New Entrants Tasting Success In Financing Rolling Stock

The global financing market has rarely, if ever, been more competitive. Industry experts are keenly aware of the need to seek out innovative and untapped opportunities. Over recent months, this has been particularly felt in the rolling stock market, where there has been a sudden significant increase in financier interest. A number of new entrants have been enjoying successes.

What Has Been Happening?Rail has been enjoying a renaissance. Passenger and freight growth hikes continue to be driven by a host of factors. These include increasingly crowded roads, better rail safety, greater awareness of carbon emissions, wider environmental concerns, and the increasing pace of technological development.

What has changed more recently, however, is the emergence of an increased interest — often from new market entrants ranging from banks and pension funds to private equity investors — in financing rolling stock. This has been driven partly by manufacturers offering new trains at very competitive prices, and the availability of cheap, long-term financing. This attractive combination is creating interest in both increasing capacity and replacing existing rolling stock with alternatives that are cheaper to operate and maintain. This is happening even in places where ordering new rolling stock was, until recently, considered uneconomic.

Liberalisation of rail markets has also continued to attract the private sector, including financiers. There is a direct correlation between the liberalisation of rail markets and the use of private finance for rolling stock. In many countries, rail freight is already largely liberalised, but

liberalisation of the passenger market typically lags behind and varies significantly depending on the type of rolling stock. Analysing Western Europe as a whole, approximately half of projects to purchase freight locomotives and wagons are financed privately, whereas by comparison only around a quarter of projects to purchase certain types of passenger train units, including electric multiple units or EMUs, and diesel multiple units or DMUs, are financed privately. There also remains a further significant opportunity that is currently untapped: using private finance for high speed rolling stock and trams / urban transport systems.

There are also numerous investment opportunities available where local and national governments continue to raise funds by refinancing and privatising existing rolling stock.

These opportunities to obtain a steady return over the medium to long term have enticed a host of new entrants to the market.

Graeme McLellan is a London-based partner in the asset finance team at law firm Stephenson Harwood, specialising in aircraft and rolling stock finance.

The Good, The Bad … and The Double-Edged SwordsMany factors relevant to investing in aircraft are similarly applicable to investing in rolling stock. But for those familiar with the aircraft financing market, there are a number of significant differences to consider when contemplating rolling stock investment. Many of these can be clearly classified as either benefits or risks, but a number of factors can create both.

The Double-Edged SwordsLet’s start by looking at two examples of the double-edged swords.

1. Bespoke Design Requirements:The physical constraints for train operation are profoundly different from those for aircraft. Whereas an Airbus A320 can operate virtually anywhere, trains ordered for a particular geography must comply with local legal and regulatory requirements, including in relation to signalling and on-train equipment, and the constraints of local infrastructure. These include the kinematic envelope (the maximum space that a particular class of train occupies on the track, including as it travels around curves) and, for EMUs, the nature and stability of the power supply.

From a financier’s perspective, routes requiring trains with particular design requirements are unlikely to be replaced by other rolling stock — such bespoke trains are potentially a safer financial investment. Conversely, if such bespoke rolling stock is replaced, it may be correspondingly difficult to find a new lessee for that fleet – counterbalancing their perception as a lower risk investment.

2. Usage Guarantees:Another double-edged sword is the usage guarantee. Some governments (both local and national) try to encourage private investment in rolling stock by providing such guarantees. Typically they guarantee that there will be a lessee for a particular fleet of rolling stock on pre-agreed terms. However, such guarantees do not always extend to non-payment of rentals or other lessee non-performance.

From a financier’s perspective, a long-term usage guarantee for 20 or 30 years may provide certainty of rental stream and reduce the residual value exposure. Equally, it may prohibit the increase of rental payments, thereby restricting financial return on the investment. Furthermore, some usage guarantees also facilitate particular types of local financing (such as German covered bonds) on extremely competitive terms, effectively barring such financing opportunities to most new entrants.

The GoodLet’s turn now to factors that financiers in the rolling stock sector may find particularly helpful:

1. Government Involvement:More extensive government involvement tends to exist in the rolling stock sector (particularly for passenger rolling stock) than in the aircraft sector. If an airline defaults on an aircraft lease or financing, the general expectation is that the lessor or financier will terminate the arrangement and repossess the aircraft — which it will store, maintain and remarket. Conversely, if a passenger train operator defaults, financiers often benefit from both passenger expectations that the trains will continue operating and pressure on (and by) politicians to ensure that they do. Similarly, a lease termination resulting in new and expensive infrastructure being unused is unlikely to be tolerated and will prompt government intervention.

2. Reduced Replacement Risk:Current historically low interest rates may equally offer a long-term risk-reducing factor to financiers. Any rolling stock fleet financed now, benefiting from current long-term interest rates, is less likely to be displaced by a replacement fleet financed using higher rates of interest. The key risk to financiers is, therefore, that long-term interest rates fall below their present levels – which may be unlikely.

