Equity arrangements for PF2 Projects H.M. Treasury investment procedure and standard form

When the Government announced its policy on public private partnerships in December last year (“PF2”), the policy included an intention to act as a minority co-investor in PF2 projects, and to require a funding competition for the provision of third party equity for PF2 projects.

The Government has concluded its consultation on equity arrangements for PF2 projects, and has now issued standard form documentation which is available here.

The documentation is to be customised by the Treasury PF2 equity unit, in conjunction with the procurement authority, prior to issue, to reflect project specific issues for each procurement. Bidders will then be asked if they accept the commercial terms of the standard documentation.

Whilst the Treasury’s approach to the investment procedure and appraisal process is broadly unchanged, and the equity documentation is very similar to the original drafts, the Treasury acknowledges that some projects will require a more bespoke, or different, approach – to be proposed (and justified) by bidders.

1. Equity investment procedure

The Government will determine on a case by case basis whether there should be public sector investment in PF2 projects (on an optional basis). This will be specified in the relevant procurement documentation. If this applies, bids will need to be made on a fully funded basis – with Government being able to require this to be scaled down. It is expected that this will always be a minority stake (set by Treasury in conjunction with the Authority) – with no obligation to provide further funding over and above that agreed at financial close of the project. The Government’s investment will be on the basis of a “firm intention” – provided that the project meets the Treasury PF2 equity unit’s eligibility criteria. Bidders will also be told if Government may wish to sell down part of its holding – and of the quantum of equity that it would want to hold as a long term investment.

At the same time, the Government will determine if an equity funding competition is required. This is envisaged to be a single stage process, run by the preferred bidder, and with the preferred bidder selecting the winner on an open and transparent basis. Neither Treasury nor the Authority that sponsors the project would be part of the selection process, but both would have access to the evaluation criteria and selection decision.

Sponsors will be able to seek informal guidance from the Treasury team on specific issues during the procurement process.

Where there is a funding competition, the overall capital structure and shareholder debt terms will be set by the preferred bidder – as the Government’s stake will need to comply with State Aid requirements, it is likely that where Government is to be a shareholder, an equity funding competition will be required.

The Government has recognised that some equity investment arrangements may be bespoke to a project, and in those circumstances bidders will be allowed to propose amendments to the standard form documentation to the Treasury PF2 equity unit at bid stage (provided these are genuinely project-specific, and are supported by a project-specific justification). However, the revised proposals must remain compliant with the Government’s policy. These amendments will form part of the Treasury PF2 equity unit’s initial due diligence.

2. Investment appraisal process

The Treasury will carry out a two stage “due diligence” process on each project, with the aim of minimising the work and cost to their team:

• as part of each bid, the bidder would provide key prescribed information, including on the allocation of risk between the project company, the supply chain, and insurances (which even where detailed documentation has not been prepared should have been priced). A description (and justification) of material proposed changes from the template PF2 equity documentation will also be required. There will not be a need to supply mark ups at this stage;
• prior to financial close, the Treasury team will carry out a review of the equity documentation (and agreements between shareholders and senior lenders) and of the financial model (with some sensitivity scenarios). The Treasury team will also require a completed due diligence questionnaire (similar to that for a secondary markets transaction), and copies of due diligence reports prepared by technical and insurance advisers. It will also require advanced drafts of the project and finance documents.

At financial close, the Treasury team will require reliance letters from the project’s lawyers and model auditors and (unless the project has its own technical and insurance advisors) from the lenders’ technical and insurance advisors.

3. Template SHA

The SHA has been prepared on the basis of there being 3 shareholders – the developer, Treasury (via a wholly-owned company) and a third party equity provider. There would be a conventional two level holding company (“HoldCo”)/project company (“SPV”) structure, and the shareholder subordinated debt would be issued by way of unsecured loan notes by the SPV to the shareholders.

Key aspects include:

