Term loans & securitisation

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<ul><li> 1. Term Loans, Debentures/Bondsand SecuritisationBy Prof Sameer Lakhani</li></ul><p> 2. TERM LOANS, DEBENTURES/BONDS AND SECURITISATION Term LoansDebentures/Bonds/NotesSecuritisationSolved Problem 3. Term LoansBonds/ debentures have emerged as substantial source of debt finance to corporatein India in the context of (I) absence of term loan support by financial institutions, (ii)freedom to corporate to design debt instruments, (iii) withdrawal of interest ceilingson debt instruments, (iv) credit rating of debt instruments, and (v) setting up of thewholesale debt market (WDM) segment by the NSE.Term (long-term) loan is a loan made by a bank/financial institution to a businesshaving an initial maturity of more than 1 year. Term loans are also known asterm/project finance. The financial institutions provide project finance for newprojects as also for expansion/diversification and modernization 4. Features of Term LoansMaturityThe maturity period of term loans is typically longer in case ofsanctions by financial institutions in the range of 6-10 years incomparison to 3-5 years of bank advances. However, they arerescheduled to enable corporates/borrowers tide over temporaryfinancial exigencies.NegotiatedThe term loans are negotiated loans between the borrowers and thelenders. They are akin to private placement of debentures incontrast to their public offering to investorsSecurityAll term loans are secured. While the assets financed by term loansserve as primary security, all the other present and future assets ofthe company provide collateral/secondary security for the termloan. 5. CovenantsTo protect their interest, the financialinstitutions reinforce the asset securitystipulation with a number of restrictive termsand conditions. These are known as covenants.They are both positive/affirmative and negativein the sense of what the borrower should andshould not do in the conduct of its operationsand fall broadly into four sets as respectivelyrelated to assets, liabilities, cashflows andcontrol. 6. Negative CovenantsAsset-Related Covenants are intended to ensure the maintenance of aminimum asset base by the borrowers. Included in this set ofcovenants are:Maintenance of working capital position in terms of a minimum current ratio,Restriction on creation of further charge on asset,Ban on sale of fixed assets without the lenders concurrence/approval.Liability-Related Covenants may, inter alia, include: Restrain on the incurrence of additional debt/repayment ofexisting loan, say, without the concurrence/prior approval of thelender/financial institution, Reduction in debt-equity ratio by issue of additional capital, and Prohibition on disposal of promoters shareholding. 7. Cashflow Related Covenants which are intended to restrain cash outflowsof the borrowers may include:Restriction on new projects/expansion without prior approval of the financial institution,Limitation on dividend payment to a certain amount/rate and prior approval of the financial institutions for declaration of higher amount/rate,Arrangement to bring additional funds as unsecured loans/deposits to meet overrun/shortfall, andCeiling on managerial salary and perks.Control Related Covenants aim at ensuring competent management for theborrowers. This set of covenants may include Boroadbasing of board of directors and finalisation of managementset-up in consultation with the financial institution, Effective organisational changes and appointment of suitableprofessional staff, and Appointment of nominee directors to represent the financialinstitutions and safeguard their interests. 8. Positive CovenantsIn addition to the foregoing negative covenants,certain positive/affirmative covenants stating what theborrowing firm should do during the term of a loanare also included in a loan agreement. They provide,inter alia, for1) furnishingof periodical reports/financial statements to the lenders,2) maintenance of a minimum level of working capital,3) creation of sinking fund for redemption of debt and4) maintenance of certain net worth. 9. Repayment Schedule/Loan AmortisationThe term loans have to be amortised according to predeterminedschedule. The payment/repayment has two components:1) Interest and2) Repayment of principal.The interest component of loan amortisation is a legallyenforceable contractual obligation. The borrowers have to pay acommitment charge on the unutilised amount.Typically, the principal is repayable over 6-10 years period after aninitial grace period of 1-2 years. Whereas the mode of repayment ofterm loans is equal semi-annual instalments in case of institutionalborrowings, the term loans from banks are repayable in equalquarterly instalments. 