Last week in North Lanarkshire, Transform Schools – a consortium of Balfour Beatty and Innisfree – closed one of the most significant PPP financing deals to have closed to date in the mature UK market

The £158 million (US$285.7m) deal to build, own and operate 21 primary and secondary schools in the semi-rural central Scottish region of North Lanarkshire is one of the largest PPP education deals in the UK and overcame substantial challenges to reach close.

The North Lanarkshire schools deal has established itself as a landmark deal being the first bond financed project in the school sector - a development which will surely have ramifications for England's ambitious Building Schools for the Future (BSF) programme.

The drivers

North Lanarkshire lies in the Scottish Central Belt between the two economic centres of Edinburgh and Glasgow. With a population of 322,000 it is the the fourth most heavily-populated Scottish regional authority after Glasgow, Edinburgh and Fife.

By the 1990s the region was suffering from an education crisis. Both primary and secondary school populations had declined substantially since the early 1980s, with primary schools feeling the brunt of the population drop.

By 2002, North Lanarkshire found itself with 23,000 surplus school places across primary and secondary schools. Looking to the future, by 2011 the council projects that a total of 21 primary and nine secondary schools will be operating at under half their capacity.

The surplus was causing administrative and maintenance burdens for the council - particularly from the schools in the 50 year age bracket - that an area listed EU Objective 2 could ill-afford to bear.

The schools were identified by the Scottish Executive as in clear need of rationalisation, but it was far from an easy issue to handle due to sectarian divides in the area. The large number of Catholic Schools the programme was to include meant that the plan needed to be sensitively handled.

The project

The council identified nearly 40 schools in need of rationalisation under its Education 2010 programme and submitted proposals to the Scottish Executive.

The Executive approved the programme's centrepiece PPP plan in September 2001, crucially agreeing to finance £11 million (US$20m) of the proposed £15.2 million (US$27.4m) annual unitary charge with the council providing the balance.

In September 2002, the project – which at £158m (US$285.7m) was one of the largest education PPPs in Scottish procurement to date – was tendered to bidders.

After the competitive tender, Transform Schools outbid the AWG-led Alpha consortium and Pinnacle Schools - a consortium of Sir Robert McAlpine, Newcourt Capital and Sodexho - to win preferred bidder status in April 2004.  

The council's plan was essentially consolidation. Three new build secondary schools in Aidrie and Coatbridge will be built to replace five existing secondary schools.

The 1,350-pupil Coatbridge Roman Catholic secondary and the the 1,120-pupil replacement Aidrie Academy will open in October 2006 and the new 1,130-pupil non-denominational school in Coatbridge will open in October 2008.

The consortium will also build six joint campuses encorporating separate non-denomination and Roman Catholic primary schools in the villages of:

• Wishaw
• Caldercruix
• Chapelhall
• Bargeddie
• Marnoch
• Plains

The joint campuses will have combined capacities of between 190 and 570 with some shared facilities and are due to be operational between January 2006 (Caldercruix) and August 2007 (Wishaw).

Finally, Transform will build six new primary schools. Non-denominational schools in Stepps, Wishaw and Viewpark in Coatbridge and RC schools in Kilsyth, Shawhead in Coatbridge and Viewpark in Coatbridge.

The six new primary schools are due to be operational between August 2006 and August 2007 and ave capacities of between 190 and 560 pupils.

In addition to the initial 21 schools, the contract allowed for the construction of a school at Clarkston and a joint campus at Wishaw, which were delayed on planning grounds. The delayed schools will b efinanced by variation bonds. 

In addition to construction, Transform negotiated to provide hard FM services (maintenance, janitorial and security systems) and limited soft FM services (including security, cleaning, and grounds maintenance) through Balfour Beatty's Haden arm.

The maintenance services would be worth £3.5 million (US$6.3m) per year over the duration of the contract.

Having agreed the scope of the project, the consortium and council set out to reach financial close by the end of the year.

However, the best laid plans quickly went awry. In Summer 2004 local Catholic church leaders in the Diocese of Motherwell objected to the joint campuses threatening a court injunction.

