STRUCTURED PRODUCTS By : Paritosh Kashyap & Manoj Gupta September 1, 2012
Vanilla Products and Structured Product Vanilla Products Loan INR / FX Secured / Unsecured Bonds / Debentures Convertible or Non Convertible Senior or Subordinate Structured Products are instruments, that are designed to achieve certain specific objectives in addition to raising financing. These revolve around Accounting, Regulations, Taxation, Credit Enhancement, etc. 2
Need for Structure Products The need for Structured Products may be for various reasons and the motives will vary from transaction to transaction. Some of the illustrative objectives of such transactions are as under: Better Capital Structure to ensure efficient utilisation of Capital Higher Leverage Capability and thereby optimizing Return on Capital and Return on Assets Managing the Asset Liability mismatch Optimize cost of funds Tax planning Managing Risks Alternate source of funds 3
Structured Products Indicative List There are no distinct and standardized types of structure finance transactions since one essential principle of these transaction is the ability to tailor a structure that will satisfy the needs and circumstances of all parties involved, provided that perceived or real risks are mitigated Acquisition Financing Mezzanine Financing Sponsor Financing / Promoter Financing Securitisation ABS / MBS Assignment of Receivables Infrastructure financing from Capital Markets Perpetual Debt / Subordinated Bonds / Preference Shares / OFCD / CCD Zero Coupon / Low Coupon NCD with Redemption Premium NCD + Warrant Credit, Interest Rate and Fx Derivatives 4
ACQUISITION FINANCE
Acquisition Scenarios Target Indian Company SPV Foreign Company Indian Company Foreign Company Acquirer Indian Company Promoters Indian Company Debt can be raised at all the above levels based on the following factors Transaction Structure Availability of cash flows for repayment Availability of security Minimizing the impact on the credit rating Taxation and other considerations 6
Key Considerations Acquisition Financing is subject to multiple regulatory guidelines: Source of Fund Raising Availability of Security ECB There are end use restrictions on using borrowed funds for acquisition of shares or investing in subsidiary companies Bank Financing For promoter's contribution towards the equity capital of a company is restricted only for infrastructure companies Capital Market Funds can be raised by way of issue of secured/ unsecured financial instruments depending on the requirement of the tenor Financial Institutions Funds can be raised from FIs and NBFCs since there are no end use restriction Leveraging the Balance Sheet of the Acquirer Company Leveraging the Balance Sheet of the Target Company Post merger of SPV and target Tax break can be achieved on Target s income SPV debt can be serviced out of the cash flows of Target Tax Planning Achieving tax breaks for borrowing in the entity with taxable income Consideration of the provisions of Section 14A of the IT Act, 1961 7
Case Study 1 - Acquisition Financing Stage 1 Acquisition Put Option Acquirer Promoters PE Investor 216 cr 100% 200 cr 18.5% 151 cr 14% Investor NCD subscription 525 cr Core Investment Company (CIC) 730 cr Target Stage 2 Merger Acquirer Core Investment Company (CIC) Target 8
Case Study 2 - Acquisition Financing Acquirer (Indian Co) Issued NCD/CP to Capital Market Investors who don t have any End- Use restrictions like Banks Unsecured Loans from Institutions other than Banks Securitisation of Receivables to Banks which doesn t qualify as debt doesn t form part of borrowing limits under Sec 292(1)(d) Efficient borrowing to minimize impact on Rating SPV (Indian Co) Investment of amount borrowed by the Acquirer as Equity into the SPV Issuance of Optionally Convertible Debentures such that it is not treated debt for the Acquirer Investment in Target Shares Target (Indian Co) Issuance of Shares to the Investors 9
Case Study 3 - Acquisition Financing Transaction Structure Key Challenges The largest domestic Infrastructure Acquisition in terms of the number of projects acquired Couldn t be placed in the Banking Market due to end use restrictions Seller Buyer Group Seller Acquisition of Target Shares for Rs 91.5 Crores 49.9% 50.1% 100% JV Co NCD Infusion of Rs. 600 Crs 50% 50% Rs. 600 Crores as OCD Infusion of ~ Rs. 509 Crores as OCD EPC Co The security structure being offered by the client only included the unlisted shares of infrastructure projects under execution and no tangible security No cash flows available as Buyer is primarily a holding Company and all projects currently under execution Target Projects of Target Payment of ~ Rs. 509 Crores to repay Target debt Target Lenders Further equity requirement in Target Projects for which no clear source of funding visible