3. Reliability and Operating Costs:Financiers of new fleets can also be confident that their rolling stock is unlikely to be replaced prematurely purely on the basis of reliability and operating costs. New rolling stock is generally very reliable and rarely breaks down. Such new trains have also been designed with an increased focus on their whole-life costs, including their environmental impact and weight / power consumption, as well as other maintenance and operating costs. As such, it is likely to be some time before new rolling stock designs can

offer a combination of further improved reliability and lower operating costs deemed sufficiently significant to justify replacing fleets currently being ordered.

4. Passenger Demand:Passenger demand for rail travel is also increasing, partly due to falling numbers of young people learning to drive in Europe, North America and Australia. Significant increases in passenger numbers are being seen in a number of countries, with acute overcrowding necessitating increases in capacity. Investors are evidently identifying and responding to the anticipated sustained growth in demand.

The BadTurning now to issues of which financiers in the rolling stock sector should be wary:

1. Less Standardisation:By comparison to the aircraft sector, there is far greater diversity in classes (or models) of rolling stock and the range of local legal and infrastructure requirements.

2. Defective Equipment:Reliability has increased very significantly but, as with any manufactured product that cannot benefit from significant and sustained mass production, there are risks of defects and faults, particularly with new or amended designs. There is, however, evidence of increasing sophistication on the purchasing side to mitigate such risks for owners and financiers. These include: put options – enabling a purchaser to return all rolling stock to a manufacturer until a specified

minimum fleet threshold has been reached; bank guarantees covering all payments to manufacturers until the agreed minimum fleet threshold is achieved; and more considered allocation between the parties of infrastructure, change of law, force majeure, etc risks.

3. Obsolescence and Other Risks:In assessing the likely useful economic life of new rolling stock (and therefore its likely rental-generating timeframe), there remain a number of risks to consider: technological innovation may render particular fleets susceptible to early replacement; a change of law may require uneconomic modifications to rolling stock; interoperability improvements resulting from multi-jurisdictional legal frameworks may result in increased competition from future rolling stock operating on a wider geographical basis; and the current trend towards increased electrification seems likely to continue, but there will inevitably remain routes for which this is uneconomic.

4. Bid Documentation:New entrants to the rail financing market should also bear in mind that bidding to finance new rolling stock can be more resource-intensive than equivalent procedures for aircraft financing. Some rail financing procurements require only brief term sheets, but others involve comprehensive mark-ups of extensive proposed contractual documentation. The scoring of such bids can, in turn, result in financiers taking strategic views to enhance their likelihood of success and an understanding of the scoring system is a key preliminary exercise.

Final ThoughtsTo conclude, the rolling stock market is enjoying an upsurge of financier interest. As we have seen, it is not a market without its issues and political, regulatory and legal hurdles, but it is increasingly viewed as capable of providing financiers with a steady return over the medium to long term – in an age of frequently elusive investment returns. An intriguing era of rail technical innovation and development combined with these new financing sources does tend to suggest that we are witnessing a sector renaissance, of which we are, arguably, only at the beginning. Interesting times lie ahead.

5. Compulsory Leases:Another factor to appreciate is that, in contrast to the freedom of aircraft lessors to refuse to lease their aircraft to particular airlines, rolling stock lessors may in some circumstances be legally required by government authorities to lease their rolling stock (and especially passenger rolling stock) to particular train operators. It is, therefore, critical to obtain from the outset contractual rights that provide appropriate protections to the owner where it might not otherwise have been willing to lease to that particular operator.

6. Young Fleets Pushed Off-Lease:Finally, there is a risk that the current competitive pricing offered by both manufacturers and new financiers results in some existing, but still relatively young, rolling stock being pushed off-lease. It will be interesting to see the impact of this on the wider market, including whether potential new financiers are ultimately dissuaded from entering the arena should such risks materialise.

Future Unknowns: Brexit & BEPS:Currently unknown issues will inevitably continue to emerge. By way of a recent example, the Brexit debate has affected the value of Sterling, in turn creating issues for rolling stock manufacturers with a non-Sterling cost base that have previously provided fixed Sterling prices. Flexit clauses (including those that enable the use of market flex provisions in the event of a Brexit) may enter rolling stock contracts.

Base erosion and profit shifting (BEPS) is also likely to have an adverse impact on some financing structures. Action 4 of the OECD’s final report on BEPS limits interest deductions as a percentage of EBITDA. The OECD has suggested recommended interest deduction limits in the range of between 10% and 30%, and countries are steadily issuing statements setting out their expected position. In many cases, it unfortunately seems unlikely that the ”public benefit projects” carve-out will extend to rolling stock financings. Financing structures which fall within the scope of BEPS are, therefore, unlikely to obtain tax deductions for all interest costs and it may not be possible to pass such increased financing costs on to operators / lessees.

© Stephenson Harwood LLP 2016. Any reference to Stephenson Harwood in this document means Stephenson Harwood LLP and/or its affiliated undertakings. Any reference to a partner is used to refer to a member of Stephenson Harwood LLP. The fibre used to produce this paper is sourced from sustainable plantation wood and is elemental chlorine free.

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Graeme McLellan Partner, London

T: +44 20 7809 2618 M: +44 7976 363 769 E: graeme.mclellan@shlegal.com