b1: from conventional loans to indexed-linked...
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B1: From conventional loans to indexed-linked finance
Speakers: Jonathan Clarke Partner, Centrus Advisors Tim Jackson Resources Director, Golding Homes Chair: Jonathan Dwyer Senior Consultant, David Tolson Partnership
Client Logo CONFIDENTIAL T R E A S U R Y & D E R I V A T I V E S ⎢ D E B T A D V I S O R Y ⎢ P R O J E C T F I N A N C E ⎢ C O R P O R A T E F I N A N C E
Centrus Advisors LLP is authorised and regulated by the Financial Conduct Authority
From conventional loans to index-linked finance Jonathan Clarke Partner, Centrus Advisors LLP 8th October 2014
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Contents
• Why do investors want inflation? • Pressures on and changes to RP business models • Pricing and terms • Negative implications for borrower • Positive implications for borrower • The future • Q&A
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Why do investors want inflation?
• Pension funds major buyers of inflation: – Total global pension fund assets ~$30tn – UK pension fund assets ~$3.5tn (130% GDP) (10% CAGR over last ten years) – Majority of pension funds assets are in defined benefit schemes: 72%
• Only 12% UK private-sector DB pension funds open to new members (and thus long-term cash inflows).
• Liability hedging very important. Full hedging of inflation implies £1tn assets, reducing with “DB run-off”
Source: Towers Watson, NAPF
£bn
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Why do investors want inflation?
• Total UK IL-gilts issuance ~£400bn • Pricing at negative real yields for couple of years
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Why do investors want inflation?
What else can represent a good hedge to inflation? • Equities and property:
– not perfect! – maybe better hedges for GDP than RPI
• Explicit inflation linkage from a strong credit, maybe some implicit
government support … – Total universe of corporate IL bond issuance only about 1/10th of the
government market – Utility companies … a few others … and housing associations?
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Pressures on and changes to RP business models
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Pre-2008 2008-2014 Beyond 2014?
• Availability of capital subsidy
• Highly liquid banking market
• Institutional investor base under utilised
• Few capacity constrains
• No impetus for innovation
• Little non-RP interest • Global Financial
crisis…
• Capital subsidy replaced by revenue subsidy
• Institutional debt market evolves to plug the hole left by banks
• RP balance sheets/ratings under strain
• Treasury tail wags the corporate dog
• Crisis in housing supply
• Ongoing interest in residential asset class
• Interest extends beyond debt to equity
• RP business model evolves
• Regulation and grant? • Legacy debt?
• Indexed funding –
part of the solution for some?
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Pricing and terms
• Index-linked debt priced against gilts, expect similar margin to conventional bond with comparable duration
• Leases priced as property, tends to make more expensive when translated into margin over gilts but also dependent on structure
• Comparing pricing – need to adjust for inflation and repayment structure. For example, with 3% inflation and flat yield curve:
• 4.55% coupon on conventional borrowing suggests • 1.50% coupon on IL borrowing suggests • 3.69% initial yield over 35 years on an annuity (asset reversing to RP)
Is implied inflation an expectation or just a reflection of supply vs demand?
• Leases more flexible in some respects (e.g. corporate covenants, default consequences, administration), less so in others (e.g. security release, restructuring).
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Negative implications for borrower
• RP revenues probably “inflation-linked”, but not necessarily RPI (or CPI) and not necessarily over any given timeframe
• Generally conservative sector – not unreasonable given core function of providing homes for the poorer in society
• Inflating revenues and static funding costs make it a lot harder to produce a business with long-term viability issues – good!
• Regulator consistently cautious. E.g. proposes stopping use of general disposal consent for security for index-linked borrowing
• Some examples of mis-use of inflation finance: Health PFI Y-o-y indexation Care homes
• … but … does that mean zero indexed fund-raising?
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Positive implications for borrower
• By deferring interest, and linking it to inflation, match revenue more closely to costs. May be a cap/collar arrangement.
• This potentially adds to capacity for new housing, depending in part on existing loan covenants and group structure
• If undertaken outside main RP, any downside potentially limited depending on loan covenants etc. – Could be market rent or simply a “fresh start” with financing
appropriate to the current environment. • Personal experience – Genesis / M&G deal in Stratford was the right
outcome, but required careful consideration of business risks as well as deal-specific risks.