Case Study 4 : Acquisition Financing thru discounting of receivables Co A (Acquirer) was in advanced stage to raise ~ Rs 1800 crores, through NCD issuance, to acquire minority stake in a Telecom Company Kotak appraised Acquirer on the tax inefficiency in the NCD issuance because of Section 14 A of Income Tax No tax deductibility on Interest paid on NCDs as the funds were being utilized to invest in equity Kotak suggested an alternative solution to fund raising which took care of tax issue while keeping in mind the complex legal, regulatory and foreign exchange related issues in the transaction The funding was arranged by an innovative transaction where Acquirer assigned the right to receive receivables to the Purchaser Acquirer had certain receivables from an offshore entity which were due in September 2012, which were sold to the Purchaser and the consideration on sale of these receivables were utilised by the Acquirer to acquire stake in the Target 11
Case Study 4 : Acquisition Financing thru discounting of receivables Key Challenges Our Solutions Taxation Issues Acquirer monetized its asset and hence the fund raising is not in form of a borrowing, hence Section 14A is not applicable Accounting Issues Achieved accounting sale as per AS 30 without a legal sale Acquirer Offshore Party agreement disallowed Acquirer to assign the receivables hence legal sale was not possible Acquirer had hedged the currency risk on receivables through a forward contract Forex related regulatory Issues The auditor contested if Acquirer is allowed to keep the forward contract without the underlying Kotak approached RBI and received an approval from RBI that the transaction is valid under regulatory regime 12
PROMOTER FINANCING
Requirement Investment in Existing/New Ventures in the form of direct equity participation Loans Against Shares (LAS) Loans Against Property (LAP) Equity Infusion in Subsidiaries through quasi-equity instruments Issue of Compulsorily Convertible Debentures (CCDs) by the subsidiaries 14
Loan Against Shares (LAS) Lender Borrower Loan backed by pledge of shares Security Trustee acting on behalf of the Lender Security Trustee holding pledge on shares Security Trustee Equity Shares Guarantee, if third party pledge Benefits Taking Leverage against equity holdings Funding for Acquisition of Shares of another entity, put capital into new ventures Funding of the Listed Company for business purpose Lenders NBFC s, Mutual Funds & HNIs Basic Terms Requirements Tenor Up to 3 years Security Cover 1.75 to 2.5 times throughout the tenure Promoter Guarantee in case of third party pledge Size of Rs 50-5000 Crores Debt amount depends on security cover and level of existing leverage Free equity shares left after borrowing 15
Loan Against Property (LAP) Guarantor Property Benefits Borrower Loan backed by charge on property Charge on Property Lender Taking Leverage against Property Lenders NBFC s, Mutual Funds & HNIs, Banks (proper end use) Guarantee, if third party pledge Basic Terms Requirements Tenor Upto 3 years Security Cover 2 to 3 times throughout the tenure Prepayment can be done from receivables from sale of property City centric property with all clearances Typically high cost borrowings Debt amount depends on security cover and level of existing leverage 16
Equity Infusion in Subsidiaries In case of Infrastructure/other Project Companies Promoters/Parent companies need to fund their subsidiaries on a regular basis. At the same time, the promoters/parent company would like to defer the cash outgo for 2-3 years Bank financing to fund the subsidiary is not available to the promoter/parent companies Given the requirements, the subsidiaries can issue fully compulsorily or optionally convertible debentures (CCDs) These instruments can be subscribed by Investors who will have a put option to sell the instrument to the promoters/parent company at the end of 2/3 years at a pre-determined price. Also, the promoters/parent company will have a call option to purchase the instrument from the investor at the same time at the same price The structure ensures that Investors are taking the promoters/parent company credit risk and not equity risk on subsidiaries 17
Typical Transaction Structure The subsidiaries can issue CCDs CCDs shall convert into equity shares at the end of 8 / 10 years (this period can be decided as per the parents comfort) Under a separate agreement, the investor in CCDs will have put options provided by the promoters/parent company which will give them a right to sell the CCDs to the promoters/parent company on specified dates at a specified price To ensure that the promoters/parent company doesn t lose the equity ownership, the promoters/parent company will also have call options provided by CCDs investors which will give the promoters/parent company a right to buy the CCDs on specified dates at the same price as Put option exercise price The put option on the promoters/parent company can be secured through pledge of equity shares of a listed company The specified price (exercise price) shall be decided such that the investor earns the required yield on the investment for holding period Issuer Subsidiary CCDs Put Option (Secured by pledge of listed shares) Investor Call Option Promoter Parent Co 18
Benefits of the Structure There is no cash outflow for the issuer for the redemption as the CCDs shall convert into equity on maturity Deferment of Promoter s/parent Company s equity commitment The coupon payable would provide tax shield to the subsidiary By virtue of the Call option on the CCDs, the promoters/parent company will not lose ownership in its subsidiaries If the Investor exercises put option, the promoters/parent company will be able to roll over the CCDs with a different investor with the help of similar put and call options The structure will give the promoters/parent company an opportunity to dilute equity, if required, at an optimal value at a later date through the sale of CCDs 19
