Submissionby Chris Cook in January 2004 to the House of Commons Treasury Sub-Committee on Restoring Confidence in Long Term Savings

Asset-Based Finance: "Open" Financial Capital

1. Introduction

1.1. There have historically been two asset classes available for long-term savings: Debt and Equity. The former is based upon obligations issued by Government, Credit Institutions (ie Banks and Building Societies) or by Corporate borrowers. These obligations may be backed by assets either directly or indirectly and this asset class constitutes "Deficit-Based" financing.

1.2. The alternative is to invest in productive Capital assets either through direct ownership or through shares in Joint Stock Companies or units in Unit Trusts which own such assets. Unfortunately we have seen how stock-market valuation of such assets may lose touch with the underlying reality of revenue streams generated by these Capital Assets and this is one of the principal reasons for this Inquiry.

1.3. HM Treasury has identified a requirement for new and tax transparent vehicles (Real Estate Investment Trusts - "REIT's" ) for investment in Real Estate both in the commercial and residential fields and is to consult on the policy issues. In the meantime, the Miles and Barker inquiries have focused upon issues relating to long term financing and availability of residential properties.

1.4. HM Treasury was perhaps unaware of the existence of a tax-transparent vehicle which has already been utilised in the Commercial sector in a transaction of some £350m value and demonstrates a new "Open" form of Asset-Based financial capital.

1.5. This transaction was an example of an "Open Capital Partnership" ("OCP") utilising the new (post 6 April 2001) UK Limited Liability Partnership, which, confusingly is not legally a partnership but is a corporate body with limited liability.

1.6. This memorandum sets out simple applications for asset-based financing using the OCP in each of three areas:
• Public Investment in infrastructure;
• Private Investment in residential properties;
• Commercial Investment in Capital assets.
Each of these areas has the potential to give rise to a separate Pension Asset class ideal for restoring confidence in long-term savings.

2. The Open Capital Partnership ("OCP")

2.1. An OCP is a "new" (post 6 April 2001) UK Limited Liability Partnership ("LLP") the purpose of which is to acquire and develop Capital assets in the UK or elsewhere.
It has two Members: (a) the "Occupier"- or Capital User; (b) the "Financier" - or Capital Provider, and the Occupier has the right of indefinite use of the Capital for so long as he pays an agreed Rental. To the extent that an Occupier pays the Rental in advance of the due date he will also be a Financier.

2.2. The OCP creates a form of "virtual" Ownership which is neither permanent (eg freehold property) nor temporary occupation (eg leasehold/tenanted property) but a hybrid. Moreover, once a Capital asset such as Land and Property is within an OCP there is no reason why it need ever again be sold, although Financiers and Occupiers may both change over time in accordance with the OCP Agreement.

2.3. The OCP was demonstrated in embryo in late 2002 in a transaction by Hilton Group involving 10 hotels in the UK. Hilton sold this portfolio for some £350m to an LLP in which they (the "Occupier") retain 40% of the "Equity" (ie a proportional share) with the balance of 60% being owned by a second LLP linking the 3 "Financier" Members. Hilton undertook to pay for 27 years 28.8% of their gross revenues from these hotels plus a further £3m pa all subject to a floor of £17.5m pa or 5%.

2.4. There is no debt, and no mortgage: equally there is no Freehold/Leasehold "sale and leaseback" either of which would have given rise to that divergence of interest between the Financier and the Occupier which is taken for granted between mortgagor and mortgagee or between freeholder and leaseholder. The outcome is of a true partnership of 27 year duration, where if Hilton has a good year then so do the Financiers, and the result is "Asset-based Finance" of some £350m value initially.

2.5. This transaction illustrates the potential for a new asset class of proportional "shares"/ partnership interests (eg one tenth, one thousandth, one millionth) in asset owning OCP's. These "shares" would be analogous to the asset class we know as Unit Trusts created through the operation of a trust law- based legal "wrapper" around assets and associated revenue flows. The OCP essentially places a different form of legal "wrapper" around Capital assets and associated revenue streams.