• a single board structure at HoldCo and SPV levels (see further comments in relation to the template Articles of Association), with Treasury being able to nominate an observer to the HoldCo and SPV boards (in consultation with the sponsoring authority) whether or not it holds shares (the observer may be excluded from parts of meetings by a majority vote of the directors);
• there is an obligation for the Treasury to have reasonable regard for representations made by other shareholders if the observer appointee is employed by/associated with a direct competitor;
• proposed reserved rights for shareholders and the board (set out at Annex 1) – requiring the approval of all material shareholders (holding over 15% of the shares in HoldCo) or a director appointed by each material shareholders. These are relatively standard;
• step aside provisions for the conduct of disputes under contracts with shareholder group members – which now also apply to the Treasury observer;
• specific obligations to supply key information to the Treasury (whether or not it is a shareholder) – including in relation to the HoldCo and SPV financial position and key project performance indicators, the IRR for shareholders, defaults, distributions and shareholder debt payments, the beneficial ownership of shares and shareholder debt and tax residence of owners, and terms of any proposed disposals of shares and shareholder debt;
• reasonably standard rights to other information and confidentiality obligations – subject to customary Freedom of Information Act 2000 exceptions;
• permitted transfer rights and a deemed transfer notice process for shareholder defaults (see further comments in relation to the Articles of Association). In addition to the usual pre-emptive purchase arrangement for transfer notices issued on shareholder default, there is an unusual sale agent procedure that applies where the non defaulting shareholders do not purchase all the defaulting shareholder’s shares and subordinated debt, under which an independent sales agent is appointed to run an auction sale. If at the end of that sale process the defaulting shareholder’s shares and subordinated debt have not been sold, the non defaulting shareholders may either purchase the shares and debt for the par value of the shares, or require that the HoldCo is wound up (it is not clear what would then happen to the SPV – its shares would (subject to the senior lenders’ security) be assets to be realised by the liquidator);
• the events of default for which the compulsory transfer process applies include the customary shareholder insolvency/breach of transfer restrictions provisions – but also a shareholder changing its business such that it becomes an “Unsuitable Third Party”, failure to comply with the obligation to supply key information to the Treasury, and breaches of anti-bribery and corruption legislation;
• the Treasury has removed material breach of the shareholders agreement, disposal of a shareholders’ business to an “Unsuitable Third Party”, and sequestration/expropriation as events of default;
• material breach of the shareholders agreement, if unremedied, now results in disenfranchisement at board level and in relation to reserved matters;
• the “Unsuitable Third Party” definition is to be adapted to reflect the nature of the relevant PF2 project (to reflect the usual Government areas of concern), but will also include persons whose tax returns submitted after September 2012 have been found to be incorrect as a result of a successful challenge by HMRC (or other tax authorities) under tax abuse principles or the failure of a tax avoidance scheme;
• a failure to take steps to address tax non-compliance, or breach of the warranties on tax non-compliance and obligations (under the Project Agreement) to notify occasions of tax non-compliance can also constitute an event of default (and give rise to the compulsory transfer process);
• any disputes would be subject to escalation between the shareholders – and if unresolved would result in a deadlock. A third party expert procedure would then apply – which would only be binding if the shareholders agree to this. Otherwise the courts would have jurisdiction. It is not clear what would happen to the SPV’s business while that deadlock was subsisting – the position is usually that the business should continue to be run as far as possible in accordance with its then current business plan.

4. Template Articles of Association

The Articles of Association would incorporate the Model Articles prescribed by the Companies Act 2006, with a number of bespoke provisions for PF2 projects.

Key aspects include:

• each shareholder to be entitled to appoint one director for every 15% of the share capital held by it (up to 3) – with one vote per director and the possibility to have an independent chairman (with no right to vote). The chairman would otherwise be a shareholder director, appointed by rotation between the shareholders;
• permitted transfer rights. There will be a very wide transfer right by Treasury in favour of the “HMT Group” – which extends to any UK government department or public body, any of their subsidiaries. The other shareholders have permitted transfer rights to group members and within investment funds. If a group member leaves its group, there is a requirement to transfer back to the original transferee – but this does not apply to the Treasury shares. It should be noted that the Treasury no longer requires the “HMT Group” definition to include investment funds;
• a right of first refusal process for other transfers of shares (using the price agreed between the seller and the HoldCo board, or if this can’t be agreed the seller’s proposed sale price), and a compulsory transfer process for shareholder insolvency/breach of transfer restrictions (using the price agreed between the relevant shareholder and the HoldCo board, or if this can’t be agreed, a fair market valuation with no discount). The procedure also requires the name of the proposed transferee to be disclosed in the transfer notice.

5. Template Loan Note Instrument

The Loan Note Instrument is pretty standard for PFI projects – notable features include:

• stapling of the loan stock with transfers of shares (so that a similar proportion of loan stock needs to be transferred with shares (the stapling requirement are set out in the Loan Note Instrument and Shareholders Agreement, but not the Articles of Association));
• no ability for the SPV to redeem the loan stock early (and in particular no “spens” formula);
• events of default to include termination of the Project Agreement and acceleration of the Senior Debt;
• the usual requirement for an extraordinary resolution of the noteholders to approve certain matters – however this is set at 100% of those voting which is a little inflexible.