Case Study : Promoter Financing Structuring Solutions by Kotak Holding Co Limited cash flow 1 Target different set of investors for different components of funding. 2 Rely on domestic non bank entities due to end-use restrictions on foreign funding. Tenor ranging from 3 months to 2 years. Trigger of Takeover Code under SEBI Tight Liquidity Conditions 3 Achieved highest short term rating of P1+ and long term rating of AA from CRISIL. 4 Effective leveraging of Target shares and unlisted Holdco shares. Involvement of Foreign Partner Key Challenges Non Bank Financable 5 (a) Minimum security by the Borrower/Issuer through structuring and negotiating to raise maximum funds under the same entity with different trustees (b) Lower security cover for short term debt instrument vis-àvis long term debt instrument Reduce ability to provide security cover Highly Aggressive Timelines 6 Structured the transaction to prevent any leakage of funds other than for purpose of acquisition of Target shares and to block the funds received from PE infusion for take out purpose 7 First ever 91 days Non Convertible Debentures to be listed on the National Stock Exchange. 8 Movement of all non Target assets from Holdco 1 to Holdco 2 by raising funds in Holdco 2. 9 Along with the company finalised the closing mechanics on setting up of escrow account, movement of shares and funds from foreign partner to Holdco 1.
Case Study : Promoter Financing PE 26% Lenders 3700 crs 500 crs Holdco 1 17.33% Holdco 2 Target Seller 8.67% Kotak advised the company in finalising the structure for acquisition entire stake to be acquired in Holdco 1 take out by way of PE infusion at Holdco 1 Possibility of fund raising at various levels for completing the acquisition. Movement of all non core assets from Holdco 1 to Holdco 2 by raising funds in Holdco 2 Tax efficient structure Closing mechanics on setting up of escrow account, movement of shares and funds 21
SECURITISATION
What is Securitisation Process of pooling / repackaging non-marketable, illiquid assets into tradable debt securities Involves true sale of the underlying assets Additional support provided by the originator/ issuer to enhance rating of the securitised paper Investors recourse restricted to proceeds from the underlying assets and the credit enhancement Securitisation transforms the risk-return characteristics of an asset to meet demands of the transaction participants Securitisation is broadly of two types: Asset Based Securitisation (ABS) An investment instrument that represents ownership of an undivided interest in a group of assets (Automobile/Commercial Vehicles(CVs)/Commercial Equipments) Mortgage backed securitisation (MBS) An investment instrument that represents ownership of an undivided interest in a group of mortgages Securitisation transforms the risk-return characteristics of an asset to meet demands of the transaction participants 23
Typical Retail Loan Securitisation Structure Originator Purchase consideration Original Loan Obligors Sale of Loans Credit Enhancement Providers SPV Servicing of securities Liquidity Facility Providers Issue of securities (PTCs) Investors Receivables Collection Agent Collection Agency Agreement Rating Rating Agency Subscription to securities Arranger Contracts Ongoing cash flows Initial cash flows 24
Benefits for Borrower/Seller Off balance sheet funding Reduces Leverage Better financial ratios Optimise Return on Equity & Return on Assets Cheaper funds given the higher credit quality Access to capital markets Provides liquidity and cash for otherwise illiquid assets Efficient matching of maturity profile and interest rate of segregated assets 25
Benefits for Financier/Investors New avenues for investment for Institutional Investors New asset classes Retail Loans Does not require setting up infrastructure for originating and servicing of these assets Facilitates participation from investors who cannot directly advance loans Securities issued pursuant to a securitisation program offers higher returns than other securities with similar maturity and rating profile Higher credit quality Cherry picking Segregated assets Credit Enhancements Regular Monitoring of the performance of the assets by Trustee, Servicer, Rating Agency 26
Regulatory Landscape Key features of the current RBI guidelines Guidelines applicable to Banks and NBFCs Capital Requirement on the credit enhancement provided by the Originator Non Recourse and True Sale criteria for derecognition of assets Amortisation of profit in the transaction and upfronting of any possible losses in the transaction Changing Regulatory landscape given the global crisis Requirement of minimum retention by the originator Minimum holding period before the assets can be securitisation 27
INFRASTRUCTURE FINANCING - From Capital Markets
