Value judgment

More companies are releasing value from their real estate assets thanks to the Opco/Propco model. By Lucy Wolley Dod and Sean Crosky

With estimates of more than £100bn worth of freehold property being held by the FTSE100 companies alone and strong demand for property and long-term investments, the opportunity to release hidden real estate value has become a key factor in driving M&A activity.

Private equity and hedge funds are targeting businesses in real estate-rich sectors – notably retail, hospitality and healthcare – that are not making maximum use of their assets. Recent years have seen high-profile private equity acquisitions such as Debenhams, Travelodge and General Healthcare Group being structured using the Opco/Propco model, which allows the purchaser to reorganise the target business to maximise leverage and optimise finance costs.

The aggressive use of Opco/Propco structures by predators has prompted potential targets and their advisers to consider their use as a defensive ploy and a means to unlock shareholder value. There is also an increasing interest in alternatives to the conventional Opco/Propco model, particularly so-called ‘market value securitisations’ and the UK real estate investment trust (Reit), which was introduced on 1 January.

Traditional Opco/Propco model
At its simplest, an Opco/Propco structure involves the transfer by the operating company (Opco) of its property assets to a newly incorporated property holding company (Propco). It is distinguished from a third-party sale and leaseback by the continuance of the Opco and Propco under the same ownership. The Propco is ring-fenced from the Opco and leases the properties back to the Opco on ‘arm’s-length’ terms. This is typically done under a ‘triple net’ lease, so that the Opco is liable for all property-related costs such as insurance, maintenance, capital expenditure and taxes.

The Propco finances the consideration for the transfer of the properties by property finance loans for which, in current markets, it can obtain a loan of up to 80 to 85 per cent of value, and services those loans from rental payments. The Opco remains free to raise conventional leveraged debt off its operating cashflows, so the traditional maximum leverage of 65-70 per cent, which the business would have been able to obtain with combined operating and property assets, is significantly enhanced.

Despite this relatively straightforward basic structure, Opco/Propco deals raise important and complex legal, tax and other issues that need to be resolved and must be structured to satisfy the requirements of both the property finance and leveraged lenders and to ensure the operational flexibility required by the Opco.

The market has seen a number of variations of this basic structure, particularly where Opco/Propco has been adopted outside the context of an acquisition, but in recent months interest in Opco/Propco and possible other alternative structures to the conventional model has been rekindled by CVC Capital Partners’ offer for J Sainsbury and reports of efforts by Robert Tchenguiz to persuade the same company to effect an Opco/Propco reorganisation via a Reit. So how real are these alternatives?

There has been much discussion and analysis of the Opco/Propco structure and its suitability to certain assets in the securitisation market. The securitisation market has absorbed the lessons and technology from the general bank market, with bankers and lawyers commenting widely on whether this technology could provide certain originators with a more cost effective and efficient form of financing to the more usual forms of securitisation used to finance real estate and real estate-rich businesses, commercial mortgage-backed securitisations (CMBS) and whole business securitisations (WBS).

This has been driven by several transactions in the healthcare and retail sectors in 2006. The innovative Talisman 2 ‘hybrid corporate securitisation’ refinancing of healthcare group Priory in January 2006 by ABN Amro was lauded for delivering a higher leverage than the market had seen to date in other transactions with similar assets. 2006 also saw highly successful refinancings by supermarket chains J Sainsbury and Somerfield, both of which used an Opco/Propco securitisation structure.

The Sainsbury deal involved 2 separate issues that raised £2bn in total and enabled it to buy back £1.7bn in outstanding unsecured bonds, saving a reported £12m per annum in finance costs, and to make a £350m payment to its under-funded pension scheme. The use of the Opco/Propco model, a low loan-to-value ratio and secured loan securitisation meant that both issues included tranches rated at AAA, whereas Sainsbury’s unsecured senior debt is rated at the bottom end of the investment grade scale.

Interest in this area can also be seen in Standard & Poor’s (S&P) issue of a new credit rating approach for Opco/Propco securitisations. S&P argues that certain market value approaches used in European CMBS analysis can be expanded to the wider corporate sector to rate corporate recovery-based or ‘market value securitisations’.

It considers several different Opco/Propco structures and discusses how these would be analysed for rating purposes. It notes that the key point that differentiates these recovery-based transactions from the traditional cashflow-based WBS is the existence of operating performance covenants which ensure that the underlying business and/or assets are sold at an early stage if market conditions decline. S&P observes that these structures are highly bespoke and there is no one-size-fits-all set of criteria, but it is willing to explore these structures with market participants and their counsel.

Despite S&P’s new approach and the apparent success of the deals mentioned above, there have been a limited number of securitisations adopting the Opco/Propco approach and a reluctance in some quarters to be seen to be ‘selling off the family silver’. In particular, Marks & Spencer has said that it would not engage in such ‘financial engineering’ following the Sainsbury’s transaction. However, the market has the appetite for more of these transactions and they will be an additional option to originators in sectors that want to refinance their existing debt or raise new debt.

2006 saw widespread speculation about the possibilities that Reits would offer as an alternative or adjunct to the traditional Opco/Propco structure, particularly in the hospitality and leisure sectors. There was much excitement about the further value that could be created from the tax efficiencies of a Reit and the ability of existing owner/operators to restructure and convert to Reit status.

As detailed regulations were published, however, during the course of the year, enthusiasm waned as it became clear that a number of restrictions would limit these possibilities. Most notable is the stipulation that, unlike in the US or Australia, rental income received within a group from operating businesses in the same group cannot benefit from Reit tax exemption – ie a Reit cannot be owner-occupied. This would prevent the use of a Reit in the unified ownership Opco/Propco structure, but nevertheless a Reit may still offer a potential exit opportunity from an Opco/Propco structure.
Lucy Wolley Dod is a partner and Sean Crosky is an associate at Norton Rose