spotlight LEVERAGED FINANCE GETTING ON THE RIGHT TRACK JOANNA HAWKES OF ANGEL TRAINS EXPLAINS SOME OF THE ISSUES FACING THE ROLLING STOCK LESSOR IN THE FUNDING AND LEASING OF TRAINS TO THE OPERATING COMPANIES. he purpose of this article is to outline the issues facing the rolling stock lessor, both from the perspective of financing the purchase of rolling stock, as well as leasing it to the trains operating companies (Tocs). It focuses mainly on the Tactivities and experiences of Angel Trains (Angel). BACKGROUND. The three rolling stock leasing companies (Roscos) Angel, Porterbrook Leasing and HSBC Rail (formerly Eversholt tandem with extended and renegotiated franchises. As the market Leasing) were originally formed in 1994 out of the privatisation of has developed, lease contracts have become more bespoke and very British Rail. Their business is owning, maintaining and leasing rolling heavily negotiated. stock. At the time of public offer, fears of re-nationalisation under For a number of reasons – partly strategic, partly historic – Angel an incoming Labour government were high. Offers to buy from the Trains finances about 80% of its portfolio in the banking market, finance sector were limited and consequently two of the three were rather than via its parent. Figure 2 illustrates the current simplified the subject of management buy outs. Over subsequent years, industry structure. however, Roscos have migrated towards their natural home for UK leasing companies, and each has become a subsidiary of a big TYPES OF LEASES. There are a number of variations in the types of financial institution: Royal Bank of Scotland (Angel), Abbey National lease structures, but generally capital rentals are fixed. Tax and (Porterbrook) and HSBC (HSBC Rail). interest rate exposure generally reside with the lessor for the period Despite a low public profile, the Roscos are perceived to be one of the lease. of the success stories of privatisation. Leasing specialists have used All new lease terms require the implicit endorsement Strategic established techniques, specifically the application of surplus tax Rail Authority (SRA), effected through the SRA ‘Direct Agreement’. capacity and low funding costs, to create a product that didn’t exist The direct agreement determines the rights of the SRA to act in the in any prior form. Competition is acute among the three companies, event of a Toc default. These rights need to be acknowledged by the from which the Tocs benefit, and ancillary support services have lessor and other interested parties with security over the lease or been improved and maintained. More than 50% of the staff the trains. Under Section 30 of the Railways Act 1993 and the employed at Angel are engineers involved in train maintenance, Transport Act 2000 the SRA has a statutory duty to provide train safety and product development. Since privatisation Roscos have services consistent with the passenger service requirement (PSR). collectively financed the purchase of £3.5bn of new rolling stock, more than 60% by Angel (See Table 1). STANDARD MOLA LEASE. All of the former British Rail rolling stock assets are leased through the standard industry Maintenance and LEASING OF TRAINS AND CUSTOMER INTERFACE Operating Lease Agreement (Mola). Heavy maintenance responsibilities are directly with the lessor and maintenance GENERAL. Angel leases to 19 out of the 25 Tocs. Prior to expenditure is recovered through the ‘non-capital’ rent. privatisation a ‘standard’ lease structure was set up, which acted as For much of the older stock, the non-capital rent is higher than an industry benchmark. Most leases were established for a period of the capital rents. All older leases are subject to the Opraf/Rosco eight to ten years until March 2004 co-incident with most of the Agreement, a wider and more favourable predecessor to the current existing franchise end dates then established. New train purchases Direct Agreement, and 80% of capital rents are ‘underpinned’ by the have become the subject of new leases which have been running in Secretary of State for Transport. 58 THE TREASURER JANUARY 2002 spotlight LEVERAGED FINANCE NEW LEASES IN RELATION TO THE PURCHASE OF NEW ROLLING through a tripartite maintenance agreement with the manufacturer STOCK. The requirements for new rolling stock has arisen out of the and Toc. need for Tocs to meet their franchise commitments. Bespoke leases ▪ Lease linked to ‘novated’ purchases. There are a few instances have consequently been agreed with individual lessees. Broadly, they where a Toc has negotiated its own purchase contracts with train fall into several categories set out below: manufacturers in accordance with an original view to ‘own and operate’ but has found the use of capital and tax capacity can be ▪ Longer term dry leases. Long-term leases that exactly match the more effectively maintained through third-party leasing. In these franchise term. Angel has no maintenance responsibilities (but is cases, Angel negotiates with manufacturer and Toc to effect