S&P: U. K.-Based Capital Hospitals (Issuer) PLC Debt Ratings Affirmed Following Fire-Stopping Progress; Outlook Negative

S&P Global Ratings said today that it affirmed its 'BBB-' S&P underlying rating (SPUR) on the senior secured A1, B1, A2, and B2 debt issued by U. K.-based special-purpose vehicle Capital Hospitals (Issuer) PLC (the issuer). The outlook on the SPUR remains negative.

At the same time, we affirmed our 'AA' long-term issue rating on the A1 and B1 debt, which benefits from an unconditional and irrevocable payment guarantee of scheduled interest and principal provided by Assured Guaranty (Europe) Ltd. (AGE; AA/Stable/--). We also affirmed our 'BBB-' long-term issue rating on the A2 and B2 debt, which has an unconditional and irrevocable payment guarantee of scheduled interest and principal provided by Ambac Assurance U. K. Ltd. (not rated). According to our criteria, the issue rating on debt guaranteed by a monoline insurer is the higher of the rating on the insurer and the SPUR. Therefore, the long-term issue rating on the A1 and B1 debt reflects the rating on AGE, which is above the SPUR. As we do not rate Ambac, the long-term issue rating on the A2 and B2 debt reflects the SPUR. The outlook on the A1 and B1 debt is stable, reflecting the outlook on the AGE. The outlook on the A2 and B2 debt is negative reflecting the outlook on the SPUR.

The A1 and B1 debt comprises ?510.2 million of senior secured bonds (A1) due 2046 (including ?137.5 million in variation bonds), and a ?125 million European Investment Bank (EIB) index-linked senior secured guaranteed bank loan (B1) due 2041. The A2 and B2 debt comprises ?510.2 million of senior secured bonds (A2) due 2046 (including ?137.45 million in variation bonds), and a ?125 million EIB index-linked senior secured guaranteed bank loan (B2) due 2041.

The debt was issued by the issuer in 2006 and on-lent to Capital Hospitals Ltd. (CHL or ProjectCo). CHL has used the funds to design construct or refurbish two inner-London hospitals: the 956-bed Royal London Hospital (RLH) and the 372-bed St. Bartholomew's Hospital (Barts). ProjectCo operates under a 42-year availability-based project agreement with Barts Health NHS Trust (the trust), which expires in April 2048. Construction completion was achieved on March 29, 2016 and the project has been operating successfully since that date, receiving a full unitary charge from the trust. The project's hard facilities management (FM) services are provided by Skanska Facilities Services (SFS), whereas soft FM services remain with the trust.

The affirmation of the SPUR reflects that we have seen a significant improvement in resolution of the fire damper and fire-stopping issues identified at the Kenton and Lucas building of Barts hospital, alleviating the threat of various contractual triggers under the project agreement. The fire-stopping issues led to a dispute between the project parties over the defect liability and level of associated service failure points (SFPs), which could have led to sustained deterioration in the working relationship of the project parties and ultimately destabilize the project's cash flow. The fire-stopping surveys undertaken by an external consultant, Mott MacDonald, and consultations with the trust's fire officer identified areas where works had been needed. These works undertaken by Skanska Facilities Services (SFS) on behalf of CHL, led the way to development of an Amnesty Agreement (AA). The AA, which was signed on March 29, 2018 by the trust, the ProjectCo and the creditors (EIB, AGE, and Ambac), documents the project parties' responsibility with respect to fire-stopping remediation works and costs, as well as the requirement to action the other findings in the report of an independent advisor, Capitec, related to record-keeping and maintenance. In return, the trust has agreed to wipe clean the disputed significant SFPs that had accrued as a result of the fire-stopping issues and to not impose the approximate ?5 million of associated unitary charge deductions. Consequently, the relationship between the trust and ProjectCo has improved markedly over recent months and this has led us to affirm the rating.