• Indexation compromise options for private placements
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The future
• What can inflation-linked funding give you:
– Deferral of cash interest costs? YES – Better accounting outcome? NO – More capacity, better risk management? POSSIBLY
Inflation funding ≠ lease funding Inflation funding ≠ annuity
• Opportunities to improve the lease model • Opportunities to reduce “bullet profile” risks with indexed debt • Ambitious RPs will take more risks to deliver development, perhaps with
new commercial structures and risk allocation • The sector will continue to diversify
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Q&A
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Disclaimers Centrus Advisors LLP (“Centrus”) is authorised and regulated by the Financial Conduct Authority Firm Reference Number 606311. This document is only directed at those Clients that can be categorised as Professional Clients or Eligible Counterparties and not those categorised as Retail Clients under the rules of the Financial Conduct Authority in the United Kingdom. This document or any of its content must not be distributed or passed on, directly or indirectly, to any other person without the express written consent of Centrus. Nothing within this document should be construed as investment advice and should not be relied upon. The information contained within this document was obtained from sources believed to be reliable but no guarantee is given to its accuracy and completeness. Centrus is under no obligation to update, modify or amend the information.
Contact us Phil Jenkins 020 3397 7684 [email protected] Paul Stevens 020 3397 7685 [email protected] Geoff Knight 020 3397 7693 [email protected] John Shinton 020 3397 7682 [email protected] Nathan Pickles 020 3397 7689 [email protected] Jonathan Clarke 020 3637 2565 [email protected] Jason Murphy +353 (0)86 0452724 [email protected] Mermaid House, 2 Puddle Dock, London EC4V 3DB www.centrusadvisors.com
From Conventional Loans to Index-Linked Finance
Tim Jackson Resources Director, Golding Homes
What am I going to cover?
• Index-linked financing – what is it?
• Impact on capacity
• Key risks
• Benefits
• Risk Management
Experience of sale and leaseback
• 2 deals completed • 1 was to raise additional finance for the Group • 1 was to fund stock acquisition – 190
properties
Sale and leaseback – what is it? • RP sells long lease to investor for a lump sum – probably around £100k a unit but
the exact price will affect the ability to pay, after management and maintenance costs, the annual sublease payments in the next bullet point
• Investor simultaneously sells a sublease for say 48 years in return for an annual
lease payment which starts low (I can’t disclose the exact figure) • The annual lease payment goes up by rpi or cpi each year • At the end of the 48 years the leases collapse and the RP can buy the properties
back for £1
• This means in effect the annual lease payments include capital repayments
• In accounting terms this is all on balance sheet and the lump sum at bullet point 1 is treated as a loan
Benefits
• Relationship and documentation very different from a bank, e.g.. far fewer default clauses – this is a key benefit
• Very security efficient – only interest is the legal interest in the lease – no other security required. Asset cover is effectively 75%-80% versus lenders who seek 110% upwards
• ‘Security’ in place day one
Benefits (continued) • Very little else in treasury portfolio benefits the business
if inflation is low
• Will pricing rise as much as loan pricing if interest rates go up?
• Cash flows match rents • Makes sale and leaseback great for stock acquisition –
cash positive day one
Sale and leaseback – capacity issues
• No financial covenants, so gearing of no concern to the investor
• So if it can be done in a part of the group that does not impact on the group’s gearing it can enhance capacity
• Very useful if gearing is constraining for non-financial reasons, e.g. lender re-pricing needed to change historic gearing covenants
• Works well where a deal can ‘stand alone’, i.e. cash flow positive day 1 – e.g. stock acquisitions
• Useful if security is a limiting factor
Risks/Issues
• CPI/RPI increases • Very long agreement • Asset security cover inefficient in later years • Accounting is odd • ‘Jam today’ – brings forward future surplus
Cash flows – so reduced strength in later years • It’s different! Regulatory interest
Risk Management – Supporting a separate lease vehicle
• Key risk is not meeting lease payment • Deal must be solid in the first place, i.e. really
strong cash flows, i.e. buffer between net income and lease payments
• Raise extra cash, use to acquire stock to increase rental income with no lease payment attached
• Other RP’s can give vehicle additional stock to increase income
• Parent has resources to support vehicle (RP)
Risk Management (continued)
• Transaction can be novated to other RP’s in the group
• Limit the amount of index linked funding to the group
• Inflation collar on lease uplift • Stress testing, etc. • Property substitution
Enhancing the leaseback model
• Proactive investor • CPI escalator • Security release • Shorter lease period and bullets repayment • Some fixed element • Range of tenure types
Summary • Challenge is to stretch but protect finances • As new sources of finance emerge, how diversified
should our funding sources be – managing multiple agreements and relationships is risky
• Real need for treasury systems and processes • Link between development risk and treasury risk has
never been greater
B1: From conventional loans to indexed-linked finance
Speakers: Jonathan Clarke Partner, Centrus Advisors Tim Jackson Resources Director, Golding Homes Chair: Jonathan Dwyer Senior Consultant, David Tolson Partnership