Regular Infrastructure Financing Project financing from banks Typical debt/equity ratio of 3:1 Floating rate structure linked to banks prime lending rate Security of the project assets Low credit rating due to the risks involved Construction Risk Regulatory Risks Project Risks Higher borrowing costs due to lower credit rating Longer tenor 29
Constraints of Regular Infra Financing The banking sector, while being able to extend significant sums to the infrastructure sector, faces the challenges of Group and company Limits being reached for most large infrastructure players despite relaxation in RBI exposure norms (Individual Company: 15%, additional 5% for Infra; Group: 40%, additional 10% for infra) Insufficient capitalization of public sector banks constraining the increase in infrastructure financing portfolio Limited ability to fund very long term projects because of ALM issues Limited ability to lend at fixed rates End-use restriction on funds Investment in equity of the SPV should be bank financiable Inability to securitize infrastructure loans because of restriction on securitization of assets with tenor > 2 years and with bullet repayment Infrastructure companies need mechanisms whereby they can issue longer tenure fixed rated bonds to investors such as insurance companies Annuity Securitisation Structure is one of the possible alternative 30
Refinancing : Annuity Securitization Structure NHAI Concessionaire Initial Project Funding Project Annuity ( Over a Concession period) Deduction of Operational & Major Maintenance Expenses Project Group Equity Apply a haircut of 5-10% ( depending on the Rating Agency Comfort) Net Annuity Cash Flow Project SPV Debt Lenders / Banks Quasi-NHAI risk Structure DSRA Rating (AAA by a Rating Agency) Annuity Securitization Structure NCDs Refinancing Investors 31
Benefits Investor Diversity Achieved by structuring the borrowing as an NCD which was perceived as a quasi-nhai risk by investors, thereby allowing access to Capital Market Investors outside of the typical lenders to a Company / Group and thus aiding the release of Group s limits from the conventional bank / FI investors Fixed Rate of Interest - A key benefit of refinancing by way of an NCD shall be the fixed nature of the borrowing, unlike a bank funded facility where the net accrual to a Company / Group may change with the bank s PLR / Base Rate Lower funding Cost The repayment risk is on NHAI and hence higher credit quality resulting in better pricing Highest credit quality 32
Refinancing in an Infrastructure SPV SPV having an NHAI BOT Annuity Project In 2005, a leading Infrastructure Group won the Concession for the Annuity BOT project for a ~ 102 km stretch of NH7 on the Hyderabad-Nagpur highway Annuity projects awarded by NHAI lead to the concessionaire receiving a regular stream of annuities from NHAI once the concessionaire has completed the work envisaged under the BOT contract A SPV was floated by the Group to develop the Project Market First Structure in India Was debt-funded by bank loans till COD Till the time the work is completed and Commercial Operations commence (COD), infrastructure SPV s are funded by commercial bank loans Which Kotak helped refinance By helping the SPV issue fixed rate NCD s rated AAA(so), for a door-to-door tenure of ~ 16 years at a very attractive yield Yielding significant benefits to the Borrower Clear Return Visibility : Bank loans are variable rate and in an increasing interest rate scenario, Annuity projects where top-line is fixed can become un-attractive for sponsors. By fixing the interest rate cost, this variability was taken out Optimum Leverage : Cash-flows were structured to yield a greater quantum of debt at the SPV level, thereby effectively optimizing the leverage available for the Borrower group and thus improving the IRR for the sponsors Investor Diversity : The Borrower got access to a different class of investors (from the capital market) and thus freed up bank limits at a group level which would help Borrower s funding capability for other projects 33
Other Structures Perpetual Debt / Subordinated Bonds / Preference Shares / OFCD / CCD Zero Coupon / Low Coupon NCD with Redemption Premium NCD + Warrant Credit, Interest Rate and Fx Derivatives 34
Thank You 35
Important Notice The information contained in this communication is strictly confidential and intended solely for the use of the intended recipient(s). The copyright in this communication belongs to Kotak Mahindra Bank Limited and/or their related entities ( Kotak ). The recipient of this communication should not copy, disclose or distribute this communication without the authority of Kotak. The information contained herein is prepared based upon public information and reflects current prevailing conditions and our views as of this date, all of which are subject to change. In preparing the information herein, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. The information was prepared exclusively for the benefits and internal use of the senior management of the recipient Company and does not carry any right of publication or disclosure to any other party. The presentation should be read solely in conjunction with the oral briefing provided by Kotak. Neither this presentation nor any of its contents may be reproduced or quoted or distributed to a third party without the prior written consent of Kotak. 36