Local authority commercialisation through innovative funding solutions
April 2022 | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE
Financier Worldwide Magazine
April 2022 Issue
Depending on who you talk to, the rise of commercialisation in local authority services in the UK is either the natural result of enterprising councils looking to bolster resources in the face of years of austerity, or it is the inevitable end game for councils that take too much risk and are not concentrating on getting the basics done properly. There are a multitude of views in between those extremes.
Years of austerity has created ever tightening budgets for local authorities. The coronavirus (COVID-19) pandemic has added considerably to those financial pressures. Local authorities have had no responsibilities removed from them. Instead, new duties and expectations have been added during these austerity years, including new proactive responsibilities in relation to the prevention of homelessness and a multitude of new building safety obligations proposed in the wake of the Grenfell Tower tragedy, as just two examples. With reducing government financial support and increasing responsibilities, every local authority has had to consider how to generate additional capital and revenue to meet their day-to-day challenges. Most local authorities want to do more than just meet day-to-day challenges, so we have seen the rise in innovation and entrepreneurialism by local authorities that are investing in their towns and communities. Government departments often use the criteria of ‘novel, repercussive or contentious’ to describe matters requiring ministerial sign off. These terms can be used to describe some elements of the growing commercialisation of local authority services and delivery. They can be very prescient when things go wrong. There has been a whole range of commercial ventures, investment decisions and groundbreaking financial transactions that have, in many respects, changed the local authority mindset about what can be achieved and how it should be done. However, these have not always been successful. High-profile failures grab the headlines, but those innovative ventures that achieve what they set out to do, and there are many of them, quietly get on with it.
According to the Ministry of Housing, Communities and Local Government’s figures, the local authority sector’s total borrowing, as of March 2020, stood at £127bn and investment amounted to £46bn. Most local authorities have declared a climate emergency and have set ambitious targets to achieve net-zero. These targets cannot be achieved through the adaptation of working practices or simply changing mindsets and behaviours. They require significant new financial investment. Local authorities will therefore be continuing the upward trajectory of borrowing and investing and the sheer scale of local authority borrowing and investment means that new and innovative funding sources are being, and will continue to be, deployed.
Innovative funding is probably a misnomer. They might be innovative for the local authority sector, but they are not necessarily new or innovative in other sectors. Local authorities benefit from access to funding from the Public Works Loan Board (PWLB), which is a lending facility operated by the UK Debt Management Office (DMO) on behalf of HM Treasury. Access to it is straightforward, the terms can be very favourable, and loans are quickly allocated. If the finance director of the local authority confirms that they are acting in line with statute and can afford to repay the loan from their revenues, the PWLB will issue the loan, usually within a couple of days. According to the PWLB Reports and Accounts 2020/21, the PWLB advanced 264 new loans last year with a value of £2.9bn to local authorities in the year. PWLB funding is by far the main lender to local authorities and accounts for over two thirds of local government debt. The rules of access were recently tightened, requiring the finance director to confirm that the local authority is not borrowing in advance of need and does not intend to buy commercial assets primarily for yield. Access to future PWLB loans would be restricted if a local authority used any borrowing to acquire commercial assets for yield. Local authorities have considered different sources of funding to the PWLB for many years. This could be because of an investment strategy which looks to have a plurality of provision to spread risk or simply to take advantage of favourable terms being offered by a new investor looking to attract the super covenant strength of a local authority borrower.
It is against that backdrop that we are seeing more local authorities entering into loan agreements with commercial lenders, issuing notes on a private placement basis, undertaking bond issues and using income strip finance leases to achieve their commercial ambitions. Local authority commercial ambitions are a means to an end. The end being the delivery of high-quality responsive services to its communities.
Loan agreements may be on a bilateral basis, where there is a single lender or on a syndicated basis where two or more lenders lend to the same local authority borrower on common terms. Loan facilities may be on a term basis, where loans are drawn and remain outstanding until they are repaid, or on a revolving basis. Term loans are similar in some ways to the facilities offered by the PWLB. As with the PWLB, it is possible to structure these on an amortising basis or to provide that all the facilities are repaid at the end in one ‘bullet’. However, loan agreements with commercial lenders would typically have a much shorter term than most PWLB borrowing – five to 10 years at most. The PWLB does not offer a revolving credit functionality.
Under a private placement, local authorities would issue notes to investors. These could have a maturity of up to 35 years or even longer. We would typically expect these to be fixed rate instruments, although there is no reason, in principle, why variants could not be agreed. Because these notes are the product of negotiation with investors, it is possible to agree bespoke terms as we have seen in recent examples. For example, it is possible for the whole or part of the notes to be issued on a deferred basis. It is also possible to agree a range of maturities under the same agreement. This market is not especially mature in the UK local government sector, but it is getting some traction given the terms can compare very favourably with the PWLB.
Public bonds are a growing market for local authority investments. These are bonds which are listed either on the London Stock Exchange or another recognised investment exchange. The advantage of this structure is that the listing means that the notes are readily tradable. A credit rating is typically required for a listed bond issue. Bonds are typically fixed rate instruments although other variants, such as inflation-linked bonds, are, in principle, possible. They can have a term of up to 30 years or longer and although there is sometimes an amount of amortisation toward the end of the term, they are usually repaid in one single ‘bullet’ at the end. The set up and ongoing costs of a public bond are significantly more expensive than other types of financing, which means that we rarely see bond issues of less than £100m and more usually issues will be in a minimum ‘benchmark’ size of £250m.
Many councils will not have a need to raise this kind of money in one hit. For them, the UK Municipal Bonds Agency (MBA) offers a viable alternative means of accessing the capital markets. The Agency will issue bonds in its own name for the exclusive purpose of on-lending the proceeds to local authorities. This could offer a significant cost saving to authorities and will be simpler for a council than entering into its own transaction. It was reported in August 2020 that the MBA issued its second bond valued at £250m with a 40-year maturity, 80bps lower than the equivalent rate from the PWLB. Although PWLB rates have since been lowered, this still offers an attractive opportunity for local authorities.
Under the income strip model, which has gained considerable traction over the last five years, investors rely on the covenant strength of a local authority (or a special purpose vehicle backed by the local authority) to develop or acquire assets to lease to the local authority for an index-linked return. These arrangements benefit from simplicity, though the local authority needs to be fully cognisant, as with any long-term borrowing or investment, of the risk arising from the long term index-linked liability.
To many, the local authority sector is seen as a moribund and ultra-cautious sector, unwilling to embrace innovation, particularly in long-term financing. We believe that this is a lazy and outdated view. Local authorities have used their borrowing and investment powers to generally amazing effect over many decades and are embracing innovative funding solutions to ensure they continue to provide the civic leadership that is so necessary right now.
Scott Dorling, Amardeep Gill and Neil Waller are partners at Trowers & Hamlins. Mr Dorling can be contacted on +44 (0)20 7423 8391 or by email: sdorling@trowers.com. Mr Gill can be contacted on +44 (0)121 214 8838 or by email: agill@trowers.com. Mr Waller can be contacted on +44 (0)161 838 2032 or by email: nwaller@trowers.com.
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Scott Dorling, Amardeep Gill and Neil Waller
Trowers & Hamlins
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Local authority commercialisation through innovative funding solutions