Is the UK rolling stock market rolling too fast?

In comparison to some of its peers in the energy, water and rail franchise sectors, the UK’s rolling stock market has come off somewhat lightly from Labour leader Jeremy Corbyn’s nationalisation rhetoric. Of course, it has been subject to his criticism as “an incredibly expensive process” and a promise to “procure rolling stock directly”. But, by and large, Corbyn’s ire has been saved for the operators of the various franchises around the UK.

Yet, this is a sector that one would imagine is likely to attract attention. The market has undergone significant transformation in recent years and garnered £767 million ($1.1 billion; €879.6 million) of private sector investment in 2016/17, the highest ever recorded by the Office of Rail and Road, going back to 2006/07. At that time, the sector was referred to the UK’s Competition Commission and the commission eventually concluded that the rolling stock lessors (Roscos) have “little incentive to compete with each other”.

Nine years on from the commission’s conclusion, the situation is looking rather different.

The Roscos born out of the privatisation process in the mid-1990s – now known as Angel Trains, Eversholt and Porterbrook – are facing unprecedented competition as newcomers seek to disrupt the established market. It’s been 10 years since infrastructure investors started buying into the Roscos from the banks that owned them post-privatisation, attracted to a market offering double-digit returns, a visible pipeline and regulatory stability.

Indeed, returns have been bountiful for those owning the Roscos. 3i Infrastructure reported a 40 percent gross IRR and a 3.4 times money multiple after realising its December 2010 investment in Eversholt. It had invested in the latter alongside Morgan Stanley and STAR Capital and sold it in January 2015 to Cheung Kong Infrastructure. Additionally, AMP Capital, which has owned part of Angel Trains since 2008 and a majority since 2015, posted returns on its investment of 21.4 percent as at July 2017.

However, one former Rosco owner, while appreciative of the benefits to its portfolio generated by its ownership, indicated he was “very happy” to have exited and warns of a “quite scary” situation.

So, what’s so scary about a sector generating such healthy returns?

NEW KIDS ON THE ROCK

The aforementioned newer entrants to the market have caused a stir and, in some respects, a structural change to how rolling stock bids are financed in the UK. The approach has been pioneered by the formation of Rock Rail in 2014, led by Mark Swindell, formerly a partner at law firm DLA Piper.

At the time, only 8 percent of rolling stock fleets were owned by those outside the three established Roscos, according to the Rail Delivery Group, a body comprised of rolling stock owners, train operators and Network Rail. By March 2018, this figure stood at 13 percent and is set to rise further given the current pipeline. Indeed, the total number of new vehicles committed for delivery over the next two to three years is 7,187, with more than 5,100 of the trains financed by parties other than the traditional trio, according to the RDG. This group also includes lessors such as Macquarie and Beacon Rail.

“We felt we could offer leases on a better value-for-money basis for both passengers and operators than was the case,” explains Swindell, who, as a lawyer, worked on the privatisation of the Roscos. “We take a longer-term view of the asset and target long-term predictable revenue streams.”

Rock Rail’s entry has increased the level of institutional capital in the sector, teaming up with the likes of SL Capital and pension consortium GLIL. Swindell declines to state the level of returns targeted through its structures, although pension fund documents have indicated SL Capital expects an average net yield of between 8 percent and 9 percent on its rolling stock deals.

“We saw a number of new entrants being competitive, which was an interesting dynamic,” says Tom Sumpster, head of infrastructure finance at LGIM Real Assets, part of insurer Legal & General, which helped finance Rock Rail’s second and third deals. “The advent of Rock Rail coming in originally took people by surprise – to see there was an alternative option – but that demonstrates to the wider public there is competition in the rail sector, which perhaps may not have been conveyed as much over the past 20 years.”

It’s the competitiveness, though, which has raised eyebrows from some within the space. Newcomers such as Rock Rail, Infracapital and DWS (formerly Deutsche Asset Management) have, according to several sources, come in at far lower lease rates than the Roscos had previously. The expectation is that higher lease rates will be achieved after the trains have finished their initial six-to-eight-year franchise term.

But this is driving returns much lower than the Roscos are used to and questions have been raised around the sustainability of such an approach.

