The age of the train

Before getting too excited about the opportunities for project finance that the privatisation of British Rail's passenger services is likely to bring, it is worth looking at the nature of the beast that is taking shape.

A successful bidder for a franchise to operate a passenger service will acquire a company (a train operating company or TOC) which will already have an operating licence (issued by the Rail Regulator), various access agreements (primarily with Railtrack giving it access to track) and a series of operating leases (with one of the rolling stock companies (or Roscos) that has been set up to control and lease the locomotives and other rolling stock).

The successful bidder will have to enter into a franchise agreement with the franchise director which will set out the minimum service requirements and the amount and terms of payment of any government subsidy required by the bidder.

For the first eight franchises on offer, the franchise director appears to be primarily interested in granting a seven year franchise period. The successful bidder will also have to post a performance bond to secure, inter alia, his obligations under the franchise agreement.

It is thought that track access charges payable to Railtrack will account for more than half of a TOC's overheads. As they are presently structured, over 90 per cent of the track access charges are fixed and cannot be influenced by any action of the TOC. A significant proportion of a TOC's remaining overheads will comprise rental payments due to one of the Roscos. The extent to which a TOC can control its overheads is therefore severely limited.

In the above structure, in the absence of a premium being paid for a franchise, obtaining and operating a franchise will not involve any significant capital expenditure. Virtually all of a TOC's transactions will be carried out on current account: the gathering of fare income, the payment of access charges, rental charges, salaries and the like. Large amounts of funds from venture capitalists and banks are unlikely to be needed.

Some finance will be required, however, particularly if any of the franchises are acquired by management buyout teams. Working capital facilities will almost certainly be needed and the performance bond will need to be issued. Depending on the successful bidder's attitude to risk and the protection of its own balance sheet, this may involve granting security over the TOC's assets.

Any bank taking such security will need to examine the implications of the making of a railway administration order in relation to the TOC in question under ss. 59-65 of the Railways Act 1993 if the TOC runs into financial difficulties.

Although there will be some involvement with venture capitalists and banks, the most important work that will be carried out in making a bid for a franchise will be business analysis – the underlying legislative and regulatory regime and the underlying contracts. A successful bidder will acquire an existing company and, on the basis that warranty protection will presumably be minimal, a significant due diligence exercise will have to be undertaken and all of the usual issues arising on a company acquisition will have to be addressed. What are the pension arrangements? What are the employees' terms of employment? What third party claims are outstanding? The agreements that have already been executed with the TOC while in public ownership (principally the Railtrack access agreement and the Rosco leases) will have to be carefully reviewed and difficult issues may need to be reopened.

The franchise agreement itself will have to be negotiated and critical decisions taken on the level of service to be offered and the level of subsidy to be sought. Under the Rail Regulator's policy statement on the structure of Railtrack's charges, the level of service originally offered may have important implications on the future variability of the track access charges that are at present fixed.

At the same time, a bidder will have to formulate his longer term policy and work out his action plan for achieving, maintaining or improving the TOC's profitability. This will probably be the most challenging task of all: if such a high proportion of a TOC's overheads are fixed, cutting back on costs can only take you so far. It would, in any event, be a bold bidder who based any business plan on streamlining the working practices of the relevant TOC's employees.

Any business plan will have to concentrate on maintaining or increasing revenues, either through increasing fares or by enticing more people to use the TOC's trains. Given the political sensitivity of fare increases, however, a business plan which concentrates on enticing more people to use trains is bound to find more favour.

The legal skills required will be those of a general projects lawyer rather than those of a pure commercial or banking lawyer. In the new age of the train, it will be the thoroughness of the due diligence exercise and in particular the ability to identify the risks to the future cashflows that will make the difference between a successful franchise and an unsuccessful one; the Rottweiler reserved for negotiations with the banks can be left in his kennel.

Graham Vintner is a partner at Allen & Overy and the author of 'Project Finance – A Legal Guide', published by Sweet & Maxwell.