In October 2004, with target dates for the project slipping, the consortium signed an early works agreement with the council and started work on the first schools.

In November 2004, after the intervention of the Scottish Executive, the Diocese of Motherwell relented. However its opposition ultimately delayed the project by six months. On 8 June 2005 the project reached financial close. 

Financing

In order encorporate the ambitious scope of the project and bankroll capital costs of around £138 million (US$249.5m), financing had to be as tight as possible.

At the end of 2003, the European Investment Bank (EIB) identified the project for a £70 million (US$126.6m) loan, a cheap financing option that the council was unlikely to reject and at a rate which the consortium would be under pressure to match.

To structure the commercial capital, Transform's financial adviser HSBC selected Royal Bank of Canada (RBC) and monoline arranger XL Capital Assurance (XL CA) - already a team working on the Newcastle hospital PFI - to put forward the commercial markets option.

Royal Bank of Canada and XLCA responded by offering an index-linked issue of £72.5 million (US$131.1m) - with provision for £15 million (US$27.1m) in variation bonds to cover the additional three schools and overruns - at just 73 basis points above the gilt spread. 

The bond route was selected over bank financing by Transform schools and the council as best VFM. 

In Summer 2005, Standard & Poor's rated the bond issue BBB-, a highly favourable rating for a PPP schools programme. The bond was launched on 2 June 2005 and was saturated in under a week.

The equity and subordianted shareholder debt is split 50:50 between Balfour Beatty and Innisfree.

Pinpoint equity of £60,000 (US$108,000) will be provided by Transform shareholders at financial close. In addition to £15.4 million (US$27.8m)  of subordinated debt raised from a senior rights issue and to the SPV in installments between March and September 2008.

In addition the unitary charge of £15.2 million (US$27.4m) that Transform will receive from completion of the schools, it will also receive a fee of £23 million (US$41.5m) over the first four years. The £3.5 million (US$6.3m) for FM services account for 25 per cent of the unitary payment.

The soft FM services will be subject to benchmarking or market testing at five year intervals after the schools are completed.

The consortium will begin senior debt principal repayments in March 2009.

Conclusion

The North Lanarkshire schools PPP was notable for its complexity, innovation and the undoubted determination of its project teams. 

While the 14-month lag time from preferred bidder to financial close was substantial for an education project: in view of the religious opposition, use by lawyers of the relatively new Scottish schools standard form contract and inevitable complexity of a project on 15 different sites.

A more telling achievement  is the six month figure from financial close to start of construction under the early works agreement.

However, the crucial element of the project is clearly the finance. The 73 basis points figure clearly sets a low watershed for education finance which may well lay down the red flag for future education projects.

Admittedly, while RBC and XLCA provided lower bond pricing for Equion's Newcastle hospital - at just 60 basis points above gilt spread - that keen pricing can be put down to exceptional circumstances, namely the presence of a single bond investor cut costs substantially.

Of equal importance, the BBB- rating from Standard & Poor's sets a positive indicator and will undoubtedly add credibility to the use of bonds in PPP.

Mark Wells, director of UK PFI at XLCA explains the importance: 'With the Building Schools for the Future coming afterwards the deal has had the spotlight on it to see how the rating agencies rated it. People are now using as a clear precedent for moving forward in an area where everyone envisages a fair amount of deal flow.'

The transaction also completes a hat-trick of recent major deals for RBC after financial closes at Manchester hospital in January and Newcastle hospital in April. 

Despite their success, Henrietta Podd, managing director of RBC's infrastructure finance team is cautious about the increasing role of bond financing in UK PPP.

‘At the moment the bond market is more competitive in terms of absolute interest rates, but that can change. We are seeing a number of banks actually tightening their margins in response to that and the market vary,' she claims.

All things being equal, there is no doubt that ever more intense competition among monolines and growing liquidity in the UK bond market is squeezing the bank loan option out of PPP.

The North Lanarkshire schools deal has laid down the gauntlet to bank finance, and with the prize of BSF at stake, banks may soon find they have to stoop to conquer.

Project at a glance