2.6. This could - in the Commercial example of the Hilton transaction - take the form of partnership interests in the LLP of (say) 10m "shares" of £35 value, each of which would be entitled to a proportionate share in the Hilton revenue stream for 27 years. Such Shares allow direct investment in commercial Capital assets and direct participation in the revenues which flow from these assets: simple, but radical.

3. Public Investment

3.1. Two scenarios follow: in the first we see a possible replacement for PFI funding; in the second a mechanism for funding the Olympic Games without recourse to the London Council Tax payer.

Education PFI Alternative

3.2. Bloggshire has 10 schools in 5 different boroughs requiring £20m rebuilding/ refurbishment. Bloggshire transfers the land to Bloggshire Land Partnership (BLP) and transfers the school buildings to the Bloggshire Schools Partnership (BSP) both of whose members are the five boroughs. BLP becomes a "Financier" Member of Bloggshire Education LLP while BSP becomes the "Occupier" Member and agrees to pay a peppercorn rental for an indefinite term to BLP for the use of the land.

3.3. BSP is divided into 10 million "shares"/ partnership interests each valued at £2.00 initially and Bloggshire agrees to pay BSP a rental for the use of the school buildings of £600k pa initially, linked to inflation and thereby providing a rate of return of 3% inflation linked. Bloggshire will aim to repay the Capital over the expected life of the school (say 25 years).

3.4. Bloggshire residents are invited to invest in these "shares" with priority being given to parents and with any Government "baby bond" money being allocated to purchase "shares" on behalf of pupils. Institutions such as the Teachers' and Bloggshire Employees' Superannuation schemes are given priority after local residents to invest, and will underwrite the share issue and provide liquidity.

Financing the Olympics

3.5. The Olympic Partnership LLP would have two members initially: the LDA as "Community" Land owner and an LLP consortium of financiers, developers, builders etc, and it would acquire necessary Land and build the Olympic Village and facilities.

3.6. A consortium of occupational pension schemes (Local Authority, Post Office, Universities, Teachers, Nurses and so on) would be invited to invest on the basis that they would be allocated a certain number of the Village properties after the Olympics for occupation by their young scheme members.

3.7. These young scheme members would then have the "right to buy" equity in the properties in which they live by simply paying in excess of the agreed rental for the property (see Para 4.2 below). In addition they would pay a rental to the Community in respect of the Land upon which the Village is built.

3.8. A substantial proportion of the Village could be dedicated to "creative" professionals unable to afford London property or alternatively to "social tenants" and this group could qualify for a reduced rental through the waiver of some or all of the Land Rental. In addition, they too would be able to build up equity in the property in which they live simply through paying in excess of the rental.

3.9. For the "Financier" Pension Schemes there is a solid asset-backed income stream. For Occupiers there is the knowledge that they benefit both directly from any increase in property value through the Equity they own and indirectly through the fact that their pension will reflect any increase in value of the Equity they do not own.

3.10. For the Development partners the proposition is that they will be paid an agreed proportional share in the future revenues they have helped create. The beauty of this model is that the development partners are therefore incentivised to collaborate to create buildings of the highest possible quality and durability at the earliest practicable time and thereby maximise both their return and their ability to realise it.

4. Private Residential Investment

4.1. The use of the OCP for residential property investment represents a simple and innovative form of property purchase, which happens to be Islamically sound in that debt and interest are not involved. Two examples are given below firstly in relation to Affordable Housing and secondly in relation to Equity Release - neither distinguishes Land from the buildings on the Land.

Affordable Housing

4.2. A property purchased for £100,000, of which the Occupier invests £20,000:
• the Occupier/Financier receives 20 "shares" and the Financiers 80 shares at a value of £1k each. (or 200/800: 2000/8000 etc - it is the 20%/80% proportions which matter, there being no par or nominal value to these shares)
• there is an Exchange of Value: in return for the use of the Property, the Occupier(s) pays a Rental to the Financier (s) for the use of the Capital.
• so a rent of £6,000 pa is agreed for two years for the above property: the Occupier pays net £4,800 pa; the Financier receives net £4,800 pa.