10. TABLE 1 Loan Amortisation Schedule (Equal Principal Repayment)(Rs thousands)Year BeginningPrincipalInterestLoanEnding loanrepayment(0.14)payment loan(1) (2)(3) (4) (5) (6)160.007.50 8.40 15.90 52.50252.507.50 7.35 14.85 45.00345.007.50 6.30 13.80 37.50437.507.50 5.25 12.75 30.00530.007.50 4.20 11.70 22.50622.507.50 3.15 10.65 15.00715.007.50 2.109.60 7.508 7.607.50 1.058.55 0.00 11. The debt servicing/loan amortisation pattern involving equal instalment(interest + repayment of principal) is portrayed in Table 2.TABLE 2 Loan Amortisation Schedule (Equal Instalment)YearBeginning Payment InterestPrincipalEndingloan instalment(0.14)repaymentloan @ [3 4] [2 5](1) (2) (3) (4)(5) (6)1Rs 60,000Rs 12,934 Rs 8,400Rs 4,535 Rs 55,4662 55,466 12,9347,776 5,16850,2983 50,298 12,9347,042 5,896 44,4064 44,406 12,9346,216 6,718 37,6885 37,688 12,9345,276 7,658 30,0306 30,030 12,9344,204 8,730 21,3007 21,300 12,9342,982 9,952 11,3488 11,348 12,9341,588 11,3460@ Payment instalment = (Rs 60,000/PVIFA 8,14) = (Rs 60,000/4.6389) = Rs12,934 12. Term Loan Procedure The procedure associated with a term loaninvolves the following principal steps:The borrower submits an application form which seekscomprehensive information about the project. The application formcovers the following aspects:1) Promoters background,2) Particulars of the industrial concern,3) Particulars of the project (capacity, process, technical arrangements, management, location, land and buildings, plant and machinery, raw materials, effluents, labour, housing, and schedule of implementation),4) Cost of project,5) Means of financing,6) Marketing and selling arrangements,7) Profitability and cash flow,8) Economic considerations, and9) Government consents. 13. Term Loan Procedure When the application is considered complete, thefinancial institution prepares a Flash Report which is essentially asummarization of the loan application. On the basisof the Flash Report, it is decided whether the project justifies a detailedappraisal or not.The detailed appraisal of the project covers the marketing, technical,financial, managerial, and economic aspects. The appraisal memorandumis normally prepared within two months after site inspection. Based onthat, a decision is taken whether the project will be accepted or not.If the project is accepted, a financial letter of sanction is issued to theborrower communicating the assistance sanctioned and the terms andconditions relating thereto.On receiving the letter of sanction from the financial institution, theborrowing unit convenes its board meeting at which the terms andconditions associated with the letter of sanction are accepted and anappropriate resolution is passed to that effect.The agreement, properly executed and stamped, along with otherdocuments as required by the financial institution, must be returned to it.Once the financial institution also signs the agreement, it becomeseffective. 14. Monitoring of the project is done at the implementation stage as well as theoperational stage. During the implementation stage, the project ismonitored through: (i) regular reports, furnished by the promoters, whichprovide information about placement of orders, construction of buildings,procurement of plant, installation of plant and machinery, trial production,and so on, (ii) periodic site visits, (iii) discussion with promoters, bankers,suppliers, creditors, and other connected with the project, (iv) progressreports submitted by the nominee directors, and (v) audited accounts ofthe company.During the operational stage, the project is monitored with the help of (i)quarterly progress report on the project, (ii) site inspection, (iii) reports ofnominee directors, and (iv) comparison of performance with promise. Themost important aspect of monitoring, of course, is the recovery of duesrepresented by interest and principal repayment. 15. Project AppraisalFinancial institutions appraise a project from the marketing, technical,financial, economic, and managerial angles. The principal issuesconsidered and the criteria employed in such appraisal are discussedbelow.Market AppraisalThe importance of the potential market and the need to develop a suitablemarketing strategy cannot be over-emphasised. Hence, efforts are made to(i) examine the reasonableness of the demand projections, (ii) assess theadequacy of the marketing infrastructure in terms of promotional effort,distribution network, transport facilities, stock levels and so on, and (iii)judge the knowledge, experience, and competence of the key marketingpersonnel.Technical AppraisalThe technical review done by the financial institutions focuses mainly onthe following aspects: (i) product mix, (ii) capacity, (iii) process ofmanufacture, (iv) engineering know-how and technical collaboration, (v)raw materials and consumables, (vi) location and site, (vii) building, (viii)plant and equipment, (ix) manpower requirements, and (x) break-evenpoint. 