Rock 'n rolling stock: insurers find an opportunity in railway assets

Having facilitated some £2bn of direct investment in UK rail in less than two years, Rock Rail is helping to ease the industry's infrastructure woes with a steady pipeline of projects insurers can gain direct exposure to. Asa Gibson reports

The dearth of quality infrastructure projects for European insurers to invest in has become something of a cruel joke. The industry is desperate to gain exposure to core infrastructure, while European authorities are determined to source financing from the private sector — but finding a solution that satisfies both sides has been problematic.

One of the key issues for insurers is the absence of a reliable and visible pipeline of core infrastructure projects, which stems from the political uncertainty inherent with any plans laid out by policymakers.

Another is the fund-based structure that is typical of infrastructure financing. In the UK, for example, the government wants the industry to invest directly in infrastructure projects before the assets are operational (greenfield assets), but there are few such opportunities under traditional funding structures.

One UK firm, Rock Rail, is beginning to make tracks in the space having facilitated direct investments in UK infrastructure from insurers and other institutional investors totalling £2bn ($2.35bn) since February 2016.

Rock Rail was established in 2014 by the founder of its sister company Rock Infrastructure, Mark Swindell. A lawyer by trade, Swindell left his role as global head of infrastructure and defence at DLA Piper to offer an alternative solution to rolling stock investment from that afforded by the UK's three incumbent rolling stock companies (Roscos) – Angel Trains, Eversholt Rail and the partially Allianz-owned Porterbrook Leasing — a solution offering institutional investors a pipeline of direct investment opportunities in UK rail.

Rolling stock refers to the vehicles used on railways, including carriages, wagons and locomotives. In the UK, rolling stock is leased to a train company by a Rosco – typically on a seven-year contract.

"There's a big demand for infrastructure in the UK from all regions, but the government has a limited amount of money to spend and it doesn't have the time to develop infrastructure itself," says Swindell. "Policymakers want more self-determination from local authorities, and they want funding from insurance companies, who want direct investments."

All aboard

Rock Rail won its first contract to finance £300m of new rolling stock for the Great Northern rail franchise in February 2016. Aviva Investors was the sole lender in that deal, with SL Capital Partners and Rock providing the equity investment. Rock's next success saw Aviva joined by Legal & General Investment Management (LGIM), Massachusetts Mutual Life, Sun Life, Standard Life and the European Investment Bank in a deal to finance £700m of new trains for Abellio's Greater Anglia franchise, which Rock signed with its co-equity partners SL Capital and GLIL Infrastructure in October 2016.

Most recently, in June 2017, Rock won the bid to finance £1bn of new trains for South Western Railway, the new train operators of the South Western franchise (a joint venture between FirstGroup and MTR). Aviva Investors committed £250m with the remainder funded by LGIM Real Assets (on behalf of clients including L&G), Munich Re's investment arm MEAG, Rothesay Life, Scottish Widows, Standard Life Investments, Sun Life and UK asset manager Barings.

"We like Rock's proposition because they focus on funding strategic core fleets ('sticky fleets') tailored to the specific needs of the network it will operate on," says Sinead Walshe, associate director of Aviva Investors' infrastructure debt fund.

Next in the pipeline is a bid to finance rolling stock for the winner of the South Eastern rail franchise, currently operated by Govia, whose contract runs until December 2018. While the winning franchise operator is expected to be announced in August 2018, initial dialogues between Rock and potential investors are already underway, some 12 months or so before the start of the new franchise term. Should Rock be successful in its bid, it will sign a manufacturing supply agreement at financial close with the chosen manufacturer to secure the assets. While it varies by deal, new rolling stock is typically in service within two-and-a-half years.

It's proven to be a popular process with insurers, owing much to the direct nature of the investment (Rock establishes a special purpose vehicle (SPV) dedicated to each contract) and the relatively short time between Rock approaching investors and the asset becoming operational.

In 2015, prior to its maiden deal, Rock signed a teaming agreement with SL Capital (SLC) that commits both parties to bid together on new rolling stock investment opportunities, with the majority of equity funding arranged by SL Capital and Rock retaining some sweat equity. The agreement enables Rock to bid for financing contracts using the financial strength of SLC's managed funds and its co-investors, and approach debt investors with a fully structured investment opportunity.

SLC manages the £516m equity fund, with the majority of investment coming from about 18 third-party pension funds and roughly one-third coming from entities in the Standard Life Aberdeen group, says Dominic Helmsley, head of infrastructure equity at SLC.

"We also arrange debt for these transactions and the quantum of debt ranged from the 'low' hundred millions on Moorgate (Great Northern franchise), to values closer to £1bn on the South Western transaction," says Helmsley.

