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Hidden treasure: changing the capital structure

This article by Phil Jenkins appeared in Social Housing Magazine on the 29th of July 2016.

As the UK continues to adjust to an apparent (pending various legal challenges and calls for a second referendum on the back of an improved ‘offer’ from the European Union) Brexit, a number of our clients have relayed that in the aftermath of the referendum, board members were requesting ‘post Brexit’ business plans and stress tests.

For the most part, finance directors appear to have followed the Ministry of Information’s wartime advice by keeping calm and carrying on.

Absent any startling new insight as to what the economic impact of the UK’s decision to leave the EU might be, we would agree with the point made by many FDs that the type of recession or economic slowdown together with tightened credit conditions and related housing market impact forecast by many economic commentators should have already formed a core part of scenario and stress testing exercises undertaken in the ordinary course of business.

For the time being at least, it mainly appears to be a case of steady as she goes, although the many housing associations with stand-alone swaps may be feeling somewhat less sanguine given the sharp falls in swap rates after the referendum which have once again brought the risk of margin calls and associated liquidity to the fore.

Aside from margin calls, the other Brexit related ‘blip’ has come from the rating agencies, with Standard & Poor’s downgrading twenty-two English housing associations as a result of its decision to downgrade the UK sovereign rating.

Moody’s also moved forty-one rated HAs to negative outlook after applying the same status to the UK sovereign rating immediately following the referendum result.

While these rating downgrades were driven by the government-related methodology employed by both agencies rather than a result of any specific credit deterioration at the borrower level, recent borrower specific downgrades and public comments from Moody’s suggest that with the housing sector continuing to expand into riskier market sales, the continuation of higher investment grade credit ratings traditionally enjoyed by housing associations is an ‘evolving question’.

Rush to market sale

In our view, as housing associations take up the gauntlet thrown down to them by the previous iteration of the current Conservative administration, it is not unreasonable for rating agencies, together with lenders, investors and the regulator, to acknowledge and reflect upon the additional commercial and market risks being taken on by businesses which were previously characterised as ‘safe and boring’ from a credit perspective.

At the large and fast-consolidating end of the market, stakeholders may take comfort from the ability of the largest operators to have the necessary skills and scale to manage this risk and the ability to carry and access sufficient liquidity through their funding arrangements to avoid the pitfalls often encountered by overstretched developers when markets turn against them.
Nonetheless, the transition from old style housing association to HA+ scale developer/housebuilder will be scrutinised carefully and will inevitably result in some degree of credit deterioration.

I would hasten to add that given the scale of housing need in the UK, far from being a cause of embarrassment, lower credit ratings (within reason!) may be viewed as a healthy sign of an organisation pushing the envelope in pursuit of its corporate and social objectives.
Of greater concern perhaps is the now apparently universal truth that the only means of achieving growth, whether you are a 100 or a 100,000 unit housing association, is to follow some variation of the one third-one third- one-third split of affordable, shared ownership and market sale.

Even amongst the larger players in the housing sector, there are few organisations with meaningful experience of managing large market sale programmes through the economic cycle. For the reasons outlined above, it is reasonable to assume that large organisations may be better placed to make this transition, albeit not without risk.

However, the assumption that the entire universe of developing associations (or those with aspirations to develop) can rapidly acquire the necessary skills, risk management capabilities, governance oversight and financial and corporate structures to successfully manage the transition into market sale activities is ambitious at best and woefully misplaced at worst.

Furthermore, it perhaps displays a lack of imagination for all developing organisations to pursue a one size fits all approach to facilitating growth.

The rush towards market sale is an apparent acceptance that delivery of non-grant funded assets within the traditional envelope of HAs’ social objectives is so inefficient from a capacity perspective that the only game in town is to balance this by delivering high profitability on higher risk commercial activities.

But what is the alternative? Well, capacity inefficiency is to some extent a function of traditional corporate loan covenants and lender valuation approaches which are ill suited to the development of affordable rented assets.

By continuing with the existing capital structure, deployment of the historic value and equity that exists within HAs will continue to take place on an inefficient basis thereby forcing a high risk cross subsidy model to make it work.

However, with new investment models coming into play, HAs (particularly small and medium sized ones) should now consider whether scarce ‘equity’ may be more efficiently deployed through alternative capital and funding structures with the added benefit of being a safe observer from the sidelines when the next downturn hits the housing market.

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