After two years, the Occupier wishes to invest £12k in the Property: at £120k valuation he buys a further 10%; at £96k valuation he purchases 12.5% and so on.

Equity Release

4.3. A property worth £500,000, from which the owner - a retired teacher - wishes to release equity of £50,000 to supplement her pension.
• the Teachers Superannuation Scheme (the Financier) purchases a 10% share in an OCP which acquires the house, while the Occupier retains a 90% interest; · a market rental of £15,000pa initially is agreed for the property of which the occupier is due to pay the Financier 10% or £1,500 pa;
• for two years the Occupier decides to pay the Rental in equity rather than cash (ie £3,000 rental due). The property is revalued at (say) £600,000 and the Equity shares are adjusted so that the Financier now has 10.5% of the Equity.

4.4. In terms of affordable housing, a young member of a pension scheme may acquire Equity in his property in three ways: firstly voluntarily, through paying rental in excess of that due; secondly, compulsorily, through a mandatory pension contribution (say) half of which is applied to acquisition of equity; and finally through his participation in the scheme itself, which owns the balance of the Capital Asset for which he pays the rental.

4.5. In relation to Equity Release, the two available options ("Reversions" and "Roll-up" mortgages) are expensive, disadvantageous or both. The OCP model allows Pension funds to market to its existing portfolio of pensioners an entirely new Equity Release product. In doing so a Pension fund also acquires a pool of investments in UK residential properties with a rental income and potential capital growth.

4.6. As a footnote a defective equity-sharing model failed in the late 1990's: the disastrous experience of pensioners using "Shared Appreciation Mortgages" offered by Barclays and Bank of Scotland arose out of the fact that in return for a 25% equity stake, the banks demanded 75% of the property gains, albeit without demanding any other return on Capital invested.

4.7. In the OCP Equity Release model the Occupier simply pays a rental for the Capital he uses, for as long as he uses it.

5. Issues

5.1. The development of this new asset class would face similar challenges to those which faced the nascent unit trust industry ie taxation issues, regulation, accounting. It would also be necessary to establish intermediary liquidity providers, and other service provision.

5.2. One of the key points is taxation, and it should be noted in particular that the UK LLP is a tax transparent vehicle which is already customarily in use as such. The capability of the OCP to allow finance to be raised without borrowing arguably exposes the REIT as an inferior vehicle for pension funds to achieve the Asset-based investment which they seek.

5.3. In terms of regulation, we can see a new and possibly optimal form of collective investment by essentially "pre-qualified" investment "clubs" constituted as LLP's.6/ Summary

6.1. There now exists a new and radical mechanism for long term asset-based investment capable of restoring confidence in long-term savings whether as part of a pension scheme or otherwise.

6.2. This mechanism is based upon a "new" (post 6 April 2001) Corporate vehicle - the UK Limited Liability Partnership - which already offers a tax transparent vehicle for property investment for which the Treasury is beginning the consultative process in relation another type of entity - Real Estate Investment Trusts ("REIT's").

6.3. Asset-based financing has already been demonstrated in use in late 2002 in the UK in a major commercial property transaction to the value of £350m over a 27 year term utilising an "Open Capital Partnership" form of LLP.

6.4. This paper gives examples of how the OCP is capable of forming the basis for entire new asset classes in the fields of public and private residential properties which provide radical new policy options capable inter alia of:
(a) an equitable new form of PFI;
(b) a financial model where "the Legacy funds the Olympics" rather than "the Olympics (and the council tax payer in particular) funding the Legacy";
(c) a new and fair form of "Equity Release";
(d) a new model for affordable housing.

6.5. The OCP literally creates a new form of "Open" Financial Capital which
is neither Debt nor Equity as we know them but a radical synthesis.

Chris Cook
January 2004