Loans and Guarantees

Introduction

The recent Renaker case heard before the Competition Appeals Tribunal (Aubrey Weis -v- Greater Manchester Combined Authority) highlights how a loan by a local authority to a developer can involve a subsidy to the developer.

The starting position is that the loan can be a subsidy if not provided on commercial terms. If this is not the case, then the value of the subsidy is just the sub-commercial element in that loan when compared to what the developer can borrow from the commercial markets (like a bank). In practical terms it will be the lower return from what the market would earn from a debt in similar circumstances. This is typically reflected in the finance costs associated with the loan such as interest, and the sub-commercial element is often referred to as the interest differential to market. 

The valuation of the subsidy element in a loan does make it easier to manage as a subsidy than an outright grant of those funds to the developer. Managing a subsidy is the job of the lender (the local authority) and is generally done by self-assessing the reasonableness of the sub-commercial element under a prescribed set of prompts called the Subsidy Control Principles and (in some cases) the Energy and Environmental Principles (“the Principles”) unless exempt from doing so. The most common exemption used in interest differentials is the Minimal Financial Assistance provisions (colloquially referred to as “De Minimis”) given the relatively low amounts of subsidy involved in such cases.

However, the full cash amount of the loan may still be treated as a subsidy if there would be little or no prospect of the business repaying the debt. This can be where the business is either already trading insolvently or would be thinly capitalised were the loan accounted for on its most recent balance sheet. This could be a particular risk where a business already has prior exposure to loans from that local authority and has applied for further loans without making repayment on those prior loans. The argument here is that the business would not be able to borrow at all from the commercial markets, and so the loan is more typical of an outright grant.
That said designing a loan to avoid subsidy is possible in many circumstances.

When does a loan avoid a subsidy

Where the local authority loan compares with what an enterprise could borrow in the financial markets then it would not involve subsidy to the developer. This is commonly referred to as a benchmark and the best evidence of this is confirmation from a bank or other financial institution such as an invoice discounter or asset financier. Other evidence could be obtained by comparing the proposed loan with commercial loans made to other similar businesses or within lending trends against the particular characteristics of the borrower, nature of the project and level of collateral (security) sought.

Another example of such evidence could be within a specific transaction if the loan is made on materially identical terms to a private sector co-financier lending alongside the State body. Terms could be regarded as empirically identical for instance if the local authority and private sector partner having no prior exposure to the developer lent the same amount on the same terms and at the same time. In other cases an evaluation would need to be carried out to ensure the return was indeed commensurate to each party’s exposure (including loss given any default).

Where such comparison is not possible, there are legislative benchmarks provided for lending to borrowers of a sufficient credit rating. These benchmarks depend on the length of the loan and its loss given default ratio (lender’s exposure through lack of security). These legislative benchmarks only cover borrowers with a satisfactory or above credit rating, meaning that for all other borrowers a local authority lender would need to consider other more operational benchmarks.  

A suitable credit rating may be ascribed to a borrower by a credit reference agency. Where this is not available, for instance where the borrower enterprise is a start-up with no credit history at all, or a not-for-profit entity, the local authority has a wide discretion in allocating it a credit rating based on evaluation of risk of default. This evaluation should be meticulously documented in case of any challenge, as it would essentially be an attempt to rectify the asymmetric or incomplete information on such loans existing in the market. 

It follows that where a suitable benchmark is not achieved, the loan is deemed to carry subsidy to the developer.

When does a loan carry a subsidy

The higher the risk of default, the less likely an actual or legislative benchmark would be available, and hence the less likely the State loan would be seen as a commercial relationship. The higher the risk of default therefore, the more likely that a subsidy would be deemed to be embedded in the loan.  

The obvious recipient of the subsidy would be the developer. However, if the loan is towards joint venture or the capitalisation of a fund then an indirect subsidy may also arise to a private sector co-investor or lender. This would typically be the case if the State subordinates its return or security to the private sector partner in any way. Such ventures are often used to deliver commercial projects or schemes such as housing or infrastructure development.

The amount of the subsidy is normally the present value of the interest differential but as mentioned above, can also be the full cash value of the loan if the borrower is otherwise deemed to be incapable of borrowing from the financial markets. In the latter case additional steps may need to be taken to justify the subsidy as reasonable, as the subsidy may involve rescue and restructuring of the borrower and is only permitted in certain circumstances.

It should be noted that the value of the subsidy is assessed at the date of its award, regardless of actual fluctuations in interest rates over the duration of the loan. An interest differential is therefore no more than a projection which must be set at the date of the loan and need not be amended over its duration. The subsidy element is the present value of that interest differential. The present value is obtained by discounting the interest differential back to the date of the loan using the borrower’s weighted average cost of capital.