16. Financial Appraisal The financial appraisal seeks to assess thefollowing:Reasonableness of the Estimate of Capital Cost While assessing thecapital cost estimates, efforts are made to ensure that (i) padding or under-estimation of costs is avoided, (ii) specification of machinery is proper, (iii)proper quotation are obtained from potential suppliers, (iv) contingenciesare provided, and (v) inflation factors are considered.Reasonableness of the Estimate of Working Results The estimate ofworking results is sought to be based on (i) a realistic market demandforecast, (ii) price computations for inputs and outputs that are based oncurrent quotations and inflationary factors, (iii) an approximate timeschedule for capacity utilization, and (iv) cost projections that distinguishbetween fixed and variable costs. 17. Adequacy of Rate of Return The general norms for financialdesirability are as follows: (i) internal rate of return, 15 percent, (ii) return on investment, 20-25 per cent after tax, (iii)debt-service coverage ratio, 1.5 to 2. In applying these norms,however, a certain degree of flexibility is shown on the basisof the nature of the project, the risks inherent in the project,and the status of the promoter.Appropriateness of the Financing Pattern The institutionsconsider the following in assessing the financial pattern: (i) ageneral debt-equity ratio norm of 1.5:1, (ii) a requirement thatpromoters should contribute a certain percentage of theproject cost, (iii) stock exchange listing requirements, and(iv) the means of the promoter and his capacity to contributea reasonable share of the project finance. 18. Managerial Appraisal In order to judge the managerial capability ofthe promoters, the following aspects are considered:Resourcefulness This is judged in terms of the prior experience ofthe promoters, the progress achieved in organising variousaspects of the project, and the skill with which the project ispresented.Understanding This is assessed in terms of the credibility of theproject plan (including, inter alia, the organisation structure, thestaffing plan, the estimated costs, the financing pattern, theassessment of various inputs, and the marketing programme) andthe details furnished to the financial institutions.Commitment This is gauged by the resources (financial,managerial, material, and other) applied to the project and the zealwith which the objectives of the project, short-term as well as long-term, are pursued. Managerial review also involves an assessmentof the calibre of the key technical and managerial personnelworking on the projects, the schedule for training them, and theremuneration structure for rewarding and motivating them. 19. Debentures/Bonds/NotesDebenture/bond is a debt instrument indicatingthat a company has borrowed certain sum ofmoney and promises to repay it in future underclearly defined terms. 20. AttributesAs a long-term source of borrowing, debentures have some contrastingfeatures compared to equities .Trust Indenture When a debenture is sold to investing public, a trustee isappointed through an indenture/trust deed.Trust (bond) indenture is a complex and lengthy legal document stating theconditions under which a bond has been issued.Trustee is a bank/financial institution/insurance company/ firm of attorneysthat acts as the third party to a bond/debenture indenture to ensure thatthe issue does not default on its contractual responsibility to the bond/debenture holders.Interest The debentures carry a fixed (coupon) rate of interest, the paymentof which is legally binding/enforceable. The debenture interest is tax-deductible and is payable annually/semi-annually/quarterly. 21. MaturityIt indicates the length of time for redemption of par value. Acompany can choose the maturity period, though the redemptionperiod for non-convertible debentures is typically 7-10 years. Theredemption of debentures can be accomplished in either of twoways:(1) Debentures redemption reserve (sinking fund)A DRR has to be created for the redemption of all debentures with amaturity period exceeding 18 months equivalent to at least 50 percent of the amount of issue/redemption before commencement ofredemption.(2) Call and put (buy-back) provision.The call/buy-back provision provides an option to the issuingcompany to redeem the debentures at a specified price beforematurity. The call price may be more than the par/face value byusually 5 per cent, the difference being call premium. The putoption is a right to the debenture-holder to seek redemption atspecified time at predetermined prices. 22. SecurityDebentures are generally secured by a charge on the present andfuture immovable assets of the company by way of an equitablemortgageConvertibilityApart from pure non-convertible debentures (NCDs), debenturescan also be converted into equity shares at the option of thedebenture-holders. The conversion ratio and the period duringwhich conversion can be affected are specified at the time of theissue of the debenture itself. The convertible debentures may befully convertible (FCDs) or partly convertible (PCDs). The FCDscarryinterestrateslowerthanthenormalrateonNCDs;theymayevenhaveazerorateofinterest.ThePCDshavetwoparts:1) Convertiblepart,2) Non-convertiblepart. 23. CreditRatingToensuretimelypaymentofinterestandred...</p>