SFS has already completed the majority of the remediation works required to fix the fire-stopping issues. The cost of the works, estimated at ?450,000, is being borne by CHL and funded from cash accrued historically due to lifecycle underspend. Therefore, there has been no financial weakening of the project as result of the fire-stopping remediation works. In addition, CHL paid half of the ?100,000 cost of the Capitec review; SFS paid the other half.

ProjectCo is exposed to the potential of increasing lifecycle expenditure. As part of the AA, SFS is undertaking an asset validation exercise to ensure that all the project's assets, including Trust Advanced Works Buildings (TAWB), are included in the asset register, and the planned preventative maintenance and lifecycle costs for these assets are included in the relevant budgets. Consequently, the lifecycle budget will be reviewed following completion of the asset validation, which is expected to take up to 18 months and could result in weaker financial ratios. According to the technical advisor (TA) the lifecycle budget may require refinements to the cost rates and replacement frequency assumptions, although it also has the potential to identify other savings as yet unknown.

There is limited headroom at the current rating level. The project's financial strength has weakened slightly following the completion of the benchmarking exercise scheduled at "first anniversary global completion" and conducted in 2017 that led to an increase in cost of the hard FM service contract by about 15%. Positively, the hard FM cost is now fixed for another 10 years and the TA opines that recent cost increase places SFS' fee in the upper quartile of a benchmark range, so an alternative service provider could be procured for a similar fee if required. Under our base case, the minimum annual debt service coverage ratio (ADSCR) is 1.13x (between 2034 and 2038) and an average of 1.20x, down from a minimum of 1.14x and an average ADSCR of 1.21x forecast last year.

Our 'BBB-' SPUR continues to reflect the project's higher operating risk compared with other rated project finance initiative hospitals. In our view, the availability-based revenue stream with no volume or market exposure, and stable operational history with low level of performance or unavailability deductions (outside the fire stopping issues), continues to be offset by a complex nature of hard FM services. This is due to the specialized nature of services provided by the trust (trauma and accident and emergency in Royal London, cancer, and cardiac in Barts) and the large size and high occupancy of the hospitals located in densely populated central London. Additional risk results from presence of several TAWB sites in both Royal London (Alex Wing, Horace Evans House, Pathology and Pharmacy Building) and Barts (Kenton, Lucas, West Wing, Surgery House). These factors mitigate, in our view, the benefit of de-scoping, as of April 1, 2017, of soft FM services, which were previously provided by Carillion PLC, and now are subcontracted directly by the trust to Serco.

The project continues to demonstrate resilience under our downside scenario, under which we include also a 0.5% deduction in the unitary charge to reflect a theoretical level of deductions that would not be passed through to the subcontractors. We reflect this resilience in a two-notch positive adjustment to the preliminary stand-alone credit profile, which we assess at 'bb'. The stable outlook on the A1 and B1 debt issue ratings reflects the outlook on the monoline insurer, AGE, and will move in line with the AGE's outlook going forward.

The negative outlook on the SPUR on the debts and on the A2 and B2 issue ratings reflects that despite the approval of the AA relating to the fire-stopping remediation works and the improved relationship between the trust and CHL, there is limited headroom at the current rating level for the project to withstand any weakening of its financial profile.

We could lower the SPUR if the minimum ADSCR under our base case falls below 1.13x or if the performance weakens under our downside sensitivity. In our view, this could happen if the currently ongoing asset verification exercise, due to be completed over the next 18 months, leads to a re-profiling of the costs or timing of the lifecycle budget, thus lowering future cash flows available for debt service. Ratios could also weaken if we revise down our long-term macroeconomic assumptions.

We could also lower our rating if there were an increased risk of relationship deterioration. From our experience on other projects, poor working relationships between project parties can swiftly lead to increased performance deductions and heightened risk of project default.

We could revise the outlook to stable if any update to the forecast lifecycle expenditure following the completion of the asset register update does not lead to a weakening of the forecast ADSCR below 1.13x, provided that SFS continues to deliver good operating performance with low level of SDPs and deductions, and CHL remains a good working relationship with the trust.
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