Forward Funding, Deferrals and Write-offs

Local authorities often “forward fund” a development by paying now for the future purchase of a developed site. The reasons are simple in that the development of a site with significant “abnormals” can require an initial cash flow injection before build begins. The abnormals mentioned above would include development costs which do not attract revenues in themselves, such as site remediation, public infrastructure, conservation deficit and energy increments. Since such forward funding would replace what would otherwise be a borrowing requirement of the developer, it is reasonably treated as a loan by the local authority and the above considerations on measuring any embedded subsidy will apply. The duration of the loan would be the time between the grant of the forward funding and the actual transfer of the completed development to the local authority. It follows that if the local authority has reached a concrete agreement to acquire the development once completed, the developer may be able to reasonably apply the local authority’s credit rating and collateralisation in assessing a subsidy, or even subsume the loan into a wider consideration of the commerciality of the project as a whole (for instance by evaluating the net present value of the entire development).

Local authorities may also grant deferrals, for instance initial repayment holidays, whether for capital only or both capital and interest. In certain circumstances such deferrals can be directly benchmarked to market offers, particularly when trading conditions are difficult. For instance, such terms were common during the bounce back from the pandemic and are still common where there is an equity rationale for significant regeneration. In some ways this is akin to rent holidays to anchors tenants in order to jump start occupancy in a new development. In other cases, just because there is a deferral does not mean that there is a subsidy, as the arrangement should be looked at “in the round”. This means that a subsidy only arises if the total amount of payment at the end of the loan term (capital, interest and other finance costs) when divided by the initial advance is less than what the market would expect (this is similar to assessing the APR in consumer lending).  

Where a local authority loan, initially granted on commercial terms, is subsequently written off, a subsidy is granted at the date of the waiver. The amount of the subsidy would be the value of the write off and would need to be managed by the lender in self-assessing its reasonableness or applying an exemption from doing so. If the State loan was initially granted as a subsidy, then the waiver may be treated as the modification of an existing subsidy making it easier to manage in some cases. In some cases, for instance a write off following a voluntary arrangement with creditors, a write off may be benchmarked to a commercial transaction.

Local Authority Loans to Subsidiaries

Local authorities often hive down a particular commercial activity (including real estate management) to a subsidiary. This may have several advantages such as securitisation, attraction of outside investment or procedural simplicity. It may also be because this is a statutory requirement or to obtain legal certainty in the aftermath of the odd decision in the Durham Waste case.

Either way, it is reasonable for the subsidiary to use the credit rating of the local authority and assess the commerciality of the loan on that basis. The idea is that this assists in the setting of a comparable uncontrolled transfer price, as if the subsidiary was borrowing from a commercial lender using a local authority guarantee. This could reasonably be used to assess risk of default and hence the interest rate on the loan.

The above position would apply even if the subsidiary was still a division of the local authority (i.e. within the same legal entity) but for the confusion generated by the Durham Waste case. This is primarily because legally an intra-group loan cancels out in a consolidation in the same way as an intra-divisional loan, so the transfer price on the interest in either case is entirely functional in nature (something which was ignored in that case).

In most cases setting a commercially bench marked interest rate on a loan to a subsidiary is not problematic. The local authority’s credit rating (which the subsidiary can use) is likely to be high, given the special position it has in the lending market. Typically, local authorities have central government backing, access to treasury loans not available to the private sector, capitalisation of tax streams in enterprise zones and historically negligible risk of default. Even in the improbable event of a default, the loss given default ratio is likely to be negligible.  

The strange case of Loan Guarantees

A local authority or fund may, instead of providing a loan to a developer, use its market credit rating to make it easier for the developer to borrow from the financial markets. This is typically done through a guarantee, where the local authority incurs a secondary liability to repay the debt if the developer defaults.

A guarantee is a strange case as giving it does not involve an actual transfer of State resources in any way. However, there is deemed to be a notional transfer of State budget to the amount of the contingent liability carried by the State as a result of providing the guarantee. The argument is that since the State budget is effectively covering a future liability, to that extent it is no longer available for use for other purposes until the guarantee ceases.

Like a loan, a guarantee is only a subsidy if granted on sub-commercial terms, typically where the fee paid for it by the borrower is less than what a commercial lender would charge. The measure of the subsidy is therefore rarely the value of the guarantee itself, but rather the discount to market of the fee paid. In certain circumstances though it may be measured by the benefit received by the borrower including the fact that it would otherwise have not been able to borrow at all without the guarantee.  

As with loans, there are legislative benchmarks to valuing the subsidy element in a local authority guarantee.

Conclusion

Subsidies can arise in loans or guarantees provided to developers by local (and combined) authorities. The subsidy is generally to the borrower, though it may also be to a co-investor to which the local authority subordinates itself in any way.  

The value of the subsidy is generally the present value of the sub-commercial return, such as interest differential on a loan or discount on a guarantee fee. Occasionally it could amount to a larger amount particularly when the borrower is in financial difficulty and would not be able to obtain a loan, or guarantee for that matter, from anywhere else in the private sector. 

The value of the subsidy must be assessed at the date of entry into the loan or guarantor relationship, either individually or against legislative benchmarks. These are based on credit rating and default risk in typical situations. Future fluctuations in interest rates for instance need not be considered.

Advance payments, deferrals and loan waivers can involve a subsidy which may need to be assessed against benchmarks and self-assessed as reasonable by the local authority unless exempt from doing so.

This article covers an area which is complex and hence not a substitute for detailed legal and accountancy advice. For further information or guidance please contact the author.