The popularity of Rock's proposition among insurers rests primarily on three features: the structuring of debt that attracts favourable treatment under Solvency II; a reliable pipeline of core infrastructure assets; and a breakaway from the Private Finance Initiative (PFI) contracts that have fallen out of favour with investors and policymakers alike.

Post-PFI

Swindell and Rock Infrastructure partner Nick English were heavily involved in the first PFI contracts deployed during the privatisation of UK rail and other public services in the mid-90s. Their experience in negotiating and constructing the early private rail contracts in the UK, and understanding of the negative sentiment towards PFI as a legal structure, is fundamental to Rock's offering.

The use of PFI contracts became widespread in the UK and in Europe before the financial crisis, after which their popularity dwindled. Investors and policymakers grew unhappy with the removal of construction risk by intermediaries included in PFI contracts, and consultants charging high fees. Over the years, negative sentiment towards PFI became an obstacle to any public-private initiatives.

"You couldn't finance any infrastructure in this country unless you used PFI, which removed the risk from the early construction phase. It's a broken way of delivering infrastructure in this country," Swindell says.

Following the 2007-08 financial crisis, public and private spending on UK infrastructure slumped, with both sides less willing to invest long term. In 2011, then chancellor of the exchequer George Osborne brokered a deal with the insurance industry that supposed insurers would invest £25bn directly in UK infrastructure developments in five years, and in return he promised to ease their transition into Solvency II.

"Osborne wanted insurers to invest directly into infrastructure, not via funds or buying operational assets after most of the risks are gone. Insurers were looking for a different way to invest in infrastructure projects that had not been developed, and we saw there was a vacuum — there was no development industry creating unsolicited opportunities," Swindell says.

"We are trying to inform insurers that we exist and that they don't have to go via a fund to access our pipeline."

Structured to Solvency II

Structuring the debt transactions in a way that meets project and insurers' needs requires a wealth of experience given the complexity of negotiations, with many issues stemming from Solvency II pressures, says Maciej Tarasiuk, investment director at SLC and non-executive director at each of Rock's SPVs.

"As part of the teaming agreement, we work side by side with Rock to structure the transactions appropriately. Rock brings predominantly the expertise regarding the rail industry and we offer our financial capabilities," says Tarasiuk.

For the most part, the difficulties that tend to arise during negotiations pertain to asset-liability management constraints brought about by Solvency II, including the long-term security of base case cash flows to investors, which bears great significance on whether the assets qualify for the matching adjustment.

"The contractual aspects of the transactions offer the lenders significant protection and comfort around likelihood of receiving the exact cash flows that they have assumed in the base case," Tarasiuk adds.

In light of the complexity and heavily-layered structure of the deals, insurers are investing in talent to build teams capable of negotiating and executing similar deals, Tarasiuk says, with most of that talent coming from the banking sector.

Aviva Investors' debt team of 22 includes significant rail industry expertise. Much of their time is spent focusing on "releasing risk" when considering investing in rolling stock assets. Releasing risk refers to the likelihood of the rolling stock not being re-let to the next train operating company at the time of the franchise renewal.

"We do a huge amount of work on rental analysis, including a very detailed analysis of the current rolling stock market in the UK," says Aviva Investors' Walshe. "We assess what the competitive landscape might look like in future franchise periods — so that might be in seven, 14 and 21 years' time."

Ensuring the assets are investment grade is a priority for most insurers, and Rock aims to create assets equivalent to a BBB rating, but does not use external rating agencies.

"Thus far, the rating agencies have developed their methodologies based on the traditional, fund-based rolling stock investment model of the three Roscos. We are creating a completely new type of product and the rating methodology used needs to appropriately reflect the fundamental differences in the Rock Rail investment model," says Swindell.

Pipelines beyond trainlines

The UK Department for Transport's (DfT) rail franchise retendering timetable provides Rock Rail with a steady pipeline of rolling stock it can bid to finance – the holy grail for infrastructure investors and one of the reasons Rock Rail can expect continued interest from the insurance industry. 

"We are looking at sectors where there is a strong pipeline of funding opportunities to match our clients' needs and the UK rail sector is providing that currently with a franchise renewal occurring every 12-18 months," says Walshe.

"With rolling stock being generally quite elderly across the network, we are likely to see further rolling stock needing to be replaced as part of these franchise renewals," she adds.

The sentiment is reciprocated by Helmsley and Tarasiuk at SLC, and both Aviva Investors and Standard Life are likely to be among the debt investors should Rock be successful in its bid to finance the South Eastern franchise winner.

For Swindell and Rock Infrastructure, their pipeline extends beyond UK rail into various other sectors, with projects including the Mersey Gateway Bridge – due to open to budget and on time this autumn, tidal energy for the Mersey region, offshore wind, the A303 Stonehenge upgrade and the Lower Thames Crossing.

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