Since 2009, Tesco (ticker: TSCO) has used special purpose vehicles (SPVs) to issue nearly £4bn of property bonds as part of its sale and leaseback programme. Despite Tesco being responsible for repayment of the bonds, they are not included on Tesco’s balance sheet, nor are they disclosed in the notes to its financial statements.
Equivalent to Tesco corporate bonds
In recent years, Tesco has regularly used sale and leaseback transactions to free up capital from its large property portfolio. Earlier transactions generally had a conventional structure: typically, properties were sold to a joint venture with a third party investor, such as a property company or pension fund, with the purchase largely funded with bank debt. However, from 2009, the company started to take a different approach, helped by some clever bankers from Goldman Sachs. The new structure is, in effect, similar to conventional debt financing, although for Tesco it has the benefit of being off-balance sheet.
Between 2009 and 2013, six SPVs, Tesco Property Finance 1 through 6, issued around £3.6bn of bonds to investors. The bonds carry a fixed rate of interest and each issue has a 30-year life. The SPVs are not subsidiaries of Tesco, but the company is contractually responsible for funding repayment of both the interest and principal, which is amortised over the bonds’ life. It should be noted, however, that the SPVs are kept at arms length from Tesco: technically, the bonds are solely the obligations of the SPVs and are not directly guaranteed by Tesco. However, because Tesco guarantees all payments to the SPVs, the bonds have the same credit rating as Tesco’s corporate debt. They were structured so that investors’ primary concern was Tesco’s creditworthiness, and appear to have been marketed to investors as equivalent to Tesco corporate bonds; the value of the underlying properties is irrelevant to the bond investors.
It is worth giving a brief overview of how the transactions were structured. This information has been primarily derived from the bond offering documents. The specifics of each transaction differ in their details, but fundamentally, they are very similar. For each transaction, Tesco established a limited partnership to which it sold a package of properties, which it leased back for 30 years with annual rent increases linked to the retail price index (RPI). The purchase was financed by the issue of 30-year bonds by the SPV, which loaned the proceeds to the partnership. The bonds and the partnership loan have identical, back-to-back terms, with the same fixed interest rate and repayment schedules. To solve the cashflow mismatch between the RPI-linked rents paid by Tesco to the partnership, and the fixed payments due on the bonds, the partnership and the SPV, and the SPV and Tesco entered into back-to-back swap arrangements. Netting off the various swap payments, Tesco receives amounts equal to the rental income and pays to the SPV amounts equal to the interest and principal repayments on the bonds. The rent payments are completely circular: Tesco pays rent out of one pocket to the partnership and receives it back (via the SPV) in another. In simple terms, netting off all the cashflows, Tesco receives the bond proceeds and repays the interest and principal; the bond investors look to Tesco as the source of all bond payments, while the underlying property leases are, in effect, irrelevant.
It appears that Tesco entered into a further swap arrangement with a bank, swapping the amount it receives equal to the rent payments for fixed payments. I suspect this is required for the transactions to be classified as operating leases.
To remove the partnership from its balance sheet, Tesco formed a joint venture with a third party investor, such as a pension fund (several transactions were with Tesco’s own pension fund) and sold 50% of the partnership to the investor. In essence, there are two separate transactions: first, the issuance by Tesco of 30-year bonds; and, second, the sale of the residual interests in the properties to the joint venture. It is not clear how much Tesco received from the sale of these residual interests, but the amounts were probably relatively small, given uncertainty about the properties’ values in 30 years and the impact of discounting to a present value.
Off-balance sheet and largely undisclosed
The property bonds do not appear on Tesco’s balance sheet; it seems that the company is able to treat the transactions as normal operating leases, which are disclosed in the leasing commitments note to its financial statements, where the future minimum lease payments is set out. The swaps are recorded under financial instruments.
The rating agencies, and many investors, include the present value of future lease payments in their calculation of total debt. Therefore, the failure to include the property bonds on Tesco’s balance sheet might have been less important if the full extent of its obligations were disclosed in the leasing commitments note. However, it appears that is not the case. While the leases have a 30-year term, Tesco has the option to break the lease after 10 years, if it buys back the properties (at market value) and repays the bonds. Tesco is only required to disclose the minimum future lease payments; therefore, only rental payments up to the buyback date are included. However, because the company has the option to buy back the properties, but is not required to do so, the cost of buying back the properties is not treated as an obligation either. It seems strange that a company in this situation that has a choice between two obligations (buying back the properties or paying the rent) can avoid recording either of them by saying both are options.
In Tesco’s 2010 annual report, which was the first one after the company started issuing the property bonds, the following paragraph was added to the leasing commitments note (Note 35):
“The Group has lease break options on certain sale and leaseback transactions, which are exercisable if an existing option to buy back leased assets at market value at a specified date is also exercised, no commitment has been included in respect of the buy-back option as the option is at the Group’s discretion. The Group is not obliged to pay lease rentals after that date and so minimum lease payments exclude those falling after the buy-back date.”
Subsequent annual reports have included almost identical wording. However, in the 2014 annual report, the following sentence was added to the paragraph:
“The current market value of these properties is £5.4bn (2013: £5.2bn) and the total lease rentals, if they were to be incurred following the option exercise date, would be £4.2bn (2013: £4.1bn) using current rent values.”
I estimate that the inclusion of this £4.2bn in future minimum lease payments would increase Tesco’s total debt by around £2bn, after discounting back to a present value, which represents a material increase. It is unclear to what extent the rating agencies have adjusted for this.
In my view, these transactions are clearly a form of financing, rather than genuine leasing transactions. The accounting treatment may comply with IFRS—and Tesco’s auditors, PricewaterhouseCoopers, have obviously signed off on it—but it is almost impossible to understand the substance of the transactions from Tesco’s financial statements. The fact that Tesco has gone to such trouble to ensure that the bonds are not included on its balance sheet, and the inadequate disclosure in the notes to the financial statements, is not a good sign. The lack of transparency raises serious concerns about what else remains hidden.