The off-balance sheet income strip is a welcome addition to the marketplace, and has a definite role to play in helping non-top tier institutions transform their estates and hopefully start to haul themselves up the national rankings. Funders like Aviva have been leading the way in developing and shaping the structure, increasing the number of deals reaching completion in the sector.
This new structure will not necessarily be for everyone, and is something finance departments must approach with their eyes open. However, as long as everyone plays their part in making the project a success, the funder, the equity investors, the university and, ultimately, the students, will all share in that success.
Why consider the off-balance sheet income strip?
Traditionally, a university finance director tasked with ensuring the delivery of additional student accommodation would have two financing possibilities: a project finance solution, probably using bonds, which would be off-balance sheet; or an income strip solution, which would be on-balance sheet, and on the surface less attractive.
Income strip deals are, essentially, traditional forward-funding deals. An investor, such as a pension fund, in conjunction with a developer delivers our accommodation project: say, a 400-bed apartment block. The university commits to the development by agreeing to take a long lease on the block, say for 35 years, on a non-assignable basis. At the expiry of the lease term, the university has the option to acquire the freehold for a nominal fee. Liability for repair and maintenance of the accommodation rests with the university, allowing the investor landlord to just 'strip' the income out of the asset.
Chances are, achieving off-balance sheet status will be a 'must have' for your project, but project finance may not be available for everyone. The off-balance sheet income strip, which relies on a special form of university-funder agreement, can provide significant benefits where:
- you might not have an alternative. Bond deals aren't available for everyone and, even where bond financing is available, can carry significant fees if the university has a lower credit score or league table ranking;
- time is of the essence. Bond deals aren't known for their speedy procurement. An income strip could well shave months off your procurement timetable, while involving fewer parties and simpler documentation;
- you are seeking to minimise costs. Termination can be expensive whether it is bond-funded or not, so being able to step into the lease and effectively pay off the funder by instalments is not necessarily a bad thing.
The documentation for an income strip deal can look very different to a bond-funded DBFO [design-build-finance-operate] deal. While there is no 'standard form' project agreement for the latter, there are at least a number of precedents within the sector from which an element of standardisation is slowly emerging. The same cannot be said for off-balance sheet income strip projects, particularly around the project agreement.
The university needs to consider how much of the typical project finance standardisation should be retained. Much of it may still be sensible to include, and it certainly helps make for a robust project. However, given that the funder is protected primarily through the university-funder agreement, there is clearly scope to remove some of the typical funder protections found in a bond deal project agreement.
One issue which quickly becomes apparent is the different dynamic surrounding the parties' roles on the deal. On a bond-funded DBFO, the security trustee and its advisors will tend to pour over the project documentation and raise numerous comments. The same does not tend to be true of the funder on an off-balance sheet income strip deal. This is because the university-funder agreement protects the funder by requiring the university to step in and deal with the situation where the project delivery special purpose vehicle (SPV) is in distress.
This second document changes the dynamics. On a bond deal, the agreement is there to prevent the university from terminating the project without the security trustee having had the chance to fix the underlying problem with the SPV. On an off-balance sheet income strip, the document almost plays the reverse role, protecting the funder.
If this is starting to sound a bit like a form of guarantee, then you aren't far wrong – but remember, triggering the funder protections in the university-funder agreement is contingent on something having gone seriously wrong. If our 400 rooms are being filled every year, and the SPV is well-run, then the agreement can sit in storage and you can sleep soundly.
There are some protections that finance directors should consider before going down the income strip route, in order to help ensure that the risk of receiving a notice under the agreement remains permanently off in the distance:
- transparency: make sure you know what is going on with your SPV and how it is being managed. Consider an equity stake, or a board observer-type role;
- robustness: make sure you understand what risks sit with the SPV, not just with you as the university. This means reading the sub-contracts, sub-lease and loan documents, and making sure as much risk has been passed down as possible in a way that doesn't contradict the project agreement;
- prudence: if the bidder tells you that they are happy to take the risk of 100% occupancy and all rooms being filled over the summer holidays and this is helping create a bigger capital receipt, pause and think. What if that doesn't happen, and how quickly will it become your problem?
- partnership: good relations with your SPV are important anyway on a 35-50 year deal, but even more so when you are to some extent standing behind it. Tackle potential problems head-on and collaboratively. Equity investors don't want the agreement being used any more than you do!
Chris Owens is a student accommodation expert at Pinsent Masons, the law firm behind Out-Law.com.