a heavily involved in the negotiations). It retains direct audit and novation of the purchase contract. inspection rights over the maintenance and a veto on any significant ▪ No leases and ‘speculative’ purchases. These are speculative changes to the maintenance arrangements. On expiry of the purchases made in exceptional cases where there is a considered and franchise Angel has the option to continue the maintenance regime justified risk that buying without a lease will enhance the ability to directly with the manufacturer and to step in, in the event of a Toc both market and price future leases. The most pertinent example of default. In practice, Angel keeps close control over maintenance this was the purchase by Angel of 25 prototype Siemens Desiro UK through its own project management. electrical multiple units specifically designed by Siemens to target ▪ Shorter term leases. In these cases, the Toc has not yet secured a the large UK mark 1 replacement market. For Angel this resulted in franchise extension, because it has not been awarded or even quick and substantial subsequent leases of 84 class 360 Desiros to tendered. These shorter term leases may be dry leases where the First Great Eastern (£75m) and 785 class 450/444 Desiros to South maintenance regime works as above, wet leases where the Angel West Trains (£640m). retains direct maintenance responsibility (even though it will often subcontract to the maintainer) or a ‘soggy’ lease, where it operates KEY FACTORS IN DETERMINING A RENTAL RATE. In general, lease rates are determined on a whole-life asset basis, typically assumed at TABLE 1 between 25 and 35 years. Assumptions are made on releasing and POST-PRIVATISATION ORDERS (1997-2001) refinancing risk over the full life. Newly negotiated leases generally relate to substantial levels of capital expenditure and will carry a Trains Lessor Producer Total Total specific risk for which a suitable return must be derived. Angel vehicles cost £m currently operates on a ‘deal by deal’ return criteria, with each contract having a bespoke financing arrangements. Typically, third 390 Virgin West Coast Angel Trains Alstom 477 593 party funders provide 80-90% of the debt with the balance funded Pendolinos directly by Angel. Issues such as construction interest, loan term, Class 67 loco EWS Angel Trains Alstom/GM 30 45 bullet can effect equity returns significantly. Financing terms are Class 66 loco EWS Angel Trains GM 250 320 critical to commercial decisions, which often results in some lengthy 333 Arriva Trains Northern Angel Trains Siemens 56 61 funding negotiations. Angel is continually re-evaluating its funding options and 450/444 Desiro – South Angel Trains Siemens 785 640 methodology in line with market changes to ensure optimal use of West Trains debt and capital. 360 Desiro – First Great Angel Trains Siemens 84 75 Eastern SPECIFIC TYPES OF DEAL RISKS 357 c2c Angel Trains Bombardier 112 92 175 First North Western Angel Trains Alstom 70 78 REFRANCHISING & RELEASING RISK. If a Toc has only a short 180 First Great Western Angel Trains Alstom 70 74 franchise, this exposes a lessor to short-dated repricing and releasing 332 Heathrow Express BAA Siemens 56 69 risk. This risk will be evaluated in the bid process and will address issues such as the likelihood of the existing franchisee securing a lease 220 Virgin Cross Country GL Railease Bombardier 352 407 (now Angel) extension (in which case, it may build conditional releasing into the deal), the SRA’s motivation towards new stock in evaluating new bids 168/0 Chiltern HSBC Rail Bombardier 9 7 (generally high), general train desirability, performance and 375 Connex South Eastern HSBC Rail Bombardier 240 180 transferability, and potential competition from vehicles that may be 170 ScotRail HSBC Rail Bombardier 18 17 cascaded from other routes by other lessors. 334 Scotrail HSBC Rail Alstom 120 100 Generally, when a new train has been successfully performing on an 220 Midland Mainline HSBC Rail Bombardier 96 115 existing route, the motivation of an incumbent to release is 375 New Southern Railways Porterbrook Bombardier 160 120 considered to be high. In addition, there are significant costs 168/0 Chiltern Porterbrook Bombardier 35 30 associated with changing trains, for example, driver training. 170 Anglia/Midland Porterbrook Bombardier 161 155 Mainline/Central REGULATORY AND POLITICAL RISK. There are a variety of regulatory and politically rated risks which we have to be aware of: 170 South West Trains Porterbrook Bombardier 16 15 357 c2c Porterbrook Bombardier 184 130 ▪ Direct Agreements. The form of the Direct Agreement has evolved 458/0 South West Trains Porterbrook Alstom 120 90 and the SRA is gradually seeking more flexibility over its step-in 460/0 Gatwick Porterbrook Alstom 64 45 rights – most specifically, the ability to ‘cherry pick’ from the assets leased under one contract, rather than operate on an ‘all or nothing’ Grand total ordered post-privatisation 3,565 3,458 basis, which presents more risk to the lessor.