“We don’t bid on something that we’re not 100 percent sure won’t be re-leased in the future,” Swindell maintains. “We don’t participate if we’re not confident.” He adds that Rock Rail isn’t looking for a specific market share and is selective in its bidding for franchises, pointing to the Wales and Borders and the West Midlands franchises, the latter of which was won by Corelink Rail, the Infracapital/DWS platform.

“Right from the beginning, we told the operators we weren’t going to bid,” Swindell says. “We feel it’s important to tell the operators what we will and won’t bid on. With West Midlands, we felt there would be too much change with HS2 coming in and lots of borders being redrawn.”

The new pricing structures and less diversified fleets have pushed Roscos to adapt, according to Sumpster. Legal & General has to date completed four rolling stock deals totalling more than £550 million ($774.4 million; €629.8 million), working with Angel Trains and the Infracapital/DWS consortium, in addition to its deals with Rock Rail.

“I think [Roscos] have to think a little bit differently about the way they are financed and the way they bid for new trains,” Sumpster outlines. “Knowing there are new entrants which come with a very different view on how to price the opportunity, means they have to look at how to address that.”

Angel Trains and Eversholt declined to comment when contacted for their views on the market developments. Porterbrook did not respond to a request for comment for this article.

“We’ve seen the rolling stock companies react and be successful in procurements,” Sumpster tells us. “This has led to investment opportunities for ourselves with the established Roscos and we’re looking at different structuring opportunities within that.”

DISPLACEMENT ISSUES

As ever with infrastructure, market opportunity and potential obstacles have been shifted by the regulatory system in which it operates and rolling stock is no exception. UK-based fleets have historically been protected by Section 54 undertakings ­– a government guarantee ensuring that the trains will continue to be leased for a defined period. It was, in a way, the mechanism which lent the ‘infrastructure’ tag to rolling stock, providing stable, long-term cashflows backed against potential merchant risk.

However, with many of the current guarantees expiring in 2018 through to 2020, the fleets are now at the mercy of the franchise operators, which are free to procure new rolling stock, regardless of the age of the existing fleet. It’s this market opportunity that has allowed recent entrants to step in and offer cheaper, newer and arguably better solutions than the trains currently locked in.

This is what happened with Rock Rail’s second deal, a £600 million transaction for the Abellio East Anglia franchise financed by SL Capital and GLIL and the first complete renewal of rolling stock on a UK rail franchise in more than 10 years. However, the deal created displacement of vehicles with significant remaining life. Displaced fleets then need to find a new home, be sold, expensively stored or completely scrapped.

The displacement issue was exacerbated in Rock Rail’s following deal, a £1 billion financing for new South Western franchise operators FirstGroup and MTR in June last year. The new Bombardier trains, once in operation in mid-2019, will replace a fleet around 30 years old, but also displace 150 trains that were not even operational at the time of the tender.

“It does mean that Angel Trains has a fleet of Siemens trains that won’t have a home after 2020,” Chris Grayling, the UK’s Transport Secretary, succinctly summarised later, adding he is “absolutely certain” they will find another home.

Rock Rail contends it is providing a better service at superior rates for taxpayers and it’s hard to argue against that. Its East Anglia trains will have 79 percent more seats, reduce journey times by 20 minutes and have a reduced environmental impact. However, while these 150 displaced trains may be at the extreme end of the scale, they are part of a wider conundrum.

“As at March 2018, there are over 1,500 vehicles less than 30 years old that do not currently have a future lessee, so while over 7,000 vehicles will be built, the net impact on the national fleet total will be less than this number,” the RDG noted. Prior to 2016, it adds, this risk was perceived as low across the industry. Contrary to Grayling’s optimism, the RDG says the market opportunity for displaced vehicles “appears difficult” amid a perceived increase in the market’s investment risk.

“Without [Section 54], I think the market is still supported, but clearly it is at a different area of the credit spectrum, more into the BBB category, subject to leverage,” explains Sumpster. “Displacements have occurred and it hasn’t affected any of the Roscos’ abilities to raise new financing or to honour their existing debt obligations.”

The outlook for the future remains unclear, with the price of procuring fleets fluctuating over the years. What is clear is that an established market has been disrupted, pitching traditional infrastructure investors against each other.

A decade on, the Competition Commission is presumably sufficiently satisfied.