Is now a great time for LSVTs to ditch legacy constraints?
Background on the legacy constraints faced by LSVTs
Large Scale Voluntary Transfers (LSVTs) have been around over 30 years and over a million now former council homes have transferred, predominantly in England and Wales. Whilst the bulk of these transfers happened during the frenzy of the 1990’s LSVTs have continued right up to 2015/16.
These LSVTs can be grouped in different ways but the most prominent is whether the original funding has been restructured or not.
Such funding was always on a long-term basis, heavily fixed, with a stepped profile to fund negative cashflows whilst the newly transferred assets where brought up to standards promised to the tenants. With no corporate history, 100% debt finance, and peak debt occurring many years post transfer it became the ‘sector norm’ to apply a project approach to the financing.
This meant business plans subject to annual lender(s) approval and a range of covenants and controls that were lender friendly and restrictive, often curtailing additional debt to fund development. Of course there are many non-LSVT loan agreements out there with terms that may be chaffing on associations and this article equally applies to those, but LSVT loan agreements form the starkest comparison against the relatively light institutional covenant suites now available.
There comes a point in time where an LSVT meets the promises given at transfer and with financial capacity is likely to consider a shift towards helping addressing the UK’s housing crisis. This point of maturation brings the visible expectations of Government and the strategic aims of boards into conflict with the terms of the original funding.
In addition, over the past decade we have seen many LSVTs at least partially restructure their original finance, often finding a compromise position with lender(s). Most often this enabled limited access to additional finance in return for in return for some margin increases.
Another notable feature of the LSVT market has been the common use of bank. Post 2008 these arrangements have tended to be become somewhat dysfunctional where participants no longer ‘sing from the same hymn sheet’ and majority lender provisions either inhibit restructure, made the outcomes sub-optimal or, in extremis, prevent any change at all.
Transfers that date before 2008 will benefit from long dated, low margin debt with out of the money hedging. On the other hand, refinance or restructure would result in an increase in margin and/or reduction in tenor of the original funding and large break costs.
Indeed, negotiating with lenders may avoid break costs, but still see rises in margin; coupled with the high fixed rate this can lead to eye-watering interest costs. Relaxing the constraints in such legacy arrangements where there may be significant value, hedging, and potentially dysfunctional syndicates is therefore not straightforward. Transfers dating from 2008 onwards may have higher margins by legacy standards but still retain the other challenges.
The golden opportunity?
Various factors such as new international investors, the increasing cashflow the UK workforce has begun funnelling into UK pension funds, and some slow investment quarters during the nadir of Brexit discussions in 2018 have led to strong levels of investor liquidity. In addition, macro-economic conditions are looking a bit sickly in places; in the UK the export sector facing the EU continues to wallow in uncertainty and more broadly international growth is slowing with protectionism on the rise. This scenario places investors in an interesting position; there is cash to invest but rising risk across many sectors.
Therefore, seeking to balance some of that risk, the UK social housing sector presents an attractive quasi-counter cyclical risk profile that is resulting in increased focus from traditional and new investors alike resulting in downward pressure on spreads.
Whilst the Gilt rate largely moves with the forward LIBOR curve (i.e. low Gilts equals high break costs on legacy hedging) the downward pressure on spreads is narrowing the gap between legacy and current margins.
As a result business cases are becoming more nuanced, particularly as the remaining tenor on the transfer funding runs down. Centrus has never been a fan of treasury dictating corporate strategy and we believe the current funding environment may offer those LSVTs (or others) who have not yet tackled legacy arrangements a reasonable prospect of being able to reshape treasury to support, rather than define, how they operate.
Furthermore, incurring break costs will reduce reserves and increase net debt, in turn consuming gearing and asset cover capacity. However, this removal of the legacy fixed rates and attractive pricing on replacement debt may significantly reduce running interest costs helping soften the loss of low margins. For those LSVTs with relatively low gearing, but equally weak interest cover as a result of legacy fixed rates this process may well rebalance the financial profile of an organisation.
Security is potentially more of a showstopper but with the changes to Section 133 and a slow move from funders to accept LSVT stock on an MV-STT valuation basis there may also be avenues to ameliorate the impact.
Lastly, a comprehensive refinance may in the final cut be a viable option even where at first glance the numbers appear unworkable.
Centrus has successfully supported a number of LSVTs achieve just this sort of outcome. For the more recent LSVTs dating to post 2008 the likelihood of driving a very positive NPV from breaking legacy arrangements is high. For those dated before 2008 there may be some cost, but where this is minimised through a currently attractive debt market with control of strategy regained the numbers may well begin to stack up.
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This content was oroginally published by the Social Housing magazine on 02/07/2019. Follow this link to visit (login necessary).