The long-term 'BBB+' debt rating reflects the following risks:
-- The project has an aggressive financing structure, which is typical of U.K. PFI transactions. The debt amortization profile is heavily backloaded, with 69% retiring in the last 10 years, and 45% in the last five years before maturity. The ratio of senior debt to equity is 90%, and the base-case annual senior debt service coverage ratio (ADSCR) is a minimum of 1.16x and an average of 1.33x, when calculated in line with the project documentation. When calculated without interest income, in line with our criteria, the minimum ADSCR is 1.15x and the average is 1.29x.
-- In common with similar PFI schemes, ProjectCo is exposed to life cycle maintenance risk for the concession period to 2029. The risk is partially mitigated by a three-year, forward-looking major maintenance reserve, although we believe that the life cycle expenditure forecast could be exposed to errors in pricing and asset life estimates. However, in our view, ProjectCo's inability to access certain wards--due, for example, to high occupancy levels at the hospital--could make delivery of the life cycle works difficult.
-- Relations have deteriorated between Carillion Services Ltd., the facilities management (FM) provider, and some of its employees who are members of the trade union GMB (which is not recognized by Carillion), leading to six days of industrial action in March 2012 with the prospect of more to come. However, Carillion has so far supplemented resources to ensure continuity of service without any disruptions and the Trust (Great Western Hospitals NHS Foundation Trust) remains satisfied with service provision.
-- Only one-half of the project's debt service reserve account (DSRA), which provides for the equivalent of the next six months' debt service, is funded by cash. The other half is currently funded by a letter of credit (LOC) provided by Lloyds TSB Bank PLC (A/Stable/A-1), which was issued for a five-year period to Jan. 9, 2015. We understand that the project will either seek to extend the LOC on its expiry or provide an equivalent instrument. Failing that, we understand that the project will increase the cash-funded portion of the reserve so that the DSRA is fully funded with cash.
These risks are offset by the following strengths:
-- The project benefits from a benign payment mechanism, with favorable conditions to limit deductions. We believe that this is unlikely to lead to substantive financial penalties. Senior debtholders are only exposed to unavailability deductions and abatement owing to poor performance, with no volume or market risk.
-- The facilities have a track record of successful and stable operations since 2002, and the hospital is performing well. This partially reflects the good project management and experience of Carillion Services Ltd. The construction contractor, Carillion Construction Ltd., retains responsibility for construction defects under a guarantee that expires in 2014 for the acute general hospital and in 2017 for the diagnostic and treatment center.
-- The FM services are relatively standard, including hard FM services (estates maintenance) and soft FM provision. As is standard for PFI projects, performance-related deductions and unavailability deductions caused by the contractor are passed through to the FM service provider. There are no technological, medical equipment-related, or other nonstandard risks. ProjectCo has successfully concluded a benchmarking exercise with the Trust and Carillion Services Ltd. By mutual agreement this was one year early and has been satisfactorily concluded. The next benchmarking exercise will not be until 2018, as per the Project Agreement standard benchmarking schedule. The ability to replace the FM services provider should the need arise, plus adequate cash reserves within the project, mitigate counterparty dependency on Carillion Services Ltd.
As of Dec. 31, 2011, after a payment of distributions, the project had GBP425,000 in free cash, in addition to GBP3.2 million in the DSRA and GBP4.4 million in the life cycle reserve account. The senior debt service on Jan. 9, 2012, was about GBP6.4 million.
The loan notes have a recovery rating of '1', indicating our expectation of very high (90%-100%) recovery of principal in the event of a payment default. To date, however, there has been limited experience of default or loss in this sector.
The stable outlook on the debt rating reflects our view of ongoing stable operations and a continued strong working relationship between the Trust, ProjectCo, and the FM service provider.
We could lower the rating if cost pressures or deductions were to weaken the project's financial profile; if the project did not fulfill its life cycle obligations and this were to have a negative effect on the hospital's condition; or if the relationship between ProjectCo and the Trust were to deteriorate. We could also lower the rating if the DSRA were to cease to be fully funded, or if the minimum ADSCR were to fail to recover and stabilize over the next one to two years at about 1.17x (as calculated in line with our criteria), for reasons including costs incurred on the LOC drawdowns.
We do not envisage raising the rating because we anticipate that any overperformance would be absorbed by increased permitted dividends to shareholders.
Related Criteria And Research
-- Project Finance Construction And Operations Counterparty Methodology, Dec. 20, 2011
-- Recovery Ratings For Project Finance Transactions, April 8, 2005