valuation of pre-finance cash flows using project weighted average cost of capital) and set the multiplier on the basis that in principle equity compensation might be regarded as the balance of the project value which is not compensated through the payments of Base Senior Debt Termination Amount and the lease(s)' value.  These two approaches will likely produce different answers and also both suggest compensation to equity which changes over time as a proportion of the present value of base case equity returns.  In general, approach (ii) shall be preferred as although approach (i) may provide suitable approximation for some projects, it is fairly simplistic as returns to equity are driven by the interaction of the various sources of revenue with costs and with financing, they are not determined solely by revenue.

In summary, compensation to equity will use the standard SoPC drafting for the "base case return option" but with a multiplier applied to it, which will be less than 1.  The recommended drafting provides for a single contractually-defined figure to be used but as noted above Authorities may wish to consider more complex variants in terms of the detail of the multiplier.

As regards the alternative equity compensation approaches in SoPC (recovery of base case IRR and market value), Authorities should consider how best to accommodate these if they wish to invite bids on that basis.  It may be necessary to make similar amendments to those required for the base case return option in order to avoid double-counting compensation to equity in respect of property profits.

The Authority's Residual Value Overage Share is netted off from the equity element of the compensation - this aspect of the commercial deal has not changed (one might argue that in the event of Authority default rather than voluntary termination the situation is different but in practical terms parties are more concerned about voluntary termination and the principle of treating voluntary termination and Authority default in the same way should be adhered to).

In addition if (A) the compensation in respect of debt (excluding the Lender RV Element) and equity less the Authority's Residual Value Overage Share would otherwise be less than (B) the Revised Senior Debt Termination Amount (which in this guidance excludes the Lender RV Element), the payment is increased by (B-A), i.e. to the level of the Revised Senior Debt Termination Amount.  This is in line with SoPC principles and with the allocation of residual value risk, i.e. lenders who take residual value risk are not fully protected.  It is not appropriate to add further complexity to try to allocate the (relatively small) amount of any Additional Permitted Borrowing - this being the difference between Base Senior Debt Termination Amount and Revised Senior Debt Termination Amount - between an amount exposed to residual value risk and an amount not.

(g)  Early termination on Authority default/voluntary termination - (Lease option exercised)

As the quid pro quo to the "lower of" formulation in (e), above, the Authority will in effect take back the residual value risk in this termination scenario.  In other words the Contractor will not receive a smaller amount for the lease(s) on termination in this scenario should actual value fall short of model assumptions. This makes the compensation calculations relatively straightforward compared to (f): the Authority pays out lenders in full as per SoPC and pays equity the net present value of the base case equity cash flows discounted at the base case equity IRR.

In addition the Authority will pay the Contractor the Contractor's Residual Value Overage Share (if any).  

As with (f) above, Authorities may wish to use the other equity compensation options from SoPC, i.e. recovery of base case IRR or market value.  If market value is used it may again be necessary to offer protection to Contractors that the Authority will not seek to time an early termination, as a quid pro quo to the position adopted in (e) above, e.g. by using the higher of outturn and base case assumptions.  

In addition if the combined compensation in respect of debt and equity would otherwise be less than the Revised Senior Debt Termination Amount plus the Lender RV Element (as above - this being added back because it has been removed in the definition of Revised Senior Debt Termination Amount), the payment is increased to the level of the Revised Senior Debt Termination Amount plus the Lender RV Element.  

(h)  Early termination on force majeure - (No lease option exercised)

Compensation will be based on SoPC principles.  The Base Senior Debt Termination Amount will be reduced by the Lender RV Element, as the lease(s) will remain with the private sector.  In relation to equity, the payment will be reduced on the basis of the principles discussed above in relation to (f), i.e. the multiplier shall be applied, as equity will have the benefit of any surplus of residual value over amounts due to lenders.

In addition, given the Authority's choice not to exercise the lease option, if an overage arrangement is in place, the Authority will be entitled to deduct the Authority Residual Value Overage Share from compensation in respect of equity.  The occurrence of a force majeure event is likely to mean that overage is unlikely to arise, but the principle of maintaining the Authority's share is right because the lease(s) will remain with the private sector.

Revised Senior Debt Termination Amount is accommodated in the same way as for early termination at the Authority's instigation with no lease option exercised (see last paragraph of (f) above).

(i)  Early termination on force majeure - (Lease option exercised)

Compensation will be calculated in accordance with SoPC.  Lenders will be paid out in full and equity will receive its net investment to date back with no allowance for the time value of money.  There is no explicit additional payment in respect of the exercise of the Termination Option.

This approach is used in preference to making a downwards adjustment to the compensation to lenders whilst in addition paying the value of the lease(s).  That approach risks either overpaying to equity (who would receive any surplus of property value over the amount required to pay lenders) or leaving lenders without full recovery and without the assets.  If, at the time of any force majeure, an Authority does not choose to make lenders whole in this way, they may choose not to exercise the option to purchase (see paragraph (h) above).

Where the lease option is exercised the Contractor will be entitled to the Contractor's Residual Value Overage Share.

If compensation in respect of debt and equity would otherwise be less than the Revised Senior Debt Termination Amount plus the Lender RV Element, the payment is increased to the level of Revised Senior Debt Termination Amount plus the Lender RV Element.

(j)  Early termination on corrupt gifts, fraud and refinancing breaches - (No lease option exercised)

The Contractor will be paid an amount equal to the Revised Senior Debt Termination Amount (i.e. less the Lender RV Element).

The Contractor will take the residual value risk.  This is because the Contractor will retain the residual interest and should therefore be exposed to the risk of this not being capable of repaying the tranche of debt exposed to residual value.

If the market value of the lease(s) at termination is greater than the Discounted Residual Value Sum, the Authority should be entitled to the Authority Residual Value Overage Share (if overage has been agreed) being netted off the calculation.  This is justifiable on the basis that Contractor default should not deprive the Authority of this share and the Contractor retains the lease(s) and the associated benefits.

More generally, given that the Contractor has the whole value of the lease(s) if the lease option is not exercised, the Authority may in principle be more likely to exercise the lease option.

(k)  Early termination on corrupt gifts, fraud and refinancing breaches - (Lease option exercised)

The Contractor will be paid an amount equal to the Revised Senior Debt Termination Amount (i.e. less the Lender RV Element).

In addition the Contractor will be paid a sum equal to the lower of (a) the Lender RV Element and (b) the market value of the lease(s).

This approach means that senior lenders will not be guaranteed full payment of senior debt, consistent with the commercial position regarding RV risk, but lenders remain in effect protected by the loan-to-value covenant as represented in the base case model at the end of the contract.

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45  The annual inflation rate used will typically be the same rate as used in the Discounted Residual Value Sum definition.  An inflation-only rate is used because the intention is to determine the amount of debt in today’s money which is intended to be exposed to RV risk.  The full cost of any swap breakage (insofar as the swap is terminated - it may only be re-profiled if some loan remains outstanding following termination of the contract) will be included in the Base Senior Debt Termination Amount but the deduction does not seek to differentiate the underlying loan from the swap breakage.